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Chapter 1: emerging from the crisis.

The Norwegian economy has been particularly resilient during the financial crisis with a relatively shallow recession and moderate increase in unemployment. As Norway moves into what is projected to be a strong recovery, the authorities need to plan how to unwind the extraordinary measures that were taken to confront the crisis. Interest rates have already been raised, the special liquidity measures have been progressively withdrawn and monetary policy will need to tighten further over the next two years. The appropriate pace of tightening will primarily depend on developments of the Norwegian economy and the outlook for inflation. Policymakers should also continue to pay attention to developments in the property market, which are fuelled by low interest rates, and trends in the foreign-exchange market, which could react to widening interest-rate differentials. An early consolidation of fiscal policy would reduce the need for monetary tightening and the related risk of exchange-rate appreciation. It is essential to maintain the basic fiscal framework, built round the "4% rule", and soon start the process of bringing down the non-oil structural deficit to a level consistent with the rule. The Norwegian financial sector came through the financial crisis without serious damage. In the aftermath of the crisis it is important to strengthen the macro-prudential approach, in co-ordination with European and other international initiatives. In addition, banks should be required to build up further their equity capital buffer, so as to prepare for possible losses in the future. Finally, aggressive bank lending practices should be discouraged.


The impact of the financial crisis was limited

The recession was relatively shallow

The global financial crisis did not spare Norway, but the economy has been more resilient than in many other OECD countries. The recession was short-lived, starting two quarters later than in the rest of the OECD area and ending one quarter earlier, and while overall GDP in the OECD area fell by 5% between mid-2008 and mid-2009, the fall was less than half of this in Norway (Figure 1.1). The impact of financial crisis on longer-term growth should be relatively limited as well (Box 1.1), though here there is particular uncertainty over the impact of the recession on participation rates and on immigration.

Box 1.1. The impact on potential output should be limited

In most OECD countries, the financial crisis has affected not only
short-term growth but also medium-term potential. In fact,
economists are struggling to understand the different mechanisms
through which the crisis will have affected potential output. A key
one is the decline in capital intensity following the fall of
business fixed investment, in part explained by the higher cost of
capital and reduced access to credit. Investment in the petroleum
sector, which has continued to grow quite rapidly up to mid-2009,
has positive effects on mainland investment and is dampening this
effect in Norway. Another mechanism depressing potential output is
the increase in the structural unemployment rate which has followed
high levels of unemployment in the past. Some estimates suggest
that the OECD area-wide level of potential output will have been
reduced by about 3%, with most of the impact being felt over the
period 2009-10, and two-thirds of it due to the fall in capital
intensity and the rest from higher structural unemployment (OECD,
2009a). With both these effects being less strong in Norway, the
loss of potential output will be correspondingly lower, perhaps no
more than 2%. These estimates do not include possible additional
negative effects coming from declining trend labour force
participation rates, or adverse effects on TFP from lower R&D
expenditure. Among the anti-crisis measures, there were some to
increase R&D expenditures, hoping to boost longer term productivity

Losses to potential output could be greater if there were more
exits from the labour market through welfare schemes, which have
been observed in past recessions in Norway. Downturns cause an
increase in long-term unemployment, which tends to result in higher
sick leave which in turn leads to more recipients of disability
benefits. Such losses in potential employment are reversed only
slowly, if ever (in what is referred to as the hysteresis effect)
as exit rates from disability schemes to employment are extremely
low, even when the economy grows fast. This reinforces the urgency
of an effective reform of the sickness and disability systems (see
later sections).

Migration is an additional factor influencing structural
unemployment. As pointed out in the last Economic Survey, the
substantial inflow of labour from Nordic and Eastern European
countries of recent years has helped to keep wage growth down,
effectively resulting in a lower NAIRU. A strong recession in
Norway might be expected to reverse much of earlier migration.
However, although the net inflow declined in 2009, it was still
substantial. Some surveys show that the demand for foreign workers
with an Eastern European background was rising again in late 2009,
particularly because the demand for highly-skilled technicians
seemed to be increasing (EIU, 2009).

The fall in output was lower in Norway than elsewhere partly because of the basic macroeconomic policy framework, based on saving most petroleum revenue in an offshore fund and spending only the underlying returns; this very successfully suppresses most of the effect of large swings in the terms of trade on both the mainland economy and budgetary policy. The short-term impact of the sudden fall in the terms of trade in 2008-09, following the equally large run-up in 2006-07, was thus minimal. This framework and the strong underlying fiscal position allowed automatic stabilisers to work fully. In addition, large fiscal and monetary stimulus was introduced in the economy in 2009.

The recession came after one of Norway's strongest periods of economic growth in the last 50 years. In the five years after 2003, mainland GDP annual growth averaged over 4%. This was initially driven by higher productivity growth and later by higher employment, with a significant proportion supplied by immigration (Table 1.1). Both productivity and employment fell in 2009, albeit less than in many other OECD countries. Exports fell significantly, but in a break with the trend of the last decade or more, Norway made relative gains in market share in 2009. The specialisation of Norwegian exports on commodities (oil, gas, non-ferrous metals) moderated the impact of the collapse of global trade as, although the traditional export sector suffered, trade in commodities was less affected by falling demand.

Underlying inflation remained above 2.5%, the central bank's medium term inflation target, (1) from mid-2007 to mid-2009, while in the OECD as a whole underlying inflation fell from 2.2% in early 2008 to less than 1.8% in late 2009. A temporary exchange-rate depreciation early in the financial crisis contributed to higher inflation, as well as food prices, which rose twice as fast in Norway as in the rest of the OECD, reflecting the effect of Norway's agricultural policy. By the end of 2009, underlying inflation was a little below the central bank target, and headline inflation much more so, with the short-term outlook for declining inflation during 2010.

The labour market was strong

With a shallower recession than elsewhere, the labour market was also relatively resilient. Having reached a historic low of 2.3% in 2007, the unemployment rate has increased in Norway by 3/4 percentage points, a relatively small increase compared with the OECD area average. An increase in active labour market programmes (Figure 1.2) and other measures to secure employment in labour-intensive sectors such as construction combined to limit the rise in unemployment. Some groups of the population have however been hit by the crisis, as shown by the fact that by mid-2009, one third of the registered unemployed were under the age of 30. This was partly accompanied by a withdrawal from the labour force of this group of the population, who appear to have decided to remain in or return to education, as often occurs during recessions. The resilience of employment was also due to firms retaining more workers than needed for production in the short term, a phenomenon which has been observed in other OECD countries with similar economic conditions such as Australia. Indicators of employment protection also show the cost of dismissal to be relatively high for firms, especially for older workers (Venn, 2009).

Financing was restricted but both banks and non-financial companies were in relatively good health

The number of bankruptcies has been rising, especially in the construction sector. Asset write-downs have also been substantial. The credit tightening of the last year has restricted new project financing and, while lower interest rates should be beneficial, lending rates to non-financial companies have not fallen in line with money market rates, as banks have widened their margins. Corporate debt growth also fell, especially for those sectors which are more dependent on the cycle, such as commercial property. However, although increases in unit costs hit profitability after the onset of recession in mid-2008, profits had been rising prior to then and even in 2009 operating margins for many companies were increasing, indicating improved profitability prospects for the future.


The Norwegian financial sector's relatively good health has been both a cause and a consequence of the resilience of the real economy. Financial institutions were little exposed to risky assets and banks' losses have been contained. The only Norwegian institution that was severely hit was Eksportfinans (a public export credit agency), which experienced substantial losses in its liquidity portfolio. In addition, a Norwegian subsidiary of an Icelandic bank, Glitnir, experienced problems and was sold to new owners. Following the collapse in its home country, the Norwegian branch of the Icelandic banks Kaupthing was placed under administration and the Norwegian government guaranteed payments to Norwegian depositors from the Icelandic deposit guarantee scheme. Kaupthing was also a "topping up member" of the Norwegian deposit guarantee scheme. (2) Equity and bond markets plunged in Norway just as, if not more than, in the rest of the OECD, having run up somewhat higher prior to the crash (Figure 1.3). A later section of this chapter discusses the experience of the financial sector and the policy response during the crisis in some depth.

Like the rest of the OECD area, however, Norwegian banks suffered from a reduced access to liquidity (Figure 1.4), accentuated by the Norwegian money market's dependence on foreign currency funding. At the same time, the currency depreciated sharply, in a "flight-to-quality" that affected the currencies of many small economies (Figure 1.5). The temporarily weaker krone helped to dampen the effect of the global crisis on the tradable sector, which in the last few years has been suffering significantly from decreased international competitiveness.



A strong contribution from the petroleum sector

While oil prices fell 75% between July and December 2008, they started picking up again during the spring of 2009 and have recovered further since then (Figure 1.6). There was no immediate impact of financial crisis on investment in the petroleum industry, which was still growing strongly in the first half of 2009. The impact of the offshore sector on the mainland economy has thus been significant: in 2008 the Ministry of Finance estimates its direct and indirect effects on the mainland economy to have contributed 0.5% to GDP growth in 2008 and 0.7% in 2009. With oil production now in secular decline, increases in gas production are however insufficient to prevent petroleum sector output as a whole from declining (Figure 1.6). Lower oil and gas prices were also the main factors behind the falling trade surplus in 2009, the value of net exports falling by an average of 30% (year on year) over the first two quarters of 2009. Together with a negative net balance of international transfers the result was a fall in the current account surplus of 2 percentage points of GDP in 2009.



A swift recovery is expected

The economy is recovering earlier and faster than elsewhere

By the end of 2009, the economy appears to have already embarked on a recovery, which is projected to accelerate over the next two years (Table 1.2). After a contraction of 1.2% in 2009, mainland GDP growth is projected to recovery in 2010 (2.8%) and accelerate in 2011 (3.2%). Private consumption growth resumed relatively early. It is likely to return to its pre-crisis path thanks to strong growth in disposable income, itself supported by rather dynamic wage growth, lower interest payments and increased public transfers. The resumption of house price growth is also likely to fuel consumption through wealth effects.

Although public investment is still growing due to massive infrastructure projects carried out under the fiscal stimulus package, private non-petroleum investment is still sluggish. But as credit tightening is unwound and global demand recovers, non-petroleum private investment is likely to strengthen during 2010 and could then quite rapidly return to its pre-crisis level (around 15% of mainland GDP).

Global trade prospects are also improving strongly. In particular, demand from emerging countries already picked up in 2009 and is growing again at a brisk pace, favouring commodity rich countries like Norway. The traditional export sector is also improving its competitiveness, in particular thanks to increased productivity and moderating wage growth; though this will probably not be enough to avoid a further deterioration of market performance; market share losses should, however, be lower than in the recent past.

Given the strong rebound in domestic and external demand, the labour market is expected to improve during 2010. While the labour force continues to increase gradually over the next three years, employment will rise progressively as output picks up and unemployment will start falling in 2011. Favourable developments are also expected on the productivity side, as labour hoarding will level off and recession-induced restructuring in firms is completed.

The benign short-term inflation outlook may deteriorate

By the end of 2009 the very short-term inflation outlook was looking relatively benign, as recovering output helped to moderate unit labour costs and prices of imported goods fell due to the recovery of the exchange rate. But underlying inflation, though just below the target, is higher than Norges Bank had expected and, under the projections presented here, the mainland economy will be growing above its estimated potential growth rate for much of 2010 and 2011. Surveys on inflation expectations report that 2 to 5 years ahead expectations have risen since the end of 2008, and are above the official target (Figure 1.7). An implicit indicator of inflation expectations in the financial market, measured as the expected five years interest rate differential between Norway and the euro area, also indicates that expectations have edged up.

It is time for macroeconomic policy to adjust

The authorities face some difficult choices in designing their "exit strategy". Even as the economy was still in recession, the housing market had begun what now appears to be a very strong recovery (Annex 1.A1 for a discussion of some of the underlying factors in the Norwegian housing market). The recession is turning out less severe than the authorities (and most forecasters) were expecting, in fact less severe than most recent recessions (Figure 1.8) and with respect to the OECD area (see Figure 1.7). As demand pressures throughout the economy now seem likely to continue to build up, there is a strong likelihood that the overheating that was evident in late 2007 may begin to re-emerge in 2011 or 2012. Monetary tightening has already begun but if the authorities wish to avoid the real exchange rate appreciation that is likely to generate for widening interest-rate differentials, action on fiscal policy is also needed. Over time, some quite substantial adjustment of both monetary and fiscal policy will be needed, to unwind the strong and appropriate stimulus that the authorities provided as the recession first hit.

The authorities met the crisis with a massive fiscal stimulus and dramatic cuts in interest rates

The fiscal and monetary policy response has played a prominent role in the resilience of the Norwegian economy during the crisis, building on the favourable position provided by the underlying macroeconomic framework. This response included a large fiscal stimulus, a dramatic reduction in interest rates and the provision of short-term liquidity and longer-term finance. Pre-crisis plans for the 2009 (pre-election) budget were already somewhat expansionary and following additional measures taken in January and May 2009 the final result was real expenditure growth of nearly 7% in 2009; tax reductions were worth approximately 0.5% of GDP. Expenditure measures included increased infrastructure spending and transfers to finance local services, but also transfers to the business sector, for example to encourage R&D (Table 1.4). Overall, the structural non-oil deficit increased by about 3.6% of GDP in 2009-10, compared with a cumulative 2.7% for the average of the OECD area. The deterioration in the actual budget balance (including petroleum revenues) was much larger, with the surplus falling from 19% of GDP to 8% between 2007 and 2009 (compared with a widening of about 6 percentage points for the OECD area-wide deficit), about half of this is due to the cycle and about one quarter to lower petroleum prices. The impact of a fiscal stimulus in such a crisis period is uncertain, estimates for Norway show an impact on growth of about 1.5% (Box 1.2).


Box 1.2. The fiscal multiplier

Providing a quantification of the impact of the fiscal stimulus is
quite difficult, especially in a crisis period when the multiplier
associated with different kinds of action may be different from
normal. Historical studies show that direct spending on goods and
services, or infrastructure investment is generally the most
effective in terms of the short term stimulus to activity, while tax
cuts and transfers to the business sector have much weaker effects
(OECD 2009b). Taking into account these composition effects and
factors such as the openness of the economy, OECD methodology suggests
that the fiscal stimulus will have boosted GDP by a little over 1% of
GDP in 2009 and by 0.6% in 2010. Compared with other OECD countries,
this is among the strongest impact of the fiscal stimulus in 2009 and
around average in 2010. The Statistics Norway estimates that the
overall fiscal stimulus in 2009-10 will imply a cumulative increase of
1.3% of GDP in these two years. In this context it is useful to remind
that the objective of the fiscal package was not only to stimulate the
economy in the short term, but also in the longer term, through
measures to support long term growth drivers, such as infrastructure
investment that, when appropriately targeted--can support potential
growth in the medium term.

Most of the extraordinary spending was originally set to be temporary, to be phased out in 2010. However, in practically all cases, the 2010 budget either made the temporary measures permanent or replaced them with other, permanent, measures; more resources were allocated to education, health and child care (via larger transfers to municipalities) as well as to the minimum old age pension. Hence the structural budget deficit is set to increase further in 2010.

As in many other OECD countries, the large fiscal injection was accompanied by an unprecedented monetary easing. The Norwegian central bank was in fact one of the last to start easing its stance, as inflation in mid-2008 was well above the 2.5% target, but between October 2008 and June 2009 it cut the policy rate by a cumulative 450 basis points (Figure 1.9). During this period Norges Bank's forecasts of the future interest rate path were systematically revised downward. Throughout the crisis, Norges Bank's flexible inflation targeting policy, along with the exceptional measures taken in co-ordination with the government, stood up well to the crisis, although at one point its communication strategy, which is based on a clear explanation of how and why it expects interest rates to evolve, gave some obscure signals (Box 1.3).

Box 1.3. Improving the communication of the central bank

As in many other countries, the financial crisis confronted the
central bank with a strong challenge. Norges Bank's response to the
crisis was prompt but communication could have been better (Bergman et
al., 2009). The first clear reaction to collapsing financial market
occurred only in mid October 2008, after the co-ordinated cut by some
large central banks. In previous meetings Norges Bank had pointed to
the increasing uncertainty worldwide but nevertheless left its
projected interest rate path unchanged and had not given a strong
signal of a downward revision. A revised projection came at the end of
October, together with the publication of the Monetary Policy Report.
Six weeks later, the Bank decided to lower the interest rate by 175
basis points, and revised the projected interest rate path down
further. In the meantime, however, the uncertainty in the markets was
growing but the Bank did not make any announcement about its likely
change of strategy. The 175 basis point cut was a surprise to many

During the autumn 2008 Norges Bank also decided to innovate in the
presentation of the factors accounting for deviations from the
interest rate trajectory, by introducing some new elements, like
"premiums in the money market" and "acceleration". While the
"acceleration" was a one-off effect, the premiums in the money market
were retained in later monetary policy reports, indicating that the
Bank put increased emphasis on the money market rates as their target
rate. Acceleration was in fact referring to the big uncertainty
prevailing at the moment. While consideration of uncertainty should
certainly enter monetary policy setting, it can be questioned whether
quantifying it as a "residual" from an explainable model is really
meaningful. In fact it appears really to correspond to some--quite
plausible--judgmental guesses about what degree of loosening was
appropriate. Factors like uncertainty are usually translated into a
distribution of risk that surrounds the projection of interest rates.
Fan charts already do this relatively well. Alternatively, the central
bank could present various scenarios for the interest rate path (as
in fact did in June 2009), each associated with a different set of
assumptions on the main forces driving the economy. This, provided the
bank is able to act in line with such scenarios, could help to sustain
the credibility of monetary policy following large deviations from the
central forecast path.

Special short-term and long-term liquidity measures

The authorities also supported liquidity through supplying fixed-rate loans with various maturities (from three months to three years) to banks and other financial institutions, including some loans in dollars, as well as facilitating exchange rate swaps; this foreign currency support was necessary because the banking sector is highly dependent on foreign currency funding. Collateral requirements were also eased in various ways: (3) for instance, the Ministry of Finance arranged for swapping covered bonds against Treasury bills that could then be sold, used as collateral e.g. at the central bank, or kept to strengthen banks' balance sheets (see Box 1.12). In some cases special measures were addressed to more vulnerable institutions, like the extension of maturity of fixed rate loans to smaller banks suffering from inability to access long term funding. As for many other central banks, the balance sheet of Norges Bank was significantly affected by all these measures although much of the effect was already being unwound in mid-2009 (Figure 1.10).


The Ministry of Finance also took measures to strengthen the capital base of the financial system, instituting the Norwegian State Finance Fund with capital of NOK 50 billion (3% of mainland GDP). The State Finance Fund is to make capital contributions to Norwegian banks through the acquisition of hybrid Tier 1 securities or Tier 1 preference capital instruments issued by Norwegian banks. Banks applying for capital injections should be in a relatively healthy situation (i.e. meet the Tier 1 capital ratio requirement by a good margin). Overall 34 banks applied to the Fund, and 28 banks have received capital injections. At the same time as the State Finance Fund, the Ministry of Finance also launched the Government Bond Fund, also with capital of NOK 50 billion, in order to strengthen the bond market. The Bond Fund is to be invested in the Norwegian corporate bond market (25-65% in banks and financial institutions and 35-75% in non-financial firms, including industry). Some restrictions are imposed on the type and quantity of assets to invest.

Monetary policy tightening has already begun

As signs of recovery in Norway and elsewhere multiplied, Norges Bank first signalled a possible tightening in the summer of 2009 and then increased policy rates in October and in December. In late 2009 the central bank projected that the key policy rate would be near 2% by mid-2010 rising fairly steadily to around 4 1/2 per cent by the end of 2012. The current interest path lags behind some simple rules such as the "Taylor rule" and the "Growth Rule" (Figure 1.11), possibly because of remaining uncertainty in global financial markets and real economy worldwide. These simple rules neglect the role played by other key factors in a small open economy, such as the transmission of credit and other asset bubbles, as well as the exchange rate influence. Monetary policy has to strike a balance between domestic and imported risks, as the following sections argue.


Household debt and housing market developments must be considered when deciding the exit strategy for monetary policy

Credit growth to households rose tremendously in the last upturn and continued to rise even after the start of the financial crisis (Box 1.4). Many factors are at the origin of this (Box 1.5): innovation and financial market liberalisation; the leniency of regulation regarding household leverage; and a long period of relatively accommodative monetary policy, in Norway as in many other OECD countries. While real income has strongly grown, households have massively invested in the housing sector, reaching high levels of leverage (Table 1.3 and Box 1.4). High loan-to-value ratios have for many years been a concern for the Norwegian Financial Supervisory Authority (FSA), which indicated in 2007 that 40% of the mortgages contracted in that year had a loan-to-value ratio above 80%. Action to discourage banks from aggressive lending practices consisted mainly of publicly focusing on the potential risks.
Box 1.4. Norwegian households are highly leveraged

During the last economic upturn Norwegian households increased their
level of debt by 15% on average every year. Housing debt increased by
10% per annum over the period 1999-2007, somewhat less than in many
other countries (Table 1.3). But, as Table 1.3 shows, the overall
level of debt, compared with GDP or with household assets, is
relatively high. The ratio of housing debt alone to GDP is around 77%
in Norway versus a euro area average of 41%. Finally, the share of
disposable income spent on interest payments is substantially higher
in Norway, though this varies considerably from one year to another,
reflecting the almost exclusive use of variable rate loans. Most
mortgages have floating interest rates based on money market rates.
Only 5% of banks' outstanding loans to households had rates fixed for
1 year or more. *

With a substantial stock of non-financial assets, the balance sheet of
the Norwegian household sector appears quite solid. However: i)
leverage seems quite high (although the cross-country comparability of
balance sheet data is not always fully reliable); ii) the ratio of
debt to gross financial assets is much higher than in continental
European countries and, iii) the ratio of housing debt to
non-financial wealth is among the highest in OECD countries. In
aggregate, then, the household sector appears vulnerable to large
swings in both house prices and interest rates.

This vulnerability may be mitigated by the fact that the richest group
of the population holds the largest portion of debt, a feature which
has not changed in the last few years, suggesting that credit growth
and financial innovation has not increased the vulnerability of the
most disadvantaged individuals, as happened in some OECD countries
(inter alia United States and Ireland). Vatne (2008) find that, while
over 50% of households have taken on new debt, growth and overall debt
is essentially dominated by relatively few large loans. Nevertheless,
increases in leverage were the highest among young households and the
interest burden is highest in the 2S-44 age group, considerably above
its level ten years ago (Berge and Vatne, 2009). But, so far, young
first-time homebuyers do not seem to have a higher probability of
default than other household groups, possibly because their mortgages
are often secured by parents' collateral. The overall mortgage default
rate is rather low.

* In addition to mortgages, fixed rates are also offered on loans for
education provided by the State Educational Loan Fund.

The dramatic reduction of interest rates that accompanied the financial crisis caused a strong rebound of house prices: with the exception of Australia, Norway is the only OECD country where the housing market has been recovering fast through 2009, despite weak underlying economic activity (Figure 1.12). A key question is whether this represents the emergence, or re-emergence, of bubble behaviour. The empirical evidence on this is very mixed (Annex 1.A1). In general fundamentals can explain a lot, suggesting housing may not be particularly overvalued in Norway. Nevertheless, there are matters of concern, such as the fact that the price-to-rent ratios are significantly above long-term average values and that price-to-income ratios are increasing relatively fast (Figure 1.13).
Box 1.5. Factors behind the strong credit growth to the household

In countries where the majority of households typically borrow at
floating interest rates, like Norway, but also Finland and the
United Kingdom, the transmission of monetary policy is particularly
fast. In both recent episodes of drastic monetary loosening (2003
and 2008), Norwegian households reacted quickly and strongly. House
prices were also immediately affected and began to rise again, as
did private consumption. Since household debt is high, the income
effect of rate changes is significant (equivalent, in this latest
crisis, to a reduction in household interest payments of around 2%
of GDP). Surveys indicate that households indeed expect interest
rates to rise again when they are at very low levels, but that they
may underestimate how high they could go. There are no systematic
studies about the formation of household's interest rate
expectations, but the share of fixed rate loans decreased when
Norges Bank's short term policy rate was raised and increased again
in 2009 after the policy rate cuts, though its level remains very
low. On the other hand, a survey by the financial supervision
agency shows that when interest rates are very low, banks may not
grant loans to customers who would be unable to service the loan if
the interest rate were 4-5 percentage points higher. In addition
banks have a duty to evaluate the borrower's financial means and
ability to service the loan, and warn against borrowing if loan
repayment is estimated to be unlikely. If sufficient advice is not
provided to customers, their debt may get reduced.

Innovations and adjustments in the structure of mortgages may have
contributed to the strong growth in household debt and house
prices. The typical amortisation period has increased, from 15-20
years in 2000 to 20-25 years today. Another radical innovation was
the introduction, in 2005, of interest only mortgages. Interest
only mortgages have the same characteristics as credit lines or
overdraft facilities and are extremely flexible. For example, they
may be used to make financial investments, and there is no cost for
having an unused credit line. Banks usually require stricter (i.e.
lower) loan-to-value ratios when granting mortgage credit lines
than for standard mortgages. Mortgage credit lines have become very
popular, accounting for about 70% of growth in mortgages in
2006-2008; by mid-2009 they represented 22% of total outstanding
mortgage debt. This clearly influenced the strong growth in private
consumption and the fall in the overall household saving rate to
zero and below.

High loan-to-value ratios have been long highlighted by the
Financial Supervisory Authority (FSA). Its home mortgage survey
showed that 40% of the mortgages contracted in 2007 had a
loan-to-value ratio above 80%. In such cases extra collateral or
guarantees are often required by the lending bank and most lenders
have an interest rate which varies according to whether the loan is
below 60%, between 60% and 80%, or above 80% of the price. The
appraisal of borrowers' financial position is usually only done at
the time the mortgage is granted. Banks typically condition high
loan-to-value ratio mortgages on proven ability to service the loan
and a good track record, while collateral plays a secondary role.
However, the FSA's mortgage survey during the spring 2009 indicated
that banks have become more careful in granting mortgages with high
loan-to-value ratio since the recession.

Norges Bank has been criticised in the past for not having paid
more attention to the effects of monetary policy on house prices,
particularly in 2004 and 2005 when the interest rate was at 1.75%
and house prices were booming. Long-lasting accommodative monetary
policy might have contributed to increased imbalances prior to the
recent financial crisis, with cheap money fuelling bubbles in the
housing and credit markets, though evidence on this remains
inconclusive (Fatas et al., 2009, and Annex 1.A1). This has renewed
the debate on whether central banks should take into account asset
prices, and what should be the optimal approach to "leaning against
the wind" (Box 1.6).



Monetary policy and asset prices

Housing prices have caused concern ...

The fact that Norwegian households respond quickly to interest rates raises the question of how monetary policy should react to asset price movements, in particular to movements in house prices and to movements in the exchange rate. The debate on this question is far from being settled (Box 1.6). The high level of variable-rate household debt means that aggregate demand is relatively responsive to interest rate policy, in general likely to be an advantage for an inflation-targeting bank, in that it should reduce somewhat the "long and variable" lags that complicate policy decisions. However, when it seems desirable to raise interest rates to head off a housing bubble or possibly unsustainable levels of household gearing, too-rapid tightening could cause a strong increase in saving, dampening demand more than required, so a relatively early response to house prices might be required.

Housing prices can thus reasonably be expected to show up in the policy reaction function even if they are not being targeted themselves (which, as with the exchange rate, would not be possibly anyway without sacrificing the inflation target itself). The current position of the Norwegian central bank is essentially in line with this view, since it has recently asserted that the monetary policy reaction function already includes these variables, though the policy objective function only incorporates one operational target, which is the inflation rate. (4)
Box 1.6. Should the central bank lean against the wind?

Central banks reaction functions are rarely found to incorporate
asset prices movements in their policy decisions (Ahrend et al.,
2008). Exceptions include Bjcrnland and Leitemo (2009), who find
that changes in stock prices in the US have triggered short-run
reactions in key-policy rate and Bjornland and Jacobsen (2009) who
found that the Norges Bank, the Bank of England and the Bank of
Sweden tend to respond to house prices, though to varying degrees.
However monetary policy conditions are known to be a relatively
inaccurate indicator of house price booms and busts (Fatas et al.,
2009). That suggests that, if monetary policy exerts an effect on
house prices, it is likely to be indirect, i.e. through an effect
on long-term rates, on the demand for mortgage loans and
residential investment.

There is however an international debate on whether the central
bank should "lean against the wind", which is far from being
settled. In this debate the partisans of the leaning against the
wind position argue that central banks should move against possibly
unsustainable price developments, even at the cost of more
variability in inflation and output (Cecchetti et al., 2000; White,
2009) as this would improve both macroeconomic and systemic
stability and ultimately social welfare. It could also reduce the
moral hazard problem generated by the alternative "benign neglect"
approach, under which monetary authorities intervene only ex-post
to clean up after periods of financial instability (Bordo and
Jeanne, 2002). An objection to the interventionist view is that
many of the standard macroeconomic variables looked at by central
banks are not consistently and systematically associated with asset
prices (Fatas et al., 2009). However credit growth, residential
investment and the current account are variables statistically
correlated with house price increases and busts and thus monitoring
and reacting to these additional variables could effectively
improve a macroprudential approach of monetary policy.

Whatever is the conclusion of the debate about leaning against the
wind, specific macroprudential tools, such as counter-cyclical
capital requirements and dynamic provisioning, would be beneficial
to prevent financial instability (White, 2009). Simulations carried
out in Fatas et al. (2009), illustrate that such macro-prudential
policy can be more effective in preempting credit bubbles than
simply raising policy rates. To moderate the imbalances that may
emerge from excessive variation in credit conditions (rather than
targeting asset prices), it is not necessary to determine whether
there is indeed a bubble; it can suffice to use various indicators
to detect deviation from what the fundamentals seem to suggest. It
is also possible that the credible announcement of official concern
and determination to act could in themselves help to stabilise
behavior in the economy, as can happen with inflation-targeting
announcements, though credibility would have to be built up first,
lest unclear communication end up doing more harm than good.

... as has exchange rate volatility ...

Since Norway is a small open economy, one of the routes by which monetary policy operates is through changes in the nominal exchange rate. Equally, movements in the exchange rate can occur for reasons independent of Norwegian monetary policy and the authorities are likely to need to adjust interest rates from time to time to take the effect of such exogenous changes into account, as confirmed by the revealed monetary policy reaction function discussed above.

Financial market behaviour interacting with the exchange rate and interest rate differentials can make this more complicated than simply assessing the stance of monetary policy through a weighted average of the level of interest rates and the exchange rate (such as calculated in a financial conditions index). If strong domestic credit growth calls for a tighter monetary stance, higher interest rates in Norway and an appreciating exchange rate can make foreign currency borrowing by Norwegians look very attractive, at least temporarily. In some countries there have been periods when capital inflows resulting from monetary policy tightening undermined the attempted tightening and caused significant exchange rate appreciation, with the likelihood of an eventual sharp reversal To avoid this, a central bank may not be able to move interest rates too far from those of trading partners as much as it would like to.

The volatility of the real exchange rate has in fact increased since Norway has switched to an inflation-targeting regime (Boug et el., 2005), which has obliged the central bank to follow more closely the interest rates of trading partners (Figure 1.14). Indeed, Figure 1.11 also shows that, when foreign interest rates are taken into account, a modified Taylor rule predicts an interest rate path quite similar to that recently published by the central bank. In the past Norges Bank has observed that carry-trade and speculative behaviour are amplified in periods of falling equity prices, expectations of increased exchange rate fluctuations between major currencies and rising oil prices. Equity markets are no longer falling in general, but the latter conditions are met at the moment.


As the dramatic recent experience of Iceland has shown, mismanaged financial liberalisation, as the entire financial sector gears up on foreign borrowing can mean that the carry-trade and other forms of arbitrage make monetary policy practically impossible for a small economy. Icelandic monetary policy was ineffective as carry-trade investors exploited the efforts of the Icelandic Central Bank to achieve its inflation target amid rising overheating of the economy. In Norway inflation expectations are much better anchored and financial liberalisation process has not led to such risk-taking as in Iceland. However, since for the next couple of years the Norwegian business cycle is likely to be decoupled from that of its trading partners, the difference between domestic and foreign interest rates will be positive, probably constraining the rate at which monetary policy can be tightened.

... but if exchange rate volatility is a concern, Norway could abandon its currency in the medium-longer term

When the exchange rate is free to move, the impact of monetary policy is amplified. Whether this advantage outweighs the potential costs of volatility and risks associated with arbitrage is an empirical matter. In practice there seems to be a positive correlation between the exchange rate and the business cycle in Norway, suggesting that in general the exchange rate has worked counter-cyclically (Figure 1.15). This may be explained by the fact that commodity price cycles are strongly correlated to business cycles in Norway. Thus, a sharp increase in the oil price, which would boost the economy (even if the effect is moderated by the GPFG), is likely to be attenuated by an exchange-rate appreciation, and vice versa.
Box 1.7. Should Norway join the euro area?

Joining the euro area, abandoning the domestic currency in favour of
the euro, would eliminate the exchange rate risk. In the early 2000s,
when the authorities reconsidered the whole macroeconomic framework,
many were worried that the exchange rate could fluctuate a great deal
if inflation targeting was adopted by the central bank (Svensson et al.
(2002) and Bergmann et al., 2009). However, a flexible exchange-rate
regime was thought to be superior to a fixed exchange-rate regime for
achieving low inflation. In addition, due to its high dependence on the
petroleum sector, Norway is likely to experience a strong volatility
of the real exchange rate, which would make it hard to achieve
exchange-rate stability in the absence of a currency union (Svensson,
1997 and Svensson et al. (2002). However, the issue remains worth
considering to resolve the difficult dilemmas discussed above.

The question of cost and benefits of being a member of the European
Monetary Union remains, at least theoretically, interesting. Clearly
the possibility of joining the euro area is subordinated to the
integration of the European Union, which Norway has formally rejected
twice (in 1972 and 1994). Norway is already part of the EEA and thus
has adopted most of the acquis communautaire and EU directives,
including for labour mobility, but not for agriculture and fishing.

Joining the euro area would lead to tighter economic integration with
the members of the area, with potentially positive effects on trade
and increased business cycles synchronization (the endogenous optimal
currency area theory). The evidence on the reduction of transaction
costs and the pro-trade effects is however mixed. The pioneering work
by Rose (2000), pointing to a significant trade increase following the
adoption of a common currency, was questioned by subsequent work (Thorn
and Waish, 2002; De Souza, 2002; Anderton et el., 2002; Fidrmuc and
Fidrmuc, 2003; De Sousa and Lamotte, 2006). Some authors find that
trade effects do exist, but are of varying magnitude (Micco et al.,
2003; Flam and Nordstrom, 2003; Berger and Nitsch, 2005) or only
present in sectors marked by differentiated products (Taglioni, 2002;
Baldwin et al., 2005) or at specific point in time (Mandni-Griffoli and
Pauwels, 2006). All in all, the conclusions from the existing
literature (Baldwin, 2006) are that the pro-trade effect of the euro is
quite modest, happens quickly but is not sustained over time and it is
not exclusive (euro usage boost imports from outside the euro area as
much as from inside the euro area). Also, the positive effects decline
significantly with the distance to other countries and are highly
dependent on the sectoral structure of the economy, being higher in
sectors with increasing returns to scale but vanishing in sectors
characterized by fairly homogenous products (including mining and
refined petroleum). * These results suggest that the trade gains
for Norway would be quite modest, given the relatively homogenous
structure of the economy and the relatively long distance from the
bulk of the euro area.

Another benefit from joining the euro area would be greater financial
market integration, which has been shown to increase domestic financial
development, in turn having a positive effect on economic growth. For
instance, there is evidence that the euro boosted investment by
financially-constrained firms. Portfolio flows in equity and bonds
among Euro area countries increased significantly due to EMU (De Santis,
2006). However, benefits from financial integration do not necessarily
stem from the adoption of the same currency. EEA regulation leads to
harmonized legislation, which could also promote financial-market

In the absence of an independent monetary policy, labour flexibility is
needed to avoid cyclical fluctuations leading to volatile employment
and persistent unemployment. This argument could be particularly
relevant for Norway, where wages are sometimes seen as being rigid
downwards (Holden and Wufsberg, 2009). A strict inflation target
favours wage moderation in countries with centralised wage setting
(Bratsiotis and Martin, 1999); Soskice and Iversen, 2000) and leads to
a lower NAIRU. Entry into a monetary union may remove such wage
moderation: there would no longer be a clear link between national wage
setting and the interest rate, since it would be set for the whole euro
area. However, critics of this view argue that, precisely because a
national inflation target may discipline wage setters, it also weakens
their incentives to co-ordinate on wage restraint (Holden, 2005). For
instance in Finland the monetary union membership has reinforced demands
for centrally agreed solution (Tiilikainen, 2005). Other studies find
that wage restraint has increased not only in many EMU countries after
the introduction of the euro, but also in Sweden and the United Kingdom
(Posen and Popov Gould, 2006).

If Norway were to join the euro, fiscal policy would be the only tool
available for stabilising the economy and adjusting to adverse shocks.
Within the current fiscal framework, deviations from the 4% rule can
already be used over the cycle to smooth economic growth. However,
fiscal policy is less able to adjust rapidly than monetary policy, and
may distort economic behaviour. Respecting Maastricht criteria would
not be a problem for Norway, which expects to run a budgetary surplus
for the next S0 years with no net debt, although this surplus would be
largely the result of the running down nonrenewable energy resources.
Furthermore, a considerable long-term financing gap is likely to emerge
(see Chapter 2) in the absence of significant structural reforms.

Overall, the economic case for the adoption of the euro area is not
clear cut. Continued public debate of its potential merits would be
worthwhile, in particular if Norwegian macroeconomic policies become
less effective in the future or if exchange rate volatility turns out
to be more disruptive than in the past.

* Baldwin (2006) also shows that reduced transaction costs were not the
main reason behind pro-trade effects, but these were caused by export
of new goods to euro area countries. "The mechanism driving this may
have been a reduction in the fixed cost of introducing new goods into
euro area markets. This mechanism, which is tantamount to a unilateral
product-market liberalisation, would account for the lack of trade
diversion (it would stimulate the introduction of new goods from
Eurozone-based and non-euro area-based exporters alike) and it would
account for the jump up in trade without price convergence."


However, volatility may be more difficult to handle in the future. Furthermore, in political economy terms, perceptions of hardship in the export sector and more generally the uneven impact of monetary policy are frequent sources of strong criticism of the monetary authority. Since no central bank can control both the exchange rate and inflation at the same time, there would be some advantages (subject to its political feasibility, which cannot be dealt with here) in joining the euro area (Box 1.7).

The massive fiscal stimulus must be withdrawn to support monetary policy and ensure the credibility of the 4% rule

In the short term, since political-economy concerns related to too-rapid exchange rate appreciation limit the manoeuvrability of monetary policy, fiscal policy has to play a more prominent short-run stabilisation role (Schmidt-Hebbel, 2006). Fiscal tightening will lighten the task of monetary policy in containing emerging labour-market pressures and resurging inflation, thus reducing upward pressure on the exchange rate. Withdrawal of the fiscal stimulus will also boost the credibility of the fiscal framework, allowing a rapid return to a deficit in line with the 4% rule. Finally, fiscal tightening will increase the value of the Government Pension Fund Global (GPFG), reinforcing long-term fiscal sustainability.

The key anchor of fiscal policy since 2001 has been the 4% rule, which stipulates that the non-oil structural central government budget deficit should average, over time, 4% of the value of GPFG. This rule helps to insulate the economy and the budget from swings in energy prices, as the large returns from the exploitation of petroleum resources are phased in gradually into the economy. This rule also allows to preserve a significant proportion of wealth from non-renewable resources for future generations. Government net earnings from the exploitation of oil and gas resources are transferred to the GPFG which holds its funds exclusively in foreign assets (thus largely "sterilising" petroleum revenue inflows in the balance of payments). In this framework, each year's budget is planned on the basis that the structural non-oil deficit should be equivalent to a 4% real return on the value of the fund, unless exogenous shocks or sudden changes in the value of the GPFG materialise. Thus in periods of strong economic growth, the 4% path can be undershot while downturns allow discretionary fiscal policy to operate counter-cyclically. The economy was hit by strong exogenous shocks in 2008-09 and the GPFG was severely hit by the financial crisis (although it recovered afterwards). The large fiscal stimulus of 2009 and the additional budgetary measures of 2010 entailed a large deviation from the 4% trajectory (Figure 1.16).

The structural non-oil budget deficit has risen more sharply than in most previous recessions, reflecting the magnitude of the discretionary stimulus. A comparable increase in the structural non-oil deficit was recorded during the 1988-93 banking crisis, though the output loss at that time was more severe. After the crisis of the early 1990s, Norway embarked on a bold fiscal consolidation process that lasted seven years and reduced the deficit by 6% of GDP (1% per year on average). Given that the recovery from the recent recession is likely to be faster and stronger than after the 1988-93 crisis, it should be feasible to withdraw the stimulus at a similar rate, though some factors, including global demand, demographic developments, competitiveness of the exposed sector and monetary policy are likely to be less supportive. In addition, in political economy terms, it might have been perhaps easier to accept that the country needed a strong fiscal consolidation given the very difficult situation faced at that time. The government is committed to return to the 4% path but has not specified any particular timetable. With early action, and if the structural non-oil deficit were to be cut by 1% of GDP per year, as after the 1988-93 crisis, the return to the path could occur by 2013 or even earlier.


Fiscal consolidation might be needed beyond 2013 to strengthen the medium term framework. The current fiscal guidelines are not usually interpreted as requiring that periods of overshooting the 4% path should automatically be followed by a period of undershooting. According to the current guidelines the overall objective of the fiscal policy is to smooth the phasing in of the expansionary fiscal stance implied by the 4% path, remaining broadly neutral through the cycle (i.e. allowing stabilisers to work fully). In fact there has been some mild asymmetry in the interpretation of the deviation from the 4% target in cases of good and bad economic times: the average overshooting was 1.5% as compared to an average undershooting of 0.5% (Figure 1.17). So far the fiscal framework has been very effective and credible and it is important that this approach is maintained in the future. For example, it is important that the government refrains from giving in to pressure to finance public spending outside the budget, e.g. through loan programmes, to circumvent the fiscal rule; such pressure may be likely in a period of fiscal consolidation. However, the approach would gain in credibility if the authorities seized the opportunity of any period of above-trend growth after 2013 to undershoot the 4% rule. This would indeed show clearly that the fiscal framework works symmetrically over the business cycle.


How to achieve fiscal consolidation in the short and medium term

In the very short-term Norway could consolidate its public accounts by withdrawing the extraordinary anti-crisis measures enacted in 2009 and 2010 (Table 1.4). Temporary tax releases for the corporate sector are already phased out and their budgetary effect terminates by the end of 2010. The 2009 fiscal stimulus package included essentially infrastructure investment but also employment and requalification measures and a number of grants (many of which not directly addressed to the household sector). Although the original intention was that these measures be purely temporary, some of these measures have been extended (about one quarter of them) and some other have been converted into new spending of a more permanent character (about one third of the initial measures). It is unfortunate that some of the measures that were initially conceived as being "timely, temporary and targeted" were replaced by structural spending, especially when there is no strong economic rationale for them (e.g. the revenues transferred to municipalities to finance public services provision see Chapter 2).

If the economic recovery unfolds as expected, the reversal of the extended measures should start soon to avoid that an expansionary fiscal policy remains in place longer than necessary; in that case the central bank would be likely to react by stronger policy tightening, but the constraints on its freedom for manoeuvre discussed above could lead to overheating later. Reversing the special anti-crisis measures that have not been phased out yet would cut the deficit by around 0.5% of mainland GDP (this includes the phasing out of the tax measures). Other measures are therefore required for further fiscal adjustment.

Research shows that fiscal consolidation is likely to be more successful when: it is enacted from the spending side (Guichard et al., 2007); favours cuts to low-priority spending over more growth-friendly spending or raising taxes (OECD, 2003; Cournede and Gonand, 2006). Since Norway has a relatively high level of taxes and since high taxes may distort economic behaviour, resulting in lower growth, it is advisable for Norwegian fiscal consolidation to concentrate on expenditure cuts.

Typically, spending on useful infrastructure has a positive effect on growth (Sutherland, 2009), while R&D spending contributes to higher innovative activity and productivity (OECD, 2003) and spending on active labour market policy can contribute to better labour market performance (OECD, 2006). Such spending--provided it meets relevant standards of cost-effectiveness--should therefore be sheltered from cuts, though in practice making the distinction is not easy (OECD 2009a). It can be politically easier to make cuts across the board (Henriksson, 2008).

To make room for spending cuts while protecting levels of service provision there is potential to enhance public sector efficiency, as discussed in Chapter 2. For example, recent OECD work found potential gains of efficiency in Norwegian compulsory education of 40%, implying potential budgetary saving of 1.3% of GDP (Sutherland et al., 2007). Similarly, in the health care sector, possible efficiency gains to move to international best practice could be up to one third (Joumard et al., 2008). These estimates are highly uncertain and provide only an illustrative indication of savings that efficiency reforms could generate. Furthermore, education and health care are two areas where reforms could improve efficiency but where they meet some of the strongest opposition from stakeholders. Chapter 2 discusses and details reforms to raise efficiency in these two sectors and puts forward strategies to overcome political-economy resistance.

The already strong fiscal framework could be enhanced

Earlier deviations from the 4% path have never been as large as at present, and have had negligible consequences for the value of the GPFG. The guidelines do not include any rule for how fast over--or under--shooting should be reversed. Given the government's intention of reverting to the 4% path relatively soon, such a rule may be unnecessary in the short run, although it might be a useful addition in the longer term, and would prove particularly beneficial in the context of the need for a period of fiscal consolidation.

However, the current approach to budgeting implements medium term plans only one year at a time, with no multi-year targets or expenditure ceilings. The budget documents do contain three-year rolling projections that take into account expected budgetary implications of demographic changes, investment programmes and new policy initiatives, but there have been deviations from these projections, though relatively small, with an apparent link with government employment growth in recent years (Figure 1.18), though of course this link does not prove causality. In a multiannual budget, such projections could be complemented by multi-year spending ceilings for each spending centre, and each centre would be responsible for adapting policy so as to use resources most efficiently. Changing circumstances would obviously mean that expenditure plans would be revised from time to time, but this would be in a medium term framework that could help avoid pro-cyclicality and keep spending pressures under check. In countries where multiannual budgeting exists, e.g. in Sweden, governments have managed to systematically stick to medium-term projections, effectively preventing overspending. For this tool to work, it is however necessary to specify that multiannual targets are not interpreted as a floor on spending.


Overall, the fiscal framework is relatively transparent and has worked credibly. However, there remain some aspects where the framework could gain in transparency even further. In particular, the methodology for measuring the fiscal stance is rather different from those used by international organisations such as the OECD and the EU, notably because it makes specific adjustments for a large number of components in calculating cyclical adjustments; the Ministry of Finance contributes to transparency by publishing some considerable detail of its calculations but they are quite complex and difficult to compare internationally. It is true, however, that there is no precise internationally accepted methodology for such calculations. In this respect and especially in the context of a medium-term view of budgetary policy, a useful role could be played by a fiscal council, which would periodically evaluate budgetary developments, including the implementation of the fiscal rule. Fiscal councils are relatively new in the experience of the OECD area and are often organised according different models (Box 1.8); very often they evaluate ex post fiscal policy and provide a complementary view of economic developments in the country in question. For example, the Swedish Fiscal Council is charged with assessing whether short-term and long-term fiscal policy objectives are achieved, but its responsibility is also to promote clarity and transparency of the budget. In Denmark the Economic Council is an advisory body to the Ministry of Finance which is supposed to analyse fiscal and monetary policy in relationship to economic developments and to co-ordinate a multilateral dialogue among various Danish institutions. These experiences and those of other OECD countries with analogous boards have resulted in more transparent and thus effective decision-making frameworks. Norway could follow this example and create a fiscal council, of which international experts could be useful members.
Box 1.8. Fiscal councils in OECD countries

The Swedish Fiscal Policy Council is a new government agency charged
with independently assessing the extent to which the government's
fiscal policy objectives are being achieved. These objectives include
long-run sustainability, the budget surplus target, the ceiling on
central government expenditure and the consistency of fiscal policy
with the cyclical situation of the economy. The council also evaluates
whether the development of the economy is in line with healthy long-run
growth and sustainable high employment.

Additional tasks are to examine the clarity of the government's budget
proposals and to review its economic forecasts and the economic models
used to generate them. Finally, the Council should try to stimulate
public debate on economic policy. The Council is to achieve its
objectives primarily through publishing an annual report. The annual
report will be used by the Swedish Parliament in evaluating the
government's fiscal policy.

The Danish Economic Council was established in 1962. The objectives of
the Council include monitoring the Danish economy and analysing
long-term economic development as well as improving co-ordination
between the different economic interests in Danish society. The Council
therefore plays an important role in the public debate on economic
policy issues in Denmark. The Economic Council has 26 members
representing unions, employers' federations, the Central Bank and the
government. The members are proposed by the individual organizations,
and are formally appointed by the Minister of Economic Affairs. The
council is presided over by a chairmanship, consisting of 4 independent
economic experts, usually university professors. The report to the
Economic Council contains economic analyses and statements on economic
policy. The reports always contain a forecast of the Danish economy for
the next 2 to 3 years. Special analyses on issues such as labour market
policies, distribution, the welfare state or the EMU are also included
in the reports.

Established in 1950, the SER is the main advisory body to the Dutch
government and the parliament on national and international social and
economic policy. The SER is financed by industry and is wholly
independent from the government. It represents the interests of trade
unions and industry, advising the government (upon request or at its
own initiative) on all major social and economic issues.

The financial stability framework is well-founded but could be strengthened

The financial system coped well with the crisis

As in other OECD countries, the Norwegian financial sector was hit by the global crisis, notably by the temporary seizure of funding markets and higher borrowing costs, but it went into the global storm in strong health and with the help of a swift reaction from the authorities returned back on its feet rapidly by international standards. Financial losses were limited because hardly any investments in toxic assets were held on balance sheets and investments in securities were relatively small (Table 1.5).

Some risks remain

Problems on non-performing loans have so far been remarkably contained (5) despite two quarters with negative growth in mainland GDP and an abrupt decline in international sectors where Norwegian banks have large exposures, such as the shipping market. This is partly due to the structural features of the financial sector (Box 1.9), which is not very exposed to business activity in the rest of the world.

The main risks are confined to two sectors, the shipping sector and the commercial property sector, and to one geographical area, the Baltics:

* Although exposure to the shipbuilding industry is on average small (though some banks have up to 12% of their lending portfolio invested in shipping), failures in the sector through difficulties in finding customers for ships or defaults on orders could lead to a downward spiral in ship prices and aggravate the situation in the second hand market. So far, however, losses on loans to the shipping sector have been much smaller than on loans to other sectors and are projected to increase only moderately in the baseline scenario of Norges Bank (Financial Stability Report 2/2009). (6)

* As in other countries, the commercial property market represents a clear risk, following boom years during when office prices increased by 10% annually. Since the beginning of 2008 the market has been contracting, and new orders were still falling at annual rates of 30% in mid-2009. Losses on loans are manageable so far. Unlike housing finance, about 50% of commercial property loans are at fixed rates. That may partly explain why the strong monetary loosening has not led prices in this market to rebound.

* The largest Norwegian bank (DnBNOR) and the biggest Swedish and Danish banks operating in Norway have some exposure to the Baltic countries and other emerging European economies (Figure 1.19). DnBNOR's exposure to Baltic countries was about 4% of the banking group's total lending at the end of 2009. About one half of DnBNOR's individual write-downs on loans and guarantees during the first nine months of 2009 were on loans and guarantees to customers in the Baltic countries.


Stress testing suggests that while these weak sectors do not on their own represent a source of systemic risk, there are still potential dangers ahead: in a scenario with prolonged disfunctioning in financial markets, sluggish recovery of global trade, low oil prices (i.e. around USD 40) and a sharp fall of commercial property prices, Norges Bank calculates that problem loans would triple by 2012 to around 11% of total lending. Under plausible assumptions about actual losses on problem loans, banks would be writing off losses equivalent to about 3% of total lending in that year (by comparison loan losses peaked at close to 4.5% of total lending in 1991). Under this scenario negative bank profitability results in lower capital adequacy levels; the average equity ratio would fall just to 4%, just below the level it reached at the end of 2008 before the increases in capital that most banks achieved during 2009. In other words, if the overall financial crisis resumed and world trade did not recover, serious problems (but less serious than those caused by the banking system collapse in the early 1990s) could still emerge.
Box 1.9. Characteristics of the Norwegian financial sector

The Norwegian financial sector is not particularly remarkable by
international standards. Its recorded share of mainland value added,
about 5 1/4 per cent, is similar to that in the EU-15. Credit
institution assets correspond to 225% of mainland GDP, somewhat lower
than in other countries. This follows relatively low asset growth in
recent years, partly reflecting the limited cross-border operations of
Norwegian financial institutions. The only significant operations
abroad, other than in the Nordic-Baltic region, which is in many ways a
local market, is in the international shipping business (DnBNOR, the
largest Norwegian bank, and the Swedish owned Nordea that has a large
subsidiary in Norway, are the two largest shipping banks in the world).
The number of employees in the sector has declined slightly since 2000,
to about 2% of total mainland employment in 2008.

Foreign owned banks have a significant market share. Total assets of
branches and subsidiaries of foreign credit institutions are about 30%
of all credit institutions' assets and their share has been increasing.
Given the small absolute size of the economy, a high foreign share is
not surprising. Foreign-owned credit institution market shares are
higher in Finland, United Kingdom and in some emerging economies in
Europe, but lower in other Scandinavian countries and in European
countries like France and Germany. The main Norwegian-owned bank, DnB
NOR, is majority owned by the government (the government holds 34%,
with another 11% held by the DnB NOR Savings Bank Foundation) with the
explicit aim of ensuring domestic ownership of this large institution.

The current banking system was shaped in the aftermath of the Nordic
banking crisis of 1988-93. At that time the three largest commercial
banks suffered severe losses, mainly on commercial property lending,
and were rescued by the government for recapitalisation and
restructuring after the value of the shares was written down to zero.
Many other banks failed and a number of regional savings banks were
propped up with equity capital from the government. After the crisis,
the government quickly privatised part of the three largest commercial
banks, but maintained public ownership to avoid foreign takeovers of
the largest banks. In 1999 two of the largest banks were finally
privatised, but control of the third (DnB) was strengthened. The
current largest bank, DnB NOR, is the result of the 2004 merger of DnB
with the largest saving bank. The three largest banks are subsidiaries
of financial conglomerates which own life insurance companies, mortgage
companies, fund management companies and specialised finance companies.

Memories of the last banking crisis induced more prudent regulation and moderated risk appetite among banks

Bank regulation played an important role in limiting risk taking by Norwegian institutions, arguably thanks to lessons learnt in the last banking crisis. Financial market regulation in Norway is built around the principle of regulating analogous risks across different types of institutions in a similar way. An important aspect of Norwegian regulation is the requirement for full consolidation of subsidiaries in group accounts, with regulatory ratios applying at the consolidated and individual levels, with the same capital requirements for specialised mortgage companies as for banks, for example; this avoided any regulatory incentive to set up special investment vehicles (SIVs). Norwegian rules do not allow the type of securitisation seen in the United States for instance. Strict requirements apply to securitisation. The main vehicle for securitisation is preferential bonds issued by a mortgage credit institution, where the bond-holders have a preferential claim over the covered pool. Eligible assets for the covered pool are primarily residential mortgages, commercial mortgages, and public sector loans. Even where loans are passed to separate vehicles and the bonds are sold in the market, banks continue monitoring that customers service the loans, though there is no legal obligation to do so.

Some macroeconomic indicators followed a similar pattern between 2004 and 2007 to that in the years before the Norwegian banking crisis of 1988-93: the household saving rate fell below zero, private consumption boomed, house prices grew at double digit rates, as did households' debt. However the response of the financial system and that of its supervisors was very different. Capital requirements had been relaxed in the 1980s, as a result of limited loan losses over the years with credit rationing and strict regulations. Part of the present regulatory set up was enacted before 1988, like the establishment of a single Financial Supervisory Authority (FSA) in 1986 and the principle of consolidated supervision. But the quality of the regulation and the supervision of the financial market improved after the 1988-93 banking crisis. Recent FSA inspection and risk assessment activities have been much more comprehensive, especially in higher risk sectors such as real estate and shipping, and generally more pre-emptive than before the 1988-93 crisis. The FSA had hardly any on-site inspections of banks at that time (Moe et al., 2004). Banks also seem to have retained good risk control routines during the recent upturn even though credit policies in some areas were relaxed, such as for lending to real estate projects.

The experience of a banking sector with a weak capital base during the previous banking crisis has probably pushed Norway to take a more restrictive position than many countries in accepting hybrid capital as Tier I capital (Table 1.6). Norway's membership of the European Economic Area (EEA) means that financial market regulations follows EU legislation, in line with Basle agreements. But the Norwegian authorities retained stricter definitions on core capital than many EU countries. Although the banks' actual risk-weighted core capital declined in 2006-08 (Figure 1.20), it remained above the legal requirement. The decline in the ratio probably reflected banks' adjustment to the Basle II accord where capital requirements on credit risk, especially on residential mortgages, were reduced, and residential mortgages represent a large part of Norwegian banks' loan portfolio. The reduced core capital ratio over recent years is also reflected in banks' leverage. The ratio of outstanding loans to core capital increased to 16, from below 13 in the years prior to 2004 (Figure 1.21).



During 2008, in connection with banks' internal capital adequacy assessment processes, the FSA was already asking a number of banks to increase their capital adequacy. More recently, observing that a Tier 1 capital ratio of 10-12% is becoming the yardstick internationally when banks have been recapitalised, the FSA is encouraging Norwegian banks to aim for such a ratio. This seems particularly appropriate for banks which need to build additional capital cushions against future risks, such as potentially bad loans for housing and shipping, and in the Baltic States.

But the significant public shareholding in the main Norwegian bank may encourage moral hazard

According to available indicators, competition in the banking sector is fairly healthy (Box 1.10). Nevertheless, competition can be hampered and profits elevated (which is the case in Norway) if key banks in practice are protected from failure. The large public ownership of the biggest Norwegian institution may increase the perceived threshold for failure, on top of having a negative effect on competition. The fact that many smaller banks were closed in the previous crisis, while the big ones were rescued, could also help to create a divide between the small and the large banks, even though the government did not hesitate to write down to zero the value of the large banks' shares. Suspicions emerge from time to time that DnBNOR receives preferential treatment from the authorities. For instance the 2004 proposed merger between DnB and Sparebanken NOR was opposed by the Norwegian Competition Authority but pushed through by the government in exchange for the sale of some branches. The combination of government ownership and its perceived status as too big to fail could also encourage the bank to take on too much risk, a behaviour that other banks might imitate--the Norwegian banking crisis in 1988-93 saw banks acting "in herds", following the leading bank as a role model (Steigum, 2004). To avoid moral hazard among banks and help to reduce perception of an uneven playing field, the government should consider abandoning the control of DnBNOR (when market conditions allow doing so). Due to its high exposure to shipping and Baltics investment, DnBNOR has just gone through a process of recapitalisation; if further recapitalisation were to be needed, the government should take the opportunity to allow its stake to fall below the threshold where it has effective control. However, if DnBNOR were acquired by a foreign bank and operated as a branch, a substantial part of the Norwegian banking system would no longer be subject to Norwegian prudential regulation, and only subject to host country supervision by the Norwegian Financial Supervisory Authority. This is a great concern for the Norwegian authorities.
Box 1.10. Competition in the financial sector

Competition is important to ensure cost efficiency in financial
intermediation and efficient allocation of capital. A high degree
of concentration in the banking sector reduces the availability of
financing for firms, especially for small and medium sized firms and
hampers growth. The negative effect of a high degree of concentration
is lower in countries with well-developed institutions, a higher
level of economic and financial development and a large share of
foreign-owned banks, features that seem to characterise Norway. A high
degree of competition, may on the other hand increases the risk for
bank failures (Bolt and Tieman, 2004); at the same time large
institutions may induce riskier behaviour through a "too big to fail"

As a member of the EEA, the Norwegian financial sector is subject to EU
competition rules and financial market regulations. Among others, they
set the requirements to new start-up, cross border establishments,
provision of services, and for major mergers and acquisitions. Entry
costs to the banking sectors are relatively low, though a joint working
group of Nordic countries competition authorities concluded in 2006
that the fees and access conditions for the payments system could
discourage new entry. The Norwegian competition authority has not
however objected to the current fee system and some fifteen new banks
were established between 2000 and 2008, all of which joined the payment

The Norwegian financial sector is relatively concentrated compared with
other OECD countries (Table 1.7). The five largest
conglomerates-alliances hold about 60% of all assets and for banking
activities alone this share rises to just over 70%. The five largest
banks' combined market share has increased in the last few years.
Concentration is significant in other areas: the five largest
management companies manage more than 70% of all mutual funds, and
about two thirds of the management companies are owned by banks or
insurance companies.

Overall, these indicators do not suggest a significant lack of
competition; entry barriers are low and concentration may be high
but it is higher in some other small countries. The cost of joining
the deposit guarantee fund is in fact probably too low, as
discussed below. Indirect measures of competition are not
conclusive--profitability has been high and rising, but the ratio
of banks' operating costs to income has fallen to a relatively low
level (Table 1.7), suggesting that profits are at least partly due
to efficiency. The return on equity of Norwegian banks has been
very high compared with other countries, and also compared with
risk-free long term interest rates in Norway (Figure 1.22), this
has been reflected in the increase of the sub-index for financial
equities relative to the broad benchmark index OSEBX on the Oslo
Stock Exchange. High profitability may indicate weak competition
but it could also reflect the strong general expansion in the
Norwegian economy. Part of the explanation for strong recorded
profits could also be that banks tended to underestimate the risks
contained in their balance sheets during the good years.


Fees paid to the deposit guarantee scheme should vary with risk taking

Norway has one of the most generous deposit guarantee systems, even after the EU's decision to increase it during the last crisis. A non-bank legal entity's deposits are guaranteed up to NOK 2 million (EUR 235 000), compared with EUR 100 000 in the European Union. A further assessment of the EU directive on deposit guarantee schemes is taking place, but if the harmonised guarantee level at EUR 100 000 stays unchanged, Norway will have to lower its guarantee level before the end of 2010. The Norwegian government has objected to this, arguing that the higher level is no real threat to a level playing field, but that the real threat was too low a level of guarantee in some countries in the past. In the aftermath of a crisis in which several countries with much lower de jure guarantees provided de facto 100% cover it is indeed difficult to see what the appropriate level might be. To cover the guarantee in Norway, banks pay a fee to the Banks' Guarantee Fund (BGF) which corresponds to 0.1% of total guaranteed deposits plus 0.05% of the size of the measurement base for capital adequacy requirement when the fund is below a certain threshold. Banks with core capital below legal requirement pay a premium proportional to the difference, while those that are above get a discount. If a bank fails, the law requires that deposits are compensated as soon as possible, not later than after three months, in line with the EU's deposit guarantee directive. The Guarantee Fund may decide to inject capital, issue guarantees or take other measures for banks in difficulties if the Fund's board estimates that to be less costly than letting the bank fail and paying out the guarantee.

A generous deposit guarantee scheme could invite moral hazard. But it certainly reduces the risk of runs on banks in critical times (OECD, 2009c). Unlike in many other countries with less favourable deposit guarantee schemes (like Germany, Ireland, Australia, Austria and partly Denmark), the authorities in Norway did not find it necessary to guarantee all deposits during the recent crisis (IMF, 2009). In addition, the authorities did not find necessary to provide other types of guarantees for the banks, e.g. for other liabilities or for assets (OECD, 2009d).

It is not only the guarantee level that varies between countries, but also how and to what extent the guarantee is prefunded by a fund. In countries like United Kingdom, (7) Netherlands and Austria there are no funds backing up the guarantee and members of the guarantee scheme are called on to make payments if depositors have to be compensated. The Norwegian guarantee fund's coverage is relatively high compared with that in other countries (Figure 1.23), except for Sweden, but is nevertheless too small to handle a major bank failure. The BGF may also borrow money if the fund at a certain stage is not large enough cover its obligations. In fact at the time of the 1988-93 banking crisis in Norway, deposit guarantees were unlimited; the current limit of NOK 2 million per customer per bank was enacted in 1996.


It is mandatory for all banks, including subsidiaries of foreign banks, to be a member of the BGF. In accordance with the EU/EEA regulations, it is also optional for branches of foreign banks to top up the deposit guarantee from their home country with a membership in the Norwegian scheme if the home country's guarantee is lower, which is the case in all other EU/EEA countries. The cost of joining the BGF has in recent years been low as no annual fees are levied on members when the Fund has a size equal the sum of 1.5% of aggregate guaranteed deposits plus 0.5% of the sum of the measurement bases for the capital adequacy requirements for member institutions. (8) When fees are levied, branches only pay the part of the fee related to the deposits.

The deposit guarantee scheme may have reduced the risk of bank runs, but the negligible cost of joining the Fund--because it was "full"--also allowed branches of banks with higher risk, such as the Icelandic Kaupting, to pay no fees, or only minimal fees, when it expanded its operation in Norway, making it less costly for such branches to conduct overly-aggressive lending and deposit-collecting policies. Kaupting paid nothing for topping up on the EUR 20 000 Iceland deposit guarantee covering its deposits, which were almost entirely used to finance lending outside Norway. It would make more sense for the fee structure to vary more as a function of the risk characteristics of banks' portfolio than they do now and for fees to be levied regardless of the size of the Guarantee Fund.

The interbank market needed support

Malfunctioning money markets abroad had serious implications for the Norwegian banking sector as it is heavily reliant on foreign funding, even to fund its lending in Norwegian krone (NOK). In this case, the foreign currency funding is swapped (9) to NOK. The main part of the Norwegian interbank market is based on swaps between NOK and foreign currencies (originally US dollars but now also euro) for agreed periods. The Norwegian interbank offer rate (NIBOR) is a swap rate. Hence the Norwegian interbank market froze for several days after Lehman Brothers' failure in September 2008. The spreads in the interbank market increased as in most other money markets worldwide (see Figure 1.4).


Both the impact of the financial crisis and also the structurally high interbank market spread itself call into question the efficiency of the swap-based interbank market, although equally high spreads can be seen in countries with money markets based on national currencies. Arguably, a pure NOK interbank market could be both more efficient and more sheltered from disturbances in the international financial markets. There is indeed an interbank market for deposits in NOK, but turnover is small and the indicative interest rate NIDR (Norwegian interbank deposit rate) is usually higher than the NIBOR rate. The NIDR based market was formalised in 1993, in the aftermath of the Norwegian banking crisis, with the aim of decreasing the dependency on foreign liquidity (see Langbraaten, 1998). The NIDR-market never overtook the swap-based NIBOR market, because the underlying funding cost was much lower in the swap market. Recently the spread between NIDR and NIBOR fell almost to zero, reflecting a reduced use of interbank borrowing as a result of the liquidity measures implemented by the authorities. (10)

Since the domestic market seems not to have worked in the past, it may make sense to continue to take advantage of the cheaper foreign currency alternative. Part of the reason why the swap market has dominated may be linked to the regime for payment of petroleum taxes. Corporate petroleum taxes are paid in NOK (while the government can take its petroleum property income, which is the same order of magnitude as tax payments, in foreign currency) so the oil companies buy large amounts of domestic currency around the time payment is due (Box 1.11). The petroleum tax payments (and other tax payments) cause fluctuations in banks' liquidity which Norges Bank tries to offset. The government has increased the frequency at which petroleum tax payments are due, reducing the magnitude of liquidity fluctuations (Figure 1.25), but it would seem more rational to keep that part of petroleum revenue which is not needed for the mainland budget in foreign currency, for example in the government's accounts with the central bank, where Norges Bank would invest surplus liquidity in money market instruments on behalf of the government, and sell such instruments and/or issue treasury securities when the government needs more liquidity. A system with a low and stable balance on the government's accounts with the central bank is operated in countries such as Sweden, United Kingdom and some of the euro area members (Williams, 2004), though countries which do not have to manage large government revenues from natural resources may be advantaged in this respect. In the immediate future, levying the petroleum tax in foreign currency would have little impact since the mainland budget is absorbing all of the petroleum tax revenue, but once the budget returns to the 4% path and the economy recovers, the amount involved is again likely to be significant.
Box 1.11. The oil tax payment system

Petroleum companies' earnings are in foreign currencies while their
tax liabilities are in NOK. Taxes are due for payment at certain
dates during the year and the amounts to be paid at each term are
based on estimates of the oil companies' earnings and production
that year. Before the payment dates, oil companies gradually sell
foreign currencies and purchase NOK forward with settlement at the
days when the oil tax payments are due. As banks are not able to
hedge all forward purchases of foreign exchange by selling foreign
exchange forward, they hedge a net forward asset position in
foreign currencies by increasing their net debt in foreign
currencies. Banks then acquire foreign exchange that Norges Bank
may buy spot to transfer to the Pension Fund. The oil companies'
forward selling of foreign currencies and Norges Bank's spot
purchase of foreign currencies does not necessarily take place at
the same time. The Bank's purchases are purely commercial and the
daily purchases are pre- announced on a monthly basis. Over time
almost all these transactions cancel each other out, except for the
part of the petroleum taxes that is used to finance the
government's non- off deficit. As oil revenues have increased in
the last years, oil companies' tax obligations have also went up
and so did their need to buy NOK forward.

This causes fluctuations in banks' liquidity situation, which
Norges Bank partly neutralises through fixed rates loans
(Fidjestol, 2007). It also increases banks' dependency on foreign
currency funding (see Figure 1.24), making them more vulnerable to
excessive exchange rate movements and consequent disruptive capital
movements. Since a relatively large fraction of this revenue has
been destined for the GPFG (this fraction fluctuates with the
domestic use of petroleum revenues and prices but has averaged 75%
since 2001, the equivalent of 15% of mainland GDP), which is held
in foreign currency, the corresponding foreign exchange
transactions have essentially been unnecessary, profitable only to
the banks carrying them out.

A partial response by the government was to increase the frequency
of oil tax payments, bi-monthly since August 2008 (previously being
twice a year). The new regime has dampened the fluctuations in
banks' liquidity but it has not eliminated them all together
(Figure 1.25) and done nothing about the underlying paradox of
having to deal with liquidity volatility problems created by a set
of unnecessary transactions. For the moment this seems to be of
only historical interest, since the overall budget surplus has
declined so much that most if not all of the petroleum tax revenue
will be required to finance the mainland budget over the next two
or three years. However if the mainland deficit returns to the 4%
path by 2013, as announced by the government, approximately 2.5% of
mainland trend GDP on average would be transferred to the GPFG over
the following ten years (this excludes offshore property income).
According to the tax law, however, Norwegian taxes have to be paid
in NOK and so this would need to change in order to levy taxes in
foreign currency in the future.

* Technically, the oil companies purchase NOK spot, but instead of
accumulating large NOK deposits, they swap the NOK against a
foreign currency, with the swap expiring on the day of tax payment.
The net effect is that they sell foreign currency forward for NOK,
but market technicalities make it more profitable for them to do it
via multiple transactions instead of one outright forward selling
of the foreign currencies.


Liquidity measures were effective in restoring financial stability

The main challenge for the financial sector during autumn 2008 was the funding situation. Even if ex post it can be seen that banks were sound, and that some may be too big to fail, the interbank market froze as elsewhere, though this may be partly because it is based in foreign currency and the transactions are effectively made abroad (see above). A number of measures were taken by Norges Bank to provide short-term and long-term funding to banks. The central bank supplied more and longer term F-loans (fixed interest loans with a specified maturity) in NOK and in US dollars, and it eased collateral requirements.

In addition to these measures under which the central bank took any collateral risk, the government introduced the covered bond swap arrangement (Box 1.12). By issuing Treasury bills in exchange for covered bonds issued by financial institutions, the government took on the limited risk of those bonds for the duration of the swap. The government phased out the scheme by December 2009.
Box 1.12. The covered bonds swap arrangement

The arrangement is supposed to extend over five years, but as the
Treasury bills have a maturity of less than one year, the banks
taking part in the swap arrangement have to constantly renew the
transaction. From the start of the arrangement (fall 2008) to the
summer 2009, the minimum interest rate in the auction was set below
the NIBOR rate and the auctions were always cleared at the minimum
rate, despite periods with high bid/cover ratios. During the autumn
2009, the minimum interest was raised with a view to gradually
phase out the scheme. The final auction was set to be held in
December 2009 but was cancelled because there were no bids.

The purpose of the swap arrangement was to supply banks with risk
free assets that can easily be sold or used as collateral to obtain
medium and longer term funding. In practice banks can use the
treasury bills as collateral when borrowing from Norges Bank
(although the covered bonds themselves are already eligible as
collateral for such borrowing), or sell the bills to other banks or
other domestic non-bank investors. The treasury bills can be also
be sold to foreign investors, or retain them as reserves, which
could improve their creditworthiness in the interbank market, and
in the domestic and international securities markets. Overall, the
swap arrangement can thus redistribute liquidity in NOK and in
foreign currency between banks but also temporarily strengthen
banks' capital position. In September 2009 30% of the emitted
Treasury Bills were held by domestic non-banks, 30% by foreign
investors and the remaining 40% was held by banks as reserve.

When the scheme was introduced, the covered bonds market was still
in its infancy and thus was barely functioning, but a few banks had
transferred loans to mortgage institutions and were about to issue
covered bonds. Hence, at the first swap auctions only very few
banks participated. As the pricing of the swaps was favorable, the
incentives for banks to exchange residential mortgages for covered
bonds were however significant, which induced more banks to
establish new mortgage companies, or reorganize existing ones, to
transfer mortgages in exchange for covered bonds. The number of
banks participating in swap auctions increased during the spring
2009. In all, NOK 230 bn (EUR 27 bn) of covered bonds/treasury
bills were swapped.

The swap against treasury bills simply ensured that the Finance
Ministry temporarily took the risk of default on the underlying
securities rather than the central bank, which normally does not
issue securities. The risk is small anyway, since at the end of the
swap arrangement, banks will have to buy back covered bonds at the
price initially paid to the government. A loss to the government
only occurs if the institutions issuing covered bonds fail for
bankruptcy before the expiration of the swap and if the debt in the
coverage pool is not paid and the collateral has depreciated. If
however no-one defaults, the government will make a profit.

Liquidity measures were generally effective, as the short-term and medium-term credit markets have progressively returned to normal, as shown by the significant reduction of the money market spread and long-term cost of funding. This is also shown by Norges Bank's liquidity survey, where banks reported that funding became less expensive and more accessible over the course of 2009.

In addition to liquidity measures, the government also took action to supply capital, through the State Finance Fund and the State Bond Fund. Announced in February, the Finance Fund provides Tier 1 capital, while the Bond Fund purchases industrial bonds. The aim of The Finance Fund is not to rescue banks, but to inject capital in banks the FSA assessed as sound but which had difficulties in obtaining capital because of the general turbulence of the markets, with the objective of boosting their lending capacity. Prices for the Finance Fund are set to be attractive (as compared to market rates} when markets are not functioning well and unattractive otherwise. Similarly, the Bond Fund is supposed to invest only in bonds that are attractive to the private sector. Each fund is worth NOK 50 billion (3% of mainland GDP). By the end of June 2009, only 10% of the Bond Fund was utilised. These small and medium sized banks represent about 15% of the banking sectors' total assets. As the conditions in the capital market improved during the first half 2009, some banks initially indicating interest in applying for Tier 1 capital from the Finance Fund instead chose to issue equity in the market, including the publicly-controlled DnBNOR. Overall these two schemes have reduced the uncertainty on the credit and capital markets, thus contributing to the relatively quick recovery of the financial sector.

Shared responsibility for financial stability and for macroprudential regulation

Financial stability supervision is the shared responsibility of three authorities (Box 1.13): the Ministry of Finance, which is responsible for overall financial stability and the regulatory framework; the Norges Bank, which is charged with monetary policy and produces a stability report twice a year; the Financial Supervisory Authority (FSA), which is responsible for supervision of individual institutions and market place. The three institutions meet regularly (usually twice or three times a year in normal times) and co-operate on a systematic basis.
Box 1.13. A three-pillar system for ensuring financial stabiliity

The FSA is an agency of the Ministry of Finance. It is responsible
for monitoring all segments of the financial market, including
insurance, the securities market, as well as estate agents and debt
collectors. The FSA's main responsibility is to follow up
individual institutions to ensure that they comply with all
relevant regulations. After the Norwegian banking crisis in
1988-93, the FSA also established a macro surveillance unit to
improve surveillance of system risks by combining macro indicators
with the FSA's knowledge about individual institutions. Each year
the FSA publishes a risk outlook report, with the aim of assessing
overall situation of individual institutions in the light of
economic and market developments. The report has also a special
focus on areas/institutions which are particularly at risk and
discusses regulatory issues. The FSA has an advisory role to the
Ministry of Finance on financial regulation.

As a lender of last resort and central bank, Norges Bank has the
role of "promoting financial stability and contributing to
efficient financial infrastructure and payment systems".* The main
responsibility for these tasks is given to the bank's Financial
Stability department, which publishes a Financial Stability report
twice a year. The first reports took a more macro oriented approach
than FSA's risk report, but models have recently been developed to
combine macro simulations with the Norges Bank SEBRA database,
containing accounting data for most Norwegian companies. Norges
Bank regularly publishes stress tests of the banking sector using
this and other datasets. The FSA also uses Norges Bank's SEBRA
database when conducting stress tests and analysing the credit
institutions risk exposure.

The Ministry of Finance is responsible for overall financial
stability and the regulatory framework. It also oversees Norges
Bank and FSA's supervisory activities, prepares legislation and
regulation (but can delegate the latter to FSA). Finally it ensures
tripartite co-ordination, regularly calling meetings between the
three pillars of the system.

* Listed as a core responsibility on Norges Bank's website.

The co-ordination of the three pillars worked well during the recent crisis (the three institutions met eight times), and the current organisation of supervisory activities seems complete and effective. In practice there was little intervention to prevent the crisis, perhaps justifiably since Norwegian financial institutions were generally sound and the main risks came from abroad. Both Norges Bank and the FSA repeatedly warned against increasing household indebtedness and relaxing of credit standards but no corrective action was taken. When implementation of Basle II rules was prepared in 2006, the FSA proposed, as part of a comprehensive set of secondary legislation, a lower maximum loanto-value rate (75 instead of 80%) for a mortgage to qualify for the lowest risk weight. (11) This part of the proposal was opposed by Norges Bank and the banking associations, since it would only apply to Norwegian banks using the standard approach to calculate capital adequacy. Thus, the Ministry of Finance decided not to implement it. Competition issues are quite central to the macroprudential discussion, and here the Ministry's concern was not to give an advantage to the many foreign banks operating in Norway, whose home regulators (largely in other Nordic countries) had not strengthened capital requirements, and to Norwegian banks using internal models to calculate capital adequacy.

In the future the three institutions responsible for macroprudential policy should continue to co-operate closely and to monitor systemic risks created by excessive credit growth, asset price increases or indebtedness. While tri-partite meetings usually bring agreement on the understanding of the situation and on the actions to take, conflicting views may arise in principle. In this case it would be helpful to have an explicit routine which rules out uncertainties with respect to the decisions to take.

Improving the supervisory architecture

The financial crisis has deeply questioned the solidity of financial regulation across the world. Solutions to strengthen the capacity of financial systems to react to systemic risks, and to act pre-emptively as to avoid a new global crisis, are being discussed in a number of international fora. Some key weaknesses of the financial systems worldwide are: banks' liquidity management; banks' capital position; pro-cyclicality of regulation of capital requirements; insufficient regulation of housing mortgages.

The surge of liquidity risk in the wake of the Lehman and Brothers collapse revealed that banks did not have a sound management of liquidity (this is less true in Norway though Norwegian banks too suffered from reduced and expensive access to short-term and long-term funding as discussed above). The Basle Committee on Banking Supervision is therefore now considering the introduction of minimum quantitative requirements for liquidity and funding stability. Since Norwegian bank assets are at the moment quite illiquid (being essentially loans), it would be quite challenging to adjust to these new requirements. However since Norwegian banks rely on deposits to a large extent, it would be easier for them to meet the funding stability requirements.

Against inadequate capital positions, two regulatory changes are being considered. One possibility is to strengthen the capital base through stricter Tier I eligibility requirements (e.g. fewer hybrid instruments) or through a minimum ratio of equity to total assets. The first solution may not be very demanding for Norway since its eligibility criteria for Tier I capital are already stricter than average. A minimum ratio of equity for assets will limit banks' leverage but also the return on equity. To the extent that returns have been particularly high for Norwegian financial institutions during the last decade, this solution too may be easier for Norwegian banks than those of other OECD countries. It should not be particularly challenging to meet higher capital requirements, but Norwegian banks need to increase their capital cushion so as to avoid further deleveraging in case of severe loan losses, as both Norges Bank and the FSA have argued. Banks which are highly exposed to shipping, commercial property and investment in the Baltics particularly need to strengthen their capital position.

One aspect of stricter capital requirements will be to decide whether banks of systemic importance have to be regulated more strictly than the others (as for instance recently decided in Switzerland). So far all Norwegian banks have been subject to the same regulation, but large banks are more leveraged than others. This is the result of lower borrowing costs amid higher credit ratings, which reflects the implicit "insurance" from being too big to fail. On the other hand, large banks have more diversified portfolios, which may warrant lower capital. All in all, however systemic risk considerations should imply higher capital adequacy ratios for large banks (Norges Bank's Financial Stability Report, 2009). Thus stricter capital requirements should be imposed on DnBNOR.

Another innovation which the Basle committee is considering is to reduce the procyclical nature of capital requirements. Under a reformed regulation banks should accumulate capital buffers beyond the minimum capital requirements in order to absorb the shocks in critical times and avoid credit crunch. One possibility is following the Spanish example, where banks use dynamic loss provisions.

Finally an area where Norway should usefully strengthen its regulation is residential mortgages. At the moment, very little equity is required to cover residential mortgage loans, as banks use internal model-based risk weights as low as 9% and generally no higher than 17%. Such lending has indeed been extremely low-risk in the past, but with recent rapid growth in mortgage lending and a change in its nature as it is increasingly used for equity extraction, it would be appropriate to reconsider the risk-weightings on mortgage loans. The FSA notes that the standardised (not internal model-based) Basle II approach requires a weight of 35%. Another option, imposing maximum loan-to-value ratios, would enhance the security of the collateral while also protecting low-income borrowers from excessive risk. Imposing limits on loan-to-value ratios through financial regulations might face the difficulty of foreign bank branches not being covered; this could perhaps be dealt with either through agreements with the foreign supervisory authorities or specific legislation, which could be based on consumer protection.

These regulatory changes need to be co-ordinated internationally. The Norwegian authorities support the work done so far at G20 level, in the EU and BIS on new regulations, and actively participate in ongoing initiatives. For a small open economy like Norway there could be a trade-off between implementing special restrictions on national credit institutions, that could improve the resilience of the financial system to future crises, but at the same time impair competition with respect to banks operating in the rest of Europe. Close co-operation with Nordic countries would be critical in this respect.
Box 1.14. Summary of macroeconomic policies recommendations

Fiscal policy

* In order to avoid the re-emergence of inflationary pressures and
thus lighten the burden for monetary policy, but also with the
objective of reinforcing the credibility of the fiscal framework,
fiscal tightening needs to be started soon, provided the economy
recovers as projected and paying due attention to the still
important downside risks. The structural non-oil deficit could be
reduced to meet the 4% path by 2013 or even earlier, e.g. through a
reduction of 1% per year.

* A fiscal consolidation package should include a reversal of the
remaining anti-crisis measures, many of which have been terminated
but some converted into new spending. In addition, transfer schemes
such as sick leave and disability should be reformed and spending
cuts may be envisaged in those areas of public spending where there
is evidence that resources are used inefficiently. The already high
level of taxation should not be increased.

* To reinforce the credibility of the fiscal guidelines, the
authorities should take the opportunity to undershoot the 4% target
after 2013 if the economy grows above trend. Credibility would also
be strengthened by developing a multi-annual approach to budgetary
planning, which would specify the fiscal measures envisaged by the
government in the coming years; this would prove especially useful
in the context of the need for a period of fiscal consolidation.

* Norway could also follow the example of some OECD countries and
create a fiscal council, which would periodically evaluate
budgetary developments, including the implementation of the fiscal
guidelines, thus providing further transparency and enhanced

Monetary policy

* Monetary policy tightening should continue progressively but
firmly as to keep inflation expectations well anchored. The pace of
tightening ought to be conditional on the speed of fiscal
consolidation as to reduce the risk of excessively sharp
exchange-rate appreciation.

* To ensure credibility and effectiveness of monetary policy, the
central bank should communicate policy interest decisions within a
transparent framework which is consistent from one report to the

* While continuing to improve its inflation forecasting procedures,
the central bank should be explicit about the way it takes asset
prices, including the exchange rate and house prices, into account
in its reaction function. It may wish to act for systemic or
precautionary reasons, even though asset prices are not a target in
themselves. Important macroeconomic variables that the central bank
should monitor include credit growth, household savings, and the
current account and property markets.

Macroprudential policy

* The three institutions responsible for macroprudential policy,
the Ministry of Finance, Norges Bank and the Financial Supervisory
Authority, should continue to co-operate closely and to monitor
systemic risks created by excessive credit growth, asset price
increases or indebtedness.

* Norway should strengthen further the macro-prudential framework
in line with the decisions adopted at the European and worldwide
levels. In addition to the reform of the European and International
financial supervisory system, these initiatives are likely to
include a set of automatic stabilisers, such as counter-cyclical
capital requirements and dynamic provisioning for banks as their
leverage grows.

* In addition, Norway should examine areas where it would be
feasible to adopt its own reforms, if doing so would address
possible areas of weakness. For example, risks linked to high
household indebtedness could be reduced by introducing a limit on
loan-to-value ratios, which would also give mortgage borrowers
additional protection against overly-aggressive lending practices.
The supervisor should continue to encourage banks to build
additional capital cushions against future risks, such as
potentially bad loans for commercial property and shipping, and in
the Baltic States. Finally fees for the Deposit Guarantee Fund
could vary more as a function of banks' risk exposure than they do
now and should be levied regardless of the size of the Guarantee


Is there a housing market bubble?

There is a large literature on housing prices determinants (for summaries see Girouard et al. (2006) and Muellbauer and Murphy (2008)). Drivers of house prices include income, the housing stock, demography, credit availability, interest rates, expectations on the fundamentals of the economy and expected price increases themselves (so-called "bubble-builder"). Demand would depend positively on disposable income and negatively on ownership costs (given by the real cost associated with a housing loan minus the opportunity cost of investing in housing rather than in another asset). Supply of housing is fixed in the short term, while on a longer term it is affected by regulatory and land policies, building costs and expectation of house prices. Either implicitly in ownership costs or separately, expectations about future real house prices can be a key driver. Because current and past house price increases are likely to influence expectations, deviations of house prices from their underlying fundamentals can be self-perpetuating or amplified. This phenomenon, known as bubble-builder (Abraham and Hendershott, 1996) arises when for instance one or more positive shocks to the fundamentals (e.g. a change in the monetary stance, or change in the credit policy of banks) causes a--rational--rise in house prices, but since no-one knows the appropriate "fundamental" level of prices, expectations of further appreciation can lead to overshooting; this can often be seen clearly only when the phenomenon goes into reverse, as in the US sub-prime episode.

Since the fundamentals are hard to observe, proxies such as the ratio of house prices to income or to rents can be used to check. Over the last six years, growth in Norwegian real house prices was one of the strongest in the OECD, with an average annual increase of 5.4%, compared with 1.5% for the OECD area. Nominal house prices have almost doubled in the last ten years, growing as twice as much as average nominal prices in the OECD area. A good part of this spectacular increase is certainly due to the strong fundamentals of the Norwegian economy--the price-income ratio is quite low by OECD standards, and fell during the boom (see Figure 1.13), as average wage growth was over 6% from 2006-08. More recently, however, the price-income ratio has started increasing again, due to the rebound in prices and the rise of unemployment. The price-rent ratio does not seem particularly high either, though the rent index is not always a reliable measure when rental markets are strongly regulated and not very competitive. Jacobsen (2006) argues that this is particularly true in the case of the Norwegian rental market.

Some econometric evidence suggests that the Norwegian housing market is not significantly overvalued. Figure 1.A1.1 illustrates contributions to house price inflation using an error correction equilibrium model estimated by Norges Bank. The model (based on Jacobsen and Bjorn, 2005) comprises disposable income, the housing stock, a lending rate, unemployment and an expectation variable calculated as the residual of a model of consumer confidence about the Norwegian economy with the interest rate as the explanatory variable. House prices started to adjust downwards from mid-2007, and fell sizeably through 2008. The model cannot explain the downturn unless one accounts for the tightening of credit standards during the financial crisis. As Figure 1.A1.1 shows, the explanatory contribution from the expectation variable has been fairly moderate, and by including a variable for credit standards, the analysis suggests that house prices have largely been following "fundamentals". Research by Miles and Pillonca (2008), also shows find that a substantial share of changes in house prices in Norway is explained by fundamentals (especially by real incomes, followed by interest rates and demographics).


A slightly different conclusion would follow from the analysis of the short-term deviation of price-to-rent ratio from its long-term value. Following Girouard et al. (2006), the equilibrium value of price-to-rent ratio should correspond to the (inverse of the) user cost of housing. The latter can theoretically be derived from the after-tax nominal mortgage interest rate, property taxes, depreciation, the risk premium on residential property and expected capital gains. From this perspective, the Norwegian housing market may have been over valued after 2005 (Figure 1.A1.2). Towards the end of 2008, the actual and the long-term price-to-rent ratios have started to converging again, reflecting both a drop of house prices and the strong reduction of interest rates. Compared with OECD countries which have gone through housing market bubbles, the deviation does not look dramatic for Norway, and the data on both rents and user cost are far from perfect (see Girouard et al., 2006, and Ortalo-Magne and Rady, 2005, for other sources of inaccuracy). Authorities should however continue to monitor them together with other indices of sustainability of house prices.


Three additional factors, which are not accounted by any of the above models, certainly played a role in explaining the extraordinary performance of Norwegian housing market. The first is immigration, which has been very strong in recent years and must have added to the demand for housing. The second factor is financial innovation and the mortgage policies of banks. Girouard et al. (2006) argue that financial deregulation in the mortgage markets has strongly eased borrowing constraints on households. Many countries have introduced interest-only loans and flexible payment mortgages (USA, Norway, United Kingdom, Australia, Denmark and Netherlands); other have lengthening mortgages terms (Norway, Iceland and France). As observed above, the Norwegian banking sector has proved to be very innovative and has responded quickly to the increased opportunity offered by the run-up of house prices. The third factor is housing taxation.

Housing taxation is low in Norway, as compared to the OECD area (Figure 1.A1.3). Property taxes on households are set and levied by municipalities within the range of 2 and 7 per mille, with an average tax rate of 5.9 per mille in 2008 (but is zero in around one third of them). In principle the tax-assessed value of the property should reflect the market value, but municipalities are free to use simplified formula and even give "discounts" on standard rates. Furthermore, while the wealth tax applies to housing as well as to financial wealth, houses are valued well below their market price and in addition the rate applied to housing wealth is much lower than that for financial wealth (see Figure 2.8). The valuation gap is illustrated by the fact that the government has just proposed to set the value for tax purposes at 25% of the estimated sale price, which is above most tax-purpose valuations so that a "safety valve" system will be continued, so that taxpayers can appeal and have the tax-assessed value reduced to 30% of the documented "fair market value". In addition, while there is full tax deductibility for interest payments, the tax on imputed rent was abolished in 2005, implying extremely low after-tax interest rates. Finally, tax rules for second homes are the same as for owner-occupied. That may explain why the demand for second or even third homes among Norwegian households has increased enormously, certainly contributing to the rise in house prices.


Van der Noord (2003) shows that tax incentives for housing can exacerbate volatility in house prices. A tax system with generous incentives for house ownership not only results in a higher steady-state of house prices but also in higher volatility due to a combination of price-inelastic supply of newly built dwellings and preferential tax-treatment for owner-occupied housing (Poterba, 1984 and 1991).


Taking stock of structural reforms

This table reviews recent action taken on recommendations from previous Surveys. Recommendations that are new in this Survey are listed in the relevant chapter.
Recommendations                     Action taken since the previous
                                    Survey(August 2008)


Minimise work disincentives in      As an anti-crisis measure,
the unemployment insurance system   maximum unemployment benefit
                                    period for temporary laid-off
                                    workers was increased to 52 weeks
                                    from 1 February 2009. To be re-
                                    evaluated in the Revised Budget
                                    for 2010.
Reduce sick leave                   No action.
Tighten disability schemes          No action. A report, due in 2009,
                                    suggesting legislative action is
                                    now expected in 2010.

B. LABOUR                           MARKETS

Increase flexibility in wage        Backwards action: The use of a
setting                             mandatory extension of wage
                                    contracts with the object of
                                    combating social dumping is
                                    introduced in the maritime
                                    construction industry, effective
                                    date 1 December 2008. Joint and
                                    several liability related to
                                    minimum wages is introduced in
                                    sectors with mandatory extended
                                    wage contracts, effective date 1
                                    January 2010.
Modernise employment protection     No action.
Enhance efficiency of job           No action. The July 2006 merger
placement services and ALMP         of the Public Employment Services
                                    and the National Insurance
                                    Services expected to be complete
                                    in 2010.


Reduce the number of schools;       No action to encourage reduction
improve accountability by           in school numbers, though some
publishing value-added assessment   small schools are closing.
of school performance on            Municipalities are required to
standardised national tests of      make reports on their performance
pupils.                             according to national indicators.
Introduce stricter selection and
graduation criteria for initial     The required level of upper
teacher training; encourage         secondary school attainment for
formal training for developing      candidates for teacher training
competencies of practising          has been increased.
Develop more structured career
paths with recognition for          No action.
demonstrated competencies.
Include school performance as a     No national action. Oslo
determinant of school principals'   education authorities have
rewards; consider school level      operated along these lines for
merit-based salary awards to        several years.


Ensure competition in the banking   After informal investigation the
sector                              Competition Authority in February
                                    2009 opened formal cases against
                                    Visa and Mastercard concerning
                                    debit and credits cards. The
                                    cases are pending before the
                                    Authority. To increase the
                                    competitiveness of savings banks
                                    compared with commercial banks,
                                    the government has proposed new
                                    regulations to allow savings
                                    banks to compete more effectively
                                    for equity and to allow easier
                                    structural changes-including
                                    mergers; regulations entered into
                                    force in July 2009
                                    See also Chapter 1.


Raise the efficiency of public      A White Paper (2009) on public
spending                            sector efficiency recognises the
                                    need to improve, but no action
                                    taken yet.
Tackle ageing issues                The reform of the private social
                                    security pension scheme is
                                    largely in place, transition to
                                    the notional defined contribution
                                    scheme begins in 2010, with
                                    specific transitional measures
                                    for some age groups. Reform of
                                    the arrangements for public
                                    sector workers stalled in 2009. A
                                    bias towards early" (as from age
                                    62) retirement remains, although
                                    a longevity adjustment and a
                                    revised post-retirement
                                    indexation system have been
                                    The means testing of pensions
                                    against income is abolished for
                                    pensioners aged 68 from 1 January
                                    2009, and for those aged 69 as
                                    from 1 January 2010.
Reform the tax system               The 2009 and 2010 budgets made
                                    several changes to the net wealth
                                    tax. The basic allowance was
                                    increased substantially. The
                                    reduction in the rate applied
                                    shares was removed. The effective
                                    valuation of commercial property
                                    for tax purposes was increased in
                                    As from 2010, the effective
                                    taxation of residential property
                                    is also to be increased, though
                                    the tax base for primary
                                    residences will increase only to
                                    25% of its estimated market
                                    value. See also Chapter 1 of this
                                    The 2009 budget reduced
                                    inheritance tax rates, increased
                                    allowances and widened the
                                    inheritance tax base.
                                    The C[O.sub.2] tax will be
                                    extended to gas for home heating
                                    in 2010 The biofuel exemption to
                                    the diesel tax is to be phased
                                    out. Incentives for buying cars
                                    with low C[O.sub.2]-emissions
                                    have been strengthened.


Limit C[O.sub.2] emissions          See above, and Chapter 2.
Develop renewable energy            Increased resources have been
resources                           allocated to the Energy Fund,
                                    whose aim is to strengthen
                                    efforts in renewable electricity
                                    production, use of renewable
                                    energy and increased energy


Enhance competition in the          Target prices removed in the beef
agriculture market                  sector from 1 July 2009 due to
                                    "amber box" constraints in the
Reduce tariffs and increase         Subsidies to agriculture have
import quotas in the agriculture    been increasing
Reduce restrictions on transfers    No further action. See Chapter 2.
of fishing quotas


Increase regulatory power of        Backward action: The procedure
competition authorities             for political decisions of
                                    overturning rulings in merger
                                    cases that involves questions of
                                    principle or major significance
                                    to society has been simplified.
                                    The government can now reverse an
                                    NCA decision before the appeal
                                    procedure in the Ministry of
                                    Government Administration and
                                    Reform has been finished. The
                                    amendment might weaken the
                                    opportunity and right to have an
                                    appeal scrutinized on the grounds
                                    of competition.
                                    Cases taken up by the NCA have
                                    notably concerned transparency in
                                    electricity supply, competition
                                    in transport and food
Increase competition and reduce     From 1 January 2010 all
barriers to entry                   advertisers get legal access to
                                    Internet real estate
                                    advertisement services. The
                                    providers have formerly
                                    restricted access to licensed
                                    real estate brokers.
Reduce state aid, public            Budgetary support for industry
subsidies and tax distortions       has increased slightly. The
                                    increase concerns support to
                                    industrial R&D, renewable and
                                    clean energy, agriculture, and a
                                    refund scheme for paid taxes for
                                    Norwegian employees in shipping
                                    companies. Further increase of
                                    refunds abated through cap per
                                    employee established from July
                                    Backward action: Fishermen's tax
                                    allowances (tax exemption, not
                                    included in budgetary support)
                                    increased in 2008 and further in
Reduce state ownership in           Petrochemicals subsidiary of
corporate Norway                    Norsk Hydro (43.8% state-owned)
                                    sold to UK petrochemicals company
                                    Ineos. Remaining 50% state
                                    interest in a fibre-optic network
                                    company sold.
                                    Backward actions: The government
                                    purchased shares after merger of
                                    Norsk Hydro petroleum activities
                                    and Statoil, increasing stake
                                    from 62.5 to 67%. The government
                                    took a 30% share, with veto
                                    rights, in Aker Holding AS (the
                                    holding company that controls 40%
                                    of Aker Kvaerner, a supplier of
                                    products and services to the
                                    energy sector). New or reverted
                                    hydro power plants will only be
                                    granted state or municipal
                                    companies (requiring 2/3 state or
                                    municipal ownership, but leasing
                                    to private interests allowed)
Improve state-owned activities      No action
Improve monitoring of cost-         No further action on monitoring.
effectiveness of support for        The ceiling on R&D expenditures
innovation and R&D                  per company eligible for the tax
                                    credit was raised in 2009.


Promote competition in the postal   No action.
Reduce barriers to entry in the     Backward actions: an exemption to
retail sector                       the Competition Act, allowing
                                    booksellers to set fixed prices
                                    for higher educational books, has
                                    been extended (again) to the end
                                    of 2010.
                                    Restrictions on establishing
                                    shopping centres outside urban
                                    areas were tightened-with the
                                    intention of limiting the adverse
                                    environmental impact of shopping.
Enhance efficiency in transport     No action.


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(1.) Deviations from the target could result from inflation forecasting errors (Nymoen, 2009) or from having paid insufficient attention to the nature of shocks. When the nature of the shock is not well taken into account, interest rates decisions may be procyclical and rise/fall too little and too late. This is because there is no conflict between the objective of stabilising output and inflation in case of demand shocks, implying that demand shocks should be counteracted as aggressively as possible, but there is a strong trade-off in case of supply shocks, entailing various optimal policy horizons as a function of inflationary persistence. Another plausible explanation for missing the inflation target is that monetary policy appears to have at times been reactive, rather than preventive. This happened in 2003, for instance, when the interest rate was cut after inflation had already started to fall, or in early 2006 when inflation started picking up but interest rate was only raised very softly.

(2.) Glitnir operated through a subsidiary in Norway, which received assistance from the deposit guarantee scheme and then was sold. Kaupthing operated through a branch, which was taken under administration in Norway following the closure of the branch while Kaupthing in Iceland remained open. Kaupthing was a topping up member of the Norwegian deposit guarantee scheme. The Norwegian government issued a guarantee for the deposits to be covered by the Icelandic guarantee scheme. This guarantee became effective, and was paid out together with the payout from the Norwegian deposit guarantee scheme. Both guarantees were covered by assets seized under the special administration regime.

(3.) The main provisions included a suspension of the requirements on credit rating and listing on the stock exchange for bonds issued by private Norwegian enterprises. Covered bonds were made eligible as collateral for loans. Units in Norwegian money markets fund are eligible as collateral.

(4.) See speech by the Governor in October 2009:

(5.) Write-downs and loan losses reduced banks' earnings in 2008, but these remained positive. Earnings went up again as from the start of 2009, partly because of reduced loan losses and partly because of higher earnings before losses and write-downs. Loan losses in the second quarter of 2009 were only 1/3 of the losses in the last quarter of 2008 and the banks net result on securities and foreign exchange market activities progressively improved over 2009. There was also a small increase in the interest margin paid by customers, as lending rates rose significantly while deposit rates fell. However, total net interest earned fell in 2009 because of higher funding costs of sources other than customer deposits.

(6.) The Financial Stability Report indicates that until mid 2009 losses on loans to the shipping sector were only 0.02% of the lending to that industry, as compared with average (i.e. across all the industry) value of 0.27%.

(7.) In the United Kingdom, there is a small residual fund, inherited from a period when the deposit guarantee system was not a so called ex post system as it is today.

(8.) Because new members increased the Fund's obligations and the Fund's capital losses in 2008, ordinary membership fee was again levied in 2009, after 1/3 of normal fees in 2008. There were no fee payments to BGF in 2005-07.

(9.) A bank may obtain NOK liquidity by borrowing foreign currency and exchange it to NOK. The debt in the foreign currency is at the same time hedged as the bank buys the foreign currency back again forward. NIBOR, the Norwegian interbank offer rate, is a function of rate on the foreign debt plus the difference between the forward and spot exchange rate. The forward contracts are off balance sheet commitments.

(10.) Limits on what banks may have of exposure to each other also are an obstacle for the development of an interbank deposit market in the small Norwegian financial market. By using swaps, larger amounts in NOK may be lent from one bank to another because the bank lending NOK receives US dollar (or euro) back as collateral until the swap expires. This reduces the counterparty exposure compared to when banks provide unsecured lending or deposits in NOK.

(11.) The standard model under the Basle II system for allocating risk weight to residential property for capital requirement purposes is as follows: the low 35% risk weight for residential mortgages is only obtained when the mortgage is within 80% of the reasonable value of the property. If the mortgage exceeds 80% of the reasonable value of the property, the risk weight of the mortgage is, for capital purposes, increased to 100%.
Table 1.1. Sources of real income differences

                                         2000   2001   2002   2003

Norway, mainland   Real output growth     2.9    2.0    1.4    1.3
                   Productivity growth    2.6    1.6    2.4    0.8
                   Employment growth      0.6    0.3    0.4   -1.0
Norway, overall    Real output growth     3.3    2.0    1.5    1.0
                   Productivity growth    2.7    1.6    1.1    2.1
                   Employment growth      0.6    0.3    0.4   -1.0
DECD               Real output growth     4.3    1.3    1.7    2.0
                   Productivity growth    2.6    0.7    1.8    1.7
                   Employment growth      1.7    0.5   -0.1    0.2
Sweden             Real output growth     4.5    1.2    2.4    2.0
                   Productivity growth    2.0   -0.9    2.4    2.6
                   Employment growth      2.5    2.1    0.0   -0.6
Denmark            Real output growth     3.5    0.7    0.5    0.4
                   Productivity growth    3.0   -0.2    0.4    1.5
                   Employment growth      0.5    0.9    0.0   -1.1

                                         2004   2005   2006   2007

Norway, mainland   Real output growth     4.4    4.4    4.6    5.6
                   Productivity growth    3.2    0.7    0.6    2.5
                   Employment growth      0.5    1.2    3.6    4.1
Norway, overall    Real output growth     3.9    2.5    2.1    2.7
                   Productivity growth    3.4    1.3   -1.5   -1.3
                   Employment growth      0.5    1.2    3.6    4.1
DECD               Real output growth     3.2    2.7    3.1    2.7
                   Productivity growth    2.1    1.4    1.5    1.4
                   Employment growth      1.1    1.3    1.6    1.3
Sweden             Real output growth     3.5    3.3    4.5    2.7
                   Productivity growth    4.2    3.0    2.8    0.5
                   Employment growth     -0.7    0.3    1.7    2.2
Denmark            Real output growth     2.3    2.4    2.4    3.3
                   Productivity growth    2.9    1.4    0.5    0.7
                   Employment growth     -0.6    1.0    2.0    2.7

                                         2008   2009

Norway, mainland   Real output growth     2.2   -1.2
                   Productivity growth    3.0   -1.2
                   Employment growth      3.1   -0.8
Norway, overall    Real output growth     0.0   -1.3
                   Productivity growth   -3.1   -0.6
                   Employment growth      3.1   -0.8
DECD               Real output growth     0.6   -3.5
                   Productivity growth    0.1   -1.2
                   Employment growth      0.4   -2.3
Sweden             Real output growth    -0.4   -4.7
                   Productivity growth   -1.3   -2.3
                   Employment growth      0.9   -2.4
Denmark            Real output growth     1.6   -1.2
                   Productivity growth    0.8    1.7
                   Employment growth      0.9   -2.9

Source: OECD Economic Outlook Database, based on national
accounts definitions (employment expressed as number of employed

Table 1.2. Norway: Demand, output and prices

                                    Current prices
                                     NOK billion

Private consumption                         881.8
Government consumption                      413.0
Gross fixed capital formation               424.2
Final domestic demand                     1 718.9
Stockbuilding (1)                            51.0
Total domestic demand                     1 769.9
Exports of goods and services             1 002.5
Imports of goods and services               612.8
Net exports (1)                             389.7
GDP at market prices                      2 159.6
GDP deflator                                   --
Memorandum items
Mainland GDP at market prices (2)              --
Consumer price index                           --
Private consumption deflator                   --
Unemployment rate                              --
Household saving ratio (3)                     --
General government financial                   --
  balance (4)
Current account balance (4)                    --

                                    2007   2008   2009    2010   2011

                                    Percentage changes, volume (2007

Private consumption                  5.4    1.3      .0    4.4     4.5
Government consumption               3.0    4.1     5.9    3.2     2.3
Gross fixed capital formation       12.5    1.4    -3.9     .4     5.3
Final domestic demand                6.6    1.9      .4    3.1     4.1
Stockbuilding (1)                   -1.1     .5    -1.6     .0      .0
Total domestic demand                5.0    2.5    -1.7    3.0     4.2
Exports of goods and services        2.3     .9    -7.8    -.4     2.6
Imports of goods and services        8.6    2.2   -11.5    4.3     5.4
Net exports (1)                     -1.4    -.3     -.5   -1.3     -.3
GDP at market prices                 2.7    1.8    -1.4    1.3     3.2
GDP deflator                         2.4   10.0    -3.3    3.7     2.9
Memorandum items
Mainland GDP at market prices (2)    5.6    2.2    -1.2    2.8     3.2
Consumer price index                  .7    3.8     2.3    1.6     2.2
Private consumption deflator         1.2    3.7     2.9    1.7     2.2
Unemployment rate                    2.5    2.6     3.3    3.7     3.5
Household saving ratio (3)           1.5    3.3     3.3    2.0     2.0
General government financial        17.7   18.8     9.6    9.9    10.8
  balance (4)
Current account balance (4)         14.0   18.3    17.4   18.6    18.1

Note: National accounts are based on official chain-linked data.
This introduces a discrepancy in the identity between real demand
components and GDP. For further details see OECD Economic Outlook
Sources and Methods (www.oecd.ory/eco/sources-and-methods).

(1.) Contributions to changes in real GDP (percentage of real GDP
in previous year), actual amount in the first column.

(2.) GDP excluding oil and shipping.

(3.) As a percentage of disposable income.

(4.) As a percentage of GDP

Source: OECD Economic Outlook 86 Database integrating national
accounts revisions as of November 2009.

Table 1.3. Norwegian households are highly indebted

                   Non-        Gross        Net       Total debt
                 financial   financial   financial    from MFIs
                  assets      assets      wealth

                                  Percentage of GDP

Belgium               n.a.       248.8        199.8         44.3
Germany              216.5       188.4        124.5         58.7
Ireland               n.a.       163.6         60.1         90.5
Greece                n.a.       139.4         85.8         43.6
Spain                580.3       182.1         93.2         82.7
France               350.1       188.8        126.3         47.4
Italy                362.9       240.9        192.8         34.7
Luxembourg            n.a.        n.a.         n.a.         77.7
Netherlands          252.8       256.6        145.6         97.7
Norway (1)             234       245.1        136.3          109
Austria               n.a.       167.8        114.4         45.6
Portugal             215.2       220.6        120.5         85.9
Finland               n.a.       119.9         65.9         48.2
Euro area             n.a.       200.5        133.0         57.1
Australia            340.8       215.5        109.1        102.1
USA                  164.7       323.6        221.0        101.7
United Kingdom       351.3       295.9        180.7        108.7

                  Housing     Growth rate
                    debt       of loans       Nominal
                 from MFIs     for house    house price      Owner
                               purchase     growth rate,   occupancy
                 Percentage    1999-2007     1999-2007     rate (%)
                   of GDP         (%)           (%)

Belgium                35.8          11.5            9.5        71.3
Germany                  40             3           -0.4        43.0
Ireland                73.9          23.4           11.1        74.7
Greece                 30.3          30.3            9.1        79.6
Spain                  61.5          19.8           11.9        86.3
France                   35          10.1           10.3        57.2
Italy                  21.8          20.3            6.3        69.1
Luxembourg             40.7          14.1           10.5        74.7
Netherlands            89.4          13.4            8.1        56.6
Norway (1)               77            10           10.3          81
Austria                24.9          13.2            1.2        58.0
Portugal               69.4          14.9            3.3        74.5
Finland                34.6          14.0            5.7        65.1
Euro area              41.5          10.4            6.1        62.3
Australia              77.0          n.a.           n.a.        69.3
USA                    76.1          n.a.           n.a.        59.0
United Kingdom         81.9          n.a.           n.a.        69.8

                                            Per capita
                 Growth in   Residential     mortgage
                 mortgage    debt to GDP      debt,
                   debt         ratio      in thousands
                                             of euros

Belgium                6.8          36.8           11.5
Germany               -2.4          47.7           14.1
Ireland               13.4          75.3           32.2
Greece                21.4          30.2            6.2
Spain                 13.1          61.6           14.5
France                12.7          34.9           10.2
Italy                 10.2          19.8            5.1
Luxembourg            22.1          38.5           29.0
Netherlands            1.9         100.0           34.1
Norway (1)             8.2          53.3           32.5
Austria                7.1          23.9            7.8
Portugal              10.0          62.1            9.5
Finland               12.4          34.3           11.7
Euro area             n.a.          n.a.           n.a.
Australia             n.a.          n.a.           n.a.
USA                   n.a.          n.a.           n.a.
United Kingdom         8.9          86.3           28.8

                  Leverage 1
                    (gross        Leverage 2
                 financial and   (liabilities/   Liabilities
                 non-financial     financial      as a % of
                  assets/ Net       assets       disposable
                   financial     + dwellings)      income

Belgium                   n.a.             0.1          87.7
Germany                    3.3             0.2         102.0
Ireland                   n.a.            n.a.          n.a.
Greece                    n.a.            n.a.          n.a.
Spain                      8.1            n.a.         148.7
France                     4.1             0.2          99.1
Italy                      3.1             0.1          62.8
Luxembourg                n.a.            n.a.          n.a.
Netherlands                3.1             0.3         250.0
Norway (1)                 3.5             0.5         213.2
Austria                   n.a.            n.a.          89.4
Portugal                   3.3            n.a.         161.5
Finland                   n.a.             0.3         113.4
Euro area                 n.a.            n.a.          n.a.
Australia                  5.1             0.3         194.0
USA                        2.2            n.a.          n.a.
United Kingdom             3.6            n.a.          n.a.

                 as a % of

Belgium                 3.3
Germany                 0.0
Ireland                 7.8
Greece                 n.a.
Spain                   4.3
France                  3.1
Italy                   2.5
Luxembourg             n.a.
Netherlands             0.0
Norway (1)             10.6
Austria                 3.0
Portugal                4.2
Finland                 4.3
Euro area              n.a.
Australia               2.1
USA                     2.5
United Kingdom          8.9

1. Mainland GDP

Source: OECD, EIB, EMA, NCBs and Eurostat.

Table 1.4. Many of the anti-crisis measures have been extended
or made permanent

Type of measure                        Of which:      in 2010

Employment or qualification measures    1 278           1 263
Infrastructure and maintenance          11 094            719
Grants                                  2 191           1 234
R&D spending                            2 288             793
Other                                     32               14
Total                                   16882           4 023
                                         (1%)          (0.2%)

                                       Not extended      Replaced
Type of measure                          in 2010      by new measure
                                                         in 2010

Employment or qualification measures         15               0

Infrastructure and maintenance            6 429           3 946

Grants                                      957               0

R&D spending                                160           1 335

Other                                        13               5

Total                                     7 574           5 286
                                         (0.4%)          (0.3%)

Note: Figures in the table are expressed in NOK (million),
figures in brackets refer to % of 2009 mainland GDP.

Source: OECD calculations on Ministry of Finance data.

Table 1.5. Banks' assets and liabilities at the end of 2007

                                    Norway             Germany
Assets                          M NOK      %       M EUR      %

Cash and balance with the        60 289   0.02      79 894   0.01
  central bank
Interbank deposits              239 114   0.08   1 482 507   0.22
Loans                         2 394 404   0.77   3 093 261   0.47
Securities                      252 610   0.08   1 712 413   0.26
Other assets                    172 408   0.06     240 426   0.04
Total                         3 118 825          6 608 501

                                    Norway             Germany
Liabilities                     M NOK      %       M EUR      %

Capital and reserves            160 669   0.05     272 820   0.04
Borrowing from central bank      75 394   0.02     223 193   0.03
Interbank deposits              507 369   0.16   1 731 508   0.26
Customer desposits            1 423 506   0.46   2 967 629   0.45
Bonds                           532 017   0.17   1 012 048   0.15
Other liabilities               419 870   0.13     401 303   0.06
Total                         3 118 825          6 608 501

                                    Sweden             Spain
Assets                          M SEK      %       M EUR      %

Cash and balance with the        28 143   0.00       60458   0.02
  central bank
Interbank deposits            1 599 052   0.27      371034   0.13
Loans                         2 654 958   0.44     1785763   0.63
Securities                    1 224 912   0.20      440327   0.16
Other assets                    519 194   0.09      179249   0.06
Total                         6 026 259            2836831

                                    Sweden             Spain
Liabilities                     M SEK      %       M EUR      %

Capital and reserves            334 320   0.06      199177   0.07
Borrowing from central bank       7 223   0.00       73433   0.03
Interbank deposits            1 551 554   0.26      520314   0.18
Customer desposits            2 009 380   0.33     1452939   0.51
Bonds                         1 285 013   0.21      395917   0.14
Other liabilities               838 768   0.14      195051   0.07
Total                         6 026 258            2836831

Assets                          M EUR      %

Cash and balance with the        15 762   0.01
  central bank
Interbank deposits              190 062   0.14
Loans                           655 811   0.49
Securities                      211 919   0.16
Other assets                    273 285   0.20
Total                          1346 839

Liabilities                     M EUR      %

Capital and reserves             56 583   0.04
Borrowing from central bank           0   0.00
Interbank deposits              307 575   0.23
Customer desposits              352 406   0.26
Bonds                           340 620   0.25
Other liabilities               289 655   0.22
Total                          1346 839

Source: OECD, Bank Profitability.

Table 1.6. Supervisory limits on inclusion of hybrid instruments
as Tier 1 capital


Hybrids with incentives to redeem                 15%
Hybrids excluding non-cumulative
preference shares (including the first row)     15% (1)
Perpetual non-cumulative preference           No limit (1)
Maximum limits on all types of hybrids            15%

                                                 Sweden      Denmark

Hybrids with incentives to redeem                 15%          15%
Hybrids excluding non-cumulative
preference shares (including the first row)       15%          15%
Perpetual non-cumulative preference           No limit (2)   No limit
Maximum limits on all types of hybrids          15% (3)      15% (3)

                                              Netherlands   Austria

Hybrids with incentives to redeem                 15%         15%
Hybrids excluding non-cumulative
preference shares (including the first row)       50%         30%
Perpetual non-cumulative preference            No limit     33% (1)
Maximum limits on all types of hybrids            50%         33%

                                              Spain      UK

Hybrids with incentives to redeem              15%      15%
Hybrids excluding non-cumulative
preference shares (including the first row)    30%      15%
Perpetual non-cumulative preference            50%    No limit
Maximum limits on all types of hybrids         30%       50%

                                              Ireland     Germany

Hybrids with incentives to redeem               15%         15%
Hybrids excluding non-cumulative
preference shares (including the first row)     49%         50%
Perpetual non-cumulative preference           No limit   Does not
shares                                                   exist (4)
Maximum limits on all types of hybrids          49%         50%


Hybrids with incentives to redeem                15%
Hybrids excluding non-cumulative
preference shares (including the first row)      25%
Perpetual non-cumulative preference           25% (1,5)
Maximum limits on all types of hybrids           50%

(1.) No issuance.

(2.) Issuance in unusual.

(3.) Does not cover non cumulative preference shares as they are
not hybrids in the law.

(4.) Preference shares can only be cumulative and therefore only
eligible as Tier 2 capital.

Source: Committee of European Banking Supervisors (CEBS), April

Table 1.7. Financial institutions indicators

                                       Norway    Germany   Sweden

5 largest credit institutions'            58.5        22        61
  share of total bank assets
Cost/income all banks (1)                 0.53      0.63      0.59
Return on equity in 2007                   15%      8.8%     11.1%
  1st half of 2009                       12.1%
Return on assets in 2007                  1.2%      1.1%      1.1%
  1st half of 2009                        0.9%
Banks' leverage (Total assets/Tier        21.0     n.a.       19.7
  1 capital, end of year)
Increase in financial equity indices    272.6%    416.6%    183.3%
  from 2 January 2003 to peak (2)
Decline in financial equity indices     -77.6%    -74.3%    -66.6%
  from peak to troughs (3)
Increase in financial equity indices    209.5%     92.3%     92.6%
  from tough to 15 October 2009

                                       Denmark   Austria   Belgium

5 largest credit institutions'            64.2      42.8      83.4
  share of total bank assets
Cost/income all banks (1)                 0.50      0.59      0.51
Return on equity in 2007                 12.0%     11.1%     16.1%
  1st half of 2009
Return on assets in 2007                  1.3%      1.1%      2.3%
  1st half of 2009
Banks' leverage (Total assets/Tier        14.8      15.2      21.5
  1 capital, end of year)
Increase in financial equity indices    254.3%      n.a.      n.a.
  from 2 January 2003 to peak (2)
Decline in financial equity indices     -77.1%      n.a.    -84.2%
  from peak to troughs (3)
Increase in financial equity indices    122.3%      n.a.    130.2%
  from tough to 15 October 2009

                                       France      EMU

5 largest credit institutions'            51.8      44.1
  share of total bank assets
Cost/income all banks (1)                 0.69      n.a.
Return on equity in 2007                 10.3%      n.a.
  1st half of 2009                                  n.a.
Return on assets in 2007                  0.7%      n.a.
  1st half of 2009                                  n.a.
Banks' leverage (Total assets/Tier       n.a.       n.a.
  1 capital, end of year)
Increase in financial equity indices    154.5%    153.3%
  from 2 January 2003 to peak (2)
Decline in financial equity indices     -79.6%    -78.6%
  from peak to troughs (3)
Increase in financial equity indices    151.9%    158.4%
  from tough to 15 October 2009

(1.) Total operating costs' share of total income.

(2.) Peaks: Norway 2/2/2007, Germany 31/12/2007, Sweden 20/4/2007,
Denmark 23/4/2007, Belgium 18/5/2007, France 11/5/2007, and euro
area 1/6/2007.

(3.) Troughs: Norway 20/1/2009, Germany, Denmark, France and euro
area 9/3/2009, Sweden and Belgium 6/3/2009.

Source: ECB, Kredittilsynet, OECD, Bank Profitability, FSA
Danish, World Bank and Ecowin.
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Publication:OECD Economic Surveys - Norway
Date:Mar 1, 2010
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