Chapter 1: emerging from the crisis.
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.
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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 growth. 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.
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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.
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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.
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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).
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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).
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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 observers. 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).
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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.
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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 sector 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).
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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.
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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 integration. 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."
[FIGURE 1.15 OMITTED]
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.
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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.
[FIGURE 1.17 OMITTED]
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.
[FIGURE 1.18 OMITTED]
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.
[FIGURE 1.19 OMITTED]
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).
[FIGURE 1.20 OMITTED]
[FIGURE 1.21 OMITTED]
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" effect. 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 system. 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. [FIGURE 1.22 OMITTED]
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.
[FIGURE 1.23 OMITTED]
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).
[FIGURE 1.24 OMITTED]
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.
[FIGURE 1.25 OMITTED]
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 credibility. 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 next. * 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 Fund.
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).
[FIGURE 1.A1.1 OMITTED]
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.
[FIGURE 1.A1.2 OMITTED]
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.
[FIGURE 1.A1.3 OMITTED]
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) A. SOCIAL PROTECTION 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. legislation 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. C. EDUCATION 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. teachers. 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. teachers. D. FINANCIAL MARKETS 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. E. QUALITY OF PUBLIC FINANCE 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 introduced. 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 2009. 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 Survey. 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. F. ENVIRONMENTAL POLICIES 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 efficiency. G. AGRICULTURE AND FISHERY Enhance competition in the Target prices removed in the beef agriculture market sector from 1 July 2009 due to "amber box" constraints in the WTD-agreement. Reduce tariffs and increase Subsidies to agriculture have import quotas in the agriculture been increasing market Reduce restrictions on transfers No further action. See Chapter 2. of fishing quotas H. SUPPORT COMPETITION AND REDUCE STATE AID 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 wholesaling. 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 2008. Backward action: Fishermen's tax allowances (tax exemption, not included in budgetary support) increased in 2008 and further in 2009. 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 governance 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. I. PRODUCT MARKET COMPETITION Promote competition in the postal No action. services 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. services
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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: www.norges-bank.no/templates/article_75641.aspx.
(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 people). Table 1.2. Norway: Demand, output and prices 2006 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 prices) 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 wealth) 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. Interest payment as a % of disposable income 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 Extended Type of measure Of which: in 2010 Employment or qualification measures 1 278 1 263 (0.08%) Infrastructure and maintenance 11 094 719 (0.65%) Grants 2 191 1 234 (0.13%) R&D spending 2 288 793 (0.13%) Other 32 14 (0%) 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 Ireland 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 Ireland 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 Norway 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) shares 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 shares 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) shares 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 shares 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% France Hybrids with incentives to redeem 15% Hybrids excluding non-cumulative preference shares (including the first row) 25% Perpetual non-cumulative preference 25% (1,5) shares 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 2007. 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 average 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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