Kingdom of the Netherlands: Concluding Statement of the 2018 Article IV Consultation

February 28, 2018

An IMF team visited the Netherlands during February 19 – 28, 2018, for the 2018 Article IV consultation. This statement describes the preliminary findings of the mission.

Outlook – A Positive Outlook with Remaining Challenges

1. The Dutch economy is in a positive phase. Growth is estimated at just above 3 percent in 2017 and is forecast to continue at about the same rate this year, supported by strong domestic demand and resilient exports. However, wage growth has been modest at around 1 percent in recent years although trending upwards, reflecting slow productivity growth, subdued inflation expectations, and remaining slack and rising flexibility in the labor market. Inflation only picked up moderately, to 1.3 percent in 2017. Credit developments have remained contained due to continued deleveraging by banks, firms, and households. The current account surplus increased further, reflecting high domestic net savings, especially in the corporate sector, and the pick-up in global trade. The output gap is estimated to have closed in 2017 and is expected to remain positive over the medium term as macroeconomic policies remain supportive and adverse demographics limit potential growth.

2. The risks to the outlook are tilted to the downside. Foreign demand could be dampened by growth uncertainties in major trading partners and intensification of the risks of fragmentation/security dislocation. Monetary policy normalization may add pressures to already leveraged firms and households and increase the risk of distress in major banks. On the upside, improvements in labor and housing markets would support consumption and investment, and growth could turn out to be stronger than expected.

3. Taking advantage of improved macroeconomic conditions and mitigating downside risks, policies adopted by the new Dutch government are appropriately aimed at reducing financial vulnerabilities in the private sector and unlocking potential growth. Under the envisaged expansionary fiscal policy, a strong focus on growth- enhancing measures would help bolster potential growth. Accelerating the phasing out of regulatory and tax distortions would help repair household and firm balance sheets. Tax and pension reforms, together with other structural reforms in housing and labor markets, would help reduce financial vulnerabilities, improve market efficiency, enhance productivity and potential growth, and help external rebalancing.

Fiscal Policy – Using Fiscal Space to Boost Potential Growth

4. Fiscal policy will continue to be expansionary in 2018 and 2019. The spending plans and tax cuts announced by the new government foresee a fiscal stimulus of almost 2 percent of GDP over the next four years. Given the strong economic growth in 2017 and improved outlook, the government would maintain a budget surplus throughout the projection period, and public debt (at about 57 percent of GDP at end-2017) will decrease further.

5. Using the fiscal space for growth-enhancing measures is appropriate and helpful for external rebalancing. Past policies created substantial fiscal space in the Netherlands, part of which is now being used for both tax cuts and expenditure increases. On the revenue side, lower corporate and personal income taxes will partly be compensated by raising the low value-added tax rate. Shifting further from direct to indirect taxation would increase work incentives and raise potential output. The mission notes that the government has recently announced a package of measures to address international tax avoidance and evasion. On the expenditure side, higher spending is allocated to security, defense, and education. To have a stronger impact on potential growth, devoting a larger share of any additional spending to education and public research and development would be desirable. Current fiscal plans would result in a pro-cyclical fiscal stance in 2018 and, to a less extent, in 2019. However, the inflation and wage growth are still subdued and most of the measures are expected to raise potential growth and help reduce external imbalances.

Labor Market - Leveling the Playing Field and Supporting Wage Growth

6. An increasing share of flexible employment helped the economic recovery, but the rising dualism might also contribute to wage moderation. Empirical analysis suggests that, apart from falling labor productivity, low inflation expectations, and remaining slack in the labor market, a rising share of temporary workers is also related to the wage moderation in the Netherlands. There is also an increasing trend of employees becoming self-employed, partly motivated by the prospects of avoiding high pension and safety net contributions, which makes wage growth less responsive to unemployment rates.

7. Policy actions should aim at reducing dualism in the labor market and supporting wage growth. The mission welcomes the government’s plan to relax stringent employment protection regulation on permanent contracts, facilitate transitions from temporary to more permanent contracts, and better regulate the registration of self-employed workers to reduce labor market dualism. Reducing the tax exemptions for self-employed people and requiring acquisition of some appropriate social insurance (e.g., disability insurance) should also help reduce labor market dualism. Stronger wage growth would be warranted given the cyclical position and it would help rebalancing within the monetary union. To support higher wages, the social partners should work together to build consensus on making wages more responsive to domestic macroeconomic conditions in the Netherlands, allowing the current wage formation process to better reflect productivity and inflation expectations. In this context, the mission welcomes the authorities’ open public communication, including in the coalition agreement, to encourage higher wages.

Housing Market – Rebalancing Supply and Demand and Reducing Household Financial Vulnerabilities

8. Rapid increases in house prices and highly indebted households reflect structural weakness in the Dutch housing market. Large subsidies for regulated renting and home ownership have crowded out investment in the unregulated rental sector. The supply shortage of private rental houses, especially in large cities, limits the functioning of the housing market, leading to higher housing prices and lower labor mobility. Comprehensive housing market reforms need to rebalance housing supply and demand, reduce household indebtedness, and promote labor mobility. The mission welcomes the authorities’ plan to accelerate the phasing down of mortgage interest deductibility (MID) by 3 percentage points instead of the 0.5 percentage point reduction per year thus far to ultimately limit deductibility to the lowest income tax rate. However, distortions to home ownership due to tax incentives will remain large even after this is fully phased down. The mission reiterates its earlier recommendation to gradually lower the maximum limit on loan-to-value (LTV) ratios from 100 percent, which remains high by international standards, to reduce household financial vulnerabilities. The mission acknowledges that actions to develop affordable houses in the private rental sector need to be taken in parallel.

Financial Sector – Strengthening Financial Resilience in a Challenging Environment

9. Dutch banks remain highly leveraged and exposed to refinancing risk due to their reliance on wholesale funding. Banks should continue to improve leverage ratios and build up capital buffers to prepare for the new regulation on internal risk models, which will likely result in higher capital requirements. In parallel, a stronger focus of bank supervision, both at the national level and by the Single Supervisory Mechanism (SSM), should be directed toward banks’ evolving business models and risk management frameworks, as the low interest rate environment and increased competition from shadow banking activities may encourage excessive risk taking. The insurance sector has come under financial stress under the effects of low interest rates and heightened competition. In this respect, the mission supports the swift elaboration of preparatory crisis plans by insurers, which will become mandatory this year, as well as and continuous efforts to streamline the insurers’ business models.

Pension System – Transition to A Transparent, Individualized, and Sustainable System

10. With protracted low interest rates and continued population aging, the defined-benefit second pillar pension funds remain under financial stress and lead to intergeneration tensions. The mission supports the pension reform outlined in the government coalition agreement, whereby collective defined-benefits schemes would be replaced by individualized defined-contributions contracts, complemented by provisions aimed at preserving appropriate risk pooling among participants and financial security at retirement.

The mission team would like to thank the authorities for their hospitality and support, as well as for open and fruitful discussions.