Jarle Bergo: The Norwegian economy and financial stability
Speech by Mr Jarle Bergo, Deputy Governor of Norges Bank (Central Bank of Norway), at the
Norwegian Savings Banks Conference, hosted by Fox-Pitt, Kelton, London, 7 November 2006.
The Charts in pdf-format can be found on the Norges Bank's website.
The text below may differ slightly from the actual presentation. The speech is based on the assessments presented at Norges
Bank's press conference following the Executive Board's monetary policy meeting on 1 November and Inflation Report 3/06.
* * *
First of all, let me tell you how pleased I am to be here with you at the Norwegian Savings Banks
conference in the great city of London, and to share with you some views on the Norwegian economy
and financial stability.
I shall structure my presentation as follows: First some stylised facts on our two economies, then set
out the special challenges to a small, open, oil-rich economy. Next, I shall comment on the current
economic situation and the prospects before I turn to financial stability issues.
Now, about our countries: The UK and Norway enjoy strong and close relations, not least trade
relations and we have done so for centuries. Our first bilateral free trade agreement was signed
between King Henry the third and King Håkon Håkonsson in 1223. Today the UK is our single largest
export market and the fourth largest supplier of Norwegian imports.
We are also bound together by a common sea. We have developed our petroleum resources largely in
parallel. The opening of a new gas pipeline from mid-Norway to Easington - Langeled - in October
this year is yet another example of the tight bonds between us.
Comparing our two countries we find strong similarities - both are affluent, growing briskly, and
experiencing low unemployment. Both are open economies with a significant public sector. The UK
economy is, however, nearly eight times larger than the Norwegian economy and with a very large and
well-developed financial sector, while Norway on the other hand has a much larger oil sector.
Challenges in an oil economy
Norway ranks as the world's third largest oil exporter after Saudi Arabia and Russia and the eight
largest oil producer.
Petroleum activities have contributed substantially to Norway's GDP, exports and government
revenues since the late 1970s. Petroleum activities give Norway an economic base that is not
available to many other countries.
But oil and gas also present Norway with considerable economic policy challenges. The experience of
other countries that have received large, unexpected income from natural resources is not
encouraging. Societies that suddenly gain access to huge wealth stemming from natural resources
have a tendency to spend the money and then fall into decline.
Spain in the 17th century provides a good example of this, as the historian David Landes observed.1
The colonisation of South and Central America gave access to a wealth of natural resources, not least
gold. Spain chose to spend a large portion of the windfalls on luxury and war. More recently the
expression "Dutch disease" reminds us that this issue is still relevant.
It can certainly be argued that easy money is bad for a country. It is tempting to live comfortably on
this income - which actually is not income but drawing on wealth - while it lasts, and forget about and
be less concerned about safeguarding other revenue sources. The challenges with large income from
natural resources and its negative impact on economic growth have also been pointed out by Jeffrey
Sachs and Andrew Warren.2
Success in managing our petroleum wealth may be particularly dependent on four key factors.
First, from a long-term perspective, oil and gas production will take place during a limited time period.
When oil is extracted and sold, petroleum wealth is transformed into financial wealth. This wealth
belongs not only to our generation, but also to future generations. We must therefore manage the
wealth as an asset.
Second, the size of the cash flow from petroleum activities varies considerably from year to year. If it
were to be spent as it accrues, this would lead to strong cyclical fluctuations in the Norwegian
economy.
Third, in terms of economic policy, an explanation for "the resource curse" has been that such
"unearned" wealth leads to an extreme focus from various groups on acquiring as much of this extra
wealth as possible. It is therefore important that the decision-making processes in the political sphere
guard against this kind of "rent-seeking" behaviour.
Finally, petroleum revenue spending will have a serious impact on the competitiveness of Norwegian
industry if spending is too rapid and variable. It is therefore important that we succeed in maintaining
an industry structure that promotes learning, innovation and development, which can give us other
sources of revenue than oil.
What we are trying to achieve is to transform petroleum wealth into financial wealth, to the benefit of
future generations as well.
Nonetheless, the discounted value of our own labour force is our main asset. Our livelihood essentially
depends, and will continue to depend, on our ability to efficiently produce goods and services and to
use our creativity and innovation to become ever more efficient.
Economic policy guidelines
During the first thirty years of the oil age, economic fluctuations, often linked to oil revenue spending,
were strong. Against this backdrop and increasing demands for spending more, new economic policy
guidelines were adopted in 2001.
A fiscal rule was drawn up for petroleum revenue spending over the central government budget.
Government petroleum revenues are transferred to the Petroleum Fund, now renamed the
Government Pension Fund - Global. The Fund serves as a buffer between current petroleum revenues
and the use of these revenues in the Norwegian economy. According to the fiscal rule, future
petroleum revenue will be added to the Fund while spending shall be limited to the expected real
annual return on the Fund, estimated at four per cent. When all the petroleum revenues have been
extracted, the Fund would grow no further, but its value in real terms would be maintained - in
principle for eternity. This ensures an equitable distribution of the petroleum wealth across
generations.
The fiscal spending rule partly insulates the economy from fluctuations in the petroleum sector - and
when followed it ensures that revenue spending is at a level that can be sustained over time. The
difference between the net cash flow and spending is reinvested in foreign financial markets. Norges
Bank manages the Fund, and our London office plays a pivotal role in the investment activities.
The Pension Fund also functions as a buffer and dampens the wide fluctuations in the krone
exchange rate that petroleum revenue inflows might otherwise have generated. The Fund is invested
solely abroad, thus acting as a kind of "revolving door" for currency inflows from petroleum activities.
With the fiscal rule, it was recognised that the most important contribution fiscal policy can make to
stabilising the Norwegian economy is to provide a sound, long-term strategy for petroleum revenue
spending.
As a consequence, monetary policy had to take responsibility for smoothing the business cycle to a
greater extent than earlier. A specific target for monetary policy was thus a necessary supplement to
the fiscal rule to ensure reasonable macroeconomic stability. The operational target states that
monetary policy in Norway is oriented towards low and stable inflation, with annual consumer price
inflation of approximately 2.5 per cent over time. In its conduct of monetary policy, Norges Bank
operates a flexible inflation targeting regime, so that weight is given to both variability in inflation and
variability in output and employment.
Current economic situation
Since the summer of 2003, there has been a clear upturn in the Norwegian economy. Low domestic
interest rates, increased petroleum investment, favourable prices in important export markets, and a
strong upturn in the world economy have contributed to solid growth in the Norwegian economy. So far
in the upturn, the mainland economy has grown by an average of close to 4 per cent annually.
Current information on economic developments indicates that the upswing is continuing. Corporate
sector profitability is good. There is strong growth in employment, unemployment has fallen markedly,
and household demand continues to rise.
Unemployment is now at a historically low level. Seasonally adjusted, registered unemployment stood
at 2.3 per cent of the labour force in October.
Nevertheless, wage moderation has generally prevailed so far. The opportunities provided by an
international labour market may have prompted participants in local and centralised wage negotiations
to place greater emphasis on the considerably higher wage level in Norway relative to our trading
partners, and potential job vulnerability. At the same time, labour migration has reduced bottlenecks in
some industries allowing the economy to expand more briskly than would seem warranted judging by
previous experience.
Inflation has remained low. According to our indicators underlying inflation appears to be in the range
of 3⁄4 - 11⁄2 per cent. Low underlying inflation is not a result of weak economic growth but rather reflects
favourable developments on the supply side of the economy. Strong competition, high productivity
growth, and a shift in imports towards low-cost countries have dampened domestic price increases.
Presently, there is little spare capacity in the Norwegian economy. Demand is still strong and real
income growth high. At the same time, the krone exchange rate has depreciated. This should over
time result in a pick-up in inflation.
The global economy has shown strong growth, and continued solid growth among our trading partners
is in prospect. However, there is uncertainty regarding the slow- down in the US economy. Consumer
price inflation among a number of our trading partners has risen as a result of rising energy prices, but
the increase in prices for other goods and services generally remains moderate.
Monetary policy
The challenge to monetary policy in the present conjuncture is how the interest rate should be set to
steer inflation towards the target while at the same time avoiding overheating in the real economy.
Central banks influence over-night market rates directly via the policy rate. However, economic agents'
consumption and investment decisions depend more on their interest rate expectations. Hence,
monetary policy works primarily by influencing expectations regarding future interest rates. Monetary
policy may thus be more efficient if economic agents understand the central bank's intentions in its
interest-rate setting.
Inflation
In the November 2005 Report, Norges Bank first published its own forecast for the interest
rate for the next three years. The aim is to enhance the predictability of monetary policy. With a
predictable monetary policy, market participants can react to new information in a way that contributes
to stabilising developments in output and inflation.
We try to establish an interest rate path that provides a reasonable balance between the objective of
stabilising inflation at target and the objective of stabilising developments in output and employment
within a reasonable time horizon, normally 1 - 3 years. Interest-rate setting is also assessed in the light
of developments in property prices and credit.
Inflation Report
The results of this trade-off are published in the in the form of a chart that presents
central projections for the interest rate, the exchange rate, inflation and capacity utilisation in the
economy.
Underlying inflation has been lower than projected in recent months. Nevertheless, several factors
point to higher inflation ahead. Capacity utilisation is high and there is little spare capacity in the
Norwegian economy. Employment is rising rapidly and unemployment has exhibited a marked decline.
There are signs of higher wage growth and expectations of rising inflation. At the same time, the krone
exchange rate has depreciated from strong values.
Monetary policy influences the economy with a lag. Over several years, interest rates have been
considerably lower than what we consider to be a neutral level. Against the background of high growth
in output and employment, rising wage growth and a weaker krone, there are prospects of higher
consumer price inflation ahead. The interest rate may gradually be raised to a more normal level at a
somewhat faster pace than envisaged earlier, although it is unlikely that rates will be raised at every
monetary policy meeting. Based on our current assessment, the interest rate will thus continue to be
raised in small, not too frequent steps.
The forecasts are uncertain. They are based among other things on an assessment of the current
situation and a perception of how the economy functions. Disturbances to the economy may result in
changes in the forecasts. Frequent data revisions imply that the current economic situation is not fully
known. The chart illustrates the uncertainty surrounding the forecasts. The wider the fan chart is, the
more uncertain the forecast. The uncertainty implies that the interest rate should normally be changed
gradually, so that we can assess the effects of interest rate changes and take into account new
information about economic developments.
Changes in forecasts are nothing new to financial market participants. There is no reason to believe
that Norges Bank will not also have to reassess its interest rate and other forecasts as new information
emerges about economic developments. Our ambition must be to reduce uncertainty with regard to
our own response pattern.
Financial stability and monetary policy
Financial stability means that the financial system is robust to disturbances in the economy and is able
to channel funding, execute payments and redistribute risk in a satisfactory manner. Experience
shows that the foundation for financial instability is laid during periods of strong growth in debt and
asset prices. Banks play a central part in providing credit and executing payments and are therefore
important to financial stability.
Monetary and financial stability are both important for economic developments. In my view, they are
often mutually reinforcing.
Financial stability can be seen almost as a prerequisite for price stability. First, it promotes stable
developments in financial markets, which is crucial to balanced economic growth. Second, financial
stability supports the transmission mechanisms of monetary policy.
Conversely, price stability has a positive influence on financial stability. A successful monetary policy
will support financial stability by removing distorted price signals associated with high and volatile
inflation. Low and stable inflation provides households and enterprises with a clear indication of
changes in relative prices, enabling them to make better informed decisions. Allocation of resources
will then be more efficient.
The Norwegian financial system and its soundness
In Norway, responsibility for financial stability is divided between Norges Bank, Kredittilsynet (the
Financial Supervisory Authority of Norway) and the Ministry of Finance. To promote efficient
cooperation, the regular exchange of information between these authorities is crucial and a framework
for cooperation has been established.
Kredittilsynet is responsible for supervising individual financial institutions, while Norges Bank
analyses the stability of the financial system from a macro perspective, aiming at identifying
developments that may lead to the build-up of excessive risk in the financial sector and the build-up of
financial imbalances that may pose a threat to financial stability. Norges Bank also has special
responsibility for the clearing and settlement systems and inter-bank payment systems.
Should a situation arise where financial stability is threatened, Norges Bank and other authorities will,
if necessary, implement measures to strengthen the financial system. Norges Bank may supply
extraordinary liquidity to individual banks or to the banking system as a whole but only against proper
collateral. The Ministry of Finance will be responsible for decisions where use of tax-payers' money
would be an issue.
Norges Bank publishes an overall assessment of the outlook for financial stability in the biannual
Financial Stability report. The conclusions in the report are summarised in a submission from the
Bank's Executive Board to the Ministry of Finance. The report is also intended to foster dialogue with
the financial industry and to increase awareness of and foster debate on the importance of financial
stability.
Norges Bank has also developed a macroeconomic model to assess developments in financial
stability based on the forecasts published in the Bank's Inflation Report. Based partly on the results
from this model, financial stability assessments are taken into account in the monetary
decisionmaking process.
Before I turn to our most recent assessment of the stability of the Norwegian financial system, let me
give a brief outline of the structure of the financial system.
The Norwegian financial system is dominated by banks, with a market share of more than 56 per cent,
calculated as the banks' share of total assets in financial institutions and mutual funds. The banking
system is relatively concentrated. The largest bank had a market share of 37 per cent in terms of total
assets in the banking sector at the end of 2005, while the largest five had a market share of 61 per
cent.
Savings banks account for a substantial part of the banking sector. However, most of the savings
banks are quite small. To partly compensate for that, some cooperate on a range of products which
provides economies of scale while maintaining their independence.
During the past decade, activities of foreign-owned banks in Norway have expanded considerably
both through take-overs and organic growth. At the end of 2005, they had a market share of over 30
per cent, in terms of total assets. Their lending growth has been higher than for Norwegian-owned
banks for several years. The development towards larger cross-border banks makes supervision and
crisis management more complicated. In the event of a crisis, central banks, supervisory authorities,
political authorities as well as deposit guarantee funds in several countries will have to be involved.
In contrast to the balance sheets of the banking sectors in many other countries, Norwegian banks'
total assets are heavily dominated by loans to households and non-financial enterprises. One reason
for that might be the lack of securitisation of loans. The work on regulations that will enable
securitisation of loans is in progress. Loans to households alone constitute around 50 per cent of
banks' total assets. Loans to households have increased as a percentage of banks' total assets,
reflecting strong credit growth to households.
Norwegian banks' main source of financing is deposits from households and non-financial enterprises.
Securities are the second largest source of financing.
Assessment of financial stability in Norway
In 2005, the International Monetary Fund (IMF) prepared a thorough assessment of the financial
system in Norway under the Financial Sector Assessment Program (FSAP) for Norway. The main
conclusions were that the system appeared sound, well managed and competitive, and shorter-term
vulnerabilities appeared low overall. Beyond the shorter term, rising household debt levels and
associated house price inflation were the most important potential risk factors that needed to be
watched.
Let me add some observations on this last topic. Unlike many other countries, house purchases in
Norway are mostly financed by loans from private banks at variable interest rates. Growth in credit to
households has been high for a relatively long period, largely driven by rising house prices. According
to our model, a rise in house prices has a strong and prolonged effect on household debt, as it takes
time before all dwellings have been traded at the new higher price level. Growth in credit to
households can therefore remain high for quite some time, even if the increase in house prices should
start to subside.
What then is driving house prices? In our empirical model, house prices are determined by household
income, banks' lending rates after tax, the housing stock, unemployment, and an indicator of
household expectations of their future financial situation and of the Norwegian economy as a whole.3
Household income has contributed most to the rise in house prices in the last two years. Interest rates
have increased since the summer of 2005. Given the lags involved, the cumulative contribution from
interest rates to house prices is still positive. Nevertheless, in the period ahead, the normalisation of
interest rates in Norway may moderate the rise in house prices.
Observations from other countries, such as the UK and Australia, indicate that a rise in the key interest
rate by the central bank has been followed by slowdown in house prices.
Growth in household debt has been higher than growth in disposable income for several years now.
The household debt burden (household debt as a percentage of disposable income) has increased to
a historically high level and is expected to rise further. However, the household interest burden
(interest expenses after tax as a percentage of disposable income plus interest expenses) is still low
as a result of the low interest rate level. The interest burden is expected to increase to fairly high levels
in pace with a normalisation of the interest rate. Still, on the whole, households' financial position is
strong.
The rise in the policy rate so far has not been fully reflected in banks' lending rates. Intensified
competition, especially for mortgages, has dampened increases. Banks' interest margin has declined
during the last decade.
Falling interest margins have, however, partly been compensated by high lending growth, and banks
have so far succeeded in maintaining good results. Pre-tax profits as a percentage of total assets have
been solid.
Norwegian banks are solid. Due to high growth in lending, capital adequacy ratios for banks as a
whole declined slightly in 2005. Nevertheless, capital adequacy ratios are still high.
Under Basel II, capital requirements for credit risk are to be calculated using either the standardised
approach or more risk-sensitive internal ratings based (IRB) approaches. The five largest Norwegian
banks have applied to Kredittilsynet to use the Foundation Internal Ratings Based (FIBR) approach for
credit risk. Under Basel II, the required level of capital for banks in Norway will be reduced. The main
reason is that mortgages constitute a substantial part of banks' total assets. These loans are
considered low risk under Basel II. The reduction in the required level of capital may be substantial for
the banks using IRB approaches for credit risk, though transitional arrangements provide for a gradual
reduction.
With solid results in banks, a good financial situation for borrowers and a well functioning financial
infrastructure, there appears to be little risk of a crisis in Norway's financial system in the next few
years. However, the long period of strong debt growth and asset price inflation may be a source of
subsequent instability in the economy and in banks' losses and results. During an upturn such as the
current one, it is therefore important to show vigilance and provide a cushion for weaker cyclical
conditions and higher interest rates. Within the framework of Basel II, banks that shift to internal risk
models based on historical losses for measuring capital requirements should take into account that
loan losses have been unusually low in recent years.
Banks are vying for market shares. Competition is fostering more cost-effective banks, better and
more flexible borrowing terms and a broader product range. This is to the benefit of customers. At the
same time, it is important that banks price risk correctly. This enhances capital efficiency and
promotes financial stability.
Thank you for your attention.
William A Ryback: Macro prudential policy - a new name for some old ways of
thinking?
Speech by Mr William A Ryback, Deputy Chief Executive of the Hong Kong Monetary Authority, at the
Macro Prudential Supervision Conference: Challenges for Financial Supervisors, organised by the
Korea Financial Supervisory Commission / Financial Supervisory Service and the International
Monetary Fund, Seoul, 7 November 2006.
* * *
Ladies and Gentlemen,
I am pleased to be here today to add my thoughts to this important discussion on emerging insights
into the macro prudential end of the supervision business. I also am pleased to be back in Seoul one
of the most dynamic cities in Asia and to be hosted by my friends in the Korean Bank supervisory
community - many of whom I have known for a number of years.
It is almost ten years from the financial crises that affected many parts of Asia. This conference then is
being held at an opportune time to allow us to reflect on the lessons learned. There has been
considerable change over the last decade. Risk management in the regions banking systems' have
become more robust. There has also been a step-change in the standards of supervision. Risk-based
supervision has replaced compliance checking. There are also now moves under way to improve
regional cooperation on issues like Basel II implementation, in which EMEAP will continue to play a
leading role.
Clearly, no financial system can be considered stable unless the individual institutions that comprise
its whole are themselves healthy. Thus risk-based supervision and proper risk assessment by banks
are essential measures to bring about financial stability. In this regard Basel II will no doubt help
strengthen our collective financial systems by encouraging banks to adopt stronger risk management
mechanisms. Pillar 2 of Basel II will add to the stability of the financial system by providing a deeper
and richer mechanism to evaluate a broader range of risks - including risks that will impact on the
system more broadly - such as credit concentration risk. Encouraging greater transparency by banks
under Pillar 3 also contributes to making financial systems more resilient by providing a consistent
framework across national boundaries for analysts to do their job in identifying weak or risky banks.
Ensuring the soundness of individual banks - what some people now call the "micro prudential"
perspective - is, however, only part of ensuring a sound financial system. Bank supervisors these
days now talk about "pillars" and in addition to the three pillars of Basel II I believe that there are also
two pillars of financial stability. One of these is the micro prudential perspective. The other one is the
macro prudential perspective. They are mutually reinforcing and both are essential for ensuring
financial stability. An important movement in the last decade has been a much more explicit emphasis
being given to the macro prudential aspects of banking supervision by central banks as well as
academics and other market observers.
What do we mean by macro prudential aspects? I think it has the following four features:
•
First, its aims to limit the distress to entire financial systems rather than distress to individual
institutions.
•
Second, its chief aim is to avoid large and burdensome costs to the economy - such as
expensive bank bailouts - rather than aiming to protect more narrowly the depositors of an
individual bank.
•
Third, it is based largely on the assumption that at least some of the risks faced by the
banking system collectively differ from those faced by individual banks. In other words, the
risk to the system is not simply the sum of risks to individual banks.
•
And, fourth, it aims to examine risks that arise from the interaction of banks as part of a
financial system rather than on a bank-by-bank basis.
While having sound and sturdy building blocks of the system is essential, it is also essential to
understand how they all fit together in a framework and this is where the macro prudential perspective
becomes critical. In short, the difference between the two pillars of micro and macro prudential
surveillance is between a system-wide health check and ensuring that individual banks are inoculated
properly from disease. The macro prudential pillar takes account of those risks that may affect all, part,
or most banks in the system - and not just individual banks.
Like most other bank supervisors I've spent most of my career looking at banking system soundness
mainly from an individual bank perspective. However, as a career central banker, I also have had to
spend a good deal of time looking at financial stability from the macro prudential perspective as well.
For much of my career we didn't call it macro surveillance but it was very much in our minds when, for
example, in the late 1980's the U.S. banking system suffered from the collapse of a number of sectors
of the economy episodically resulting in a very unhealthy and unstable banking system as a whole.
Over 1,500 banks failed and public confidence in the industry was understandably threatened. In fact,
on two occasions during that period the system was so close to collapse that major banks were
unwilling to settle transactions unless the physical documents were in hand. At that time public policy
was being directed toward eliminating weak and unstable banks so that trust and confidence could
return - a necessary precursor to turning around a weak economy. That's why - to use the title of my
speech - I wonder whether the trend toward macro prudential surveillance isn't just a new name for
something we, as supervisors, have been doing all along.
An interest in macro prudential policy is part of what Tomasso Padoa-Schioppa has called the "genetic
code" of central banks. Throughout their history central banks have aimed to ensure the overall
soundness of the financial system and this followed naturally from their basic functions. Three
historical developments were the key to this. In the beginning central banks were first and foremost
banks - and like any bank they needed to consider the soundness and creditworthiness of their clients
as well as factors in the general trading environment that might cause them losses. Second, over time,
central banks developed a monopoly over ultimate liquidity, the means of final settlement, and they
facilitated the settlement of inter bank payments through the rediscounting of commercial bank assets
and the collection of reserves in the form of bank deposits. Third, as commercial bank money
progressively developed into a larger share of the money stock, the value of money became
dependent on the soundness of commercial banks. In this environment the concern of the central
bank for the orderly functioning and stability of the banking system arose from the need to maintain the
public goods of a stable means of payment, a unit of account and a store of value. This included last
resort lending when commercial banks suffered from liquidity strains.
This historical development meant that by the end of the nineteenth century, or by the early years of
the twentieth at the latest, central banks' concern for financial stability was an already well-established
part of their function. However, the second half of the twentieth century saw many central banks also
taking on the responsibility for statute-based micro prudential supervision. In many parts of the world
banking laws were passed for the first time and the central bank often became the bank supervisor. In
this process the distinction between the micro- and macro- perspectives became blurred.
What has changed in the past ten to fifteen years is that central banks have started to give much more
explicit emphasis than in the past on their macro prudential responsibilities and have distinguished it
more clearly from the micro-supervision perspective. This renewed emphasis has several different
sources.
One of them was undoubtedly the financial crises that hit Asia in 1997. This experience showed that
even if the individual banks in a financial system appear to be sound, the system itself can still be
overwhelmed by financial shocks. For example, the system can be exposed to a common risk that isn't
obvious from looking at each bank individually. In the Asian crisis countries the exposures of banks to
foreign e