The Norwegian economy and economic policy viewed from an investment perspective

Presentation by Mr Jens Stoltenberg, The Norwegian Minister of Finance, in London on 22 January 1997

Ladies and gentlemen,

Let me first say that I am glad to for this opportunity to talk about the Norwegian economy. I will focus on our economic policy and developments, and also say something about our newly established Petroleum Fund. I hope this will give you a balanced picture of the Norwegian economy and give you a foundation for long term investment decisions.

1 economic DEVELOPMENTS

Figure Output (GDP).

Since 1993 the Norwegian economy has experienced a strong cyclical expansion, after several years of sluggish growth. Mainland GDP grew by approximately 3.5 per cent last year. We expect continued growth this year but at a lower rate.

Figure Unemployment rates.

The expansion of the economy has been accompanied by strong growth in employment. Last year, the growth in employment was sligthly above 3 per cent, the highest rate of growth measured in a single year since 1945. The unemployment rate has declined from the 1993 peak of 6 per cent to a seasonally adjusted rate of 4.3 per cent at the end of 1996, and is expected to continue to fall.

Overall, economic conditions are conducive to further growth in output and employment:

Figure Consumer prices.

• Since 1989 inflation in Norway has been lower than in our trading partner countries. In 1996 the consumer inflation was 1.3 per cent. Inflation for 1997 is estimated at 2½ per cent.
• After several years of moderate pay increases there was a pick up in the wage growth last year. Wages are estimated to have risen by an average of about 4 per cent, and given the low price inflation, real wages have increased significantly.
• Long term interest rates are currently slightly below 5 per cent while short term interest rates are 3½ per cent. In December 1992 we had to abandon the fixed exchange rate peg to the ECU, but since then, the krone exchange rate has remained relatively stable against the ECU. However, there has been considerable upward pressure on the krone lately.

Figure General government surplus as a percentage of GDP

• Public finances are strong. General government balance is expected to show a surplus of 6.5 per cent of GDP in 1997. This measure is comparable to the Maastricht deficit criterion of 3 per cent of GDP. General government gross debt, which was 42 per cent of GDP at the end of 1995, is expected to decline further. General government net assets stood at 22 per cent at the end of 1995, and is forecast to increase in the years to come.

Figure Current account of the balance of payments

• The current account of the balance of payments in Norway has been in surplus since 1989. It is estimated at sligthly below 8 per cent of GDP both in 1996 and 1997. In 1995 Norway became a net creditor nation, and net foreign assets are expected to increase further in the coming years. It is important to note, however, that these surpluses on the current account to a large extent reflect our exports of oil and gas, which again correspond to a depletion of our petroleum assets.

There are of course some risks and uncertainties. A major one is the amplitude of the present upturn, which may prove to be on such a scale that it will trigger pressures resulting in accelerating wage and price inflation. Such a development might be a threat to the tradable sector in Norway.

Given the size of the Norwegian petroleum sector, the economy and especially government finances are of course sensitive to fluctuations in oil prices. The price of oil is relatively high at the moment, but history tells us that large unexpected drops do occur. A drop in oil prices could result in significant reductions in state revenues. One might say that the importance of the petroleum sector gives added uncertainty to the economic forecasts in Norway compared to other European countries.

2 ECONOMIC POLICY

A key element in Norwegian economic policy over the past few years has been to try to reverse some of the loss of competitiveness we experienced in the 1970s and 1980s. The efforts to maintain low inflation and a stable exchange rate has given positive results. It is our aim that the expected increase in petroleum revenues in the years to come should not, once again, weaken the competitiveness and erode the basis of our tradable goods sector.

The central basis for our economic policy is to maintain stable economic growth combined with low price and wage inflation, while gradually achieving reductions in unemployment. After a long period of steady growth, this task may be more difficult in the time to come. We saw wage growth picking up last year.

With the great increase in petroleum revenues, it has become a difficult political challenge to enforce a sufficiently tight policy to prevent the economy from overheating. In some respects, the Norwegian economy has now come to a cross roads.

Figure Exchange rates against the ECU.

Monetary policy remains firmly established. Monetary policy shall, in conjunction with other policy instruments, contribute to a stable economic development. The operational target for monetary policy is to maintain the stability of the krone's exchange rate vis-à-vis other European currencies.

Since the floating of the krone in December 1992 the exchange rate has remained quite stable. Since November 1996, however, there has been considerable upward pressure on the krone, and the krone has appreciated by some 4 per cent since then. In order to limit the appreciation of the krone the Bank of Norway has cut its official interest rates by 1¼ per cent in three rounds in the last couple of months. This has brought Norwegian short term interest rates almost 1 percentage point below the ECU-rates and only slightly above German rates. At the same time the central bank has undertaken substantial interventions in the currency market. In connection with the last rate cut on January 10th the central bank also announced that it will not carry out large currency interventions for some time. This decision must be seen in light of the developments in the currency market.

These recent developments have, however, not entailed any change in the guidelines for monetary policy. In the present regulation of monetary policy it is said that the monetary policy to be conducted by Norges Bank shall be aimed at maintaining a stable krone exchange rate against European currencies. At the same time, the regulation recognizes that there may arise situations when limited use of monetary policy measures may not suffice to keep the krone within the prescribed range. In these situations, however, monetary policy intruments will be oriented with a view to returning the exchange rate over time to its initial range.

The most important monetary event in Europe in the years to come will be creation of the European Monetary Union (EMU). The EMU will be important both for countries that join as well as for those countries that can not or choose not to take part. A zone of currency stability in Europe will also be in our interest. EMU does not require any immediate changes in the Norwegian monetary regime, but entails new challenges for monetary policy in the time ahead. We will continue to work with these questions and decide how to face the challenges when the EMU is established.

When monetary policy is aimed at maintaining a stable exchange rate, it follows that the main responsibility for avoiding excessive growth in domestic demand lies with fiscal policy.

Figure Fiscal budget's real underlying spending growth and growth in mainland GDP.

In the current phase of the business cycle, fiscal policy is directed towards avoiding excessive growth in domestic demand. As private demand has picked up, fiscal policy has been significantly tightened in the last few years. The budget for 1997 is based on a real growth in government spending of 1 per cent. A tight fiscal policy is an important element of the present economic policy.

Figure Developments in old-age and disability pensions and in central government's net cash flow from petroleum activities.

Budget discipline must be maintained in order to cope with the expected decline in petroleum revenues at the beginning of the next century. We know that these revenues sooner or later will decline. The decline will probably come at the same time as the welfare expenditures start to increase due to the ageing of the population and maturing of the pension system.

3 THE GOVERNMENT PETROLEUM FUND

The expected increase in welfare expenditures means that the government should in the years to come build up financial reserves. The estimated increase in petroleum revenues will be a good opportunity for building up such reserves.

The Government Petroleum Fund is a tool for long-term economic management of our petroleums assets. The petroleum revenues are not like other government revenues:

• They are uncertain and fluctuate strongly over time. The Petroleum Fund may serve as a buffer in the use of these revenues.
• They are based on the depletion and sale of a non-renewable natural resource. Through the Petroleum Fund we may reallocate our assets from oil to financial assets.
• They can cause overheating of the economy and erode the basis for the tradable goods sector. A sudden decrease in the use of petroleums revenues may in turn necessitate painful structural changes in the economy. The Petroleum Fund may help to even out the use of the petroleum revenues.

It is important to note that the Government Petroleum Fund is an integrated part of the goverment fiscal budget, and the Fund is to reflect goverment financial saving. Money is only accumulated in the Fund when the fiscal budget including petroleum revenues shows a surplus. And when the total fiscal budget shows a deficit, money will be taken from the Fund. This means that the Fund will grow when government saving is positive and shrink when government financial saving is negative.

The Government Petroleum Fund can simply be seen as just a different way of doing the government accounts. This is intentional. If it had been a fund separated from the budgetary process, there would not have been a clear link between the stance of fiscal policy and the capital accumulating in the fund. One could then get a situation where the fund is growing, while at the same time the fiscal budget shows a deficit. Such a fund would have made the actual development in the government finances less transparent.

Figure Fiscal budget and the Government Petroleum Fund.

The first allocation to the Petroleum Fund was made in 1996. At the end of 1996 there was an allocation in the Fund of nearly 46 billion kroner, which is the expected surplus for 1996. We estimate a net allocation in the fund of 55 billion kroner in 1997. The forecasts then show an increase to 71 billion kroner in year 2000, bringing the capital in the fund to an estimated 270 billion kroner at the end of that year. This is approximately equivalent to 25 billion Pounds Sterling.

Of course, such forecasts rarely prove to be right, but they illustrate a possible development based on some technical assumptions, among other things on future oil revenues and fiscal policies and on our understanding of the economy. According to these forecasts the Fund would grow from scratch to 25 per cent of GDP in five years. It is likely to continue to grow the following five years as well, but then rather slowly.

Even though the Government Petroleum Fund is expected to become rather large relative to the size of the Norwegian economy, it will not be that dominant in the international financial markets.

An important point with a fund of this magnitude, is setting the investment guidelines and ensuring a competent management of the fund. The Ministry of Finance is responsible for the management of the fund.

The Ministry has issued guidelines and regulations but the daily management of the Fund has been delegated to the central bank of Norway. The task of Norges Bank's to maximise return on investment given the guidelines set by the Ministry.

The Fund is to be invested abroad in financial assets. The reason for this is as follows: The Fund mirrors to a large extent Norway's large current account surpluses, which in part are due to the oil revenues. These current account surpluses represent the financial savings of Norway as a nation. The only end use of these current account surpluses, is of course future imports. The aim is therefore, given an acceptable risk level, to maximise the Fund's international purchasing power, or if you will, the future capacity to import. The currency distribution in the investment guidelines is therefore set broadly according to Norway's import weights, according to the share each country has of Norway's imports.

The guidelines stipulate that the assets are to be invested mainly in low-risk bonds. As the Fund grows in size, and exceeds the buffer that might be needed to finance a budget deficit, the question of investing in other asset classes arises. Experience shows that expanding the guidelines to encompass also equity capital instruments can yield both a higher expected return and give increased diversification compared with investing in only low risk fixed income instruments. We expect to make an assessment of the investment guidelines later in 1997.

All in all, the Norwegian economy is in good health. The main reasons are sound economic policies combined with favourable developments in the economy. In the time ahead it is necessary to continue to pursue sound macroeconomic policies to prevent the economy from overheating and keep it on a sustainable growth path. The major economic participants in Norway - government, labour and business - are all well aware of this, and I am confident that we will manage to face the changing economic framework in a successful manner. Thank you for your attention. If you have any questions, I will be more than happy to try to answer them.