The recovery is projected to remain slow

Global GDP growth remains modest (). This reflects a combination of subdued aggregate demand, poor underlying supply-side developments, with weak investment, trade and productivity growth, and diminished reform momentum. In recent months, soft domestic demand in the advanced economies, especially the United States, has added to the pressures stemming from the growth slowdown in many EMEs. Policy stimulus is helping to hold up demand in China, but deep recessions persist in Brazil and Russia. Global trade growth is again weak this year (), with little or no growth in the first quarter, especially in many Asian economies, consistent with the recent slowdown in the level of new orders in global business surveys. Though firming recently, commodity prices remain relatively low, reflecting ample supply and persisting concerns about future demand strength. Financial market sentiment has improved after considerable volatility earlier in the year. Nevertheless, declines in equity prices and stronger effective exchange rates, and in the United States a further tightening of credit conditions, mean that aggregate financial conditions in the major economies generally remain tighter than in the latter half of 2015, despite additional supportive monetary policy measures in the euro area and Japan ().

Global GDP growth is set to remain subdued

Year-on-year percentage changes

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367262

Non-OECD import volume growth collapsed in 2015

Year-on-year percentage changes

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367279

Financial conditions in major advanced economies have become less supportive

OECD financial conditions index

The OECD financial conditions index is a weighted average of real short and long-term interest rates, real exchange rate, bank credit conditions, household wealth and the yield spread between corporate and government long-term bonds. A unit increase (decline) in the index implies an easing (tightening) in financial conditions sufficient to produce an average increases (reduction) in the level of GDP of ½ to 1% after four to six quarters. See details in Guichard et al. (2009). Based on available information up to 18 May 2016.

OECD Economic Outlook 99 database; Thomson Reuters; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367289

Only a slow recovery appears likely for global growth and trade over the latter half of 2016 and through 2017 ().

The global recovery will gain momentum only slowly

Statlink http://dx.doi.org/10.1787/888933368831

• OECD GDP growth is projected to be just under 2% on average over 2016-17, broadly in line with outcomes in the previous two years (, Panel A). Supportive macroeconomic policies and low commodity prices () should continue to underpin a modest recovery in the advanced economies, assuming that wage increases and business investment growth both start to pick up and tensions in financial markets do not reoccur. However, weakness in external demand stemming from the EMEs remains a drag on the advanced economies.

• In the United States, a moderate recovery is expected to continue as headwinds from the strong dollar and declining energy sector investment fade. A gradual upturn in wage growth is projected to support domestic demand as the labour market approaches full employment, with a slow improvement in productivity growth limiting the emergence of labour market pressures. In Japan, GDP growth is likely to remain modest, with the tightening labour market having only a limited impact on nominal wage growth and sizeable fiscal consolidation projected in 2017. In the euro area, growth is projected to improve slowly, helped by the gradual impact of recent monetary policy easing on credit growth and, in some countries, additional fiscal spending to assist asylum seekers. However, still sizeable labour market slack, elevated debt burdens and non-performing loans continue to hamper the recovery in some countries.

• Non-OECD GDP growth should edge up as the sharp downturns in many commodity producers gradually ease (, Panel B), provided commodity prices stabilise at their current level. However, EMEs are likely to experience diverse outcomes, reflecting differences in available policy support, the impact of low commodity prices, progress in enacting structural reforms and the extent of financial vulnerabilities. GDP growth is projected to continue moderating gradually in China, to around 6¼ per cent in 2017, as the economy rebalances from manufacturing to services. Recent fiscal policy measures provide considerable support to growth, via infrastructure and real estate investment, but also add to the challenges of achieving a smooth rebalancing and avoiding financial tensions. Solid growth should persist in India and Indonesia, helped respectively by a large planned increase in public sector wages and substantially higher infrastructure spending. The outlook for Brazil and Russia remains challenging, given the hit to incomes from low commodity prices, still high inflation, fiscal difficulties and, in Brazil, heightened political uncertainty.

GDP growth projections for the major economies

Year-on-year percentage changes

Fiscal years.

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367297

Given this low level of aggregate demand growth, only slow additional improvements are anticipated in investment growth and labour market outcomes in advanced economies.

• OECD business investment is projected to rise by between ½ and ¾ per cent in 2016, with global demand and low commodity prices checking investment in many countries, including the United States, Canada and Australia, and heightened uncertainty damping near-term spending in the United Kingdom. As these factors fade, albeit against a backdrop of continued moderate global demand growth, OECD business investment could rise gradually by between 3½ and 3¾ per cent in 2017.

• The OECD-wide unemployment rate is projected to decline to under 6¼ per cent by the latter half of 2017, despite only small changes in some of the larger economies now close to or even below estimated longer-term sustainable unemployment rates, including Germany, Japan, the United Kingdom and the United States (). Unemployment remains much higher in the euro area overall, especially in the countries hardest hit by the crisis and by fiscal consolidation. In most countries, broader measures of labour market slack also remain high. With consumer price inflation projected to remain low, only modest productivity growth and possibly greater slack than estimated, wage inflation is projected to remain moderate (). In the OECD economies as a whole, the growth in compensation per employee is projected to edge up to around 2½ per cent by 2017, from 1¾ per cent on average per annum in 2014-15.

OECD labour market conditions will improve slowly

Statlink http://dx.doi.org/10.1787/888933368848

Labour market outcomes are improving slowly

The unemployment gap is the difference between the unemployment rate and the estimated structural rate.

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367302

Investment, trade, labour market developments, and their implications for potential output and inflation are discussed further below.

Reflecting recent behaviour, these projections are conditional on traditional key linkages between macroeconomic variables remaining generally weaker than over a longer historical period. These include the links between unemployment and wage growth, trade volumes and exchange rates, and interest rates and investment. If the links are even weaker than assumed, the pick-up in growth will be slower than outlined above. On the other hand, if the strength of these relationships were to return to historical norms, the recovery would be firmer.

Weaknesses in demand, investment, trade and potential output have reinforced each other

A prolonged period of weak demand is being reflected increasingly in adverse supply-side developments. Estimates of potential output per capita growth in the major OECD economies have been revised down repeatedly in the aftermath of the crisis and, in some countries, fiscal consolidation. For the OECD as a whole, it is estimated at 1% in 2016, which is between ¾ and 1 percentage point below the average in the two decades preceding the crisis (). If policymakers fail to take action, this slowdown will deepen, with negative longer-run consequences for employment, income and inequality.

Weak investment and productivity growth have hit potential output growth

Contribution to potential per capita growth

Assuming potential output (Y*) can be represented by a Cobb-Douglas production function in terms of potential employment (N*), the capital stock (K) and total factor productivity (E*) then y* = a ∗ (n*+e*) + (1 - a) ∗ k, where lower case letters denote logs and a is the wage share. If P is the total population and PWA the population of working age (here taken to be aged 15-74), then the growth rate of potential GDP per capita (where growth rates are denoted by the first difference, d( ), of logged variables) can be decomposed into the four components depicted in the figure: d(y* - p) = a ∗ d(e*) + (1-a) ∗ d(k - n*) + d(n* - pwa) + d(pwa - p).

Potential employment rate refers to potential employment as a share of the working-age population (aged 15-74).

Active population rate refers to the share of the population of working age in the total population.

Percentage changes.

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367317

Two main factors have contributed to the decline in the growth rate of OECD potential output per capita:

• Weak capital stock growth accounts for around one-half of the slowdown. Investment in many advanced countries remains below pre-crisis levels, though it is increased in recent years, especially in the United States (). At the same time, depreciation rates are high following the rise in the share of ICT and intangible investment in total investment (OECD, 2015b).

• The rest of the decline in potential growth per capita is accounted for largely by declining total factor productivity growth. This reflects the moderation of the pace at which innovations spread across the economy, a decline of business dynamism as entry and exit rates have fallen, and only limited new product market reforms (Adalet McGowan et al., 2015).

Capital stock growth and the investment rate will pick up from low levels

The investment rate is investment as a percentage of the previous period's capital stock.

OECD Economic Outlook 99 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367327

In addition, weak labour markets have also reduced potential growth in some economies through increases in the structural unemployment rate and the number of people withdrawing from the labour force, and indirectly through deterioration in the skills of people without employment for an extended period. The slowdown in global trade, partly reflecting weak investment, has also been an important intermediate factor in slowing potential output growth in many economies, by reducing competitive pressures and technological spillovers and hence innovative activity (discussed below).

Investment dynamics are broadly aligned with output factors

Investment growth and its composition have varied across the main OECD areas, reflecting differences in demand dynamics and country-specific developments. This tendency is expected to continue in 2016 and 2017 (, ).

Investment growth is expected to strengthen in the euro area and the United States

Year-on-year percentage changes

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367339

The composition of total investment growth in advanced countries will continue to differ

Country coverage differs for business and public investment aggregates, which include only Australia, Belgium, Canada, Denmark, Finland, France, Germany, Iceland, Japan, Korea, the Netherlands, New Zealand, Norway, Sweden, Switzerland, the United Kingdom and the United States.

Country coverage differs for business and public investment aggregates, which include only Belgium, Finland, France, Germany and the Netherlands.

OECD Economic Outlook 99 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367347

• In the United States, total investment increased between 2010 and mid-2015 at a pace similar to that seen before the crisis and in line with overall GDP growth. However, in the second half of 2015, investment levelled off and demand for commercial and industrial loans weakened. This was associated with lower profits, increasing defaults and a sharp fall in investment by oil producing companies as global oil prices collapsed. As these effects ease, business investment should pick up, supported by generally healthy corporate finances, although soft global demand conditions could offset more favourable domestic demand. Companies have reduced their leverage and hold large amounts of cash and deposits. Housing investment is expected to be more robust, reflecting pent-up demand, rising incomes and still favourable financing conditions.

• In the euro area, investment strengthened somewhat in the second half of 2015 together with corporate profits. So far, bank lending to enterprises has barely grown in the area as a whole. However, loan demand by enterprises has increased, reflecting the low cost of credit and increasing needs for working capital and fixed investment. The total cost of bank borrowing for enterprises has fallen, especially in countries hardest hit by the crisis, and intra euro area differences in bank rates have diminished. Credit standards on loans to enterprises have also continued to ease. Nevertheless, modest growth prospects together with political uncertainty (see below) and not fully resolved problems in the banking sector mean that investment will grow at a broadly similar pace as in recent years.

• In Japan, business investment, which has been supported by record high corporate profits and large cash holdings in the corporate sector, is expected to continue increasing as labour shortages worsen and firms report capacity shortages in the service sector. Nevertheless, due to the decline in public investment as reconstruction spending wanes, total investment growth is expected to remain weak.

• In EMEs, investment dynamics are even more diverse. In China, total investment has moderated over the past year but policy-induced investment in infrastructure and real estate has already begun to offset this weakness. In Brazil and Russia, investment is set to continue declining given the prolonged recession, political uncertainty and low commodity prices. In contrast, in India and Indonesia, strong investment is expected to continue, helped by reforms to bolster infrastructure spending and robust demand growth.

If companies continue to doubt that national and global demand will strengthen, or if economies are hit by negative shocks, business investment growth will be weaker than projected. As in recent years, the very low cost of capital is not likely to offset weak confidence or heightened uncertainty. On the other hand, more robust policy reforms to improve competitive conditions could be an impetus for investment (Chapter 3 in OECD, 2015b). In oil producing countries, adjustment to investment in the energy-related sectors will hinge upon developments in oil prices, with a renewed decline in prices implying further fall in investment. In several EMEs, repeated downward revisions to expected potential growth, reduced rates of return and the build-up of excess capacities in some sectors may constrain investment (OECD, 2016b).

Trade growth is set to recover but still remain subdued, checking productivity

Global trade volume growth eased to 2½ per cent in 2015, representing a further marked slowdown relative to GDP growth. Import growth picked up in the advanced economies, largely due to an upturn in the euro area, but declined by around 1 percentage point in the EMEs. Import weakness was especially marked in China, other economies in Asia connected in value chains with China, and Brazil and Russia, where import volumes in 2015 are estimated to have fallen by one-fifth due to deep recessions ().

Contributions to the annual growth of OECD and non-OECD import volumes

Asia-Pacific includes Australia, Chile, Japan, Korea and New Zealand.

The Other Asia group comprises India, Indonesia and the Dynamic Asian Economies.

OECD Economic Outlook 99 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367353

No improvement is projected in 2016, with global trade growth rising by between 2 and 2¼ per cent (). After a pick-up in the latter half of 2015, trade flows have weakened again in the early part of this year, especially in many Asian economies and also in the United States. For 2017, global trade growth is projected to edge up to around 3¼ per cent. The investment-led stimulus in China, a gradual stabilisation of demand in the commodity producers and, in 2017, the weak cyclical improvement in investment growth in the advanced economies all contribute to this gentle upturn in trade growth.

World trade growth remains very weak

Statlink http://dx.doi.org/10.1787/888933368850

Such outcomes would be markedly weaker than in the two decades prior to the financial crisis when trade grew twice as fast as output (measured in constant dollar exchange rates). In retrospect, however, the pre-crisis period may have been unusual, in part due to the boost from a strong one-time boom in manufacturing and investment in China that raised commodity demand and imports of intermediate and capital goods. A slow transformation away from investment and export-led growth in China, and a growing tendency for some Chinese firms to use domestically-produced intermediate inputs (), appears to be an important structural factor behind the more recent softening of the global trade-GDP elasticity. The weak post-crisis recovery in investment, with global capital goods imports largely stagnating from 2011, is a persisting cyclical factor.

China is on-shoring its value chain

General Administration of Customs of China.

Statlink http://dx.doi.org/10.1787/888933367361

An accumulation of trade restrictions in the major economies has also contributed to the moderation of trade intensity. Indeed, the number of trade restrictive measures introduced by G-20 countries since the onset of the crisis now covers around 6% of G-20 merchandise imports (OECD/WTO/UNCTAD, 2015). G-20 economies continued to add new trade restrictive measures through 2015, with over three-quarters of the total measures imposed since 2008 still in place. With around three-quarters of global trade comprising purchases of intermediate inputs, capital goods and services that contribute to final production (OECD, 2015a), the cost of barriers to cross-border trade can quickly cumulate along value chains. Barriers to cross-border foreign investments may also hit export capacity in some countries.

Moving from the pace of trade growth in the two decades prior to the crisis to trade growth becoming aligned with GDP growth could reduce the level of total factor productivity by around 4 percentage points after 20 years, all else equal, drawing on estimates in Égert and Gal (forthcoming) (). The slowdown in production fragmentation in global value chains reinforces these adverse effects on productivity substantially. Slower trade growth and reduced participation in global value chains both limit the diffusion of innovations at the global frontier to national firms (Adalet McGowan et al., 2015). Weaker competition also discourages incentives to innovate and invest, and hampers the growth of the most productive domestic firms, especially in smaller economies in which the minimum efficient scale of production is high relative to the size of the home market. Better framework policies and the institutional environment, particularly with regard to barriers to the entry of new firms and obstacles to the exit of less efficient ones, have an important bearing on the productivity outcome (Saia et al., 2015).

Stronger trade growth would help to boost productivity

The evolution of trade openness assumes annual real GDP growth of 2%, and the evolution of productivity assumes that a 4-percentage point increase in openness raises total factor productivity by 0.8% after 5 years.

OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367372

The cost of persistently soft trade growth reinforces the need to undertake additional measures to boost global demand, particularly investment (as discussed below), and reduce structural barriers to trade. The new Trans-Pacific Partnership agreement is a welcome step in this regard, and will boost trade growth and global activity in the medium term (Petri and Plummer, 2012). Ratification and prompt implementation of the WTO Trade Facilitation Agreement, reached two years ago in Bali, would provide a further stimulus. Regulatory reforms in services are also needed to reduce trade facilitation costs and increase cross-border competition, particularly in network industries and commercial services which are increasingly incorporated in merchandise trade. Anti-competitive regulation is generally higher in services and there is much wider dispersion across countries. In Europe, implementing the EU single market directives and reducing regulatory differences could raise cross-border trade and investment substantially, possibly by up to one-fifth (Fournier, 2015; Fournier et al., 2015).

Labour markets are healing slowly

Whilst unemployment rates are gradually declining in most OECD economies, and in a few are now at or below estimated longer-term sustainable rates, other indicators of labour market slack are still elevated. Long-term and youth unemployment rates remain high and broader measures of unemployment, incorporating part-time workers who want to work full-time, and inactive persons wanting to work (but not actively seeking a job), remain above pre-crisis norms in most economies (). High persistent labour market slack can result in hardship for a large number of people and gradually undermine the productive potential of the economy as skills are either not developed or erode.

Broad measures of labour market slack remain elevated

: U-6 is a measure of labour underutilisation calculated as the sum of total unemployed, all persons marginally attached to the labour force and total involuntary employed part time for economic reasons, as a per cent of the civilian labour force plus all persons marginally attached to the labour force. The age group is 15 years old and above.

2016Q1 for Canada, Japan and the United States.

Eurostat; Ministry of Internal Affairs and Communications of Japan; United States Bureau of Labor Statistics; OECD Labour Force Statistics; OECD Main Economic Indicators; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367380

Participation rates are also well below pre-crisis levels in a few countries, including the United States, but this appears to be partly linked to demographic developments (and retirement age) and therefore may not fully translate into sizeable cyclical slack. However, in the majority of countries, participation rates are now higher than a few years ago (, Panel A), in part due to the impact of reforms, including higher female labour force participation through improved access to childcare services, and measures to reduce labour taxation on low-paid workers and pathways to early retirement (OECD, 2016a). Overall, demographic headwinds have intensified, resulting in a stagnant or declining working-age population in some countries, and labour force growth in recent years has been weaker than prior to the crisis in several countries (, Panel B).

Participation rates have risen but labour force growth has slowed in several countries

OECD Economic Outlook 99 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367391

Against the backdrop of low inflation, weak underlying productivity growth and elevated slack, nominal wage growth has been low in recent years, although minimum wage increases are boosting overall compensation growth in some countries. The unemployment gap is now small or even negative in a few countries, but this may not result in rapid wage growth, especially in real terms. The relationship between wage growth and labour market slack, as measured by the unemployment gap, has shifted since the crisis in some countries, particularly in the United States and the United Kingdom (). In Japan, nominal wage growth in recent years has remained broadly in line with what might have been expected given the unemployment gap, but there is little apparent relationship between real wage growth and slack. In contrast, wage growth in Germany has recently been somewhat stronger than implied by past experience, especially after the estimated unemployment gap became negative.

The relationship between wage growth and unemployment has changed in some countries

Nominal wages are measured as compensation per employee. Real wages are nominal wages deflated using the consumers’ expenditure deflator. The unemployment gap is the difference between the unemployment rate and the estimated sustainable rate.

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367406

In addition to changes in the relationship between wages and slack, there are a number of other factors that may presently be limiting wage growth:

• Downward nominal rigidities may have limited the extent to which wage growth was lowered in the aftermath of the crisis, when slack was very high. If so, firms may be slower than usual to increase wage growth as the labour market returns towards equilibrium, particularly when future demand growth rates are uncertain, until labour shortages start to become pressing.

• In most economies with small unemployment gaps, broader measures of labour market slack often remain elevated (), although less so in Germany and Japan, and labour force participation rates have picked up (, Panel A).

• Against a background of persisting supply-side shocks and uncertainty about future employment prospects, workers may be reluctant to press for wage increases to the same extent as in the past, particularly as low price inflation may still imply real wage gains despite subdued growth in nominal wages.

Inflation is projected to remain low

In advanced economies, inflation is projected to edge up slowly, with oil prices assumed to stabilise and no longer reduce the price level, but significant further acceleration is unlikely given muted labour market and resource utilisation pressures.

• Recent declines in inflation across the OECD can be largely accounted for by the fall in energy prices that started in mid-2014 (). The overall effect was smaller than some years ago, owing to the downward trend in the oil intensity of GDP, which is now roughly a third of what it was in the early 1970s for the larger OECD economies.

• Inflation expectations have remained broadly anchored for the larger OECD economies. Those based on the opinions of professional forecasters have remained stable, but market-based measures of long-term inflation (which are calculated from the price differences of financial securities with different levels of inflation protection) have remained low. However, in the United States, this may be due to specific factors, such as changing liquidity premia for different types of securities, rather than changes to expectations, suggesting stable and well-anchored US inflation expectations (Gospodinov and Wei, 2016).

• Unemployment and output gaps now tend to have a smaller impact on consumer price inflation than in the past. This decline began in the mid-1970s, but has stabilised more recently (Blanchard et al., 2015; Rusticelli, 2014; Rusticelli et al., 2015). This is likely to reflect better anchored inflation expectations, downward nominal rigidities at a time when inflation is very low, and a smaller impact of domestic pressures on consumer price inflation, with globalisation leading to more consumer items being imported (IMF, 2006; Pain et al., 2008; Woodford, 2010; and IMF, 2013).

• Inflation models estimated for large advanced economies, and which assume anchored inflation expectations (Rusticelli et al., 2015), suggest that a sustained increase in the unemployment gap by 1 percentage point should reduce core inflation on average by about 0.4 percentage point after 1½ years. In this context, the contribution of unemployment gaps to inflation since mid-2014 has been relatively minor, with the exception of Italy and France (), owing also to the fact that estimated gaps have been relatively small. In Germany and Japan, unemployment gaps have been negative and inflation has risen, in contrast to the other countries analysed.

Energy prices have pulled down inflation across the OECD

Data for Japan exclude the estimated impact of the consumption tax increases in April 2014 and April 2017.

Average annualised monthly contribution of food, energy, and inflation excluding food and energy prices to the change in consumer price index from July 2014 to March 2016.

For the euro area, food also includes alcohol and tobacco.

OECD Economic Outlook 99 database; OECD, Main Economic Outlook database; Eurostat; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367410

The unemployment gap has recently contributed little to price inflation

Average year-on-year core inflation rate between 2014Q3 and 2015Q4

According to the anchored expectations Phillips curve as used by the OECD (Rusticelli et al., 2015), changes in the core consumer price inflation rate (i.e. excluding prices of food, drink, tobacco and energy) can be explained by the unemployment gap, import prices, anchored inflation expectations, previous changes in inflation, and residual error terms. The above figure compares predicted inflation given the observed outcomes for all the explanatory variables with predicted inflation assuming a zero unemployment gap between 2014Q3 and 2015Q4.

The price level for Japan is adjusted for the estimated effect of the consumption tax rate increase in April 2014 of 1.9%.

Data for the United Kingdom refers to headline consumer price inflation.

OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367424

A prolonged undershooting of inflation targets could reduce longer-term inflation expectations, resulting in lower consumer price and wage inflation. Inflation projections continue to be surrounded by upside and downside risks in part due to uncertain oil price developments. Oil prices and inflation will be lower if oil supply does not adjust downwards and a possible renewed weakness in global economic activity damps demand for oil. An effective agreement among the main oil producers to cut production and stronger global activity would lead to higher inflation, but recent meetings to coordinate producers have failed to achieve consensus and global growth projections remain modest. Similarly, large exchange rate moves will affect domestic prices, especially in small open economies. Risks of further currency depreciations, and thus stronger inflation, are particularly high in EMEs and the United Kingdom.

Geopolitical risks are intensifying

The potential exit of the United Kingdom from the European Union (Brexit) is a major downside risk. In the run-up to the referendum, financial markets have increasingly begun to price in the possible risk of Brexit, with a depreciation of sterling and an increase in risk premia across several asset types. Business confidence has eased, policy uncertainty has risen and investment growth has slowed. However, the projections are conditional on the United Kingdom remaining in the European Union, with growth beginning to pick up from the latter half of 2016. A decision to exit would result in considerable additional volatility in financial markets and an extended period of uncertainty about future policy developments, with substantial negative consequences for the United Kingdom, the European Union and the rest of the world. This is illustrated in a recent OECD analysis (Kierzenkowski et al., 2016):

• In the near term, after a vote to leave the European Union, heightened and prolonged uncertainty would be likely to push up risk premia in the United Kingdom and, to a lesser extent, other European economies, and depress asset prices. A shock to sentiment could also be reflected in households and companies temporarily postponing spending decisions amid tighter credit conditions. A sharp depreciation of sterling could mitigate these effects, but at the same time hurt other European economies and raise UK inflation. Overall, this would reduce UK GDP growth significantly in the latter half of 2016 through to 2018, possibly by around ½ percentage point per annum on average. By 2018, there would be a significant hit to activity in other European economies, especially those who have strong economic linkages with the United Kingdom (), with many non-European economies also experiencing a decline in output due to weaker demand in Europe.

• On exit from the European Union, which is assumed to occur at the start of 2019, the UK economy would be hit further by a substantial shock to trade. There likely would be a marked change in the UK trade regime, raising barriers to market access for many exporters, especially in the European Economic Area and in the 53 countries with which the European Union has trade agreements. This would provide a renewed shock to demand through the trade channel, and likely keep economic uncertainty elevated for a considerable period. By 2020, GDP in the United Kingdom could be over 3% below the level it might otherwise have been if it had remained in the European Union, with GDP in the rest of the European Union around 1% weaker than otherwise.

• Over time, the UK economy would also face growing supply-side challenges. In the longer term, the impact of exit on the United Kingdom would depend on supply-side effects. Lower trade openness would hit economic dynamism and productivity. The reduced access to the EU market would also lower inward foreign direct investment, with associated adverse effects on innovation and managerial quality. The weaker UK economy, as well as possible new restrictions after exit from the European Union, would lower net migration inflows, adding to the supply-side challenges by reducing the size of the labour force. Some of these effects could be offset by reductions in domestic regulatory burdens, but the overall net effect on living standards would be strongly negative. By 2030, UK GDP could be over 5% lower than otherwise if exit had not occurred.

Financial market shocks from Brexit

A UK vote to exit from the European Union could be expected to heighten uncertainty, reduce confidence and result in a series of financial market shocks in the United Kingdom and other European economies. The stylised scenarios set out in this Box provide some illustrative estimates of the possible impact on global activity by 2018, using simulations on the NiGEM global macro model, building on Kierzenkowski et al. (2016).

In the United Kingdom, financial market shocks are assumed to be of a magnitude similar to those observed during the acute phase of the euro area crisis in 2011-12, but much smaller than during the financial crisis in 2008-09. Investment and equity risk premia in the United Kingdom are raised by 50 basis points in the first half of 2016, 150 basis points over 2016H2-2017 and 100 basis points in 2018. This broadly reflects the stylised shock reported by Kierzenkowski et al. (2016), based on a two standard deviation increase in the UK economic policy uncertainty index and in UK stock market volatility. The wedge between bank borrowing and lending rates for the household and corporate sectors is also raised by 100 basis points over 2016H2-2017, reflecting the possibility that enhanced uncertainty could tighten credit conditions. Finally, the term premium on UK government long-term bonds is raised, initially by 20 basis points in 2016 and then by 50 basis points in 2017 and 2018. After 2018, these financial shocks can be expected to fade gradually, although not completely, since formal exit of the United Kingdom from the European Union (assumed to take place in 2019 in Kierzenkowski et al. (2016)) would itself be an additional source of uncertainty and additional risk.

The exit vote can also be expected to hit confidence, leading UK households to undertake additional precautionary saving. Higher saving adds to the negative impact on consumption from the decline in activity and lower asset prices. To take this effect into account, an additional shock was applied, raising the ex ante household saving rate in the United Kingdom by a little over 1 percentage point in the latter half of 2016.

The aftermath of a vote to leave would also be likely to raise sterling risk premia, leading to an additional sharp exchange rate depreciation. The impact of this depreciation is likely to be more limited than in the past, but at the margin it would be likely to reduce the overall impact of the other forces acting on the UK economy, whilst adding to challenges in other economies, especially in Europe. A 10% depreciation of sterling against the US dollar is assumed to occur in mid-2016, with all other bilateral exchange rates held unchanged. The depreciation is assumed to be persistent, but to gradually fade over the simulation period. On average, the sterling effective exchange rate is around 6% below baseline in 2017 and 4% below baseline by 2018, implying an appreciation of the euro and other currencies relative to sterling. Other bilateral exchange rates are held constant.

The UK decision to exit could reinforce uncertainty about the future of the European Union and the Single Market. The resulting uncertainty would lead to more difficult financial conditions in other European countries. To illustrate the possible magnitude of such factors, investment and equity risk premia and the spread between household borrowing and deposit rates are widened in all European Economic Area (EEA) countries plus Switzerland.

Some differences across countries could be expected, given the underlying differences in the strength of their economic linkages with the United Kingdom. Three different sets of linkages are explored for the European economies: UK imports of goods and services from each country as a share of that country’s GDP in 2014; the end-2014 stock of direct and portfolio assets invested in the United Kingdom by each country as a share of that country’s GDP in 2014; and a big data indicator of linkages from Google Trends, based on the relative intensity of searches for Brexit, from February to mid-May this year. There is a considerable degree of similarity in the respective country rankings on each of these metrics, with a cross-country rank correlation between trade and the other two indicators of 0.5, and a correlation of 0.8 between the rankings for the degree of financial linkages and Brexit searches:

• Ireland, Luxembourg and the Netherlands are relatively highly exposed to the UK economy on all three metrics, with Switzerland and Norway highly exposed through financial linkages and also in the Brexit search indicator.

• Austria, Belgium, Denmark, Germany, Finland, France, Greece, Spain and Sweden are moderately exposed to the UK economy on all three linkages, broadly in line or above the median exposure across the European economies.

• The Czech Republic, Estonia, Italy, Hungary, Poland, Portugal, the Slovak Republic and Slovenia are relatively less exposed directly to the United Kingdom. A number of the smaller economies have trade linkages that are at or above the median European economy, but are well below the median on the other two metrics.

These differences are reflected in the different financial shocks applied to each country in NiGEM:

• In most of the highly-exposed economies, the shocks applied are between one-third and one-half of those in the United Kingdom, with investment and equity risk premia rising by 75 basis points at their peak and the interest rate spread by 34 basis points. Ireland is an exception, given the strength of its bilateral trade and financial linkages, with investment and equity risk premia rising by 100 basis points at their peak and the interest rate spread by 50 basis points.

• In the moderately-exposed economies, the shocks applied are between one-quarter and one-third of those in the UK, with investment and equity risk premia rising by 50 basis points at their peak and the interest rate spread by 25 basis points.

• In the economies with lower bilateral exposure to the United Kingdom, the shocks applied were between one-fifth and one-quarter of those in the United Kingdom, with investment and equity risk premia rising by 40 basis points at their peak and the interest rate spread by 20 basis points

No shocks were applied directly in the European economies to either term premia on government bonds or to the household saving rate.

The NiGEM model was run in backward-looking mode, reflecting a judgment that in a period characterised by considerable uncertainty, businesses and households would be unlikely to behave as if the future was known with certainty. Monetary policy was left exogenous (although the depreciation of sterling changes UK monetary conditions), and the budget targeting rule was left unchanged, implying that governments react to the various shocks by attempting to maintain their announced budget path. Differences across economies in their response to the shocks imposed reflect the strength of trade linkages with all other European economies, differences in the sensitivity of domestic demand to changes in financial conditions and differences in the sensitivity of trade to changes in the real exchange rate.

The results indicate that Brexit would generate a large negative shock to the UK economy by 2018, with UK GDP declining between 1¼ and 1½ per cent relative to baseline by that time (see figure below), as in Kierzenkowski et al. (2016). Around 1 percentage point of this stems directly from the financial shocks in the United Kingdom (including the sterling depreciation), with the remainder stemming from the adverse impact on demand of the additional financial shocks in other European countries. The near-term hit to the UK economy would be larger without the depreciation of sterling. Whilst cushioning the decline in activity, this initially raises inflationary pressures, through higher import prices, adding around ½ percentage point to consumer price inflation in 2016-17. Business investment weakens significantly, by over 10% in 2017 and 2018 relative to baseline, and the unemployment rate is ¾ percentage point higher by 2018.

Output in the other European economies is reduced by around 1 percentage point by 2018. Around four‑tenths of this stems directly from the UK financial shocks (including the sterling depreciation), with the remainder stemming from the additional financial shocks in their own economies. Overall, the hit to the economies most exposed to the United Kingdom is around a ¼ percentage point higher than that to the economies with a comparatively low exposure to the United Kingdom. A larger sterling depreciation against domestic currencies would magnify the negative impact on other European economies, as would any deeper confidence shocks in those economies. On the other hand, a euro depreciation could help to offset some of the negative impact, but at the expense of magnifying the negative effects on output in the UK and non-European economies.

Weaker demand in the European economies also adversely affects the rest of the world, with GDP in the BRIICS and other non-OECD economies lowered by over ½ percentage point by 2018. Within these groups, Turkey and Russia are relatively heavily hit, reflecting their comparatively strong trade linkages with the European economies.

The impact of financial shocks on real GDP by 2018

Difference from baseline

The UK shock includes shocks to financial conditions and confidence in the UK alone, plus a sterling depreciation. The Europe shock includes shocks to financial conditions in all European Economic Area economies plus Switzerland.

See text for criteria used to classify European countries into high, moderate and low.

Europe high includes Ireland, the Netherlands, Norway and Switzerland.

Europe moderate includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Spain and Sweden.

Europe low includes the Czech Republic, Estonia, Hungary, Italy, Latvia, Lithuania, Poland, Portugal, the Slovak Republic and Slovenia.

OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367244

UK exit would have much stronger spillovers if it were to undermine confidence in the future of the European Union. In such a scenario, equity prices would drop further and risk premia for euro area sovereign and corporate bonds would increase by more, slowing GDP growth more substantially. Together with a fall in the euro, this would add to pressures on private and public finances, especially in countries where debt remains high. This risk would compound the existing political tensions in the European Union related to high refugee inflows and ongoing financial efforts to stabilise Greece. Downside risks to global activity also relate to a possible escalation of conflicts, including in Ukraine and the Middle East.

Financial vulnerabilities persist in EMEs

The recently announced stimulus measures in China are projected to help hold up demand. So far, the reaction of financial markets has been positive: stock markets have stabilised, the fall in foreign exchange reserves has ceased, the renminbi has strengthened against the US dollar, and capital outflows have eased. These particular policy measures will, however, inevitably slow the necessary rebalancing of current and capital expenditures that needs to occur and entail the risk that already-high leverage, excess industrial capacity and public debt could increase further. Indeed, year-on-year credit growth for the whole economy continues to increase around twice as fast as nominal GDP and China's fiscal rating outlook has been downgraded by one of the main rating agencies. In this context, a sharper slowdown in China and ensuing financial turbulence remain a risk which could have a sizeable negative impact on global growth (OECD, 2015e).

After a strong deterioration at the beginning of 2016, confidence in EMEs has recently strengthened, with stock markets and exchange rates recuperating earlier losses, sovereign bond spreads narrowing and portfolio capital outflows reversing. However, several domestic vulnerabilities persist in some EMEs, even though many are better placed than before past crises, with higher foreign exchange reserves and lower public debt ().

• Past experience suggests that a rapid pace of private debt accumulation could give rise to debt repayment problems as growth and profits slow and the cost of financing increases. In Brazil and Russia, both of which remain mired in recession, and in China, Indonesia and Turkey, the debt of non-financial corporations as a percentage of GDP increased by between 40 and 120 percentage points between 2007 and the third quarter of 2015 (). While EMEs have benefited from favourable costs of borrowing, both domestically and from abroad, since 2014 these costs have been increasing for many of them. Moreover, the profitability of non-financial corporations in EMEs as a whole has been on the decline since late 2011 (Chui et al., 2016; OECD, 2016b). In Brazil, China and Turkey, household indebtedness also nearly doubled over the same period (but from a low level).

• Escalation of political or geopolitical tensions in some EMEs, especially Brazil, Russia, South Africa and Turkey, could dent investors’ confidence. Stronger than expected increases in US policy interest rates could also trigger capital outflows from EMEs.

• Past currency depreciations have raised the cost of servicing debt denominated in foreign currencies, especially in Brazil, Russia, Turkey and South Africa, given the size of their exchange rate depreciations since mid-2014 and the large shares of external debt denominated in foreign currencies ().*

  In addition, the majority of bank loans in US dollars to non-bank borrowers in Russia and Turkey are issued by local banks (McCauley et al., 2015), and thus are not classified as foreign debt. In most EMEs, the majority of foreign-currency denominated external debt is estimated to be in US dollars, with the shares of yen and euro-denominated debt at low levels, other than in economies with relatively strong trade links with Japan and the euro area respectively (OECD, 2015b).

  Although these depreciations have not resulted in a major stress in the banking and corporate sectors of these economies, it remains to be seen whether these countries would be resilient to further depreciations.

Credit has increased substantially in some large EMEs

End-period stock, per cent of GDP

Credit from banks and non-banks adjusted for breaks. For South Africa, 2008Q1 instead of 2007.

Bank for International Settlements (BIS).

Statlink http://dx.doi.org/10.1787/888933367433

EME's external vulnerabilities have increased due to exchange rate depreciations

Negative numbers imply a depreciation of the indicated country's currency against the US dollar (USD) and against a trade-weighted basket of currencies (effective).

Foreign-currency external liabilities are approximated by the sum of a positive difference between debt securities issued by nationals and residents from the BIS debt securities database (a proxy for off-shore external bond liabilities) and external liabilities for financial derivatives and other investments (the latter includes bank loans) from the IMF international investment position database.

OECD Economic Outlook 99 database; Bank for International Settlements; International Monetary Funds; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367441

The number of corporate debt defaults rose in 2015 in EMEs, but as yet there are few signs of widespread financial difficulties for businesses and households despite the slowdown in growth, the weakness of commodity prices and large recent currency depreciations. Regarding foreign currency exposures, one possibility is that currency risks have been hedged successfully, either due to a high proportion of revenues in foreign currencies or via financial instruments. For commodity producers, whose export revenues are also largely in US dollars, the natural hedge has been weakened by the decline in global commodity prices. A further possibility is that large debt repayments have not yet come due. Government interventions in some countries have also eased the stress, with central banks effectively acting as the lender of last resort and using foreign exchange reserves to provide foreign currency swap lines for affected businesses.*

For instance, the central bank in Brazil has offered currency swaps that protect their holders from currency depreciations, with the losses born by the fiscal authorities.

The need and scope for policy to offset current cyclical weakness varies across major EMEs

In China, the sustained monetary and fiscal stimulus, with further cuts to interest rates and higher spending (), appears sufficient to ensure that growth, in the near term, eases only gradually, while raising potential risks in the medium term. However, shifting the focus of the stimulus towards reducing precautionary household saving (through supportive pension, education and health policies) would spur the desired transformation toward a more service and consumption-based economy and temper the financial risks associated with high debt burdens and equity and exchange rate volatility. In Brazil and Russia, sharp recessions call for accommodative policy but the scope for stimulus is limited in view of high budget deficits and inflation. Government spending should be reduced in line with lower commodity prices, with cuts focused on subsidies rather than infrastructure and education where the negative consequences for growth are magnified. The expected moderation of inflation and recent appreciation of domestic currencies provide some room for lowering policy interest rates. Similarly, in India, if inflation continues to decline, the monetary authorities could cut interest rates in 2017, whilst further steps should be taken to improve monetary policy transmission. The Indian authorities should also continue to reduce the budget deficit via improved tax mobilisation, while shifting more spending towards physical and social infrastructure.

Monetary policy cannot revive near and long-term growth by itself and distortions are increasing

In advanced economies, monetary policy has been extremely supportive in recent years () but it cannot provide sufficient support for an extended period by itself, as shown by persisting weak growth and low inflation. In the euro area and Japan, it has recently been further eased by expanding the size and duration of asset purchase programmes and making deposit rates negative. In contrast, the US Federal Reserve raised the policy rate by 25 basis points in December 2015 and it should continue gradual tightening in 2016-17 provided that its full employment and inflation objectives look set to be attained as projected. On balance, the US monetary policy stance remains accommodative and the FOMC has lowered the expected path of future interest rates.

Real short and long-term interest rates have been low or negative

Real interest rates are calculated using year-on-year core consumer price inflation. Data for Japan exclude the estimated impact of the consumption tax increases in April 2014 and April 2017.

OECD Economic Outlook 99 database; and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367458

The prolonged period of highly accommodative monetary policy has also created a number of distortions. This suggests that the net marginal benefits of monetary policy in raising aggregate demand have diminished and that supply-side constraints, which monetary policy cannot target directly, are undermining monetary policy efficiency.

• Following this period of very low interest rates, some central banks are now pursuing negative interest rates. If sustained for a long time, banks' profits will be lowered further if bank deposit rates cannot be made negative (). Banks' profitability is stressed by the ensuing flattening of the yield curve () and the general low-interest rate environment (Borio et al., 2015; Claessens et al., 2016). In response, private banks could be forced to maintain or raise the cost of credit and fees as compensation. Financial stability requires the achievement of the appropriate balance between lending to riskier borrowers at higher rates or investing in riskier assets (which is part of the objective of more accommodative policy) and the growth outcome of the accommodative policies.

• The protracted low/negative-interest rate environment also increases financial strains for pension funds and financial institutions offering life insurance policies that promise pre-crisis or fixed nominal returns (OECD, 2015c). A fall in the discount rate increases the present value of liabilities of defined-benefit pension funds and life insurance companies more than of assets, and thus undermines solvency. In this context, life insurers with capital buffers close to the regulatory minimum have already been investing more in riskier assets (IMF, 2016). Greater sensitivity to interest rates has also raised the correlation of the stock price of life insurers, suggesting greater systemic risk.

• Very low or negative interest rates sustained for a prolonged period will be less potent in stimulating consumption if some households increase savings to compensate for lower future returns or if pension funds raise employee contributions. These possibilities are particularly likely in countries with ageing populations and large household financial assets, and also when declining interest rates cease to be passed through to indebted households.

• With continuing purchases of government bonds, central banks have become dominant buyers and holders of sovereign debt (). This could limit market liquidity, with potential negative consequences for market volatility.*

  According to some measures, liquidity in the Japanese government bond market diminished after the expansion of the qualitative and quantitative easing programme in October 2014 but it is not clear if this was due to bond purchases by the Bank of Japan (Kurosaki et al., 2015). More recently, Japanese bond dealers have reported perceptions of deteriorated liquidity (Bank of Japan, 2016).

Effects of central bank negative interest rates

Several central banks have introduced negative policy interest rates to raise inflation closer to target or alleviate the appreciation pressures on domestic currencies.

Negative interest rates signal an easier monetary policy stance and thus should stimulate the economy by lowering short and longer-term market interest rates. This, with unchanged monetary policy abroad, should weaken the domestic currency. Negative interest rates should also encourage banks to take more risks and thus ease credit conditions (Buiter and Panigirtzoglou, 2003), and could strengthen the portfolio rebalancing channel when combined with large-scale purchases of long-term bonds and thus lower longer-term interest rates (Goodfriend, 2000).

Negative policy interest rates have been passed through to short-term market interest rates. Money market rates have turned negative in all economies adopting such measures apart from Hungary and Norway, and, in Denmark and Sweden, interest rates on large time deposits have fallen below zero too (Jensen and Spange, 2015; Jackson, 2015; table below). In most countries, longer-term bond yields and bank lending interest rates have also declined, with some rates turning negative. However, these effects cannot be entirely attributed to interest rate cuts as several central banks have continued to buy government and private bonds. However, in Denmark and Switzerland, selected bank lending rates and fees have been raised (Bech and Malkhozov, 2016).

Isolating the impact of negative interest rates on exchange rates is difficult as other measures can affect the domestic monetary stance and monetary policy abroad can evolve as well. Nevertheless, negative interest rates have likely helped limit the appreciation pressures in Denmark and Switzerland. However, in the euro area, the effective exchange rate first depreciated by nearly 10% but then reverted back to the initial level, while in Japan the yen appreciated.

Interest rates have become negative across different maturities

Statlink http://dx.doi.org/10.1787/888933368868

If implemented in pure form, negative interest rates would have side effects with a perverse impact on loan demand and growth, as they reduce banks’ profitability when lower returns on reserves held at central banks cannot be offset by lower funding costs. However, as implemented and in conjunction with current bank behaviour, the theoretical outcome is not observed. Interest costs on banks’ funds at central banks have so far been limited and tiny compared to banks’ profits (table below, final column). This stems from various forms of exemptions (tiered reserve systems in Denmark, Japan, Norway and Switzerland; exemption for required reserves in the euro area and Japan). In Sweden, the costs are lowered as banks effectively do not use the deposit facility given that they can purchase Riksbank’s certificates or use overnight fine-tuning operations that are remunerated at less negative interest rates than the deposit rate. Consequently, in all countries the average interest rates on funds placed in the central banks are less negative than the central banks’ deposit rates. Currently, the system is the least costly in Japan, Hungary and Norway. In Japan, banks as a whole continue to earn net positive interest income from excess reserves. In Hungary, the negative deposit rate effectively does not apply as there is no excessive liquidity and banks can use the 3-month deposit facility remunerated at a positive interest rate (currently at 1.2%). Similarly, in Norway, banks have kept deposits at Norges Bank largely below the quotas and thus deposits have been remunerated at a positive sight deposit rate (currently at 0.5%).

Characteristics of negative interest rate frameworks

Statlink http://dx.doi.org/10.1787/888933368870

The cost of negative interest rates for banks is going to increase with the expansion of central bank balance sheets (either due to asset purchases or exchange rate interventions) and the concomitant increase in reserves. The possibility for banks to compensate profit losses will depend on their business models and competition pressures. It will be particularly limited for banks with a large share of retail deposits, given that passing negative interest rates risks widespread withdrawals, especially of small retail deposits, as storing small amounts of cash is not very costly. Japan will be the exception despite the Bank of Japan's intention to sustain asset purchases, as the negative-interest tier has been capped at around 30 trillion yen.

The Sveriges Riksbank in July 2009, the Danmarks Nationalbank in July 2012, the European Central Bank in June 2014, the Swiss National Bank in December 2014, Norges Bank in September 2015, the Bank of Japan in February 2016, and the Magyar Nemzeti Bank in March 2016. This measure involved mainly negative central bank deposit rates, but the Sveriges Riksbank introduced also a negative repo rate and the Swiss National Bank introduced a negative target range for the 3-month LIBOR.

The slope of the yield curve has declined

Difference between 10-year government bond yield and the overnight interest rate

Thomson Reuters.

Statlink http://dx.doi.org/10.1787/888933367461

Some central banks have become dominant holders of domestic government bonds

Government debt securities held by central banks as a per cent of total government debt securities

Board of Governors of the Federal Reserve System; Bank of Japan; UK Debt Management Office; European Central Bank (ECB); and OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367478

• Distortions in government debt markets can be alleviated by expanding asset purchase programmes to include private bonds and equity, but this involves different risks for central banks and distributional effects. Purchases of corporate bonds or equities lower the cost of financing primarily for large companies, with small firms benefiting less.

• The exchange rate channel of monetary policy is muted when several monetary authorities are reducing interest rates at the same time. Even to the extent that a reduction in interest rates results in a depreciation of the currency, negative policy rates may be less effective in boosting the economy than in the past given some evidence of a declining sensitivity of trade volumes to changes in competitiveness (Ollivaud et al., 2015).

• In several advanced economies, partly as a result of monetary stimulus, house price inflation has been on the rise. Rapid house price appreciation increases financial stability risks and thus calls for prudential measures. While these should help contain the rise in property prices, even very strict measures may not be sufficient in practice to check continued increases in house prices, raising issues of whether they would conflict with the continued need to support demand.*

  Akinci and Olmstead-Rumsey (2015) find that macro-prudential measures, specially directly targeted at limiting housing credit growth, are associated with lower house price inflation. However, Cerutti et al. (2015) suggest that macro-prudential measures are less effective in more developed and open economies as their usage comes with greater cross-border borrowing.

The side effects of highly stimulative monetary policy for the banking sector are exacerbated by recent prudential regulation. Senior bonds issued by banks have become riskier and thus costlier as they can now be used to cover banks' losses, which is the objective of such bail-in versus bail-out policies. In several European countries and Japan, negative yields for sovereign bonds, which are held by banks as part of the Liquidity Coverage Ratio, reduce banks' profits and returns on assets (OECD, 2016b).*

Domestic (euro area) government securities account for only around 1% of total assets in Denmark, Sweden and Switzerland, and between 5% and 12% of total assets in most euro area countries and Japan.

Markets have become pessimistic about the outlook for banks

Thomson Reuters.

Statlink http://dx.doi.org/10.1787/888933367481

Fiscal and structural policies should be used more actively to reduce the burden on monetary policy

The declining net benefits from additional monetary policy actions suggest that accommodative monetary policy needs to be complemented by enhanced use of fiscal and structural policies. Policy strategies that explicitly combine macroeconomic and structural efforts in a common framework are especially desirable, allowing full advantage to be taken of their complementarities for demand and resource reallocation.

Fiscal policy in the OECD as a whole and many EMEs in 2016 and 2017 is projected to be either broadly neutral or tighter, with the notable exception of China, Canada and some EU countries (). However, consolidation is set to be implemented in Japan (amounting to 1.7 percentage points of GDP over 2016-17) and also the United Kingdom and Australia. In the United States, the structural deficit as a share of potential GDP is to be reduced by just over ½ percentage point over the next two years. In contrast, easing is projected in many euro area countries, including Germany and Italy, partly through the additional spending to assist asylum seekers.*

These expenditures are estimated to be between ¼ and 1% of GDP in countries affected the most by the refugee inflows (Box 1.1 in OECD, 2015b).

Fiscal stances in OECD countries

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367497

Despite the rise in debt ratios since the crisis (as GDP has yet to recover fully in some countries), the current period of exceptionally low interest rates effectively increases fiscal space in many countries by offering an opportunity for governments to borrow for long periods at very low cost. Almost all countries have room to reallocate spending and taxation towards items that offer more support to growth (Cournède et al., 2014). The need to expand public investment is pressing in many countries, reflecting the extent to which infrastructure spending, including necessary maintenance, was deferred as part of past consolidation efforts. Such measures would be particularly beneficial in countries where the initial level of public capital is low, and returns to investment are accordingly likely to be high, and in countries where demand has been persistently weak (). A commitment to raising public investment collectively would boost supply and demand while also improving fiscal sustainability. In particular, collective action across OECD countries to expand investment spending could raise the first-year multiplier effect by around one-half on average in some major advanced countries (OECD, 2015e).

Conditions for an increase in public investment to lift growth in OECD economies

Unusually low interest rates offer most OECD countries a temporary increase in fiscal space that can be exploited to increase public investment. Long-term rates are unprecedentedly low in nominal terms, in particular in Japan, France and Germany, and negative in real terms in some countries. They justify any public investment projects that have an expected positive real rate of return after allowing for risk. At the same time, infrastructure needs are sizeable in OECD countries, especially as fiscal consolidation in recent years has pushed down public capital spending to very low levels in many countries. In such a situation, additional public investment is likely to benefit from high rates of return (Fournier, forthcoming).

OECD analysis suggests that increasing good-quality public investment is likely to bring output gains, whose amplitude will vary across countries (OECD, 2015e, and Mourougane et al., forthcoming). A permanent budget-neutral increase in public investment of 0.5% of GDP in each single economy, assuming fixed interest rates, helps stimulate demand in the short term with growth effects of around 0.3-0.4% in the first year in the major advanced economies. Being relatively closed, the United States gets stronger output gains than more open economies, such as the European countries and Canada. By contrast, the ability of Japan to stimulate its economy through additional public investment will depend on the size of its fiscal multipliers, which has been very hard to estimate in the most recent period (Auerbach and Gorodnichenko, 2014), and the type of projects chosen. Thanks to the increase in output, the public debt-to-GDP ratio falls in the short term notwithstanding the increase in debt levels, by around 0.3‑0.4 percentage point of GDP in most of the countries.

An investment-led stimulus of 0.5% of GDP in each single economy could also have longer-term benefits, although these are hard to pin down precisely. Depending on the modelling approach used, the long-term output gains could amount to between 0.5% and 2% in the large advanced economies (figure below). There are substantial uncertainties regarding the long-term impact on the debt-to-GDP ratio, reflecting different output gains, changes to the price level and the extent to which budget neutrality is achieved in the different types of models. A sustained rise in the stock of public capital and in potential output will help reduce risks on debt, notably in small European economies.

Countries where the initial level of capital is low are likely to benefit the most from the stimulus on the assumption that all forms of additional investment have a high rate of return in these economies. Amongst the large advanced economies, the effect on output would be above average in Germany and the United Kingdom, where the stock of public capital is relatively low. On the other hand, depending on the type of project chosen, the output gains could be very negative for Japan, reflecting a large initial public capital stock and associated low marginal rates of return. Lowering returns to public capital by one standard deviation would significantly reduce the long-term effect on output, which would now amount to 0.7% on average for the OECD countries and 0.5% for the major advanced countries.

If persistent demand weakness gradually undermines the productive capacity of the economy (hysteresis) the case for an investment-led stimulus is reinforced, as the stimulus would lead to stronger long-term output gains. The amplitude of these gains depends on the initial situation in the business cycle, and to a lesser extent on the degree of labour market rigidity. They would be particularly important for Italy and France.

Collective action among the major advanced economies to raise good-quality public investment is estimated to bring additional GDP gains of about 0.2 percentage point on average after one year in the economies concerned compared to a scenario where countries act individually, taking the first-year multiplier above unity in almost all countries. This would represent a gain of around one-half on average in all the major advanced economies but Japan, where the gains are uncertain as mentioned above. As a consequence, the debt-to-GDP ratio would also fall more than otherwise. Germany would be, amongst the major advanced economies, the country that benefits the most from collective action to boost public investment.

Some structural reforms can increase the short-term growth impact of an investment-led stimulus and accentuate the extent to which it lowers the debt-to-GDP ratio. In particular, reforms targeted at frictions that hold back demand for investment, such as increasing product market competition, can lower the opportunity costs of investing. Lowering product market regulations by the average improvement over two years in a typical OECD country could add around 0.1-0.3 point to the growth impact after the first year. The resulting effects on public debt ratios would be marked in Japan, Italy and France, by around 1 percentage point after one year.

Long-term effect of a sustained increase in public investment by 0.5% of GDP

F&F refers to the stochastic model described in Fall and Fournier (2015), FM refers to the fiscal maquette developed in Botev and Mourougane (forthcoming) and NiGEM refers to the macro-economic model from the UK National Institute of Economic and Social Research (NIESR).

OECD calculations.

Statlink http://dx.doi.org/10.1787/888933367253

Investment spending has a high-multiplier and good-quality infrastructure projects, including additional spending on clean energy projects, education, skills and telecommunication, would help to support future growth and the capacity of the economy to deliver higher living standards. Possible near-term clean energy measures include improvements to public building standards, new low emission vehicles in public transport and new smart technologies (OECD, 2015e). Options for telecommunication include investment in high-speed broadband networks and deeper fibre deployment (OECD, 2015d).

The impact of additional fiscal stimulus on the private sector would be enhanced by collective efforts to revive structural reform momentum, thereby creating greater scope for productivity-enhancing improvements in resource allocation. In recent years, the pace of structural reforms in both advanced and EMEs has slowed. This slowdown is particularly troubling for long-term growth prospects. Actions across a broad range of reform objectives, such as product market competition, labour mobility and financial market robustness are essential in order to help to reverse the widespread slowdown in productivity and improve inclusiveness by addressing poor labour market performance and widening wage dispersion ().

Packages of structural reforms to promote long-term improvements in employment and productivity growth should also focus on possible short-term demand benefits, given the weak global economy (). Aside from higher investment in public infrastructure, these include reductions of barriers to entry in services sectors with pent-up demand, as well as reforms in the area of housing policies and job-search assistance to facilitate geographic and job mobility. Additional labour market measures may, however, be needed to support low-skilled and low-income workers, who are the most vulnerable to job loss when competitive pressures intensify. Reforms that initially place downward pressure on economy-wide wages are less likely to offer short-run benefits at a time of weak demand.

In the euro area, there is also a need to unblock the bank-lending channel. To this end, speeding-up the restructuring of non-performing loans through stronger bank supervision, debt enforcement and insolvency frameworks is needed. The resolution of the large amount of distressed debt on banks' balance sheets would also facilitate the development of a market for such assets. In this context, the latest private-sector agreement among Italian financial institutions to create a fund to support the recapitalisation of weaker lenders and facilitate the establishment of a secondary market for non-performing loans, together with the government promise to markedly speed up bankruptcy procedures, are welcome. Improving corporate governance of financial institutions is an important complement to new institutional frameworks.

The productivity slowdown

Productivity growth in advanced countries has been much weaker since 2000 than in the 1990s. For several economies, the productivity slowdown goes back to the early 2000s. But since the global financial crisis the decline in productivity growth has become much more pronounced and has affected nearly every country in the OECD. Slowing productivity, not declining employment, has been the principal factor behind slowing GDP per capita. Discussions about productivity growth have therefore taken centre-stage in policy circles, reflected for example in the creation of productivity commissions in many countries.

Hourly labour productivity growth in OECD countries averaged 2.0% during 1990-2000, 1.9% during 2000-07 and 0.9% during 2007-14 (). From the 1990s to 2007, OECD economies experienced different productivity trends, with productivity slowing in 19 countries and accelerating in 14. The United States is among the countries where productivity accelerated in the early 2000s, while productivity slowed in the euro area and Japan. Most worrying are the developments since the global financial crisis, when productivity has grown at less than half the rate in the 1990s.

Productivity growth has declined since the 1990s

Annualised growth of labour productivity (output per hour worked)

OECD, euro area, G20 and non-OECD are aggregated using GDP PPP weights. OECD includes all OECD countries, and euro area includes all euro area countries, in both cases except Estonia. G20 includes all G20 countries except South Africa. Non-OECD is Argentina, Brazil, China, Colombia, India, Indonesia, Latvia, Lithuania, Russia and Saudi Arabia. Data for several countries begin between 1991 and 1995, not in 1990. Labour productivity for non-OECD countries is measured per worker, not per hour worked.

OECD estimations using OECD National Accounts database; OECD Productivity database; International Labour Organisation database.

Statlink http://dx.doi.org/10.1787/888933367500

The productivity slowdown in advanced countries is apparent whether productivity is measured as output per worker or per hour worked. It is also apparent when productivity growth is corrected for the business cycle, even if such adjustments are difficult given the protracted slow recovery. Some of the post-crisis decline is thus likely to remain when economies will be back at full employment. In a longer historical perspective, the low growth rates of the 2000s have been even more unusual, as growth until the 1970s was very strong (OECD, 2015a). More recently, productivity has also slowed in some emerging market economies, including China and Russia, although on average less markedly than in advanced countries.

The rise in inequality

Declining productivity growth has been bad news for workers, since it has reduced the room for productivity-driven real labour income growth. The picture has, however, been even gloomier for two reasons (Kappeler et al., 2016): average labour income has grown less than productivity, and labour income inequality has risen. The increase in labour income inequality began earlier than the post-2000 slowdown in productivity. It is, for example, evident in below-average growth of the labour income of the median worker, i.e. the worker at the midpoint of the distribution.

The combined effect of the productivity slowdown and the rise in inequality has been a decline in income growth to very low rates for many workers. Labour incomes of the majority of workers have continued to grow, and thus people’s well-being, in particular aspects relating to income and consumption, should have improved. But these rates of improvement have no longer been as strong as in the past, and they may have been lower than what people expected. Disparities in other well-being dimensions, such as health, education or employment opportunities, are also large (OECD, 2016a).

A simple calculation illustrates how the productivity slowdown, the low growth of labour income relative to productivity and the rise in labour income inequality have pulled down labour income growth. Analysing the period 1990-2013 for 23 OECD countries, productivity grew by 3.1% per year during 1990-2000 and 0.9% during 2000-13.*

These growth rates are somewhat different to those in , mainly because the country coverage for the present calculation is smaller.

Rising inequality has damped the labour income growth of many workers further. Labour income growth of the median worker was 1.3%, about one-tenth less than the 1.5% average labour income growth rate. Lower-income workers have fared even worse. Labour income of the median worker has grown less than productivity in 21 of 23 OECD countries (). The two exceptions are Chile and Iceland.

Labour income of the typical worker has grown less than productivity

Annualised growth rates, per hour worked, 1990-2013

OECD is the unweighted average of the countries for which data are available. Labour income and value added are deflated using the value added price index. For several countries, the time period begins later than 1990 or ends earlier than 2013. Median labour income growth is calculated by adjusting average labour income growth in the earnings data to average labour income growth in the national accounts. The earnings data cover full-time workers.

OECD estimations based on Kappeler et al. (2016), Decoupling of Productivity and Median Wage Growth: Macro-Level Evidence, OECD Economics Department Working Papers, forthcoming; OECD National Accounts database; OECD Earnings database.

Statlink http://dx.doi.org/10.1787/888933367510

Labour income makes up the bulk of what is referred to as market income, i.e. the sum of labour and capital income. Studying market income, for which more comparable cross-country data are available, is thus quite similar to analysing labour income. Market income inequality has risen in line with labour income inequality. It is to some extent offset by redistribution through taxes and cash transfers. In other words, inequality in market income is higher than inequality in disposable income, i.e. income after taxes and transfers.

The redistributive power of tax-and-transfer systems has been lower in the 2000s than the 1990s. Even though market income inequality has increased since 2000, the amount of redistribution has stayed the same. The rise in market income inequality has not been offset with additional redistribution through taxes and transfers. No change in redistribution since 2000 is the result of reduced redistribution before the crisis and higher redistribution since the crisis (OECD, 2015b). Tax-and-transfer systems may have been deployed less strongly to counteract market income inequality, or they may have become less effective at redistributing income. Such changes in inequality can be quantified with the Gini coefficient, a measure of income inequality that scores 0 when everybody has the same income and 1 when all the income goes to only one person. The Gini for disposable income is about two-thirds of the Gini for market income.

Time series since the 1990s for inequality in market and disposable income are available for 13 OECD countries. From 1990 to 2000, the Gini coefficient for market income increased substantially in this sample. The Gini coefficient for disposable income rose less, as taxes and transfers offset the increase in market income inequality in the 1990s somewhat more than in the past. From 2000 to 2011, the Gini coefficients for market and disposable income increased about the same, albeit much less than in the 1990s (). Redistribution through taxes and transfers did not offset at all the rise of market income inequality in the 2000s. Overall, the redistributive power of tax-and-transfer systems in 2011 was about the same as pre-1990. The rise in the redistributive power of taxes and transfers during the 1990s was undone by the reduction in their redistributive power during the 2000s.*

Redistribution is measured as the difference, in Gini points, between the Gini coefficient for market income and the Gini coefficient for disposable income. Redistributive power is measured as unity minus the ratio of the Gini coefficient for disposable income to the Gini coefficient for market income. When the Gini coefficients for market and disposable income are the same, i.e. when there is no redistribution, this measure takes on value 0.

The redistributive power of taxes and transfers has declined since the 1990s

Change in the Gini coefficient, total population

The figure depicts the unweighted average of the 13 OECD countries for which data are available: Canada, Denmark, Finland, Germany, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Sweden, the United Kingdom and the United States. Some data points have been interpolated or use the value from the closest available year.

OECD estimations using OECD Income Distribution database.

Statlink http://dx.doi.org/10.1787/888933367524

To sum up, labour income inequality, market income inequality and disposable income inequality have all risen over the past two to three decades in advanced economies. The analysis above shows that pay has grown faster for the mean than the median worker. Has inequality risen mainly around the middle of the distribution or at the extremes? Income growth rates at different points in the distribution can be examined for disposable income, the income concept probably most closely related to people’s well‑being.

Since 1990, real disposable income has risen more for the average than for the median household, even if the difference is small (). Differences in growth rates have been larger at the extremes of the distribution. Since 1990, disposable income of the top 10% households has increased by 30%, that of the bottom 10% households by only 4%. The top 10% households have seen their incomes rise at a higher rate than the bottom 10% households in every five-year period since 1990, including during the crisis years when real incomes of the bottom 10% shrank by 7%. Increases at the very top of the distribution, such as for the top 1%, have been even stronger, and may not be fully reflected in these statistics.

Disposable income inequality has increased since 1990

Household disposable income, total population

The figure depicts the unweighted average of the 17 OECD countries for which data are available: Canada, Denmark, Finland, France, Germany, Greece, Israel, Italy, Japan, Luxembourg, Mexico, the Netherlands, New Zealand, Norway, Sweden, the United Kingdom and the United States. Some data points have been interpolated or use the value from the closest available year.

OECD estimations based on OECD (2015), In It Together: Why Less Inequality Benefits All; OECD Income Distribution database.

Statlink http://dx.doi.org/10.1787/888933367530

In many emerging market economies, income inequality increased during the 1990s, similar to the pattern for advanced countries. But since then inequality has declined in several of them, for example Argentina and Brazil. Nevertheless, inequality levels in many emerging market economies continue to be higher than in advanced countries (OECD, 2015b).

Explanations for the productivity slowdown

The evidence suggests that both cyclical and long-term structural factors are responsible for the current low productivity growth. The following four factors are likely to be part of the explanation:

• Weak aggregate demand since the global financial crisis.

• Declines in business dynamism.

• Increased dispersion in productivity growth between the best-performing and other firms.

• Misallocation of capital.

The prolonged cyclical downturn and weak aggregate demand since the global financial crisis have resulted in below-trend labour productivity growth on average (, Panel A). Productivity growth during 2000-07 is estimated to have exceeded its trend by 0.3 percentage points per year on average. This pattern then reversed during 2007-15, when productivity growth averaged 0.2 percentage points less than trend. Thus, some of the productivity gains during the boom period were cyclical. One half of the productivity growth decline since 2007 is attributable to the cycle, the other half to a reduction in trend productivity growth (Ollivaud et al., 2016). These calculations come, as any such estimates, with some degree of uncertainty, given the unobservability of trend productivity.

Labour productivity growth has been low during the cyclical downturn after the global financial crisis

The figure depicts the weighted average of OECD countries. In the calculation of trend productivity, the production function is assumed to be Cobb-Douglas, and total factor productivity is labour-augmenting. Ollivaud and Turner (2015) and Johansson et al. (2013) provide further details on the OECD method of estimating trend productivity.

OECD estimations based on Ollivaud, P., Y. Guillemette and D. Turner (2016), The Links between Weak Investment and the Slowdown in OECD Productivity and Potential Output Growth, OECD Economics Department Working Papers, forthcoming; OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367544

Trend labour productivity can be decomposed into capital per worker and total factor productivity (TFP). Capital rises with more investment in both tangible and less tangible forms of assets (machines and equipment, infrastructure, software, R&D). TFP increases when better technologies or improvements in business products, processes and workplace practices raise the efficiency with which workers and machines are utilised. Capital per worker grew by 0.6% per year during 2000-07 and 0.3% during 2007-15. TFP growth declined from 0.7% before the crisis to 0.5% since the crisis (, Panel B).

The declining contribution of capital per worker to trend productivity growth over the post-crisis period reflects the persistent weakness of investment. Trend productivity removes cyclical variation from TFP and employment, but not from the capital stock. Investment fluctuates strongly with the cycle. The contribution of capital per worker has thus been smaller in the post-crisis period when the cyclical downturn brought investment down. Similarly, capital per worker contributed increasingly more to productivity growth during the boom before the crisis as investment rose in the upturn. Investment has lagged the recovery in GDP, especially in Europe (OECD, 2016b). Weak demand and growth prospects for the world economy, a slowdown in pro-competitive reforms and, in some markets, high costs of finance have been inhibiting investment (OECD, 2015c). Other recent analysis also suggests that the depletion of the capital stock in the United States has played a key role in propagating the shock of the financial crisis (Hall, 2016).

In addition to weak aggregate demand, long-term structural factors have weighed on productivity growth. Business dynamism has declined, as is evident from the fall in business start-up rates and the slowdown in investment in knowledge-based capital (OECD, 2015a). Knowledge-based capital can, for example, take the form of R&D, firm‑specific skills, organisational know-how, databases, design or intellectual property. In Europe, productivity growth has been weaker in industries that have recorded larger declines in the share of young firms (Andrews et al., 2016a).

A disaggregation of firms by productivity shows that the productivity growth of the top firms, i.e. the most productive or innovative ones, has been more robust than that of non‑frontier firms. Based on industry-level data for 15 OECD countries, the productivity of industries in countries where the industry has the highest productivity level has grown at a similar speed in the 2000s as before. By contrast, productivity of non-frontier industries has slowed markedly. Andrews et al. (2015, 2016b) come to a similar conclusion when using firm-level data for 24 OECD countries. Productivity of the most productive firms in their sector worldwide has risen since 2001 at more than four times the speed compared with other firms (). Preliminary results show that the crisis seems to have had a negative impact on the frontier firms, slowing down their productivity. Still, non-frontier firms appear to have experienced even lower productivity growth, thereby leading to a growing gap between the two groups.

The productivity gap between the globally most productive firms and other firms has widened

Labour productivity

Frontier firms is the average labour productivity (value added per worker) of the 100 or 5% globally most productive firms in each two-digit industry. Non-frontier firms is the average of all firms, except the 5% globally most productive firms. Included industries are manufacturing and business services, excluding the financial sector. The coverage of firms in the dataset varies across the 24 countries in the sample and is restricted to firms with at least 20 employees.

Preliminary results based on Andrews, D., C. Criscuolo and P. Gal (2016), Mind the Gap: Productivity Divergence between the Global Frontier and Laggard Firms, OECD Productivity Working Papers, forthcoming; Orbis database of Bureau van Dijk.

Statlink http://dx.doi.org/10.1787/888933367557

The question of what may have caused the productivity divergence between frontier and non-frontier firms cannot be answered definitively with the evidence to date. Declining growth rates of firms away from the global productivity frontier may be attributable to several, possibly complementary, factors (OECD, 2016a): Diffusion of technology and knowledge from frontier firms to others may have declined; poorly‑performing firms may remain longer in the market, rather than exit, thereby trapping resources in unproductive activities; high-skilled workers may sort into the same firms to a greater extent than in the past; and a rise in the concentration of market power and rent-seeking by frontier firms may have left non-frontier firms behind.

Evidence on the third possible structural factor for the productivity slowdown, misallocation of capital, is comparatively less solid to date and warrants further research, including through more cross-country evidence. Several studies suggest that misallocation of capital has been particularly pertinent for the euro area. Following the introduction of the euro, countries in the periphery experienced large capital inflows and low productivity growth (Gopinath et al., 2015). Detailed analyses of Belgium, France, Italy, Portugal and Spain indicate that capital has been allocated to low-productivity firms (Calligaris, 2015; Dias et al., 2015; Gamberoni et al., 2016; García-Santana et al., 2016).

This misallocation of capital may have resulted in lower productivity growth also after the crisis. The slowdown of the capital stock since the crisis has been sharpest in OECD countries, which had the lowest interest rates before the crisis and may have over-accumulated capital (Ollivaud et al., 2016). Further, in some countries, the industries that are the main sources of productivity growth are no longer the same, suggesting misallocation across industries before and after the crisis. In the United Kingdom, for example, the contribution of financial services to productivity growth was strong and positive before the crisis, likely reflecting excessive leverage, but it has been negative since the crisis (Kierzenkowski et al., 2016).

Explanations for the rise in inequality

Several reasons underpin the upward trend in labour income inequality, and consequently market and disposable income inequality. Factors that are likely to be part of the explanation include:

• High unemployment since the global financial crisis.

• Skill-biased technological change.

• Decreased worker bargaining power.

• Globalisation and increased international connectedness.

• Productivity divergence across firms.

• Rising income shares at the top of the distribution.

Income inequality continued to increase during the global financial crisis and subsequent period of fiscal consolidation. The fall in employment, not relative wage developments, was the main factor behind the rise in inequality of both market and disposable income. In fact, income poverty also increased after the crisis (OECD, 2015b). Disposable income inequality rose less than market income inequality, as more redistribution, in part due to automatic stabilisers, offset some of the income losses of households at the lower end of the distribution. The increase in redistribution during the crisis reversed the decline observed earlier in the decade so that the overall amount in 2011 was about the same as in 2000. As a result, inequality in market and disposable incomes increased by very similar magnitudes between 2000 and 2011 (as shown in ).

Several factors have contributed to the long-term rise in inequality. Inequality in the distribution of labour income has accounted for most of the increase in income inequality. To a certain extent, the increase in labour income inequality is likely related to technological progress, which may itself have been driven by investment in R&D and innovation. Technical advancements may have benefited high-skilled workers more; for instance, earnings gains have been particularly large for people with much-demanded skills to deal with new information and communication technologies. In addition, a growing share of non-standard labour contracts and a lower coverage of collective bargaining in some countries may have further curbed the wage growth of low- and medium-skilled workers (OECD, 2011). These trends might have been compounded by globalisation and increased interconnectedness, for example through the integration of China in international trade flows (Autor et al., 2013, 2014).

At least in some countries, the rise of labour income inequality has been primarily due to a rise in wage differences between firms, not within firms. This has been shown to be the case in Germany (Card et al., 2013), Sweden (Håkanson et al., 2015) and the United States (Song et al., 2015). According to this research, inequality has risen because some firms now pay all their employees much more than other firms, not because top managers have increasingly been paid more than support staff. The results in these studies indicate that some of the wage divergence between firms may be related to so-called assortative matching, whereby high-wage workers and high-wage firms increasingly match with each other.

This phenomenon is in line with  on productivity divergence between firms, which would imply rising dispersion of labour incomes across firms. When advanced countries are compared with one another, dispersion of firm productivity is highly positively correlated with dispersion of labour income across firms ().*

Regressing the P90/P50 ratio in the firm distribution of average labour income on the P90/P50 ratio in the firm distribution of labour productivity yields a coefficient estimate of 0.47 and a p-value of 0.0001. The R-squared is 0.58, and the number of observations is 21.

Labour income inequality and productivity dispersion across firms are positively correlated

2013

OECD is the unweighted average of the countries for which data are available. The country-specific data points indicate the unweighted average of within-industry labour income inequality and productivity dispersion between firms. The coverage of firms in the dataset varies across countries and is restricted to firms with at least 20 employees. The P90/P50 ratio is average labour income or labour productivity of the firm at the 90th percentile divided by the corresponding value of the firm at the median. Labour income is total compensation including taxes and the employer's and employee's social security contributions. The data point for Japan refers to 2008, the most recent year for which data are available.

OECD estimations based on Saia and Schwellnus (2016), Decoupling of Productivity and Median Wage Growth: Micro-Level Evidence, OECD Economics Department Working Papers, forthcoming; Orbis database of Bureau van Dijk.

Statlink http://dx.doi.org/10.1787/888933367560

Income at the very top of the income distribution has grown far more rapidly than for the rest of the population (Alvaredo et al., 2013; Förster et al., 2014), notwithstanding the observation that household surveys, including those used by the OECD, have the drawback of under-coverage of the top 1% incomes (Ruiz and Woloszko, 2016). Rising inequality in wealth and capital income, which are already more concentrated than labour income, is likely to have increased total incomes at the top. Other factors that may have contributed to the strong rise of top incomes are reductions in top marginal income tax rates and stronger protection of rents. In the United States, for example, corporate profits in the technology and financial industries are close to record highs and many industries have become more concentrated. This growing market power may have benefited employees in high-wage firms the most. Further analysis of the sources of top income inequality is an important area of future research.

Policies to support aggregate demand

The productivity slowdown has become much more pronounced since the global financial crisis, in part due to weak aggregate demand. Policies that strengthen aggregate demand, in particular through stronger investment, may therefore increase productivity, employment and household income. Monetary and fiscal policies support demand most directly. Structural reforms improve economic growth prospects in the long term and, with appropriate choices, can also support aggregate demand in the short term.

Monetary, fiscal and structural policies must be deployed in a consistent and synergistic manner. None of the three levers can work alone. Experience to date suggests that the strong reliance on monetary policy has been insufficient to deliver satisfactory growth. With monetary policy close to its limits, fiscal policy is important to generate demand, and structural reforms can facilitate the necessary reallocation of resources.

Monetary and fiscal policy options to support demand vary across economies (Chapters 1 and 3). In several economies, the macro policy mix, which needs to remain accommodative, would benefit from the enhanced use of fiscal policies, given growing concerns about the potential distortions caused by non-conventional monetary policy actions and diminishing returns of further easing. The very low interest rates for government borrowing have in effect increased fiscal space, providing many countries with room for expansion. Collective fiscal action, that lets countries mutually benefit from the positive spillovers of fiscal actions in other countries, would raise the pay-off for individual countries from undertaking fiscal expansion and is consistent with fiscal sustainability.

The effects of such aggregate demand policies on income inequality have a cyclical and structural dimension. The current situation of inadequate aggregate demand, where many economies operate at less than potential output, is synonymous with low employment rates. Low employment rates are an important source of poverty and income disparities, because they generate no labour income for an unusually large number of workers. As emphasised above, the decline in employment over the cyclical downturn since the global financial crisis has increased poverty and income inequality.*

Effects from the very expansionary stance of monetary policy on income inequality via financial channels are likely to have been small (O’Farrell et al., 2016).

Macroeconomic expansion to further stimulate aggregate demand would be suited to reduce this cyclical effect of a temporary rise in poverty and income inequality. Demand management in today’s economic environment can have the additional benefit of countering increases in income inequality even over the longer term. Continued economic weakness may damage the employability of workers who have been out of work for too long. Long-term unemployment erodes the skills of workers and their earnings prospects and could thus result in permanently higher inequality.

A very powerful fiscal tool to raise demand, productivity and income would be to increase public investment. Public investment has fallen as a share of GDP compared with pre-crisis levels at the aggregate OECD level (Ollivaud et al., 2016). Multiplier estimates are usually larger for investment than other spending components (Auerbach and Gorodnichenko, 2012; Ilzetzki et al., 2013). Infrastructure is often perceived to be deficient, and many governments are now able to borrow at very low interest rates for long maturities. Public investment can be particularly effective when it catalyses private investment (OECD, 2015c). More investment would have the twin benefit of not only expanding demand today, but also supply tomorrow, by adding to the capital stock. Evidence in the next section on the structural composition of public spending suggests that higher levels of public investment should be maintained, even when monetary policy eventually gains more traction again and the global economy gets back to potential. Insofar as reductions in public expenditure are needed in the long term to preserve fiscal sustainability, they should be sought in areas other than investment.

Public spending and tax policies

Governments in advanced countries collect on average about 40% of GDP in taxes and spend a similar amount on public goods, services and transfers. Size, composition and design of spending and taxes may influence productivity growth and the distribution of income. As the first part of this chapter showed, the redistributive power of taxes and cash transfers, an important component of public spending, has been less in the 2000s than the 1990s. This section studies the long-term effects of government effectiveness and size, the composition of public spending and specific taxes on productivity and inequality.

Public spending policies

Besides the overall size of government, the composition of public spending is important as well. Better and more education is associated with higher growth and productivity, and also greater income equality, when years of schooling count only time in primary and secondary education, not tertiary education.*

The analysis uses a quality-adjusted measure of the level of education, instead of education spending which can take long to translate in better educational achievement. In particular, the average number of years of schooling of the working-age population is interacted with the country’s score in the OECD Programme for International Student Assessment (PISA).

This is in line with evidence that investing in early childhood education yields high returns since it enhances equality of opportunity and skill acquisition throughout life (Wößmann, 2008; Cuhna et al., 2010; Heckman, 2011; Cingano, 2014; OECD, 2015b). The empirical links of better and more education with higher growth, productivity and equality suggest long-term benefits from a greater share of education in public spending.

Governments allocating a larger share of total expenditure to good-quality public investment tend to boost growth and productivity over the long term in the average advanced country (Fournier, 2016). Higher public investment raises disposable incomes of households across the distribution, leaving income inequality broadly unchanged. Illustrative simulations similar to those in Fournier and Johansson (2016) have been conducted, wherein public investment in countries with public investment relative to trend GDP below the average ratio of that of countries in the top half converges to this average ratio over ten years. Households in many countries could experience income gains, of up to 15%, from a shift in spending towards public investment (). Differences between low- and high-income households are small and far from statistical significance.

Changing the spending structure in favour of public investment can deliver large income gains for households across the distribution

Long-term effects on household disposable income

Public investment in countries, where public investment to trend GDP is below the average ratio of that of countries in the top half of the sample, is assumed to converge to this average ratio. The figure reports the effects after 45 years of a reform phased in over 10 years.

OECD estimations based on Fournier and Johansson (2016), The Effect of the Size and the Mix of Public Spending on Growth and Inequality, OECD Economics Department Working Papers, forthcoming.

Statlink http://dx.doi.org/10.1787/888933367576

Education and public investment are the two areas of public expenditure that are estimated to be associated with higher long-term productivity. They should thus receive priority in government budgetary plans. Two other spending items, social spending on family and child care and public subsidies, appear to reduce income inequality. Family benefits tend to target lower-income households, and more child care may facilitate access to the labour market especially for lower-income households with children. Some subsidies may be used to redistribute, lowering income inequality. Subsidies are, however, negatively related with economic growth, although they do not appear to be associated with lower productivity. No statistically significant effects have been identified for other areas of public spending, for example health.

Competition and innovation policies

In the aftermath of the global financial crisis, many advanced countries have undertaken structural reforms, such as reforms in product and labour markets. These structural reforms have improved resource allocation and the prospects for economic growth. Their benefits may be due to higher productivity, higher employment or both, and they might, or might not, be evenly spread across income groups. This section highlights reforms that are likely to promote productivity and examines their effects on income inequality.

Reforms of product markets

Product market reforms raise productivity. Evidence on this beneficial effect of product market reforms comes from several cross-country sources: the macro-level analysis of Égert (2016), the industry-level analysis of Cette et al. (2016) and the firm-level analysis of Andrews et al. (2015). Égert (2016) uses annual data over a long time horizon on the extent of regulation in three network industries: energy (electricity and gas), transport (air, rail and road) and communication (telecom and post). The indicator combines information on entry barriers, public ownership and other aspects of regulation. Reducing the stringency of network industry regulation is estimated to raise both labour productivity and TFP in a statistically significant manner. Andrews et al. (2015) reach a similar conclusion for overall product market regulation, not only the regulation of network industries. Product market reforms also increase employment (Gal and Theising, 2015).

Product market reforms are inclusive in that they lift the disposable income of households across the distribution. Income equality remains broadly unchanged. Causa et al. (2016) nest the macroeconomic estimate of Égert (2016) in an empirical framework that estimates how product market reforms translate into income gains for households at different points in the distribution. Their analysis shows that the disposable income of households across the distribution increases when the regulation of network industries is eased (). Wage disparity rises, but so does employment. The effects are statistically significant across the distribution and not significantly different for low- and high-income households. Andrews et al. (2015) conclude that product market liberalisations leave the productivity distribution of firms broadly the same. This suggests too that income inequality may not change much, insofar as productivity and wage dispersion move together.

Reduced regulation in network industries has increased income across the distribution

Effects on household disposable income after a 1% reduction in the regulation index

The shaded area indicates the 90% confidence band for how the total effect of reduced regulation is distributed across households. The total effect itself is assumed to be certain.

OECD estimations based on Causa, O., M. Hermansen and N. Ruiz (2016), The Distributional Impact of Pro-Growth Reforms, OECD Economics Department Working Papers, forthcoming.

Statlink http://dx.doi.org/10.1787/888933367580

Related research links slowing productivity and rising inequality with higher firm market power (Krugman, 2015; Reich, 2015; Council of Economic Advisers, 2016). Greater market power may lead to higher rents and allow companies to block new competitors from entering the market. Furman and Orszag (2015) argue that some firms, such as in the technology sector or finance, benefit from consistently high supernormal profits and share these with workers through wage premiums. To a certain extent, such winner-takes-all phenomena can be efficient due to the way technologically-advanced services benefit from a large user base. In other cases, however, anti-competitive actions by firms (such as mergers and acquisitions) may have exacerbated market power. Robust enforcement of the competition regime, combined with a reduction in regulatory barriers to entry and exit, can thus improve efficiency and equality. Competition regimes may also have to be reviewed and adapted to new technologies. Furthermore, in areas, such as intellectual property rights protection, copyright systems or R&D support, well-intentioned policies designed to boost innovation efforts may inadvertently give an edge to incumbents at the expense of innovative start-ups (Bravo-Biosca et al., 2014).

Coherence between policies

Coherence between policies is important for ensuring that they work together to enhance the overall well-being of citizens. Labour market policies, for example, can interact with other policies, such as product market policies, and influence the productivity benefits from reforming product markets. Product market reforms often enhance economic flexibility. Labour market policies can facilitate the reallocation of workers, which would help reap the benefits from more flexible product markets.

Product market reforms imply a higher likelihood of losing a job and of finding a job for people who are unemployed or out of the labour force. Which income groups are affected by the increased labour market churn that comes with product market reforms? Low-income workers have a higher probability than other income groups of leaving employment (Cournède et al., 2016a; Garda, 2016). They are also the income group for which the job exit rate rises after reductions in network industry regulation (, Panel A). This higher job exit rate is, however, offset by a higher job entry rate for low-income workers (, Panel B).

Reduced regulation in network industries has increased labour market transitions for low-income groups

Changes in average transition rates after a typical reform in network regulation

Black segments indicate 90% confidence intervals. Quartiles are calculated over the previous year’s average monthly labour income in months during which the individual worked. The effects are estimated with micro data for 26 OECD countries over 1994-2012.

OECD estimations based on Cournède, B., O. Denk and P. Garda (2016), Effects of Flexibility-Enhancing Reforms on Employment Transitions, OECD Economics Department Working Papers, forthcoming.

Statlink http://dx.doi.org/10.1787/888933367595

Hence, product market reforms increase the labour market turnover of low-income workers. This effect of enhanced economic flexibility suggests accompanying product market reforms with active labour market programmes (ALMPs) to help individuals transition to new jobs (Cournède et al., 2016b). ALMPs tend to benefit workers in the lower half of the income distribution (Causa et al., 2016). The combination of product market reforms and effective ALMPs can therefore raise productivity and household income, while lowering income inequality. Complementary evidence on mass lay-offs underlines that ALMPs also improve re-employment prospects of displaced workers (Andrews and Saia, 2016).

Other policy interactions are likely to be important for productivity. For instance, implementing regulatory reforms in product and labour markets jointly may be better than a one-sided reform (Égert, 2016). The effectiveness of policies is also likely to depend on the economic environment in the country. An example is higher R&D spending, where favourable effects on productivity increase with a stronger rule of law, market settings more conducive to business start-ups and growth and lower barriers to trade. Estimating empirically the inequality effects of such policy complementarities is an important area for future research.

Financial market policies

Finance is important for funding investment and innovation. But finance is also likely to have contributed to the initial shortfall in aggregate demand and the current weakness in investment. Excessive leverage has been stifling household consumption, and credit supply constraints may have exacerbated the investment slowdown. Write-downs of non-performing loans and faster bank recapitalisations would help households deleverage and facilitate the provision of new credit, which is particularly important for the euro area. For some European countries, inefficient insolvency regimes have been identified as a barrier to addressing the rise in non-performing loans (Bergthaler et al., 2015). In the United States, high household debt levels were an important source of the contraction in consumption (Mian and Sufi, 2014).

One finance-related factor which is likely to hold back long-term productivity growth is that many banks and similar financial institutions benefit from too-big-to-fail (TBTF) guarantees by governments and central banks, despite new regulatory measures in Basel III. TBTF reflects the perception by the holders of bank debt and, to some extent, bank equity that their investments are protected. One way such TBTF guarantees may have found their way into the real economy is the rapid pre-crisis rise of bank credit.

Empirical evidence supports this conjecture. Data from the past 50 years show that above-trend credit expansions have led to a slowdown in GDP per capita, and that the effect is particularly strong in countries where TBTF is larger (Cournède and Denk, 2015; Denk et al., 2015). By contrast, a stronger reliance on stock markets has been associated with higher economic growth (, Panel A). When the regressions use productivity instead of GDP growth, estimates appear weaker and less stable, but they remain negative for bank credit and positive for stock markets.

Equity finance has been more favourable to growth than credit finance

The bars show the effects of a 10% of GDP increase in private credit or stock market capitalisation. Private credit is credit to the non-financial private sector by banks and similar financial institutions, and stock market capitalisation is the value of all shares listed in a stock market. Black segments indicate 90% confidence intervals.

Cournède, B. and O. Denk (2015), Finance and Economic Growth in OECD and G20 Countries, OECD Economics Department Working Papers, No. 1223; Denk, O. and B. Cournède (2015), Finance and Income Inequality in OECD Countries, OECD Economics Department Working Papers, No. 1224.

Statlink http://dx.doi.org/10.1787/888933367607

Credit overexpansion may be particularly harmful by inducing labour reallocations to industries with lower productivity growth (Borio et al., 2015). It may also exacerbate misallocation of capital, for example through too much lending to households (Turner, 2015). More recently, credit has expanded very rapidly in several emerging market economies, including China and Turkey. The positive productivity effect of higher equity finance concurs with the finding that countries with better developed venture capital markets are more effective at channelling resources to young innovative firms (Andrews and Criscuolo, 2013).

The rise of finance is also linked with changes in income inequality (Denk and Cournède, 2015). More bank credit and larger stock markets are both correlated with a less equal distribution of household disposable income, when accounting for many other factors (, Panel B).

Another channel through which TBTF has arguably found its way into the real economy is overly high pay in finance. In Europe, the financial sector wage premium (or how much financial employees receive in excess of what similar workers are paid in other industries) is 25% of average earnings (Denk, 2015a). It rises across the earnings distribution, reaching nearly 40% for top-paid workers (). High wage premiums are one reason why finance is the industry most disproportionately represented among the top 1% earners (Denk, 2015b). Such financial rents raise inequality and, as a symptom of excessive returns to the conduct of banking activities, they are likely to reduce productivity as well, not least considering the importance of banking services as inputs for other industries. Restricting compensation practices that reward short-term success with no claw-back provisions would cap very high financial sector pay when it is the most unjustified.

The phasing-out of TBTF bears a similar promise of promoting both productivity and equality. One avenue would be to break up TBTF banks into small entities which can go bankrupt without creating systemic risk. Alternative approaches would be, for example, to impose higher capital surcharges on TBTF banks or to force creditors to take losses more frequently in the case of insolvent banks (Cournède et al., 2015). In the short term, however, such measures can hurt economic activity.

The financial sector wage premium

increases along the earnings distribution

European countries, 2010

The shaded area indicates the 90% confidence band. The figure depicts the unweighted average of the 18 European countries for which data are available.

The financial sector wage premium is the percentage by which annual labour earnings of full-time employees in finance exceed what other industries pay. It is obtained from regressions using micro data and controlling for age, gender, highest level of education, years of experience in the firm and their square, number of employees in the firm, geographical location of the firm, type of financial control, level of wage bargaining, type of employment contract, number of overtime hours paid and occupation.

OECD estimations based on Denk, O. (2015), Financial Sector Pay and Labour Income Inequality: Evidence from Europe, OECD Economics Department Working Papers, No. 1225.

Statlink http://dx.doi.org/10.1787/888933367613

Rebalancing away from resource sectors continues

Resource-sector investment and employment face ongoing decline and commodity prices remain low, although new liquefied-natural-gas (LNG) production is boosting exports. Non-resource activity continues to pick up, especially in services exports, in part reflecting past depreciation of the currency. Non-resource activity is now driving employment growth. In addition, house-price and mortgage-credit growth are slowing, assisted by macro-prudential tightening. Consumer price inflation remains low. Also, uncertainty about global economic prospects is impacting Australia’s stock market and business sentiment.

Economic rebalancing and housing market

Data are smoothed to reduce the impact of the irregular component of the seasonally adjusted series.

Australian Bureau of Statistics; OECD Analytical House Price database.

Statlink http://dx.doi.org/10.1787/888933367620

Continued policy support for economic adjustment and productivity growth is required

The Reserve Bank reduced the policy rate by 25 basis points in May to 1.75%, the first rate change in 12 months, prompting a depreciation of the exchange rate. The projection envisages no further easing and assumes that policy-rate increases begin in 2017. Nevertheless, room for further rate cuts remains in the event of below-par growth. Fiscal policy needs to let the automatic stabilisers operate while keeping a medium-term objective of reducing the public-debt burden.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369200

In structural policy, the OECD has long emphasised the scope for improving Australia’s tax system, in particular through greater use of efficient tax bases, such as the Goods and Services Tax and land tax, and reforms in specific areas, such as the taxation of pensions (superannuation). Reform to the latter could lower inequality by narrowing differences across households and between women and men among older cohorts. Strengthening of consumer-protection regulation in banking would also benefit households. Australia’s greenhouse-gas reduction policy relies principally on the Emission Reduction Fund, which provides financial incentives for businesses to reduce emissions and as of July 2016 it will backed by a safeguard mechanism that discourages offsetting emissions.

Boosting productivity requires strengthening capacities for generating and absorbing innovation. Research collaboration between the university and business sectors remains a point of weakness. Also, ensuring value-for-money in financial incentives, such as R&D tax breaks, remains a challenge. Policy responses to disruptive internet-platform innovations have generally been positive. Australian product and labour market regulation is broadly conducive to resource re-allocation, thus helping innovation via creative destruction. However, ICT infrastructure and services require ongoing policy attention and there is scope for greater innovation in public services.

The pick-up in growth will be gradual, but risks and uncertainties remain sizeable

Output growth is projected to be just under 3% in 2017. Negative effects from shrinking mining investment are set to ease and new LNG production will boost exports. Exchange rate depreciation and supportive macroeconomic policy have helped rebalance activity towards non-mining sectors. Employment growth will drive a further decline in the rate of unemployment. Household consumption is expected to remain solid, helped by further erosion of the household savings ratio. The pick-up in activity will not generate significant inflationary pressure, due to remaining economic slack.

Australia’s exposure to commodity-market developments, particularly those linked to the Chinese economy remains an important source of uncertainty and risk. Domestically, the unwinding of housing-market tensions to date may presage dramatic and destabilising developments, rather than herald a soft landing. Uncertainties on future economic policy ahead of the Federal election, which is scheduled for 2^nd July, are also adding a degree of risk.

The recovery is gaining momentum

A tax reform, which came into effect at the start of 2016, boosted disposable household income and confidence. Investment growth resumed in 2015 but the investment rate remains considerably below historical average. Despite weak economic growth since 2011 and rising unemployment, inflation has been persistently higher than in other euro area countries. Falling labour productivity in services has raised intermediate costs which may have weakened international competitiveness and contributed to subdued export performance. Structural changes in regional value chains, in particular the relocation of supply chains from Austria to central and eastern European countries, may also partly explain losses in export market shares.

Export performance and inflation

Export performance is measured as actual growth in exports relative to the growth of the country’s export markets.

HCPI.

OECD Economic Outlook 99 database; and Statistics Austria.

Statlink http://dx.doi.org/10.1787/888933367632

Supply-side reforms should supplement recent demand-side boosts

The fiscal stance will be slightly expansionary in 2016 owing to expenditures for migrants and a decline in net revenues induced by the tax reform. The winding-down of failed banks is still not completed, but announced bail-in of senior creditors would be an important step towards containing expectations of implicit guarantees. The projection assumes that no additional capital transfers or subsidies to troubled banks will be necessary. Growth could be boosted further and become more inclusive by promoting a more gender-equal society with a tax-and-benefit system that encourages a more balanced distribution of work, the provision of more full-day schools and care centres, and more family-friendly workplaces and working-time models.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369211

Stringent regulations in the service sector hamper labour productivity and partly explain the relatively high level of inflation. Tackling rigidities in the services sector would improve productivity and provide better jobs in the sector. It may also help to preserve and extend employment in the tradable sector as participation in global and regional production chains increasingly depends on the provision of high-quality services. The integration of refugees into the labour market may temporarily weigh on average productivity but is of critical importance for the preservation of social cohesion, Austria's growth potential and its fiscal position.

Growth will be led by domestic demand

GDP growth is projected to increase gradually driven by a pick-up in private consumption and investment. The current account surplus will continue to be supported by buoyant tourism. Some risks surround the projection. Overall export performance may be stronger than projected if lost market shares are regained or weaker if the slide in market shares continues amid subdued competitiveness and restructuring of regional value chains. The restructuring of the banking sector is ongoing which may continue to affect public finances. Associated uncertainties could weigh on confidence and hold back investment more than projected. On the upside, the tax reform could boost private consumption more if saving rates pick up less than expected. Second-round effects of the reform on employment and investment may also be stronger than anticipated. The projected rebound of investment could be hampered by weaker-than-expected growth in the euro area and emerging markets or substantial increases in oil prices.

The economic recovery remains modest

Economic growth is becoming more broad-based. Stronger growth in main trading partners, in particular the United States and Europe, are supporting exports. High capacity utilisation rates and the decline of unit labour costs for the second consecutive year are feeding a slow rise of private investment, but a large one-off investment in the pharmaceuticals in 2015 has not been replaced. Low oil prices have boosted household spending, but the pace of consumption growth is slowing as the suspension of the automatic indexation of wages and social benefits and restrictions on collective wage bargaining bear down on real incomes. The terrorist attacks in Paris and Brussels have driven down private consumption growth during the first half of 2016. Inflation, the highest in the euro area, is trending up, mainly due to the increases of indirect taxes, in particular on electricity.

Labour market and inflation

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367640

Gradual fiscal tightening will resume after a pause in 2016

The fiscal deficit is the lowest since the financial crisis. Gradual consolidation is appropriate, as public debt exceeds GDP. However, the remaining slack in the economy requires letting the automatic stabilisers operate fully if growth disappoints. Public investment, in particular in transport infrastructure where investment has been comparatively low for decades, should be enhanced to boost competitiveness and productivity.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369222

The 2015-2019 pro-growth policy of increasing taxation on capital gains, excise duties and value added taxes is welcome. Lower social security contributions for employers, and corporate tax deduction for productive investment in SMEs and for high tech investment, are expected to strengthen labour market performance and productivity growth. Higher tax relief for low wage workers can, by increasing take-home pay, enhance inclusiveness. However, more is needed to ensure equal educational and labour market opportunities, especially for migrants and the low-skilled, notably by reducing the concentration of disadvantaged students in particular schools, delaying tracking in secondary education, and expanding training offers and diversity plans in firms.

Economic growth will progressively strengthen but external risks remain

Exports will pick up as activity in the euro area strengthens. The inflation gap with trading partners is expected to remain positive but to narrow as euro area inflation gets closer to the target set by the European Central Bank. Favourable financing conditions will boost private investment. Wage growth is projected to pick up in the second half of 2016 as the indexation mechanism is restored, supporting private consumption. The recovery will lower unemployment but labour market slack will remain.

Prolonged weaker-than-projected growth in main trading partners would reduce growth. A Brexit scenario combined with lower economic growth in the United Kingdom would in particular undermine exports as the United Kingdom accounts for almost 9% of total exports. Another risk is lower growth in emerging markets, including China: even though the markets represent only a small portion of exports, the effect could be substantial through global value chains. Increased financial volatility in emerging markets and uncertainty regarding the oil price could also lower business confidence and investment. By contrast, domestic demand could be stronger if the tax shift policy has a stronger-than-expected impact on labour and capital demand.

Political uncertainty is high and confidence low

The economy is in a severe recession. Over the past 12 months, almost 2 million formal jobs have been lost and the currency has depreciated by almost 20%, despite a slight appreciation in recent months. Corporate bankruptcies and debt have risen. The low investor and consumer confidence have fallen further as political uncertainty has deepened. A presidential impeachment procedure is ongoing and an interim government has been formed, but political uncertainty and instability are likely to remain.

Confidence and bankrupcy

Fundação Getúlio Vargas; Confederação Nacional de Indústria; Serasa/Experian; and CEMEC-IBMEC.

Statlink http://dx.doi.org/10.1787/888933367654

Fiscal results have deteriorated further and inflation remains high

The fiscal deficit has risen to above 10% of GDP and the primary deficit exceeds 2% of GDP, even though Brazil requires primary surpluses to keep its public debt on a firmly declining path. Another rating downgrade occurred in December, and no major rating agency now considers Brazil’s sovereign debt to be investment grade. This deterioration is due to declining revenues in the face of the recession, and there may be further revenue shortfalls. The plan to unwind significant tax exemptions was not fully implemented, further weakening the fiscal position. Expenditures continue on an upward trend while spending efficiency remains low. Year-on-year inflation is slowly coming down as the recession reduces inflationary pressures and the strong increases in administrative prices in early 2015 are beginning to fall out of the 12-month window. Still, inflation remains well above the ceiling of the target range of 6.5%.

Macroeconomic indicators

Statlink http://dx.doi.org/10.1787/888933369473

Structural reforms should support economic adjustment and inclusive growth

Structural reforms have a significant potential to boost growth. Reducing the compliance costs and distortions imposed by Brazil’s fragmented system of indirect taxes would provide an almost immediate cost reduction for firms, and could be achieved by consolidating indirect taxes into a single, broad-based value-added tax with full deductibility for inputs and a zero-rating for exports. In addition, reducing barriers to international trade would reduce the costs of imported inputs and strengthen incentives to enhance productivity. Improvements in infrastructure could also reduce transport costs, particularly for exporters. Stronger trade integration would benefit low-income earners in particular, as an expansion of the export sector would have a larger impact on the demand for low-skilled labour. Further improvements in educational attainment would not only raise productivity, but also allow more low-income households to join Brazil’s growing middle class.

Fiscal policy and inflation

The inflation target is met whenever the accumulated inflation during the period January-December of each year falls within the tolerance band.

Central Bank of Brazil; and IBGE.

Statlink http://dx.doi.org/10.1787/888933367663

The economy will remain in recession over the projection period, but political upside risks exist

In the baseline scenario, the political situation will remain highly uncertain throughout the projection period and confidence levels will remain subdued. In this scenario, growth will be negative in both 2016 and 2017 as domestic demand fails to show any significant signs of recovery. Only export growth remains solid, buoyed by a more competitive exchange rate and new export opportunities gradually being seized by businesses. Imports are projected to decline as domestic demand shrinks. As a result, the current account deficit narrows. Unemployment is projected to rise further. Inflation will continue to decline due to weak activity, and the monetary authorities will be in a position to lower the monetary policy rate. While remaining above the 4.5% inflation target, inflation is projected to return into the tolerance band during 2017, whose ceiling will then be at 6%.

As the political panorama has a major impact on economic performance, it presents both upside and downside risks for the projections. If uncertainty about future policies is resolved more rapidly than assumed and a consensus for reforms is achieved, confidence could improve rapidly and growth could even be positive in 2017. At the same time, the deep political divisions could also lead to further instability well into 2018, which would make it very difficult to pursue the economic policies needed to sustain growth.

Volatility on international capital markets could return in the context of monetary policy normalisation in the United States, but Brazil’s high foreign currency reserves of USD 351 billion (20% of GDP) provide a strong cushion. Additional downside risks could come from the corporate sector, where the effects of the ongoing recession are becoming increasingly visible. Bankruptcy filings are increasing across all company sizes and corporate defaults may rise going forward. Among publicly traded companies, net financial debt rose by 24% during 2015, at the same time as earnings declined by 29%, without counting the three large companies with public participation (Petrobras, Vale, Electrobras). Further currency depreciation could help exporters, but it could also imply difficulties for corporate borrowers, even if almost half of the corporate debt in foreign currency is hedged or backed by export revenues. A further slowdown of growth in China, the export destination for many of Brazil’s commodity exports, could also reduce growth in Brazil.

The economy is recovering

Looking through quarterly volatility, real GDP is expanding at an annual rate of around 2%. Growth in non-commodity export-related industries has picked up to still higher rates, aided by the earlier fall in the Canadian dollar and the recovery in export markets, but industries most affected by commodity prices remain depressed. Business investment in the oil and gas sector continues to fall sharply – it is likely to be about 60% below its 2014 level in 2016 - but should be a smaller drag on growth thereafter. Other business investment is also weak but should pick up as capacity utilisation in many non-commodity exporting sectors is already high and credit conditions are easing. Growth in private consumption has been subdued, reflecting adjustment to the terms of trade losses since mid-2014 (amounting to about 3% of national income), but should get a boost from the new Canada Child Benefit. At the national level, housing starts are running at the higher end of demographic requirements and housing investment is robust, especially in British Columbia and Ontario, although it is declining in oil-producing provinces. The recent fires in Alberta have shut down some oil-sands production, depressing economic growth in the second quarter of 2016, but activity is likely to bounce back in the third quarter as production resumes.

Exports and Investment

Three-month moving average of real output.

For more details on the composition of the industries and their weight on GDP, see note in Chart 9 of Bank of Canada (2016).

Includes oil and gas. Also includes some engineering structures investment that may relate to other sectors.

Bank of Canada (2016), Monetary Policy Report, April, Chart 9; Statistics Canada, Tables 379-0031 and 380-0068; OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367670

Despite steady employment growth, the unemployment rate has remained slightly over 7% since late 2014. High involuntary part-time employment and long-term unemployment, as well as weak wage pressures, point to continued labour market slack. Consumer price inflation has fallen to the lower end of the Bank of Canada’s 1-3% target range despite the exchange rate depreciation, but this reflects falling gasoline prices — excluding these, inflation is near 2%.

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888933369127

Macroeconomic policies are expansionary

Fiscal stimulus in the recent budget could boost GDP growth by around 0.5% in both 2016 and 2017. The general government deficit is projected to rise by 0.5% of GDP over 2015-17, to 2.2% of GDP. This increase mainly reflects 2016 federal budget measures to boost demand, notably infrastructure spending, which is a government priority. The new policy package also includes measures to redistribute income towards low- and middle-income families. The most important of these is the replacement of existing programmes to help families with children, some of which are not means tested, by the means-tested Canada Child Benefit. There is also a substantial increase in funding to improve conditions for Aboriginal peoples.

Labour market and inflation

Twelve-month moving average.

Percentage of firms reporting more intense labour shortages minus the percentage reporting less intense shortages.

Statistics Canada, Tables 282-001, 282-0047 and 326-0020; Bank of Canada (2016), Business Outlook Survey - Results of the Spring 2016 Survey, April.

Statlink http://dx.doi.org/10.1787/888933367683

The central bank held its policy rate unchanged at 0.5% at its April meeting, despite upward pressure on the dollar. Based on the Bank’s projection that economic slack will be taken up by the second half of 2017, the projection assumes that monetary stimulus will be gradually withdrawn starting in late 2016. Very low borrowing rates have encouraged household credit growth and underpinned rapidly rising housing prices, particularly in Vancouver and Toronto, which together are a third of the Canadian housing market. In relation to household incomes, both house prices and household debt are high. Macro‑prudential measures have been strengthened recently but should be tightened further and targeted regionally.

Financial indicators

Statlink http://dx.doi.org/10.1787/888933369131

A number of policies could raise productivity and reduce income inequality. In telecoms and broadcasting and air transportation, easing restrictive foreign ownership rules would sharpen competitive pressures, raise productivity and reduce prices for consumers. In the electricity sector, developing more east-west connections where economic and allowing competition in generation and retail distribution would also lower prices. In inter-provincial trade, to reduce non-tariff barriers, which raise costs and prices, coverage of the Agreement on Internal Trade should be broadened and provincial authorities should reconcile regulatory differences, in some cases by recognising each other’s regulations.

Demand and output

Statlink http://dx.doi.org/10.1787/888933369148

Growth in non-energy exports and investment should lead the recovery

Economic growth is projected to strengthen in 2016 and reach 2.2% in 2017. The drag from falling investment and employment in the resource sector should soon peak and then gradually fade away. Non-energy exports should lead the recovery as they continue to benefit from the lower Canadian dollar and strengthening export market growth. Business investment outside the resource sector should rise with a lag as sectoral capacity constraints become binding. Growth in housing investment, on the other hand, should weaken, as further supply comes onto the market and the boost from past interest rate cuts fades. With moderate growth in household incomes, private consumption should continue to grow steadily. The unemployment rate is projected to edge down to 6¾ per cent by late 2017, and, with gasoline prices and the exchange rate stable and excess capacity eliminated, the inflation rate could rise to around 2%, the midpoint of the Bank of Canada’s target range.

External indicators

Statlink http://dx.doi.org/10.1787/888933369150

The greatest risk surrounding these projections is global oil prices. If they were to be higher than assumed, this would limit cuts in energy-sector investment and employment, while further falls in prices would accentuate these cuts. Developments in emerging market economies, notably China, will have an important bearing on commodity prices and export demand. The main domestic downside risk is a disorderly housing market correction, particularly in the high-price Toronto and Vancouver markets. This would damp residential investment and private consumption, and could threaten financial stability. In addition, the rotation of economic activity from commodity-producing sectors to other sectors could be more protracted than expected. The main upside risk is that the US economic expansion could be stronger than projected, lifting demand for Canadian exports.

Growth is moderate due to lower commodity prices

Economic growth has continued to moderate due to low copper prices and weak external demand, which has cut private investment, especially in mining. More restrictive lending conditions and lower business confidence have also held back investment. Private consumption growth has also declined significantly, reflecting weaker real income growth and a deterioration of consumer confidence. As growth slows, the labour market has weakened and unemployment is drifting up.

Inflation and productivity

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367697

Monetary policy is supportive although fiscal policy is becoming less expansionary

Inflation remains above the central bank’s tolerance range of 2% to 4% due to the partial pass-through of currency depreciation. To make inflation converge to the target, the central bank has appropriately raised its interest rate by 50 basis points, to 3.5%, in the last quarter of 2015, stating that further increases would be required, but at a slow pace. However, since inflation is already showing signs of decline and inflation expectations are well anchored, monetary policy should remain supportive given that economic slack is expected to rise in the next several months. Furthermore, fiscal consolidation measures, concentrated mostly on current expenditures and consistent with the fiscal rule, were recently announced in response to lower expected medium-term copper prices. As a result, there will be little support from this source.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369230

Measures such as the recently announced first Strategic Programme to increase mining productivity should help to develop providers, technologies, and services for mining that could be used in other sectors and exported to foreign markets, allowing for larger inclusion of domestic producers in global value chains. Initiatives to diversify exports and encourage non-mining investment are also welcome to broaden the base of the economy and support inclusive growth. A credit line to enhance small-company financing, allowing insurance and pension funds to invest in infrastructure, and simplifying procedures for service exporters should all facilitate entrepreneurship and investment. However, measures to strengthen inclusivity by bridging skills mismatches in the labour market and to foster female and youth participation to reduce inequalities are still needed to expand opportunities for everyone to enjoy the benefits of greater prosperity.

Growth will gradually recover in an uncertain external environment

Growth in 2016 will moderate as investment and external demand stay weak, and fiscal policy moves from an expansionary to a neutral stance. As growth weakens, the unemployment rate is projected to increase in 2016 and 2017. Activity will pick up in 2017 driven mainly by an improving export performance reflecting competitiveness gains and stronger external demand, which will spur investment and private consumption.

The main risks to growth relate to the growth of Chile’s trading partners and the evolution of commodity prices. Weaker-than-projected demand from China and Latin America, or volatile global financial conditions, would reduce external demand. Growth could also be weakened if business confidence does not revive. On the upside, a recovery of the price of copper would boost confidence and investment, and increase government revenues. New measures to boost competition and productivity could improve the business climate more than assumed. Risks for inflation remain closely tied to the evolution of the exchange rate and oil prices.

Supply-side reforms to curb overcapacity are gathering momentum

Growth continues to decline as adjustment in manufacturing sectors plagued by excess capacity gathers momentum. Capacity cuts started in the coal and steel sectors, with cancelling or delaying new construction as well as closing inefficient and heavily-polluting firms. Consequently, manufacturing investment remains sluggish by historical standards. Real estate investment is bottoming out, although trends in upper and lower-tier cities are increasingly diverging with sharply rising demand and prices in the former, prompting new home purchase restrictions. The implementation of programmed infrastructure projects is accelerating.

Industrial output and Investment

Fixed asset investment and manufacturing investment refer to nominal values and do not include investment by rural households.

CEIC.

Statlink http://dx.doi.org/10.1787/888933367704

Consumption has remained robust, supported by stable employment prospects and steadily rising incomes, in particular in rural areas, showing that growth is becoming more inclusive. Some services, such as tourism and cultural services as well as e-commerce, are thriving. Weak business investment demand weighs on imports and so do rising costs on exports. Producer price declines have moderated as excess capacity is being removed and infrastructure and real estate investment strengthened.

Macroeconomic indicators

Statlink http://dx.doi.org/10.1787/888933369489

Policy easing and structural reforms support growth

Monetary policy has remained accommodative with a combination of conventional and non-conventional easing measures to provide liquidity, resulting in strong lending growth. Financing costs have come down slightly, but are still high in real terms as producer prices keep falling. Continued easing will reduce costs further and provide sufficient liquidity amid capital outflows. Corporate profitability is recovering after a sharp fall in 2015, against the backdrop of more moderate producer price deflation. Leverage, especially in the state-owned sector, remains high. Debt-equity swaps may provide only temporary relief, and may also delay necessary adjustment, including the exit of unviable firms. Loans with past due payment have risen sharply, foreshadowing a surge in bad debt. Recent defaults are expected to instil greater market discipline and better credit risk pricing. Collateralisation of land operation rights will allow farmers to buy housing in small cities, where inventories are high, though for such cities to become attractive, they need to provide better public services and job opportunities.

Capacity utilisation and state-owned enterprise

Leverage is defined as the liabilities-to-equity ratio. Overall as well as state-owned refer to industrial enterprises.

CEIC.

Statlink http://dx.doi.org/10.1787/888933367713

Exchange rate transparency has improved. The People’s Bank of China started to publish a trade-weighted currency index at the end of 2015, and disclosed its weights. Notwithstanding the delay of further US interest rate hikes, capital outflows continued, leading to a contraction of foreign exchange reserves through February 2016 and putting pressure on the exchange rate. Expected renminbi depreciation has led the corporate sector to reduce its foreign liabilities and boost its foreign assets. Individuals will also likely diversify their asset holdings as the capital account opens up further. Continued expectations of depreciation could trigger additional outflows, exacerbating the pressure on the exchange rate.

Fiscal policy is set to loosen further with a 3% of GDP deficit target for 2016, up from a deficit of 2.4% in 2015. In terms of a broader and internationally more comparable definition of the budget, adding up all four budget accounts, this implies a deficit of 1.3% of GDP in 2015 and 1.8% in 2016. Additional large-scale quasi-fiscal spending through policy banks, which will partly finance the 2016-18 grandiose infrastructure package, will further ensure that the growth target is met. Local government investment vehicles, which have fuelled the urbanisation boom but also the accumulation of illicit sub-national government debt, will have fast-track access to the enterprise bond market and to subsidised loans, which may lead to another potential round of bailouts. Conversion of the business tax into a value-added tax in the remaining service industries will support services growth and more specialisation in general through outsourcing, thereby enhancing overall efficiency.

Rebalancing might stall

The large ongoing stimulus measures will ensure that growth remains in the range of 6.5-7% in 2016. The structure of investment is tilted towards infrastructure and real estate, while excess capacity will continue to weigh on business capital spending. State-owned enterprise reform will focus on mergers and acquisitions as well as streamlining business operations, leaving exit as a last option. Investment is increasingly financed by public funds, crowding out the private sector and potentially leading to further misallocation of capital. Slow corporate profit growth and high leverage will constrain household income growth, holding back consumption growth. Gradual adjustment in the industrial sector is expected to lead to moderate producer price reflation. While the planned adjustment in the steel and coal sectors will not have a major labour market impact, creating enough jobs for new graduates that meet their expectations appears more of a challenge.

Greater-than-expected stimulus would result in stronger growth in the short term, though it would increase vulnerability over longer horizons. By the same token, faster-than-planned adjustment in the industrial sector would drag growth down, although that would improve the economy's resilience. Supply-side policies, including deleveraging and working off excess capacity, are crucial to avoid a sharp slowdown. Delayed adjustment continues to exert downward pressure on prices, which in turn hinders profit recovery and potentially increases future non-performing loans. In addition, the re-leveraging of local government investment vehicles could augment future government debt due to the assumed implicit guarantees and bailout. A further rebound in commodity prices could ease downward price pressure in upstream industries and help profit recovery in some industries.

Adjustment to the terms-of-trade shock continues

The value of exports of crude oil and coal, which represent two-thirds of total exports, has collapsed since 2013. As a result, the exchange rate has depreciated sharply and the current account and fiscal deficit have widened, despite recent spending cuts introduced by the government. The intensification of El Niño is hurting the agricultural sector and power generation, weakening consumer confidence, private consumption and employment growth. Inflation has accelerated to nearly 8% since mid-2015 due to the exchange rate depreciation and pressures on food and energy prices created by El Niño.

External trade and inflation

OECD Economic Outlook 99 database; Central Bank of Colombia.

Statlink http://dx.doi.org/10.1787/888933367723

Macroeconomic policies are appropriate, but structural reforms are required to boost productivity

The central bank has increased interest rates by 250 basis points since September 2015. With real interest rates in negative territory, monetary policy remains appropriately accommodative, but is assumed to cautiously move to a more neutral stance to bring inflation expectations back into line with the target of the central bank. Financial soundness indicators have been strong and the exposure of the financial system to the oil sector is very low. Due to the fall of oil revenues, the government announced a reduction of public expenditure to comply with the fiscal rule in 2016. The cuts are appropriately well‑targeted to smooth the social impact. However, in the medium term, a comprehensive tax reform is needed to raise more revenue, given the need to accommodate public finances to the seemingly permanently lower commodity prices, and make growth more inclusive.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369536

Structural reforms that improve public infrastructure, raise productivity and make growth more inclusive are essential for strong and sustainable development. Barriers to trade and competition, which prevent entry of new innovative and dynamic firms and prevent allocation of labour and capital resources towards high-productivity firms and sectors, should be reduced. Broadening access to quality education and training is also essential for boosting labour productivity and reduce income inequality. Finally, policies to address labour market duality, create quality jobs, and reduce gender gaps and informality can increase growth by enhancing domestic demand, while reducing income inequality.

Growth is projected to pick up only gradually

Growth in 2016 will continue to be weakened by falling real incomes, increasing interest rates, and low demand. The envisaged fiscal consolidation, a decrease in private investment due to low commodity prices, and deteriorated business confidence will add to the weak growth outlook. However, activity is projected to improve in 2017 supported by the implementation of the government’s infrastructure agenda, the re-opening of Cartagena Refinery and a pick-up of exports, which will benefit from the depreciation of the exchange rate and stronger external demand. The persistence of El Niño and the activation of an indexing mechanism will continue to put pressure on prices during 2016, but as these effects dissipate, inflation will gradually come down in 2017.

The still significant current account deficit, large near-term external financing needs and potential capital inflow reversals resulting from volatile global financial conditions bear on the outlook. A deterioration of growth prospects of China or regional trading partners’ could also generate negative financial and real spill-overs. Declines in oil prices could also fuel additional currency depreciation and inflation. On the upside, bringing the peace process to fruition could improve business confidence and capital inflows, reinforcing the recovery that will follow the necessary adjustment process.

Activity is rising

Real GDP rose by 2.9% in 2015. Domestic demand was boosted by the improved terms of trade, from lower import commodity prices, and higher investment, which more than offset the withdrawal of a large electronics company and adverse weather conditions related to El Niño. Household consumption recovered significantly, supported by the favourable terms of trade, low interest rates and price stability. Owing to falling oil prices and the stability of the exchange rate, consumer prices fell in the second half of 2015.

Budget balance and labour productivity

OECD refers to the 17 upper half countries based on GDP per capita; GDP is expressed in 2011 PPP.

OECD Economic Outlook 99 database; and OECD calculations based on the Conference Board Total Economy Database.

Statlink http://dx.doi.org/10.1787/888933367739

Reforms are required to tackle the fiscal challenge and boost productivity

Increased budget deficits have resulted in rising public debt, which almost doubled in the period 2008-2015, reaching 42.4% of GDP. The authorities have proposed a plan to start gradual fiscal adjustment this year, which is under discussion in the parliament. The package of tax reform and stricter expenditure control, if legislated and implemented, would cut the deficit by about 2% of GDP during 2016-17. However, additional fiscal adjustment of 1% of GDP will be needed to put debt on a firm downward path. Steps towards this include the recent legislative proposals to reform public employment conditions, thus preventing excessive automatic increases in current outlays, and further tax reform to increase revenues and reduce Costa Rica’s high inequality.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369558

Structural reforms are needed to boost productivity and to make the society more inclusive. Enhancing productivity requires a comprehensive strategy to strengthen institutions, enhance competition, promote innovation and access to finance, and improve transport infrastructure. Raising the quality of education and work prospects for women would decrease inequality by expanding opportunities and sharing prosperity more widely.

Strong GDP growth will be led by domestic demand, but downside risks loom

Growth is projected to continue to accelerate, supported by domestic demand and an improving export performance; however, it will not reach a pace sufficient to reduce unemployment from its high level. Factors supporting strong growth include the continued US recovery, domestic monetary stimulus and continued real credit expansion. Inflation will remain weak in 2016, slowly returning towards the new central bank target range of 2‑4% as the economy strengthens.

As Costa Rica is a small open economy, external developments are critical. Costa Rica is an energy importer, so global energy prices are important for growth and incomes. Global market volatility, deeper-than-expected slowdowns in advanced and emerging market economies and currency depreciation, could create problems for the stability of the banking system given its high credit dollarisation. On the domestic front, persistently large fiscal deficits and rising public debt make the economy vulnerable to sudden changes in financial market conditions. In addition, large government gross financing requirements could push up domestic interest rates, weighing on private investment and consumption, and limiting the transmission of the monetary stimulus to lending rates.

Growth has slowed after an exceptional year

In 2015, a push to use expiring EU funds contributed to the fastest GDP growth since 2007. Private investment has been supported by growth in profits and credit, but public investment is falling. The buoyant labour market, income growth and accommodative financial conditions have bolstered consumer confidence. The saving rate has declined and consumption growth is robust. Exports accelerated in late 2015 and are benefitting from favourable developments in the important automotive industry. Falling food and energy prices are temporarily holding down inflation, but increasing wages are pushing up costs.

Consumer confidence and inflation

OECD Economic Outlook 99 database; and OECD, Main Economic Indicators database.

Statlink http://dx.doi.org/10.1787/888933367746

Monetary and fiscal policies are supportive

The policy rate remains near zero and borrowing rates have eased further. The central bank announced that it expects to maintain the exchange rate floor until mid-2017. It has intervened to maintain the floor in most months since July 2015. It will be appropriate to exit the floor as the effects of food and energy price falls pass and inflation rises. There is room for fiscal policy to support activity if the exchange rate appreciates too sharply.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369244

Public investment will subtract from GDP growth with the transition to the new EU programming period, although fiscal policy is projected to be expansionary in 2016 due to other spending. More domestically-funded investment could reduce infrastructure gaps or improve energy efficiency and also smooth the cycle. The fiscal responsibility package – including a fiscal council and a debt brake – should be passed to buttress medium-term fiscal sustainability.

Structural policies are needed to boost productivity and accelerate income convergence

The government is gradually raising the retirement age and expanding childcare availability, to foster greater participation of older people and women in the labour market. Labour participation rates are rising but further steps are needed to offset population ageing and prevent labour market tightness from constraining the economy. Increased childcare access could reduce the gender pay gap by facilitating mothers’ return to work.

Faster productivity growth would speed up income convergence. Reforms are needed to allow successful firms to expand and unproductive firms to exit more easily. These include increasing competition in product markets and reducing the cost of bankruptcy proceedings. Spurring domestic innovation would boost productivity. Increasing skills and reducing barriers to worker mobility could reduce mismatches and raise productivity and wages alike.

Private domestic demand will continue to drive growth

Household consumption will continue to drive GDP growth, supported by growth in employment and wages. The unemployment rate is expected to fall below its pre-crisis level. Profit and credit growth will support private fixed investment. Housing starts data suggest housing construction may soften the effect of falling public investment on construction activity. Stronger demand from trading partners, including in Europe, will boost exports. Domestic costs will maintain inflationary pressures. Headline inflation is projected to remain subdued in 2016 but should reach 2% by end-2017.

External developments pose both upside and downside risks, given the economy’s integration in global value chains. Reduction in the degree of European integration, disappointing growth in Europe or the transmission of slower growth in big emerging economies would hit exports and investment. On the upside, a faster pick-up in wage growth or a lower savings rate would result in stronger consumption growth. Faster take-up of EU funds would boost public investment.

The economy is growing – but only slowly

Exports have been weak, in part because of the slowdown in Europe and Asia. On the other hand, private consumption continues to underpin growth as households benefit from private sector job creation and real wage gains. Consumer sentiment is supported by loose monetary conditions, low inflation and rising house prices. Business investment is expanding only slowly, reflecting in part weak exports. Housing investment has not yet reacted to higher property prices, partly reflecting the lack of building land in metropolitan areas, where prices have increased most. Consumer price inflation hovers around zero, pulled down by low energy prices, while core inflation has come down to less than 1%.

Consumption and house prices

OECD Economic Outlook 99 database; and Statistics Denmark.

Statlink http://dx.doi.org/10.1787/888933367759

Economic policy remains accommodative

The central bank’s policy rate is -0.65% and has been negative since the fall of 2014, to contain surges in demand for the krone. The peg to the euro means that the policy rate is likely to remain negative and the interest rates are assumed to be low over the projection period. This may increase the risk of unsustainable increases in property prices. Before this risk materialises, fiscal and macro-prudential policies need to be stepped up to avoid a repeat of past boom and bust episodes. Fiscal policy has been accommodative overall. Low oil prices and declining oil production in the North Sea has weighed on government revenues, and are expected to continue to do so. Fiscal policy is expected to tighten only gradually, partly through a reduction in investment. However, this may be insufficient to contain emerging imbalances in the economy, particularly, given the already small degree of labour market slack. Further decreasing interest rate tax deductibility and regularly updating property valuations are the preferred forms of fiscal tightening in the medium term and would also establish tax neutrality across different asset classes.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369254

Growth will remain slow in 2016 before accelerating

Growth is projected to pick up during 2016 as exports recover, notably due to improvements in the euro area. Private consumption should continue to support growth, underpinned by the strong labour market although high household debt will weigh on household finances. This will support property prices across the country, which should underpin residential investments. Investment should firm on the back of broad-based demand increases, higher capacity utilisation and low interest rates. Inflation is projected to rise gradually, as the spare capacity in the economy declines and commodity prices recover.

Continued trade weakness linked to a slowdown in emerging markets, in particular China, or disappointing growth in the euro area pose the main downside risks to exports. A potential Brexit could also hamper exports, as the United Kingdom is the fourth largest market for Danish exports. On the domestic side, stronger debt reduction among households would weaken domestic demand in the short term, but would provide room for stronger consumption and investment later on. The very supportive monetary policy stance, low energy prices and rising property prices could boost domestic demand further in the projection period. Likewise, recent labour market reforms could have a larger-than-expected effect on labour supply.

Economic growth is subdued

Economic growth has been driven by robust private consumption, supported by strong wage growth, low energy prices, as well as by lower personal income tax and unemployment insurance contributions. Recorded employment has grown strongly, but this partly reflects stepped up requirements for employers to register informal workers. Unemployment has fallen, pushing up wage growth. Exports to Russia have dropped while growth of exports to other major trade partners, notably Finland, has remained modest. Transportation, storage and wholesale trade services have been particularly affected by the drop in trade with Russia. While cheaper oil has reduced import and consumer prices, it has weighed on the production of oil shale and oil shale products. Weak exports have held back business investment despite the favourable funding conditions.

Business confidence and labour costs

Export performance is measured as the ratio of actual export volume and the country’s export market.

OECD Economic Outlook 99 database; and OECD Business Tendency and Consumer Opinion Indicators.

Statlink http://dx.doi.org/10.1787/888933367761

The government has taken steps to address labour shortages

The decline in the working-age population and shortages of skilled workers keep the labour market tight and wage pressures high. The increase in the minimum wage by 10% in both 2016 and 2017 will reduce in-work poverty and boost wages more generally, thereby encouraging Estonians to remain, rather than emigrate, and easing labour shortages. The reform of disability benefits in 2016 will also increase labour supply by introducing stricter assessments of work capacity and offering more counselling and training. The government also took measures to alleviate skill mismatch, such as extending the apprenticeship programme and strengthening capabilities to forecast the supply of, and demand for, skills.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369263

To improve the position of poor workers and encourage work, the basic personal income tax allowance will be raised in 2016 and 2017, further income tax reductions will apply to workers earning less than EUR 649 per month and in 2017 health insurance contributions will be reduced. The impact on tax revenues will be partly offset by higher taxes on alcohol, tobacco and fuels. These measures will boost employment, competitiveness and private consumption, especially among low-income households. Government investment is expected to dip as the use of EU structural funds from the 2009‑2013 allocation period has come to an end.

Investment will strengthen as export markets recover

GDP growth is projected to pick up as stronger exports encourage business investment. The government’s tax measures and structural reforms will mitigate the effect of wage growth on Estonia’s competitiveness. The unemployment rate will fall further, raising inflation somewhat. The current account balance may turn negative. The government budget will move into deficit in 2016, as tax-benefit reforms reduce revenues and raise spending, but is projected to return to surplus in 2017 as higher excise taxes and economic growth boost revenues.

The tax, disability-benefit and education reforms may boost employment and competitiveness more strongly than expected. Stronger euro area recovery would enable Estonia to expand its export markets and reinvigorate investment. On the other hand, major trading partners, in particular Russia and Finland, may experience a more prolonged economic slowdown than projected. Further escalation of the conflict in Ukraine could also undermine exports and investment. A further fall in oil prices would raise real household income but result in further downscaling of production in the oil shale industry. Although financial market turbulence in emerging market economies could spill over to Estonia, low debt levels, strong equity buffers in the banking sector and euro membership are likely to mitigate such risks.

A moderate recovery has continued

Growth continued at a moderate pace in early 2016. As in the second half of 2015, domestic demand has been the main driver of activity, with private consumption, public consumption and investment all displaying some dynamism. However, the slowdown in global growth has weighed on exports. Unemployment has declined further but remains high. The sharp drop in oil and commodity prices reduced headline inflation to levels around zero. Cyclical slack, recent euro appreciation and declining inflation expectations have kept core inflation hovering somewhat below 1%.

Growth and inflation and monetary and fiscal policies

Headline refers to the harmonised index of consumer prices and core excludes food, energy, alcohol and tobacco.

Change in the underlying primary balance as a percentage of potential GDP.

Estimates from second quarter of 2016 based on monthly increases of EUR 80 billion.

OECD Economic Outlook 99 database; and Thomson Reuters.

Statlink http://dx.doi.org/10.1787/888933367770

Economic performance has remained uneven from country to country, with only a modest reversal of the very divergent output and unemployment dynamics brought about by the sovereign debt crisis. Among the countries hit hardest, only Ireland and Spain have had growth clearly above the euro area average. The countries most affected by the crisis have largely or fully eliminated their current account deficits, but, in most cases, this reflects still weak domestic demand. Ireland and Spain again stand out for their stronger export growth, which is essential to avoid external deficits reappearing as the recovery continues.

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888933369165

Growth and equity need further support from fiscal, structural and financial sector policies

Despite some improvement in credit conditions, the recovery in investment will be limited by modest growth prospects, uncertainty about developments in European integration and still high private sector debt. Private consumption remains hampered by labour market weakness and high indebtedness. Subdued global trade growth will limit export growth.

Credit and Productivity

Loans to non-financial corporations adjusted for sales and securitisation.

Real GDP per person employed.

OECD Economic Outlook 99 database; and European Central Bank.

Statlink http://dx.doi.org/10.1787/888933367789

In the euro area as whole, fiscal policy is projected to remain slightly expansionary in 2016 and 2017, which is a sharp contrast to the consolidation in the 2011-13 period. However, more support will be needed to move growth to a higher track. Some countries have room to provide additional fiscal support. In this context, well designed and chosen infrastructure investment is attractive in that it has a high short-term multiplier and lays the foundations for a more sustained expansion. In addition, tax and spending policy reforms can be growth and employment friendly. Decreasing labour taxation, especially for low earners, shifting the composition of expenditure towards investment, education and childcare, and increasing public spending efficiency would help to boost growth and make it more inclusive. Further efforts to strengthen national budgetary frameworks hold the promise of improving the quality of public finances.

Financial indicators

Statlink http://dx.doi.org/10.1787/888933369175

In December 2015 and March 2016 the European Central Bank took additional expansionary measures, inter alia by decreasing policy rates, increasing the scope and size of asset purchases, and by providing stronger incentives for bank lending in another round of targeted longer-term refinancing operations. The very accommodative monetary conditions are assumed to persist over the projection horizon. To further spur credit growth and make it flow towards productive firms, faster resolution of non-performing loans is essential, and could be fostered by prudential tools and the setting up of asset management companies, possibly at the European level. To further reduce financial fragmentation and ease crisis management, a common backstop to the Single Resolution Fund and deposit insurance at the European level would be helpful.

Demand and output

Statlink http://dx.doi.org/10.1787/888933369185

Investment is still far below pre-crisis levels in many countries, which slows down productivity growth, notably by hindering the diffusion of innovation. While innovation gives a temporary advantage to leading firms, enabling them to pay higher wages, the full gains from innovations are realised only when they are diffused through the market. Completing the Single Market in services and network sectors would spur investment by increasing competition and reducing regulatory burdens (in part by harmonising regulation). In turn, market integration would benefit from faster deployment of Trans-European transport and energy networks. Improving the availability and effectiveness of lifelong learning and job-related training would enhance knowledge diffusion and labour reallocation towards high-productivity firms.

External indicators

Statlink http://dx.doi.org/10.1787/888933369193

Mild growth is projected for the coming quarters

GDP growth is projected to accelerate modestly to 1.7% in 2017. Monetary stimulus and cheap oil should continue to support private consumption and investment, and fiscal policy in the area as a whole will no longer be a brake on demand. Though gradually recovering, export growth will remain subdued throughout most of the projection horizon, and the large current account surplus will decline only slightly. Unemployment is projected to fall, but it will remain high in a number of countries. Due to cyclical slack and low inflation expectations, core inflation is projected to increase only slightly and remain well below 2%.

A decision by the United Kingdom to leave the European Union could significantly weaken growth across the euro area through higher risk premia, lower asset prices, and euro appreciation vis-à-vis the sterling. Financial turbulence in emerging market economies, induced by high corporate indebtedness or other vulnerabilities, would weaken demand for euro area exports and could also harm investment through higher interest rates. Lower-than-expected inflation would compound deleveraging challenges, but could boost real wages. Faster progress in cleaning up banks’ balance sheets and reforming product markets, spending and tax policies, in tandem with regained momentum in European integration, would boost GDP growth.

Growth is picking up slowly

Output growth is driven by private consumption and investment. However, exports are being held back by the recession in Russia, weak global demand and eroded competitiveness. Low inflation is lifting household real disposable income and consumption, although some policies to support consumption in 2015 have expired. Following a long slump, investment is starting to rise again. Low interest rates and migration into growth centres is raising residential construction, while large-scale projects are lifting business investment. Unemployment shows signs of stabilisation, albeit at a high level. The fiscal deficit is back under 3% of GDP, thanks to spending containment and increasing tax revenues.

Trade and investment

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367794

The government is struggling to implement structural reforms

The government is facing opposition to some of its plans to enhance labour market flexibility and improve competitiveness, as well as to some of its intended public spending cuts. Hence, the extent and timing of the reforms remain uncertain. Fiscal consolidation efforts, assumed to be about half a percentage point of GDP per year, exert a drag on growth, even though spending cuts are partly offset by strategic expenditure on key government projects financed through balance-sheet transactions. However, expansionary euro area monetary policy and relatively easy access to credit are supporting growth.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369276

Successful implementation of the government’s programme would raise employment and productivity, thereby fostering inclusive growth. A recently announced entrepreneurship programme will use wage subsidies start-up grants and tax incentives to encourage companies to hire their first employees. The government has initiated social welfare and health care reform to raise public-sector productivity and reduce health and social inequalities. Streamlining land-use planning regulations would improve housing affordability and allow productivity gains in retail trade.

The recovery is facing headwinds

The recovery is being driven by domestic demand but needs further impulse from exports to gather speed, especially as the temporary factors which have been boosting consumption have expired. The investment recovery is broad-based and set to continue. Residential investment is fuelled by low interest rates and high demand in growth centres, while major commercial building projects are underway. Investment in machinery and equipment is rising, including for capacity expansion, as utilisation rates increase, notably in the forest and metal industries. Such investments will raise productivity, which has been lacklustre over recent years. Nevertheless, projected growth will be too weak to markedly reduce unemployment, even if policies enhance labour market flexibility. Inflation is set to remain subdued. The fiscal deficit will decline slowly, as consolidation measures are partly offset by rising ageing-related costs.

As a small open economy, Finland is sensitive to developments in the global economy and particularly in Nordic countries, Germany and Russia, which implies both downside and upside risks. Worsening geopolitical tensions, a further economic slowdown in China or increased volatility in emerging market economies and oil prices could disrupt the recovery. The ability of the government to implement its programme in the face of public resistance conditions medium-term growth and fiscal sustainability. In the short term, uncertainty over reform implementation and potential industrial action could weigh on the recovery.

A gradual recovery has taken hold

Falling energy prices and low inflation have led to rising real wages, supporting stronger private consumption growth. Business investment began to rebound in 2015, thanks to strong profits, low energy prices, accelerated depreciation allowances, and cuts in social contributions and business taxes. However, public-sector spending restraint has led to declining local government investment. Residential investment is still contracting although building permits and housing starts have levelled off since early 2015.

Investment and inflation

As a percentage of gross value added.

Harmonised consumer price index, excluding energy, food, alcohol, and tobacco for core inflation.

OECD Economic Outlook 99 database; and INSEE.

Statlink http://dx.doi.org/10.1787/888933367801

A lower euro and tax reductions have helped French exporters restore their competitiveness and regain market share, while cheaper oil has lowered the cost of imports. This has led to a substantial decline in the external deficit. The rise in the unemployment rate has stopped, thanks to subsidised jobs for young and low-skilled workers, mainly in the non-market sector, and more recently growth in temporary agency jobs. Despite extremely accommodative monetary policy, widespread excess capacity and falling oil prices have pushed inflation down.

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888933369024

Labour tax cuts and training reform promote employment and productivity of low‑skilled workers

Owing to sharp cuts in local government investment the general government deficit fell to 3.5% of GDP in 2015, lower than had been expected. Spending restraint and the pick‑up in economic growth will help the government lower the deficit further to the target of 3% of GDP in 2017, notwithstanding a number of measures that will increase spending. This gradual pace of consolidation is appropriate, given the still fragile recovery.

Consumption and employment

OECD Economic Outlook 99 database.

Statlink http://dx.doi.org/10.1787/888933367816

A number of recent and envisaged reforms could help improve the productivity and employment chances of lower-skilled workers. Following a 2014 reform the unemployed will receive rights to additional training hours. The envisaged reform to improve legal certainty regarding dismissals would make employers more willing to hire on open-ended contracts and this could improve chances to obtain more stable employment for low‑skilled workers, many of whom work currently on short-term contracts with poor access to training. That said, this would come at the cost of increasing risks to be dismissed for workers who already have an open-ended contract today. The cuts in social contributions mainly targeted at low-wage workers will also increase labour-market inclusiveness. However, as the measure is phased out as income rises, the associated increase in taxes could weaken incentives to participate in training and create low-wage traps. Further personal income tax cuts on low- and middle-income households, streamlined and more effective in-work benefits and additional reductions in employers’ social contributions will improve employment chances of low-wage workers, supporting consumption and making growth more inclusive. The recent product market reform should be extended to a wider range of regulated professions and retail regulation should be further eased, in order to expand job opportunities.

Financial indicators

Statlink http://dx.doi.org/10.1787/888933369039

Growth is projected to increase gradually

Further social security contribution cuts and new hiring subsidies should support a moderate pace of employment and private consumption growth. The recently announced extension of the accelerated depreciation allowance beyond April 2016 and lower business taxes and employers’ social security contributions will underpin gains in business investment. Residential investment should bottom out around mid-year, but the subsequent pick-up will be modest. Exports are expected to grow broadly in line with external demand.

Demand and output

Statlink http://dx.doi.org/10.1787/888933369045

This is a central scenario, and a number of factors could lead to different outcomes. The series of recent reforms could strengthen household and business confidence more than expected, leading to stronger consumption and investment following recent increases in the household savings rate and profit margins. On the other hand, a stronger-than-expected slowdown in emerging market economies, notably China, or lower euro area growth, e.g. related to a vote for Brexit, could hit external demand and confidence.

Domestic demand is supporting activity but skill mismatch holds back productivity

Activity expanded vigorously in the first quarter, especially in construction, which was boosted by unusually mild winter weather. Wages and employment rose, while low oil prices damped consumer prices, boosting private household consumption. Government employment has risen to deal with the needs of refugees. About 1 million refugees arrived in 2015 (1¼ per cent of the population). Most of them have not yet started looking for a job, as asylum procedures and first training measures are being completed. Unemployment remains at historical lows. However, close to one half of the unemployed have been looking for a job for more than a year, while at the same time skill shortages are contributing to rising vacancies. Barriers in the tax system and only limited full-day childcare and schooling hold back full-time female employment, restraining women’s careers and productivity.

Construction and exports

Prices for owner-occupied apartments in 7 cities.

Construction of new dwellings.

Average of growth in January and February 2016 for 2016Q1.

OECD Economic Outlook 99 database; OECD Analytical House Price database; and Statistisches Bundesamt.

Statlink http://dx.doi.org/10.1787/888933367820

Rising household incomes and the large number of refugees have boosted demand for housing, pushing up rents and prices in urban centres and spurring construction. Nonetheless, lending to households remains modest. Foreign orders for investment goods, on which German manufacturing is specialised, have weakened. Exports to China, which absorb 7% of German merchandise exports, have fallen.

Employment, income and inflation

Statlink http://dx.doi.org/10.1787/888933368998

Immigration and higher government spending are boosting domestic demand

Many refugees will start entering the labour market in the second half of 2016, once their asylum requests have been processed. Since they have no German language skills and most lack formal qualifications, many will not find jobs quickly. The government has taken stock of immigrants’ skills, expanded training opportunities and facilitated access to the education system. It is planning to ease legal barriers for asylum-seekers to look for a job. In view of the young age of many immigrants, such steps have a high long-term pay-off.

Labour market and real wages

Population aged 15-74 years. Based on the German labour force survey.

Percentage of unfilled job vacancies relative to total employment.

Average nominal wage per employee. Projection from 2016Q1.

Harmonised consumer price index (HICP). Core HICP excludes energy, food, alcohol and tobacco.

OECD Economic Outlook 99 database; and Statistisches Bundesamt.

Statlink http://dx.doi.org/10.1787/888933367835

Government spending to receive and integrate immigrants is expected to increase by ¼ per cent of GDP in each of 2016 and 2017. Spending for child benefits, child tax allowances and long-term care benefits will rise by 0.2% of GDP. The child tax allowances have little impact on labour supply or poverty reduction, whereas the child benefit supplement for low-income children reduces poverty risk. Government investment spending for transport infrastructure, broadband networks, energy efficiency, housing, childcare facilities, universities and other research institutions will also increase by 0.2% of GDP. The supply of childcare facilities is progressing, helping to reconcile professional and family lives, but gaps remain, and most primary schools continue to provide teaching only in the morning. The federal government has also made higher transfers to local governments for investment and plans to create a long-distance road infrastructure corporation, to which it has assigned the revenues of road use charges. Most of the additional spending will make economic growth more inclusive.

Financial indicators

Statlink http://dx.doi.org/10.1787/888933369002

Domestic demand will be the main driver of growth

Economic growth is projected to remain robust, driven by private household demand and higher government spending. Strong domestic demand will push up consumer prices somewhat, as the impact of low oil prices fades and wages grow more strongly than productivity. Unemployment is expected to rise somewhat. World trade and investment in key trading partners are expected to remain subdued, damping exports. Moreover, the euro has appreciated and strong wage growth will reduce Germany’s competitiveness. Strong tax revenue growth and declining debt servicing costs are expected to keep the government budget in surplus, notwithstanding rising spending.

Demand and output

Statlink http://dx.doi.org/10.1787/888933369011

A sharp slowdown of activity in emerging market economies and protracted weak demand in the euro area would weaken exports and investment. Rising geopolitical tensions would affect the export-oriented German economy particularly strongly. An exit of the United Kingdom from the European Union would also increase uncertainty about trade and investment prospects. If they materialise, these risks would spill over to consumer confidence and financial markets. Lower oil prices would boost household consumption and business profitability but could also contribute to global financial market turbulence. The low leverage ratios in systemically important banks could aggravate the consequences of financial market turbulence. On the other hand, steps to implement reforms to complete the Single Market in the European Union and establish a comprehensive banking union in the Euro Area could boost exports and the attractiveness of Germany as a location to invest. Adopting policies to deal with domestic long-term challenges, notably with respect to population ageing and long-term greenhouse gas emission reduction targets, could boost investment in the near term.

The economy is recovering gradually from a deep recession

The financing programme agreed with the European Stability Mechanism in August 2015 has reduced uncertainty and, together with the gradual softening of capital controls, boosted confidence and growth. Investment rebounded in the last quarter of 2015. Job creation improved and the high unemployment rate declined further. The inadequate social safety net has been unable to stem the rise in poverty. Inflation was still negative at the end of 2015 due to large spare capacity and falling oil prices.

Confidence and Unit labour costs

Unweighted average of data for manufacturing industry, construction, trade and business-related services.

OECD Economic Outlook 99 database; and OECD National Accounts Database.

Statlink http://dx.doi.org/10.1787/888933367848

Despite the recapitalisation of banks last December credit conditions are still sluggish due to large non-performing loans. Due to continuing fiscal consolidation, the primary balance became positive at 0.7% of GDP in 2015, outperforming the target of -0.25% of GDP. Public debt is still very high, however, bearing on investment and confidence.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369286

Policies to reduce poverty and structural reforms are needed for more inclusive growth

The slower pace of consolidation set out in the August agreement is appropriate. The implementation of planned social policies, such as the Guaranteed Minimum Income, would alleviate poverty and help to deal with the high social costs of the crisis. The modernisation of the public employment service and the expansion of active labour market policies would reduce unemployment. Fighting tax evasion and rationalising the pension system will raise revenues to finance these policies.

The full implementation of the structural reforms agreed under the August agreement will significantly boost output over the next decade. Further reforms are needed to shift the economic structure towards exports and the expansion of new enterprises. Easing regulation in network industries will increase competitiveness and enhance exports. Further reducing regulatory procedures and administrative burdens on firms will enhance productivity and investment.

The recovery is expected to gain strength but uncertainty remains high

Output growth is projected to turn positive only in the second half of 2016 but the economy should recover in 2017 as structural reforms spur domestic demand and stronger external demand enhances exports. Increases in VAT will raise headline inflation temporarily in 2016, but inflation will stay negative or close to zero given the large economic slack. Unemployment will continue to decline alleviating poverty further.

Successful negotiations to lower the gross financing needs of the public sector could significantly improve the medium-term outlook by addressing debt sustainability risks. Full and swift implementation of structural reforms would boost confidence and lead to a stronger and faster economic recovery; but slippage in this area will be harmful for growth. Rising global risks such as weaker global trade, low oil prices and weaker growth in China and the euro area would reduce Greek exports. The cost of the refugee crisis, estimated at 0.4% of GDP for 2015, could be higher in 2016.

Growth is driven by domestic demand

The economy contracted in early 2016. A major factor was the slower disbursement of EU structural funds in the beginning of the new funding cycle, which has cut public investment. Business sector investment has also been lacklustre despite an increase in demand, still high business confidence and favourable credit conditions. On the other hand, private consumption has accelerated on the back of rising real incomes and the strength of consumer confidence. Exports in 2015 benefitted from past currency depreciation, but have slowed in line with the deceleration in export markets.

Confidence and labour market

Thomson Reuters; Hungarian Central Statistical Office.

Statlink http://dx.doi.org/10.1787/888933367853

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369296

Employment growth is being mainly driven by the private sector, although the expanding public work schemes continue to be an important factor behind the fall in unemployment. Bottlenecks have started to appear in the labour market and wage growth is increasing. Inflation is hovering around zero as the result of falling energy prices; core inflation, which removes food and energy, is about 1½ per cent.

Macroeconomic policies are supporting growth

The fiscal policy stance is now broadly neutral in 2016, but will become expansionary in 2017 as public investment, public wages and housing subsidies are set to rise. However, in view of tightening cyclical conditions, such an expansion could increase economic tensions. In the first half of 2016, the central bank lowered again its policy rate twice, to 0.9% – a level that the bank judges to be in line with the medium-term achievement of its 3% inflation target, signalling an end to the policy rate cutting cycle.

The central bank’s use of unconventional monetary policy is evolving. The funding for growth schemes, which provide liquidity to banks for SME lending, are being phased out during 2016 and replaced by the Market-Based Lending Scheme where the central bank will assume some of the interest rate risks for loans to SMEs, reduce supervisory risk weights on loans to SMEs, and provide credit data for better risk assessments. While support for SMEs may be helpful in raising economic dynamism, reduced risk weights may lead banks to take on too much risk. With both monetary policy and supervisory responsibilities, the central bank is in a position to monitor these trade-offs closely.

After a pause, growth is expected to accelerate in 2017

For 2016, economic growth is projected to slow temporarily as public investment contracts, reflecting lower disbursement of EU structural funds at the beginning of a new funding cycle. Economic activity is projected to pick up during the course of the year and into 2017. Private consumption is set to expand strongly as real incomes are boosted by higher employment, lower personal income taxes, lower VAT rates on selected products, and a new family housing programme. Exporters are expected to continue to gain market shares, which will raise the current account surplus further. Sustained private employment growth and public work schemes will continue to drive down unemployment. Inflation is projected to edge up, despite the reduction in VAT rates, as the temporary effects of lower energy prices run their course and economic slack diminishes.

If the employment content of growth surprises on the upside, private consumption could accelerate further. Likewise, if the measures to advance infrastructure investment are more effective than envisaged, growth could be stronger in 2016. External risks are mostly negative. A weaker-than-projected recovery in world trade would hurt exports. Financial turmoil in Europe could force the central bank to tighten its policy rate earlier than assumed now. If temporary border controls recently put in place by several countries are maintained, this could hamper the free movement of goods and cross-border labour, hurting Hungarian workers and exporters.

The economy is booming

The economy continues its robust recovery, underpinned by strong private demand, a surge in investment activity and a boom in tourism. Household income continues to benefit from the double digit wage increases awarded in 2015. In March, wage growth accelerated to around 13% relative to a year earlier. These pay rises are far above productivity growth, which remains subdued, and will affect competitiveness. Employment growth has also been robust, bringing the unemployment rate down to just 3.1%. The tourism boom has continued and is supporting construction. In addition, investment in a number of energy-intensive projects is boosting business fixed investment during 2016.

Wages and output and unemployment

The output gap is the three-month centred moving average inverted.

OECD Economic Outlook 99 database; and Statistics Iceland.

Statlink http://dx.doi.org/10.1787/888933367863

Macroeconomic policies need to tighten

Inflation has remained below the central bank’s target of 2½ per cent, reflecting the appreciation of the Krona and the fall in energy prices. Longer-term inflation expectations have begun to stabilise, but some way above the central bank’s target. However, considerable inflationary pressure has built up, not least owing to the high wage increases. The central bank needs to prevent a wage-price spiral emerging and establish monetary policy credibility if it is to achieve low and stable inflation. The projections assume that the short term interest rates on 7-day deposits will rise above 6% from the second quarter of 2016.

Demand, output and prices

Statlink http://dx.doi.org/10.1787/888933369306

The budgetary position has improved substantially and a surplus is assumed for 2016 and 2017, although the underlying primary balance will deteriorate somewhat. Substantial windfall receipts, expected to be around 13% of GDP, from agreements with the estates of the failed banks (part of the plan to lift of capital controls) should be used to reduce public debt as planned, thereby reducing high interest payments. Given demand pressures, fiscal policy should tighten to prevent overheating.

Lethargic productivity growth in part reflects the shifting composition of the economy towards tourism, but productivity is generally weak except in fishing and energy-intensive metallurgy. The small size of the economy can limit opportunities. However, a number of artificial barriers and anti-competitive behaviour of incumbents limit competitive pressures. Reducing barriers to entry and enforcing competition policy robustly to prevent abuse of dominant position or tacit collusion would boost productivity.

Output growth will remain robust with risks of overheating

Robust income growth and investment will support the economy in 2016. Maintaining a relatively tight monetary policy combined with the moderation of investments in energy-intensive projects will eventually begin to slow the economy and slacken employment growth, edging up the unemployment rate. However, wage increases remain particularly strong and the danger of a wage-price spiral is acute. In an election year it is imperative for macroeconomic policy to remain tight. Fiscal policy needs to resist calls for relaxation when the large windfall receipts from reaching agreements with bank resolution committees are received.

India remains one of the fastest growing countries

Private consumption in urban areas has been buoyed by prospects of higher public wages and pensions combined with declining inflation. Government investment and consumption have been strong. However, demand in rural areas has suffered from two consecutive years of bad weather. Moreover, private investment has failed to pick up, reflecting low capacity utilisation rates, the weak financial position of some corporations and high non-performing loans in public banks. While the government has succeeded in fast-tracking public infrastructure projects, stalled investment projects have again risen to more than 8% of GDP, with the private sector accounting for the bulk of the delays. Acquiring land and getting clearances remain difficult. Inflation has remained contained, helped by subdued commodity prices, active management of food stocks to avoid spikes in food prices and still low capacity utilisation in the industrial sector.