Svein Gjedrem: Asset prices and economic policy
Address by Mr Svein Gjedrem, Governor of Norges Bank (Central Bank of Norway), at the
Centre for Monetary Economics (CME)/BI Norwegian School of Management, Oslo,
12 September 2008.
The text below may differ slightly from the actual presentation.
* * *
Inflation targeting
Inflation targeting was introduced in Norway by Royal Decree in March 2001, after it had
been applied for a period in many other countries. Our experience so far has been that
inflation targeting has provided a sound basis for stabilising inflation and inflation
expectations.
In the period from 2003 to the beginning of 2008, inflation was below target. Ever-cheaper
goods flowed into Norway from Asia, and with solid productivity growth in Norwegian
enterprises, the rise in prices for domestically produced goods and services was also
subdued. In an environment of low inflation, the interest rate was also low. At the same time,
it was stated that when inflation picked up, the interest rate level would again return to a
normal level.
Solid growth in output and demand for goods and services gradually led to prospects for
higher inflation. Since summer 2005, the interest rate has gradually been raised again to
prevent inflation from becoming too high. The interest rate was raised well before inflation
moved close to 2.5 per cent. In 2007, the key policy rate reached what we consider to be a
normal level.
From 2003 and up to the end of 2007, growth in the Norwegian economy was high and
gathered momentum both more quickly and more markedly than in the business cycles in
the1980s and 1990s. The interest rate has by and large curbed the effects. The interest rate
was low in the years between 2003 and 2005 while activity in the economy was still
moderate, and has gradually been raised since then. Because inflation was low, the interest
rate was kept low in a period of high growth and increasing capacity utilisation. Three factors
were important:
First, labour has flowed into Norway from other countries. The opening of the labour market
to the new EU countries has provided us with access to a reserve of labour. Inward labour
migration rose towards the end of the cyclical upturn and has contributed to sustaining the
high level of growth. In 2007, the population expanded by more than 56 000, with net
immigration at 40 000. This is the highest population growth ever recorded in Norway.
Second, businesses in Norway have become increasingly efficient, resulting in lower costs. It
has been profitable to hire more employees despite the high wage level in Norway. The
business sector has made use of new technology and businesses have been restructured.
The many sweeping reforms of the 1980s and 1990s - the fundamental shift in the
Norwegian economy1 - resulted in more efficient markets. Over the past few years, we have
reaped the benefits of the measures implemented then.
Third, Norway's terms of trade have improved. Sales of Norwegian exports have been high,
and we can import more goods in exchange for the goods and services sold by the business
sector. Lower import prices have led to low inflation and a strong increase in employees' real
wages. High export prices have resulted in solid corporate earnings. Norway's disposable
income increased in real terms by more than 35 per cent in the five years to 2007.
Owing to the growth in productivity and improved terms of trade, enterprises have been able
to increase their share of value added in spite of higher real wages for employees. At the
same time, employment rose sharply and unemployment fell to the lowest levels recorded
since the beginning of the 1980s.
These factors are now becoming less prominent. It is not likely that developments in
Norway's terms of trade will be as positive in the years ahead. Productivity growth seems to
be declining - at least cyclical. Wage-earners' share of value added is rising again, and this
restrains labour demand. At the same time, inflation has quickened.
High energy and commodity prices are fuelling global inflation. Food and energy prices are
also rising in Norway, even though the import share is low. The shift towards imports from
low-cost countries has moderated. After falling for several years, prices for imported goods
are now beginning to rise.
Looking back, inflation has varied somewhat. The three supply-side shocks reduced inflation
while boosting production capacity. Low interest rates, favourable economic conditions
internationally and substantial investment in the petroleum sector increased demand for
goods and services. High capacity utilisation gradually pushed up inflation. Now that interest
rates have risen to a more normal level and the global economic situation is deteriorating,
growth is slowing and capacity utilisation may again seem to be approaching levels that are
more sustainable. The impact of the downturn abroad on the Norwegian economy is
uncertain, but on balance it now seems that inflation will gradually stabilise near 2.5 per cent
without unnecessary wide fluctuations in output and employment.
By and large, we must then be able to assert that inflation targeting has served us well during
these years.
There have been surprises. The growth potential of the Norwegian economy has been very
high. It took a long time for employment to rise after the recovery started, and in 2006 - well
into the upturn - inflation fell markedly. Over the past year, import prices and food prices
have increased, and against this background the monetary stance may have to be on the
tight side for a period.
Prevention of systemic risk
At the same time, developments in other countries, and probably also in Norway, have
shown that financial and property markets can be a source of instability in prices, output and
employment. The US is facing a deep crisis in its financial system. Extensive intervention on
the part of the government authorities and the central bank, most recently by placing Fannie
Mae and Freddie Mac in conservatorship, has probably mitigated the effects, but confidence
in banks and financial undertakings has not been restored. European financial markets are
also marked by turbulence and uncertainty. Even in Denmark - after nearly 25 years of a
highly successful economic policy - a medium-sized bank has failed.2
These problems have prompted many countries to review regulations and the functioning of
financial and credit markets.
Financial and credit markets in Norway have changed considerably over the past 10-20
years, resulting in substantial welfare gains. Enterprises now have access to credit at a more
correct interest rate. Households have greater opportunities to smooth saving and
consumption over a lifetime. Less rationing and higher required returns have boosted the
growth potential of our economy.
Since the end of June 2007, money and credit markets in other countries have been
characterised by sharp fluctuations, tight liquidity and reduced risk appetite. The problems
started in the US mortgage market, but quickly spread to other financial market segments.
Banks, funds and financial undertakings had to bring bonds back onto their own balance
sheets, they began to doubt the financial position of their counterparties and held on to their
money. As a result, premiums on interbank loans rose markedly.
Norwegian banks rely heavily on international markets for their funding. The rise in money
market premiums in the US and Europe therefore rapidly spread to Norwegian interest rates,
even though Norwegian banks are profitable, enjoy confidence and have limited loss
exposure.
When banks would no longer lend to each other, many central banks provided liquidity with a
longer maturity and lower collateral requirements than usual. Norges Bank has also, in
periods, increased the volume of lending to Norwegian banks. We have provided extra
shortterm liquidity, for example through currency swaps. We have also offered banks loans with
longer maturities than earlier.
We have not changed the collateral requirements for loans. This is because we already
accepted a broad range of collateral than those central banks. This is because - for reasons
we appreciate - the Norwegian government bond market is very thin. For a long time, nor did
we have a well developed market for other bonds. At the same time, bank demand for loans
from Norges Bank is considerable in some periods of the year. In this decade, we have been
able to tighten the collateral requirements somewhat, most recently in 2005, when we among
other things restricted access to using bank securities as collateral. At that time, we
announced that we would later go a step further. This promise remains intact.
Central bank measures have curbed the fluctuations in interbank interest rates, but only for
loans with short maturities.
For longer maturities, premiums have continued to rise, and the premium on 12-month
money market rates is now more than one percentage point.
The turbulence has particularly affected banks with low deposits and considerable money
market loans. Both Roskilde Bank, recently taken over by Denmark's Nationalbank, and
Northern Rock, which had to be bailed out by the Bank of England last year, had fairly low
deposit-to-loan ratios. Combined with large exposures in the property and construction
sectors, this made them vulnerable. Norwegian banks generally have higher deposit-to-loan
ratios, although there are differences.
Banks and investors, both in Norway and abroad, are now charging higher premiums and
higher prices for providing capital for acquisitions, restructuring and investment, and highly
leveraged enterprises must pay high risk premiums when they borrow. It has become more
difficult to obtain funding. Norges Bank's survey of bank lending indicates that banks are
gradually tightening their lending standards. Household debt growth has recently edged
down. At the same time, consumption growth has slowed, but consumption is still higher than
disposable income. Corporate credit growth remains high, at least for the time being.
The experience of the financial crisis has prompted governments and others to put liquidity
risk higher on the agenda. In June, the Basel Committee on Banking Supervision published
Principles for Sound Liquidity Risk Management and Supervision.3
Norges Bank has a role as lender of last resort. This means that Norges Bank can provide an
individual bank or the banking system with extraordinary liquidity when demand for liquidity
cannot be satisfied by other sources.4 Our view is that the provision of extraordinary liquidity
should be restricted to situations when financial stability may be threatened without such
support.
Experience shows that the seeds of financial instability are sown during periods of rapidly
rising debt and asset prices, including house prices. Over the past 15 years, house prices
have surged, and particularly in 2006, even though Norges Bank had at that time already
raised the interest rate on several occasions. High household income growth and bank
competition for lending and market shares are contributing factors. Nor can we disregard the
possibility that in periods developments have been driven by the conviction that prices would
only continue to rise.
Unusually low long-term interest rates have probably also fuelled house price inflation in
recent years. Norwegian households primarily finance home purchases with adjustable-rate
mortgages. Nonetheless, long-term interest rates are important because they provide
information about developments in short-term rates that borrowers can expect over time.
Now that the interest rate has moved up to a fairly normal level, the rise in house prices has
come to a halt, and prices are now falling. We have seen that when the interest rate is raised
to curb the rise in prices for goods and services, interest-rate setting also contributes to
stabilising asset prices. Moreover, we believe that our communication, where we emphasise
that the interest rate is set with view to stabilising inflation, and with forecasts for the interest
rate ahead, has contributed to dampening fluctuations.
It is nevertheless important to be aware that in a small open economy like Norway there is
little room for setting the interest rate at a level that diverges from that of other countries with
the aim of influencing property prices and credit growth. The task of steering inflation is in
itself demanding. With Norway's balance-of-payments position, the effects on capital
movements and the krone exchange rate may be considerable. Pursuing a very firm
approach to steering property prices and credit will easily lead to a krone out of balance and
result in adverse effects on inflation and inflation expectations.
Monetary policy contributes to stabilising developments in the economy. Nonetheless, in
some areas, the framework may lead to a situation where business cycles may be
selfamplifying. In the following, I will focus on aspects of the functioning and regulation of the
housing market and banking activities.
The interplay between developments in the housing market and the credit market is
important for stability in our economy. Prices, investment and home sales show considerable
swings. Homes are important forms of collateral and price developments influence household
borrowing and give rise to credit cycles. Housing loans account for 40 per cent of Norwegian
bank balance sheets.5 The framework conditions for the housing market are thus important
for how wide fluctuations in output and employment are and for the risk of financial shocks
and instability. The experience of the banking crisis in the early 1990s did admittedly entail
limited bank losses on loans to households, and substantial losses on loans to business and
corporate customers, which were affected by a fall in household consumption. Banks may
certainly refer to this when they assess the credit risk of their loans, but they should perhaps
not be as certain that people will stand by their creditors in the future as they did 15-20 years
ago. Household debt is very high. Attitudes may change and debt servicing discipline may
also be influenced by the debt settlement scheme that has gradually become less
restrictive.6 Banks should make ample allowance also for this risk in their loan disbursement
and interest rate premiums.
It is important for stability in the housing market that the supply of housing reacts rapidly to
changes in demand. On this score, our experience has been fairly positive with a high level
of residential construction in recent years.
The tax system should treat investment in residential property neutrally and on a par with
other investments. Several official studies in recent decades7 - from Sekse to Skauge -
have shown that the tax system favours residential property consumption and investment.
This leads to overinvestment in residential property, displacing other types of investment. At
the same time, the tax system makes it more advantageous to own a home instead of
renting.
Through the years, the tax on the advantage of homeownership has been gradually reduced.
In 2005, it was removed. Tax deductibility of debt interest was maintained. In practice, this
implies a housing investment subsidy. Homeowners benefit from an income deduction for
expenses for income acquisition, but do not pay taxes on the income. In central areas where
available sites are scarce, the tax advantage will result in a higher level of house prices.
A more neutral taxation of residential property - for example as proposed by the Skauge
Commission in 2003 - would also have a stabilising effect on the price level in the housing
market. A tax that is based more on market values will increase when house values rise and
fall when house values decline. This will curb the willingness to pay when purchasing homes
during upturns and sustain it during downturns.
The exemption for residential property tax is a source of more unstable house prices and
credit cycles. Interest rate setting cannot remedy this.
Banks primarily rely on lending funds that they have borrowed, either in money and securities
markets or from depositors. Norwegian bank equity capital only accounts for about 6 per cent
of bank balance sheets. By way of comparison, Norwegian limited companies have an equity
ratio of close to 40 per cent. Since banks manage customer deposits and because they have
low equity capital, it is important they have effective risk management systems. Banking
activities are also subject to regulation and supervision by the authorities. The law
establishes minimum levels of capital for banks.
Banking activity is pro-cyclical. During an upturn, the value of assets increases more than
debt. This strengthens bank earnings and solidity. Increased equity capital provides room for
additional lending. During a downturn, securities values fall and loan losses rise. Banks will
then tighten up.
Banks state financial assets at market value.8 When value changes rapidly come into
evidence in the accounts, bank owners and creditors are provided with better insight into a
bank's financial position, and banks can then rapidly act to maintain their capital adequacy.
The new capital adequacy rules - Basel II - are designed to strengthen the stability of the
financial system. The capital requirements seek to ensure that a bank's capital is
commensurate with its risk profile. For Norwegian banks, which have a large proportion of
housings loans in their loan portfolios, Basel II entails a substantial reduction in capital
requirements after a transitional period. This is because highly secured housing loans have a
low risk profile. Bank equity ratios have fallen in recent years. At the same time, Tier 1
capital, which is a risk-weighted measure of financial strength, has been stable. This reflects
a sharp increase in bank lending secured by mortgages on residential property in this period.
The Basel II framework offers limited experience so far. It presupposes that risk assessments
consider the prevailing macroeconomic environment. There is still a risk that banks give
excessive weight to recent years' experiences in their assessments and models. The
supervisory authorities can help remedy this by ensuring that banks' assessment of risk in
internal models is based on data from at least on complete business cycle. The supervisory
authorities also have the possibility of imposing an extra capital requirement on a bank if the
bank has large risk exposures. Banks must therefore perform stress tests to demonstrate
that they have sufficient capital to weather a downturn.
Regulatory changes can probably reduce fluctuations in banks' eagerness to lend. Banks
could be required to accumulate additional reserves. One example is that in a favourable
economic situation banks could be required to make additional provisions for future losses,
as is the case in Spain.9 Another proposal10 is that the capital requirement should be raised
when lending growth increases.
Banks may be forced to sell large volumes of assets in a crisis situation. Three US
academics11 have recently proposed a supplement to the capital requirements in order to
reduce this selling pressure. They propose that banks acquire a form of insurance that is
paid out when the banking sector as a whole has losses over a certain level. When a crisis
occurs, banks will then be assured of a supply of fresh capital.
Foreign-owned branches and subsidiaries have a market share in Norway of close to 35 per
cent in terms of total assets. Most of them are chartered in the other Nordic countries. Rules
or practices in Norway that diverge from other countries will influence the competitiveness of
Norwegian-owned bank and is in practice hardly feasible.12 Other countries will be of the
same mind. It is therefore easy, particularly in an upturn, to be drawn into a negative spiral
that culminates in a least common multiplier for capital requirements. It is my view that it is
important to strengthen cooperation in this area, particularly between Nordic finance
ministries and supervisory authorities. We must aim at a common approach to preventing
systemic risk.13
Nordic cooperation is already extensive, but primarily focuses on crisis management of a
potential crisis in cross-border banks. Crisis simulation exercises with the participation of
finance ministries, supervisory authorities and central banks - 15 participants from 5
countries14 - illustrate that interests may easily conflict and that coordination is very
9
See Ordonez, M.F. "Speech by the Governor. 2008 International Monetary Conference - Central bankers
panel, Banco de Espana, 2008.
10
See article in Financial Times, 4 June 2008, " A party pooper's guide to financial stability".
11
See Kashyap, A.K., R. Rajan and J.C. Stein, "Rethinking Capital Regulation", 2008. www.kansascityfed.org.
12
In 2006, the Financial Supervisory Authority of Norway recommended that the highest loan-to-value ratio for
home mortgages with the lowest risk weight using the standardised approach under Basel II be lowered from
80 to 75 per cent of sound mortgage lending value. The Ministry of Finance did not follow the
recommendation. Norges Bank agreed with the Ministry of Finance, referring to the effect on competition.
13
See "Can the authorities manage crises in the financial system?" by the Governor Stefan Ingves, Sveriges
Riksbank, www.riksbank.se.
14
In the crisis simulation exercise in autumn 2007, all the Nordic countries participated. In addition, the Baltic
central banks were observers.
BIS Review 110/2008
demanding. Perhaps above all, the exercises show that we must double our efforts to
prevent any further crises in the Nordic banking system.
It is also possible that the authorities' hands are tied to a further extent that during the Nordic
banking crisis under the EU rules on state aid. It is my impression that the rules are practiced
in a way that limits the scope for recovering government funds. If this is the case,
government will be more reluctant to intervene in the event of a crisis.
Norway has a generous guarantee scheme. Deposits are guaranteed up to NOK 2 million
per depositor per bank - an amount that is substantially higher than the statutory minimum of
EUR 20 000 in the EU, i.e. about NOK 160 000. Of the other Nordic countries, Denmark has
the highest amount at around NOK 325 000. In the UK, the amount has recently been raised
to a good NOK 350 000, and a further increase to about NOK 500 000 has been proposed.
Other EU countries generally have lower guaranteed amounts.
Since 2007, many branches of foreign banks have become members of the Norwegian
scheme to increase their deposit to loan ratio. This is not purely coincidental. The Norwegian
scheme is probably slightly naïve in its design. As mentioned, the amount guaranteed is very
high, and there has been a period without fee payments. At the same time, the competition
for deposits has intensified at home and abroad.
There is an element of moral hazard associated with any insurance scheme. In Norway,
even depositors with very large deposits do not have to assess the financial strength of a
bank. Our deposit guarantee scheme has a flypaper effect, and under the protection of the
scheme the banks have bid up deposit rates to strengthen their liquidity. This will eventually
have an effect on lending rates as well.
Norges Bank has reviewed the Norwegian guarantee scheme and in a submission to the
Ministry of Finance recommends the following revisions15:
•
Member banks must always pay a fee
•
The membership fee is differentiated more clearly according to the banks' risk
exposure
•
... and thus becomes counter-cyclical by using growth in banks' activities as a
supplementary measure of risk exposure
•
A reduction in the guaranteed amount per customer
•
An increase in the notice of withdrawal for voluntary members of the Norwegian
Banks' Guarantee Fund from one to two years
•
Branches of foreign banks pay to the extent possible a membership fee according to
the same rules that apply to Norwegian banks
We have constructed a simple example of how such a fee system could be designed. Our
example shows what banks' total fee payments would have been since 1993 compared with
actual payments. The fee rates depend on both the banks' lending growth and bank's core
capital ratio. The chart also shows actual payments of membership fees.
In our example, the fee payments would have been considerably lower early in the 1990s
and large in recent years when lending growth has been high. This provides a better profile
with small payments in periods of low growth in bank activities and high payments when
growth is strong.
Conclusion
The experience so far is that inflation targeting has provided a good basis for stabilising
inflation and inflation expectations. Interest rate setting and interest rate forecasts have also
contributed to stabilising output and employment and prices in property markets.
In some areas, regulations and frameworks can result in amplifications of fluctuations in
asset prices and credit flows. For example, tax subsidisation of homeownership can be a
source of recurrent instability in house prices and credit.
The turbulence in financial markets has prompted many countries to consider measures to
improve regulation and the functioning of markets. In Norway, the authorities can also
strengthen the work on preventing systemic risk. With our cross-border banks, broader
Nordic cooperation, particularly between finance ministries and supervisory authorities,
would be appropriate. But there is also work to be done at home. Norges Bank is proposing,
for example, revisions to the Norwegian Banks' Guarantee Fund with a view to reducing
moral hazard.
Thank you for your attention.
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