Mr Gjedrem reports on economic perspectives in Norway
Annual address by the Governor of the Central Bank of Norway, Mr Svein Gjedrem, at the meeting of
the Supervisory Council of Norges Bank on 18/02/99.
Background
Twenty-two years ago, in 1977, the Norwegian economy witnessed the onset of a deep crisis. An
economic recession in industrial countries, high price and wage inflation in Norway and the
expansion of public welfare services resulted in large current account deficits. Thirteen years ago, in
1986, the Norwegian economy was also in a difficult situation. A debt-financed upswing in
consumption and investment, a fall in oil prices and a reduction in working hours gave rise to major
imbalances in the Norwegian economy.
In 1998 clouds again gathered over the economic horizon. Costs rose to a high level in Norway
compared with other countries, oil prices fell, and the current account balance deteriorated sharply.
This signalled a period of sluggish growth following six years of a strong upswing in economic
growth and employment. The krone depreciated and interest rates were raised.
There are many features that distinguish the three turning points in economic developments. However,
one common denominator is the sudden shift in the assessment of future oil revenues. Fluctuations in
petroleum revenues have proved to be a source of instability in the mainland economy.
Following the last two turning points, the Norwegian economy went through a period of major
restructuring, particularly at the end of the 1980s. Today the situation in the Norwegian economy is
different. However, this time there is also reason to ask whether we are sufficiently prepared. Is our
economy sufficiently robust?
The fall in oil prices was triggered by an international financial crisis and slower growth in the world
economy. The Norwegian economy is highly exposed to international fluctuations. Is our own
financial system and business sector strong enough to cope with this situation? How should monetary
and fiscal policy be formulated in such an exposed and oil-dependent economy? These are the issues I
would like to address this evening.
A turbulent world
Even before oil prices started to fall, the warning signals were flashing for everyone to see. The
Norwegian economy was overheating in an environment of global economic distress. The signals
from Asia were clear.
The problems first appeared in Thailand a little more than 18 months ago, but spread quickly to
Malaysia, the Philippines, Indonesia and South Korea. In most of these countries, a sharp upturn had
been stimulated by low interest rates and financed through a considerable accumulation of debt in the
business sector. Borrowers became increasingly nervous and withdrew capital. Capital inflows from
industrial countries were suddenly reversed to massive capital outflows.
Equity and property prices fell sharply and currencies came under pressure. The contagion effect led
to a sharp downturn in production and employment. Large population groups that had recently
experienced a pronounced increase in living standards slid back into poverty.
The crisis in Asia spread to Russia, where the decline in commodity prices led to an even further
deterioration in government finances. The announcement that Russia could no longer service its debt
was met with strong reactions in global financial markets in August and September. There were
growing fears that the world economy would be caught in a financial crash. Many investors withdrew
from small and risky markets, particularly in Latin America. The Brazilian currency came under
pressure. It was difficult to raise loan capital even in the most advanced markets. As financial
institutions throughout the world experienced growing losses, fears of a world economic depression
intensified.
Reductions in interest rates in the US and Europe facilitated access to credit and prevented a market
collapse. Measures perceived as credible were finally implemented to resolve the Japanese banking
crisis. Additional capital was allocated to the International Monetary Fund.
There are still many challenges ahead. Brazil and Russia are running government budget deficits and
are having problems establishing a credible monetary policy. China is bearing substantial costs as a
result of the crisis in surrounding countries and may experience difficulties of its own. Other
countries may also feel the contagion effect. However, even though the outlook points to lower
growth in the global economy this year than forecast earlier, fears of a worldwide depression have
receded.
This is by no means the first time we have experienced an international financial crisis. In this decade
alone we have seen a currency crisis in Europe in 1992-1993 and the Mexican crisis in 1994-1995. A
number of the countries affected were suffering from major economic imbalances, which triggered
currency outflows and capital flight. These crises also revealed fundamental shortcomings in the
functioning of the international financial system.
In principle, access to efficient international capital markets is an advantage for a country, not a
disadvantage. Norway used international capital to finance the development of its oil sector and
sizeable current account deficits in the 1970s and 1980s. Norwegian enterprises have access to credit
that would be very expensive in periods if we were to rely solely on domestic financing. The central
government invests the capital in the Petroleum Fund in foreign markets because this is expected to
generate high returns.
In the long term there is hardly any better alternative than to improve the functioning of capital
markets. This is in the interest of Norway and other industrial countries, particularly countries that
have a surplus of saving that must be invested abroad. This is also in the interest of many developing
countries that sorely need international capital to develop their economies.
One solution that is not effective is the reimposition of direct capital controls, given the vast increase
in technological capabilities to evade them. The business sector is already international. Capital
controls are disadvantageous to the business sector in the countries that introduce them. Nor are taxes
on capital movements or currency trading a realistic or effective alternative. Taxes will not prevent
substantial short-term speculative waves. A tax system would have to have broad international
support, because without it currency trading would only shift to countries without taxes. The benefit
of remaining outside would increase with the number of countries that participate.
What can be done to improve a system that is functioning poorly? If a country is to benefit from a free
capital market, it must draw up legislation providing for regulations and supervision that ensure
stability. Countries with poorly developed capital markets may benefit from some limitations. They
should exercise some caution in opening these markets too suddenly. The flow of capital is like
electricity. Adequate insulation should be in place before turning it on.
When the Nordic countries liberalised credit markets in the 1980s, we experienced considerable
problems because supervision and rules were not adequate. The same has been witnessed in the crisis
in Asia and Russia. Inadequate and ineffective legislation and supervision resulted in weak control of
financial sectors in the beleaguered countries.
The crisis is not only due to an unsuccessful policy in the countries concerned. Banks and funds in
industrial countries accounted for the sharp growth in capital inflows to emerging market economies
in the years prior to the crisis. Those who invested in these countries based their decisions on
insufficient and, in part, misleading information. With hindsight, we may ask why so much capital
was lent to countries about which lenders knew very little.
An additional problem is moral hazard: lenders may have assumed that the authorities or international
organisations would bail them out if borrowers experienced payment problems. As a last resort, they
may have expected the IMF to back the national authorities, which again are expected to support their
banking systems. Lenders can thereby neglect to make a thorough evaluation of credit risk.
The liberalisation of the capital market within a country requires national regulations and supervision.
The liberalisation of capital movements across national borders requires coordination and regulations
at an international level.
Countries on the European continent have a regional approach to this. They have drawn up a set of
laws and rules that govern a common European market, the single market. Norway also participates in
this market by virtue of the EEA Agreement. From 1 January 1999, 11 EU countries introduced the
single currency, thereby implementing one of the greatest monetary reforms of this century.
Moreover, European monetary union effectively eliminates the opportunity to speculate between
countries' currencies, thereby enhancing the stability of the financial system in Europe.
International rules for economic relations with other countries are important, particularly for small
countries. Cooperation within the framework of the WTO and GATT agreement on trade in goods and
services is an example. The OECD Capital Code, which provides a framework for member countries'
laws and regulations on capital movements, is another example.
Initiatives have been taken by both the International Monetary Fund and the Bank for International
Settlements to create a new international regulatory framework and system. This work is aimed at
reducing the risk and effects of severe financial crises, and is so far-reaching that it has also been
referred to as a new 'architecture' for the global financial system. Norway should support these
endeavours.
First, the new architecture must improve surveillance systems and promote greater openness and
transparency in the finances and practices of government and enterprises. Necessary measures include
more uniform accounting procedures and the development of international statistical standards. More
modern company, bankruptcy and securities legislation must be drawn up in many emerging market
economies. Second, private investors must to a greater extent bear the costs of their ill-advised
investments. The IMF must impose requirements on banks in industrial countries so that they
contribute to resolving the crisis they have contributed to creating. This will deter banks from
assuming excessive risk. Third, supervision of the financial sector must be tightened. Capital
requirements that are more closely linked to financial institutions' exposure to risk are among the
measures under consideration. In addition, it is important to enhance crisis management systems
because, irrespective of what we do on the preventive level, we will probably never be able to
eradicate financial bubbles that escalate into financial crises.
The work on a new international financial architecture is a demanding and long-term process. This
work nevertheless offers hope of achieving international agreement on some effective measures. Over
time, it should also reduce the risk of local and regional crises and their contagion effect on the rest of
the world.
There is still a long way to go. As far as Norway is concerned, we must act on the assumption that we
will continue to live in an unstable world. The financial crises have shown that a small country is
vulnerable to international turbulence. The Norwegian economy is fragile and vulnerable.
Stability and buffer against financial shocks
Norway has also experienced a banking crisis. If nothing else, we learned from it. Laws, regulations
and supervision have been tightened. Financial institutions place greater emphasis on risk
management. The debt burden of households is lower than in the 1980s, and for a long period the
business sector was also more cautious about incurring new debt.
Losses at Norwegian financial institutions have been low since the banking crisis. There is greater
uncertainty now as the economy is approaching a turning point. The sharp growth in fixed income
business has led to a substantial increase in corporate debt, which has been reflected in the high level
of credit growth in recent years.
The rise in interest rates has made it more demanding for households and enterprises to service their
debt in the short term, but has had a restraining effect on credit growth. If interest rates had not moved
up, the business sector could have continued to build up debt for a somewhat longer period, which
would hardly have promoted long-term stability. Somewhat higher losses on corporate lending are
now expected, although there is hardly any imminent risk to the financial strength of the banking
system.
However, there is cause for concern about the evolution of the structure of the Norwegian financial
industry in the longer term.
The free flow of capital in Europe paves the way for structural changes in the European financial
industry. These changes will be prompted by the increased use of fund-based pension systems and the
ever wider application of technology in the euro area. Banks in Europe will become larger, more
efficient and more competitive, and securities markets will be larger and more liquid.
Structural changes are also taking place in the financial industry in the Nordic countries. Nordic
financial institutions are adjusting capacity, enhancing efficiency and realising economies of scale.
The largest banks are developing their activities, with the Nordic area as their home market, by
building up their branch networks or through acquisitions. Not many Norwegian financial institutions
have found it profitable to participate in this process.
The government's ownership in the banking sector was expanded as part of the solution to the
Norwegian banking crisis. It was not necessary to allow ownership to be permanent. Currently, the
government owns the state banks, Postbanken and more than 50% of Norway's two largest
commercial banks. The government therefore controls banks that account for about 50% of bank
lending in Norway. The stake in the two largest commercial banks is to be reduced to a third.
State ownership of banks constitutes, in my opinion, a structural weakness in the Norwegian financial
system.
There is a risk that the ownership function is not exercised actively enough. A lack of control on the
part of active owners may give the board and management excessive influence in these banks. In the
long run this could lead to less efficient operations and lower profitability. Private owners with lower
capital stakes may also wield a disproportionately high level of influence if the state as owner is too
passive.
The political parties widely disagree on the issue of government bank ownership. This may be a
disadvantage when decisions on mergers and other structural measures are to be taken. When there is
a profitable basis for growth, which requires increases in capital, the state-owned banks must pose the
following question: is it possible to gain political support? They cannot merely ask: will investors find
this profitable?
It is important to reach political consensus on the question of state ownership. One example of a case
where the political parties reached agreement on structure and ownership in the 1980s is the
petroleum sector. The oil companies have therefore enjoyed stable operating parameters over the last
15 years, although this sector is also faced with the challenge of finding new solutions in response to
the sharp shifts in market conditions that we have witnessed recently. This will once again require
forward-looking strategies and willingness to compromise.
The government's supervisory tasks are substantial. Confidence in the banking system in critical
situations may also be contingent on the government's willingness to provide financial backing. There
is a fundamental conflict between these two roles and the government's role as bank owner. People
must be confident that the government does not conceal its own mistakes when intervening in the face
of a crisis in the banking system should this again prove necessary. It is virtually impossible to
establish such confidence if the government is also responsible for the crisis through its ownership.
State ownership in the banking industry has been maintained with a view to ensuring stable national
ownership. It seems that, in practice, most comparable countries attach importance to having large
financial institutions with a national anchor, but most of them avoid state ownership and the
associated conflicts of interest. We should also be able to do this.
However, I would like to stress that a greater number of foreign financial institutions could also be
advantageous. Foreign institutions will normally be larger and more diversified than Norwegian
institutions. This could generate better and cheaper services in the Norwegian market. Moreover,
these institutions might be in a stronger position to cope with a cyclical downturn in Norway or a
crisis situation than banks concentrated in Norway.
At the beginning of the recession at the end of the 1980s, the Norwegian financial system plunged into
a deep crisis. The debt consolidation that was necessary in the business and household sectors
contributed to a sharp and prolonged downturn.
In the long term our financial system may, in my opinion, suffer in the absence of restructuring and
growth capabilities. However, the overall picture is that we are better prepared this time. Households
are not grappling with the same debt burden and our financial industry is in better balance.
An oil-dependent economy
The fall in oil prices has resulted in a substantial loss of revenues in Norway. Since 1997 this has
resulted in a decline in export earnings corresponding to about 5.5% of total national income. This
represents the same decline in our disposable income as between 1985 and 1986, when oil prices fell
by close to 50% over a few months. This time, however, the current account balance has deteriorated
by a smaller margin. Growth in imports has been slower than 12 years ago. The value of non-oil
exports has increased this time, while it fell in 1986. But the effect on the external account has been
substantial this time as well.
The fall in oil prices has weakened Norway's terms of trade. The terms of trade measure the price of
imported goods in relation to exported goods. When oil prices decline and import prices remain
steady, we must export more in order to buy the same quantity of imports.
This is not the first time that we have experienced substantial changes in our terms of trade. The most
pronounced variations - in 1986 and 1998 - were due to the sharp drop in oil prices. Variations in
Denmark's terms of trade are negligible compared with Norway.
In this sense, the Norwegian economy has more in common with countries like New Zealand and
Australia, which are also large exporters of commodities. A substantial change in the terms of trade
translates into considerable changes in these countries' earnings and balance of payments. Over the
years this has resulted in sizeable exchange rate fluctuations.
The exchange rate is a buffer against changes in the terms of trade. While a country like Denmark has
also managed to maintain a stable exchange rate, commodity-producing countries typically experience
fluctuations in the exchange rate in tandem with changes in the terms of trade.
In New Zealand, Australia and many other countries, monetary policy is oriented directly towards
price stability, and these countries permit short-term fluctuations in the exchange rate. This means
that monetary policy bears the primary responsibility for price stability, whereas fiscal policy is to a
greater extent oriented towards long-term stability in government finances.
Norway has established the Government Petroleum Fund in order to promote long-term stability in
government finances and ensure fiscal leeway in the long term. The Government Petroleum Fund also
acts as a buffer against fluctuations in petroleum revenues. Swings in oil prices lead to changes in
allocations to the Fund. As a large share of petroleum revenues accrues to the state, smaller variations
in these revenues will only have a limited effect on the wider economy. This makes the Norwegian
economy more robust and in the short term less dependent on oil, at least as long as the government
budget is running a substantial surplus. This is part of the reason why Norway seeks to maintain
exchange rate stability rather than orienting monetary policy directly towards the objective of price
stability.
Many countries are struggling with government finances. After several years of large government
budget deficits, interest expenditure is laying claim to a considerable portion of tax revenues and
thereby limiting the government's scope for carrying out its tasks. The main challenge to fiscal policy
is to eliminate these deficits and reduce government debt and interest expenditure.
Norway has had greater fiscal scope for manoeuvre, although this has not solely been used to promote
long-term balance. Therefore, Norway established a different division of responsibility in economic
policy. As the objective of monetary policy is to maintain a stable exchange rate, fiscal policy has an
important responsibility for stabilising the economy.
Division of responsibility fails
Stabilisation policy is a very demanding task in an economy like Norway, with occasional major
exogenous shocks. The question that must now be asked is how our system functions when exposed to
pressure.
Oil prices were high in 1996, 1997 and into 1998, which resulted in large surpluses on the current
account and the government budget. Domestic activity was also rising, with strong growth in
employment. Deliveries to the petroleum sector generated a strong and uncontrolled growth impetus
to the mainland economy. During the budget deliberations in the Storting (Norwegian parliament),
major changes were made. Compared with the large surpluses generated by petroleum revenues, the
changes to the budget may have seemed small, but these changes were important for economic
developments.
I will illustrate this by means of an example. Assume that the oil price temporarily increases by NOK
10 per barrel, or a little less than USD 1.50 per barrel. This is a small change in the oil price, well
within normal variations from one year to the next. Government revenues - and thereby the budget
surplus - would then increase by about NOK 9 billion in the first year and NOK 11-12 billion the
next year. This corresponds to about 1% of Norway's GDP. The assumption is that all the revenues
from such a minor increase in oil prices will be transferred to the Government Petroleum Fund and
that fiscal policy will remain firm. In this case, the additional revenues will not influence the
economy, but be invested abroad via the Government Petroleum Fund.
On the other hand, if the additional revenues are absorbed in the domestic economy through increased
government budget expenditure, total domestic demand is influenced. Increased expenditure requires
an increase in the public sector's use of resources, primarily labour. In this case, 1% of GDP is
substantial. If such an increase in oil revenues is used domestically, it corresponds, for example, to
around half of average annual growth in the economy. If the private sector of the economy also
expands while the economy is nearing capacity limits, such a policy will heighten the pressures on
resources in the economy, which in turn fuels inflationary pressures.
Unfortunately there was a clear tendency of such a policy in 1996, 1997 and 1998. The non-oil
government budget deficit was indeed reduced, but the division of responsibility in economic policy
required a more active tightening. Rather than conducting a tight policy and countering the higher
growth in the business sector, the increase in budget expenditure entailed that the public sector also
contributed to fuelling pressures in the labour market. As a result, a small change in oil prices had the
effect it was not intended to have: it was accompanied by an increase in public sector demand.
Foreign exchange market participants observed that economic policy was not oriented towards
containing pressures in the labour market. In a different situation such a policy could have
undermined confidence, leading to a depreciation of the krone and higher interest rates. Owing to high
oil prices, however, the krone was very strong in 1996 and 1997. It may be that the foreign exchange
market accepted that Norway was in a situation - with large government budget and current account
surpluses - where the country both could and should have transferred resources from the business
sector to the public sector. It could be that market participants believed that this transfer of resources
would occur with the help of a strong krone exchange rate, which reduces profitability in the business
sector.
Appreciation pressures mounted and culminated in a reduction in interest rates by Norges Bank in
January 1997 in order to counter the sharp strengthening of the krone.
If the central bank had not acted, the krone might have appreciated by an even greater margin. This
could have given a strong signal to the business sector to move out of Norway. However, in a
situation where fiscal policy was not sufficiently tight, the reduction in interest rates increased the risk
of an acceleration in price and cost inflation.
Then came the fall in oil prices, with an associated erosion of the external account. Income growth for
liberal professions had been substantial, wage growth for salaried employees accelerated and the
wage and income settlement in 1998 was very generous. This eliminated the basis for the strong
krone. In late summer the international financial crisis escalated and the krone depreciated.
High wage growth cannot be attributed to flaws in wage and income determination. On the contrary,
the flexible wage and income system can probably be cited as the main factor behind the high level of
employment and low unemployment in Norway. In periods of strong labour market pressures,
particularly in 1974-1976, 1986-1987 and last year, wage growth accelerates sharply. Such periods
are normally followed by a slacker labour market and higher unemployment. The positive feature of
income determination in Norway has been that wage growth returns to normal relatively quickly,
which has allowed Norway to avoid the persistently high levels of unemployment experienced by
most West European countries. Even though some increase in unemployment must be expected, we
should be able to avoid a rise in unemployment to European levels or to the level prevailing in the
period 1989-1992 if wage and cost inflation is rapidly reduced also during this business cycle.
Fiscal policy failed in 1996, 1997 and 1998. Developments illustrate that budget discipline must be
exercised down to the last billion.
The economy overheated because fiscal policy was not sufficiently tight when the economy was
faring well. This brought the krone under pressure and external conditions intensified this pressure,
making it impossible to keep the krone on track. It is only this year that fiscal policy is again well
adapted to the economic situation.
If fiscal policy is systematically too expansionary during booms and when petroleum revenues are
higher than expected, Norway will in periods experience pressures in the economy and rising price
and cost inflation. This will often give rise to situations where the krone depreciates, thereby
undermining the credibility of our monetary policy. There is a price to be paid for this. Market
participants will lose confidence in the krone and demand a higher interest rate for maintaining krone
positions rather than switching to other currencies. The result is a permanently higher interest rate
level in Norway compared with other countries.
Intricate relationships
Earlier, monetary policy was based on extensive use of interventions - in other words, purchases and
sales of foreign exchange in order to defend the krone exchange rate. Denmark has used this
instrument with positive results. There are probably many reasons for this in addition to its stable
terms of trade. For instance, fiscal policy in Denmark has on numerous occasions made a substantial
contribution to exchange rate stability.
Over time our experience of large-scale and persistent interventions has been mixed. When the central
bank intervenes heavily to defend the krone, market participants may easily move into a game
situation and perceive central bank intervention as an interesting opportunity to make a profit. Market
operators know that a situation in which the krone is being propped up only because Norges Bank is
buying kroner cannot continue. It is then tempting to take reverse positions in the foreign exchange
market in relation to the central bank. This means that heavy and prolonged interventions may
intensify the pressure on the krone over time, steadily increasing the necessary volume of intervention
purchases. The foremost example of such a game situation in Norway's exchange rate policy history
was Friday 20 November 1992, when Norges Bank made intervention purchases for NOK 37 billion
from the time the market opened until the time it closed. Intervention purchases amounting to
NOK 14 billion were also made the previous day after Sweden allowed its currency to float. Norges
Bank had thereby depleted its foreign exchange reserves by more than NOK 50 billion in the course
of six trading hours over two days.
Norges Bank does not want to intervene in such a way that this type of game situation arises. Nor can
we expect other central banks to help us to an extent that makes a decisive contribution to our
resistance. However, the Bank may use interventions to a limited extent if the krone moves
substantially out of line with what we consider to be reasonable based on fundamentals or in the event
of exceptional short-term volatility in thin markets. In such situations, we must assume that the risk of
ending up in a game situation against exchange market players is marginal.
The instrument available to Norges Bank for influencing economic fundamentals is the interest rate. If
the exchange rate comes under pressure, Norges Bank can counter this over time by adjusting interest
rates. However, we must take into account that in the long run the krone exchange rate cannot deviate
substantially from the level implied by economic fundamentals. We must therefore to some extent
expect a change in the krone exchange rate in response to major changes in our terms of trade.
Norges Bank's mandate has been formulated in the light of the experience of a fixed exchange rate
policy earlier in the 1990s. This experience does not imply that the central bank is to conduct a
traditional fixed exchange rate regime, with established fluctuation margins and the obligation to
intervene, as reflected in the mandate. Norges Bank will orient monetary policy 'towards maintaining
a stable krone exchange rate against European currencies'. However, it is taken into account that the
krone exchange rate will vary. The Exchange Rate Regulation therefore states that 'in the event of
significant changes in the exchange rate, monetary policy instruments shall be oriented with a view to
returning the exchange rate over time to its initial range'.
We must learn from the situation that arose in the autumn of 1996 and winter of 1997 when strong
appreciation pressures prompted Norges Bank to reduce its key rates.
Norges Bank's first response to such appreciation pressures is to provide advice concerning changes
in the budget.
Norges Bank will orient its instruments towards maintaining a stable krone exchange rate. We must
not allow ourselves to be blinded by daily exchange rate quotations. The experience of recent years
shows that Norges Bank must take into account the fundamental conditions for exchange rate stability
over time.
The krone is influenced by unrest in international financial markets, changes in oil prices,
inappropriate fiscal policy responses and high cost increases peculiar to Norway. Norges Bank cannot
fine-tune exchange rate movements through exchange market interventions. This means that the krone
exchange rate will fluctuate. It is up to Norges Bank to evaluate the best means of returning the krone
to its initial range. This also means that the Bank must exercise a large degree of discretion when
using the Bank's instruments, essentially th