Public Information Notice No. 05/88

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Kingdom of the Netherlands

July 14, 2005

On June 29, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of the Netherlands.¹

Background

After a long period of comparatively strong economic performance, the Netherlands hit a difficult stretch going into the new millennium. Growth was relatively poor during 2000-03, turning negative in 2003 for the first time in 20 years. A weakening external environment contributed to the sharp slowdown of activity. On the side of domestic demand, wealth effects (associated with developments in equity and house prices) and changes in pension fund contributions (stemming from the exposure of these funds to equities) amplified the cycle.

Deteriorating external competitiveness has also been restraining export performance and overall growth. Wage pressures, reflecting tightness in the labor market that had built up in the second half of the 1990s, weakened external competitiveness. This was later compounded by an appreciation of the euro. The loss of competitiveness has not been especially apparent in aggregate, value-based, export market share data. However, falling market shares have strongly been in evidence in volume terms. More detailed analysis of sector trade shares has also raised warning flags about competitiveness.

The recovery has so far been weaker than during past upswings. Growth was significantly below potential in 2004. It is expected to remain that way this year, with large uncertainties over confidence and its effect on private consumption, which has been unusually lackluster. Disposable income and unemployment cannot fully explain the sharp fall in the growth of private consumption since 2000, and less tangible factors affecting confidence, in addition to wealth effects, have clearly been at play. Fundamentals have been showing improvement, however, and the expansion is expected to gather pace in 2006.

Inflation is now subdued, and there is little pressure from wages looking ahead. Wage growth was about 1½ percent in 2004, reflecting the two-year economy-wide wage moderation agreement of the social partners that aimed at improving competitiveness. The agreement allows for somewhat more discretion in 2005, but the strength of the euro, moderate pace of economic activity, and slack labor market conditions are expected to keep a lid on wage pressures.

After the public finances deteriorated markedly during 2000-03, there was a significant reversal in 2004. The general government balance worsened by almost 5½ percentage points of GDP during 2000-03 as a result of both cyclical and structural effects, the latter amounting to roughly 2 percentage points of GDP. While the 3 percent Maastricht deficit ceiling was unexpectedly breached in 2003, the deficit, primarily through expenditure restraint, was reduced to 2.3 percent of GDP in 2004.

In addition to the near-term outlook, the discussions focused on key measures to bolster confidence and enhance growth prospects while ensuring fiscal sustainability and resilience to population aging. In this context, restoring external competitiveness as an essential element of sustaining economic recovery was an important topic of the discussions. Measures to raise participation and productivity were also important topics. The authorities had implemented or were in the process of implementing key reforms, including by tightening disability and unemployment benefits and early retirement arrangements, lessening inactivity traps, enhancing competition, and reducing the administrative burden. Finally, the financial sector, including a follow-up of the recommendations made in the Fund's Financial Sector Stability Assessment of last year, was another key topic.

Executive Board Assessment

Executive Directors noted that the successes of the 1980s and 1990s—underpinned by synergies between fiscal discipline, structural reforms, and wage moderation—amply demonstrate the benefits of strong policies and the Netherlands' ability to deliver them. They were also encouraged by the improvement in some key economic fundamentals. However, Directors expressed concern that the recovery has so far failed to gather steam. In this regard, they noted that downside risks appear to be materializing, delaying the anticipated acceleration of Dutch economic growth.

Against this background, Directors agreed that the Netherlands' main challenge ahead is to support and sustain the economic recovery. In this regard, they stressed the need to restore external competitiveness after its deterioration in recent years so as to take full advantage of future export market growth. While commending the authorities' efforts to rein in the fiscal deficit and strengthen the structural underpinnings for growth, Directors emphasized the importance of sustaining efforts in these areas, with a view to boosting confidence and ensuring that the fiscal pressures of an aging population remain manageable.

Directors welcomed the positive underlying developments that should support recovery, noting in particular the strengthening of corporate balance sheets and turn-up in profit margins that should favor future investment. Directors also applauded the impact of the recent moderation in wage increases in helping to restore external competitiveness. They stressed, however, that such moderation needs to continue if exports are to be a sustained driver of growth.

Directors welcomed the authorities' commitment to fiscal consolidation, reflected in the quick response to bring the fiscal deficit back into line with the Maastricht criteria. They stressed that continued fiscal adjustment over the medium term will provide further impetus for returning to a sustainable fiscal path as the population aged, while also helping to build a buffer against unanticipated shocks and the continuing risks in containing health care costs. Directors attached particular importance to those fiscal consolidation measures that would help raise employment rates and potential growth, and thereby exploit synergies with structural reforms—for example, by rationalizing and restraining unemployment benefits and rent subsidies. In addition, Directors supported the authorities' commitment to use any future windfalls for deficit and debt reduction. At the same time, Directors supported the full use of automatic stabilizers. While most Directors also emphasized that in the short run the need for fiscal tightening and reform should be balanced against the objective of strengthening the fragile cyclical upswing, they supported the authorities' choice to underpin confidence with strong fiscal consolidation and a well-sequenced structural reform program.

Directors lauded the many favorable features of the fiscal framework, including the use of multi-year expenditure ceilings as an anchor and the disciplining role of the Bureau for Economic Policy Analysis (CPB). However, they encouraged the authorities to enhance the transparency and coverage of the expenditure ceilings. While welcoming recent measures to improve coordination of policies at various levels of government, Directors also encouraged the authorities to make such coordination a permanent feature of the fiscal framework. Directors looked forward to the results of the forthcoming fiscal Reports on the Observance of the Standards and Codes.

Directors noted that raising labor participation is a key element for enhancing potential growth and sustaining sound public finances. Thus, they welcomed the many structural reforms the authorities have implemented or that are underway. These include tightening disability and unemployment benefits and early retirement arrangements, and lessening inactivity traps. Nevertheless, looking ahead, Directors cautioned against a potential weakening of disability reform and urged continued progress to deal with inactivity traps. They also noted that the shortening of the duration of unemployment benefits could be more ambitious.

Directors agreed that structural reforms should focus on raising productivity growth, in addition to boosting labor participation. They therefore supported the authorities' efforts to reduce the administrative burden on business and urged them to persevere with efforts to broaden competition, including by reinforcing the powers of the competition authority. Directors supported the authorities' objective of spurring greater innovation. In this latter context, with a view to facilitating more efficient resource allocation, they urged the authorities to review employment protection legislation, noting that overly stringent protection acts as an implicit tax on new hiring and can stand in the way of productivity raising entrepreneurial activity. Directors also urged greater wage differentiation, with a view to attracting labor to higher productivity companies and sectors and to strengthen the incentives for human capital investment.

Directors noted that the financial system appears to remain sound, resilient to potential adverse shocks, and well supervised. They welcomed the authorities' responsiveness to the recommendations made last year in the Financial System Stability Assessment, which demonstrates the authorities' resolve to preserve financial stability over time. They encouraged the authorities to monitor closely the risks associated with a possibly prolonged low-yield environment, the increase in household indebtedness, and the possibility of a decline in house prices. Directors also welcomed the authorities' efforts to strengthen cross-border financial supervision, and the steps taken in recent years to further strengthen the regime to combat money laundering and terrorism financing.

Directors strongly commended Dutch development assistance, and the Netherlands' support for the Doha Round objectives of agricultural trade liberalization, market access for developing countries, and trade facilitation. They noted that even in the face of budgetary pressures, the Netherlands have exceeded the United Nations official development assistance target.

Directors noted that while data are adequate for surveillance, the impact of institutional changes, in particular in healthcare reform, on upcoming data will be quite visible. They therefore stressed that these changes in the economic data must be effectively communicated to avoid misunderstandings, making it clear for example that overall GDP growth will not be affected.