Public Information Notice No. 05/94

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Austria

July 25, 2005

On July 20, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Austria.¹

Background

Economic activity gathered speed in 2004, supported mostly by strong export performance. Growth of real GDP rose to 2.2 percent in 2004 from 0.8 percent in 2003. Consumption growth was modest, in view of small gains in employment and nominal wage growth barely matching inflation. Investment demand continued to expand, benefiting from the improved prospects for exports and the extension of tax incentives through end-2004. The export boom that began in early 2004 (exports of goods surged over 12 percent in real terms in 2004) lost momentum towards the end of the year, but still made a considerable contribution to growth.

Short-term prospects are relatively favorable. Economic growth is expected to slow down to slightly below 2 percent in 2005 with a slight increase projected for 2006, while inflation is estimated to remain low and stable over this period. There are uncertainties related to the behavior of consumption and external developments, however, and downside risks to this outlook warrant close monitoring.

The fiscal policy stance became more accommodative in 2004. Concerned about a faltering recovery, the authorities took discretionary fiscal measures after the passage of the 2004 budget, namely a fiscal package announced in late 2003 with measures aimed primarily at supporting Research & Development and investment, and the front-loading in 2004 of some of the tax measures initially planned for 2005. In the event, the budgetary cost of these measures was larger than planned. Against an initial budget deficit target of 0.7 percent of GDP, the additional measures—plus higher spending on pensions of civil servants due to a surge of early retirements in view of pension reform—contributed to a widening of the general government deficit to 1.2 percent of GDP in 2004 and a fiscal impulse of nearly ½ percent of GDP. There will be a temporary widening of the deficit in 2005-06 resulting from tax reform preceding compensating expenditure measures. The authorities plan for a gradual return to a balanced budget during 2007-2008, when expenditure measures come on stream.

Progress in the structural area has been impressive, and this has contributed to Austria's relatively favorable growth performance in the past period. In particular, pension reform is well advanced, including through the recent harmonization of pension schemes. Additional tasks remain regarding the need to also include pensions of civil servants at the subnational level in the unified system, as well as with regard to the further liberalization of labor, product and services markets.

Following a favorable assessment in the context of the Financial Sector Assessment Program last year, overall financial sector conditions improved further, including in terms of capital adequacy and profitability. Financial sector supervision has been strengthened and adapted to the changes in financial markets. The continuing growth of foreign currency loans to Austrian households, as well as the rapid expansion of the activities of Austrian financial institutions abroad remain areas of potential risk.

Executive Board Assessment

Executive Directors commended Austria's recent economic performance as among the best in the euro area, with GDP growth gaining strength on the back of strong exports, low inflation, and low unemployment. They noted that much of this favorable performance can be traced to sound economic policies, wide-ranging structural reforms, and a social partnership that, by delivering wage moderation, has helped maintain strong competitiveness. Directors supported the authorities' main objectives to balance the budget over the cycle, reduce the tax burden, and increase Austria's growth potential. Welcome achievements so far include a marked reduction in the size of government, major pension reform, privatization and deregulation in product and labor markets, and tax reform. Directors emphasized that identifying expenditure measures to return to a budget balance by 2008 will be key to ensuring the credibility and success of the authorities' strategy.

Directors observed that Austria's sustained focus on Eastern Europe has made it one of the EU-15 countries that have benefited most from the transition in that region and the subsequent entry into the EU of 10 new member states. In particular, they noted that Austria's early attention to building economic and financial relationships with Eastern Europe is now bearing fruit, and that the country can be expected to continue to benefit from this diversification of the economy.

Directors considered the short-term growth outlook to be relatively favorable, although the pace of expansion is likely to moderate. They expected robust growth in productivity, and the fiscal stimulus in the 2005-06 budgets to provide ongoing support to economic activity. At the same time, they acknowledged that domestic demand has yet to gain decisive traction, and that higher oil prices and concerns about the strength of activity in the euro area could weigh on short-term prospects.

Directors commended the authorities' success over the last few years in reducing the size of government and maintaining limited deficits. They noted that the recent shift in focus to tax reform and reducing the tax burden is appropriate as it will increase Austria's attractiveness as a business location. Directors observed that the tax reform will contribute to larger deficits in 2005-06 as offsetting spending cuts are to come on stream gradually. They agreed that this widening of the deficit does not raise sustainability concerns as long as it is limited and temporary, and stressed that it will be important for the authorities not to spend unanticipated windfalls or introduce additional spending packages.

Directors supported the authorities' objective to eliminate the fiscal deficits by 2008 and return to budget balance. They underscored the importance of designing and setting in motion now the expenditure cuts necessary to achieve this objective on time as envisaged. Unless the government identifies the areas where expenditure savings can be achieved and proceeds expeditiously to mobilize the necessary consensus, the feasibility of reaching the budget targets in 2007-08 will be compromised as will plans for further reducing the tax burden. Directors saw scope for rationalizing public administration—especially at the subnational level—the health sector, and various subsidies. They welcomed progress made in designing a medium-term expenditure framework that will enhance fiscal transparency and credibility, and encouraged the authorities to ensure that it becomes operational by 2007. Directors regretted the lack of agreement on substantial changes in federal-provincial relations. They expressed the hope that the necessary political consensus can be reached to modernize this relationship in the future, with a view to increasing efficiency, streamlining the functions of various levels of government, and realigning spending responsibilities and revenue-raising powers.

Directors commended the authorities on the impressive pace of structural reforms in Austria in comparison to European peers, but stressed that there is no room for complacency. They advised the government to complete the outstanding reform agenda taking advantage of the current favorable conditions. The priority should be on further measures to deregulate the services market, liberalization of shop-opening hours by local governments, and continued labor market reform, including a move towards more flexible work hours and further efforts to facilitate the integration of older workers. Directors supported the authorities' emphasis on raising research and development spending to international levels. Welcoming the reforms on competition policy, they advised that the role of the Federal Competition Authority be further strengthened.

Directors observed that substantial pension reform in recent years has put Austria in a better position to face demographic challenges. Pension reform and harmonization have been major steps in reducing inequities, enhancing labor mobility, and achieving fiscal savings. Directors stressed that follow-up measures should include bringing the pensions of civil servants at the subnational level under the unified pension system, and close monitoring of the disability scheme to ensure that access is restricted to those who qualify for this pension.

Directors welcomed the resilience of Austria's financial sector, but emphasized that developments in financial markets require continued close monitoring. They welcomed the authorities' implementation of a variety of measures recommended during last year's Financial Sector Assessment Program exercise. However, Directors noted that there remains a discrepancy between developments in Austria's home market, where margins are tight and further consolidation can be expected, and the strong growth abroad. Given the continuing growth of foreign currency loans to households, Directors underscored that all relevant authorities should continue informing the public about the risks involved, including in the context of consumer protection. They also urged the supervisory authorities to remain vigilant with regard to risks associated with the rapidly expanding activities of Austrian financial institutions in Eastern and, more recently, Southeastern Europe. In this context, they pointed to the rapid growth of lending to the private sector in these countries, including in foreign currency. They recommended close cooperation and exchange of information with local supervisors, as already set in motion.

Directors commended Austria's official development assistance reaching 0.4 percent of GNP in 2006, and encouraged the authorities to raise it further toward the U.N. target of 0.7 percent.