This Background Paper examines the medium-term economic outlook (1997–99) for Norway. The central feature of Norges Bank’s reference case projection for the medium term is that the expansion of mainland output will slow from 3.3 percent in 1995 and 2.8 percent in 1996 to an annual average of 2 percent in 1997–99. Overall GDP growth will also slow from about 4 percent in each of 1995 and 1996 to 2 percent in 1997–99. Inflation is forecast to remain low, at 2 percent in 1996 and on average 2.3 percent per year in 1997–99.

Abstract

This Background Paper examines the medium-term economic outlook (1997–99) for Norway. The central feature of Norges Bank’s reference case projection for the medium term is that the expansion of mainland output will slow from 3.3 percent in 1995 and 2.8 percent in 1996 to an annual average of 2 percent in 1997–99. Overall GDP growth will also slow from about 4 percent in each of 1995 and 1996 to 2 percent in 1997–99. Inflation is forecast to remain low, at 2 percent in 1996 and on average 2.3 percent per year in 1997–99.

II. Norway’s Exchange Rate Experience 1993-951/

1. Introduction

Until a few years ago the Norwegian krone, as well as the currencies of other Nordic countries, was pegged to the ECU within narrow fluctuation bands. However, these pegs had to be abandoned following exchange rate crises in the latter half of 1992. This chapter looks at the experience of the Norwegian krone since it was delinked from the ECU in December 1992. In contrast to the experience of other Nordic currencies like the Swedish krona and Finnish markka, the krone has remained remarkably stable during its float despite occasional turbulence in financial markets in Europe during this time. This stability was achieved largely through Norway’s sound fundamentals and through the increased credibility of its monetary and exchange rate policy.

This chapter is organized as follows. The next section provides a brief background on monetary and exchange rate policy in Norway. The third section reviews recent developments in the foreign exchange and money markets and contrasts the experience of the Norwegian krone since its float with those of other Nordic currencies. The fourth section concludes the note.

2. Background

Norway has traditionally emphasized a policy of exchange rate stability but was until the mid-1980s prone to periodic devaluations. Between 1978 and 1990, the krone was pegged to a trade-weighted basket of currencies, comprised mainly of other Nordic currencies, the dollar, the deutsche mark, the sterling and the franc. The emphasis on exchange rate stability gradually strengthened, and in 1986 this became the primary objective of monetary policy. 2/ The krone was pegged to the ECU in October 1990, and the arrangement lasted until December 10, 1992 when the peg was finally abandoned following the ERM crisis and the delinking of the markka and krona in the second half of 1992. Although the krone has since been allowed to float, the authorities have maintained the underlying emphasis on exchange rate stability.

In May 1994, new guidelines for the long-term objective of monetary policy under a floating rate were announced in connection with the Revised National Budget. These guidelines were issued on the basis of recommendations from Norges Bank after it became clear that unilateral arrangements such as the ECU peg was not likely to work and, given the widening of the ERM fluctuation bands in August 1993, an early return to narrow bands was remote. 1/ However, the guidelines did not call for a new direction in policy but essentially endorsed the practice adhered to since the float. In other words, the operational objective for monetary policy remains that of maintaining a stable exchange rate against European currencies, namely, within a range of 3-5 percent below the pre-float central rate. Norges Bank would intervene when necessary--through purchases and sales of foreign exchange or changes in interest rates--to smooth short-term fluctuations in the exchange rate. However, the Bank would not be committed to defending any particular parities and would not use instruments to the same extent as under a fixed exchange rate. The purpose, instead, is to return the exchange rate to its initial level over time. Within this framework, monetary policy should contribute to low inflation and sustainable growth in the long run.

3. Recent exchange rate and monetary developments

The krone has been largely stable vis-à-vis European currencies since the delinking from the ECU. This stability was sustained through periodic bouts of turbulence in the foreign exchange market associated with the widening of the ERM bands in late 1993 and the cycle of EU referenda in some of the Nordic countries, including Norway, in 1994. The success of monetary policy in bringing inflation down has also led to a substantial narrowing of the interest rate differentials with respect to the deutsche mark. Interest rate differentials are currently negative vis-à-vis the theoretical ECU after having narrowed substantially between the late 1980s and early 1990s.

a. Exchange rate developments

The krone depreciated by about 6 percent immediately after it was delinked from the ECU in December 1992 (Chart 2.1). However, in the ensuing months it regained some of the losses with an appreciation of some 2 percent between January and March 1993, despite substantial purchases of foreign exchange by Norges Bank and reductions in interest rates. From mid-1993 to end-1994, the exchange rate for the krone was generally stable, fluctuating within a range of 3-5 percent below its pre-float central rate against the ECU. Although the widening of the ERM bands in the summer of 1993 placed some downward pressure on the krone--Norges Bank sold close to Nkr 7.5 billion of foreign exchange between July and September 1993 to defend the krone--it emerged essentially unscathed from this episode. The krone also easily weathered the period of uncertainty associated with the cycle of EU referenda in Finland, Sweden and Norway in the fall of 1994. After falling by 0.5 percent against the ECU in November 1994, the krone gradually appreciated through March 1995 once the uncertainty regarding EU membership had been resolved.

CHART 2.1
CHART 2.1

NORWAY EXCHANGE RATE DEVELOPMENTS

Citation: IMF Staff Country Reports 1996, 015; 10.5089/9781451829624.002.A002

Sources: IMF, International Financial Statistics; Treasurer’s Department.1/ An upward movement indicates an appreciation.

The krone depreciated somewhat in April and May 1995 in line with the weak U.S. dollar. The depreciation reflected krone sales by some investment funds, as well as the decision by some companies to postpone krone purchases in anticipation of an increase in the dollar exchange rate. To resist downward pressure on the krone, Norges Bank sold foreign exchange and tightened liquidity through swaps and interest rate increases. The krone stabilized through the summer before strengthening against the ECU beginning in August. The appreciation was due to the recovery of the U.S. dollar and interest rate reductions in Europe in the second half of August; by September 1995 the krone had climbed to about 2.8 percent below its pre-float central rate against the ECU. As of January 1996, it stood at 3.5 percent below that rate.

In effective terms, both the nominal and real effective exchange rates declined steadily from end-1992 to end-1993 (Chart 2.2). The fall in real effective terms (based on unit labor cost) contributed to improving external competitiveness during this period. 1/ From 1994, however, the gains in competitiveness were largely eroded. The real effective rate rose by 7 percent between February 1994 and December 1995 due largely to nominal appreciation and the slow productivity growth in Norway.

CHART 2.2
CHART 2.2

NORWAY INTEREST RATE DEVELOPMENTS

(In percent)

Citation: IMF Staff Country Reports 1996, 015; 10.5089/9781451829624.002.A002

Sources: IMF, International Financial Statistics; and WEFA, GERFIN Database.1/ Three-month Euro money market on ECU.2/ Benchmark government bond yields, variable maturities.

b. Monetary developments

From 1986-92, interest rate developments in Norway can be characterized by declining interest rate differentials with respect to European currencies (Chart 2.2). The significant narrowing of differentials reflects the successful reduction of inflation to less than 3 percent from double digits in the early and mid-1980s (Chart 2.3). In particular, the spread against the German three-month interbank rate narrowed from 1100 basis points in 1987 to 240 basis points in 1992. The declining trend was also evident on the long-end with the spread on ten-year government bond yields falling from 700 basis points in 1987 to 200 basis points in 1992. Official interest rates were raised sharply in November 1992 to defend the krone during the turmoil in the European foreign exchange markets but by the beginning of 1993, they had fallen back to pre-crisis levels. From mid-1993 through early 1994, interest rates on both ends were lower than their corresponding German rates. However, the uncertainty associated with the cycle of EU referenda pushed interest rates upward from mid-1994, and the differential with respect to the German three-month interbank rate became positive and widened to over 200 basis points in November 1994. Immediately following the Norwegian referendum, short-term rates again declined to 5.8 percent in January 1995, or 65 basis points above German rates. The spread on long-term rates also narrowed from about 120 basis points above German bond yields in September 1994 to only 6 basis points in January 1995.

CHART 2.3
CHART 2.3

NORWAY CONSUMER PRICE INFLATION

(Twelve-month percent change)

Citation: IMF Staff Country Reports 1996, 015; 10.5089/9781451829624.002.A002

Source: IMF, International Financial Statistics; and OECD, Main Economic Indicators.

Short-term interest rates declined through most of 1995 except between May and the first half of June when short-term rates rose as liquidity was tightened in response to temporary weakening of the krone. As the krone strengthened and tight conditions eased, short-term rates resumed their downward trend. The differential against the German three-month interbank rate narrowed from end-1994 through March 1995. However, because of the decline in German rates especially in the second half of the year, the spread on short-term rates widened again. As of late January 1996, the Norwegian three-month interbank rate stood at 5.6 percent or over 200 basis points above the German rate compared to 65 basis points in January. Although Norwegian short-term rates are above German rates they are lower than corresponding ECU rates. On the latter, the three-month interest rate differential narrowed substantially as interest rates fell more sharply in a number of European countries than in Norway. By December, the interest rate differential against the ECU was a negative 10 basis points compared to a negative 140 basis points in March. On the long end, the Norwegian 10-year bond yields also generally declined through the year though staying above German rates.

Official overnight lending and deposit rates have remained unchanged since February 1994 at 6.75 percent and 4.75 percent, respectively. These rates effectively imposed an upper and lower limit on money market interest rates.

Turning to the monetary aggregates, following an increase in the money supply (M2) of 7.3 percent in 1992, money expansion slowed in 1993 to 0.5 percent before picking up again in 1994 with a year-on-year growth of 6.6 percent in December, in line with the expansion in the economy. During this time, the uptake in total credit rose from negative 1 percent in 1992 to 1.2 percent in December 1994.

The pace of money expansion was maintained in 1995 with the year-on-year growth averaging about 5 percent. Credit growth from domestic sources was also higher than in the previous three years; the year-on-year growth rate in August was 4.4 percent, almost double the rate of a year earlier. 1/ However, the uptake of credit from foreign sources continue to remain generally negative or near zero for most of the year. Hence, as in 1994, total credit growth in 1995 was lower than the growth in domestic credit.

c. External reserve developments

Norges Bank intervened heavily in the tumultuous period leading to the delinking from the ECU in the latter half of 1992. In net terms, Norges Bank sold about Nkr 43 billion of foreign exchange--with close to Nkr 37 billion on November 20 or over 30 percent of reserves, the day after the floating of the Swedish krona--in defense of the krone between November and December 1992 (Chart 2.4). By end-1992 international reserves fell to Nkr 85 billion or approximately 4 months of imports of goods and non-factor services. In 1993, the level of international reserves gradually recovered as large capital inflows during the first half of 1993 resulted in purchases of foreign exchange, and by end-1993 reserves had climbed to Nkr 150 billion. The substantial capital inflows in 1993 reflect the return of capital that had previously fled the country during the foreign exchange market crises of the previous year as the credibility of Norway’s monetary policy gradually strengthened. In 1994, Norges Bank’s intervention in the foreign exchange market was quite limited despite the spate of nervousness related to the EU referenda in the Nordic countries. In net terms, Norges Bank purchased close to Nkr 3.5 billion foreign exchange in 1994. However, international reserves declined to Nkr 142 billion by end-1994 largely as a result of valuation effects.

CHART 2.4
CHART 2.4

NORWAY FOREIGN EXCHANGE RESERVES

Citation: IMF Staff Country Reports 1996, 015; 10.5089/9781451829624.002.A002

Sources: Data provided by Norwegian authorities.

In 1995, Norges Bank intervened relatively more heavily than in the previous year. From January to March 1995, Norges Bank bought foreign exchange to ease upward pressure on the krone. However, during the period of dollar weakness in April and Hay, Norges Bank sold about Nkr 7 billion in foreign exchange to support the krone. This measure was taken in addition to the tightening of liquidity through swaps and interest rate increases. International reserves dropped to Nkr 134 billion at end-Hay due to the nominal appreciation of the krone against the U.S. dollar in early 1995 but subsequently recovered to Nkr 148 billion at end-October, equivalent to a comfortable six months of import coverage.

d. A comparison of exchange rate experiences

The depreciation of the krone in the immediate aftermath of the abandonment of the ECU peg was limited in comparison to the 12 percent and 13 percent devaluation of the Swedish krona and Finnish markka, respectively, when they were delinked. 1/ 2/ Furthermore, while the exchange rate for the krone has been quite stable since the abandonment of the peg, the exchange rates for the krona and markka have fluctuated considerably during this period (Chart 2.5). As shown in Table 2.1, between January 1993 and September 1995, the average deviations of the krona and markka from their pre-float ECU central rates range from negative 19.5 percent to negative 10.2 percent; these are significantly higher than the average deviation for the krone of negative 3.7 percent. 3/ In addition, volatility with respect to the ECU is more pronounced for the krona and markka than for the krone, as indicated by their respective variances. It is worthwhile noting, however, that both the markka and Swedish krona have appreciated in recent months.

CHART 2.5
CHART 2.5

NORWAY BILATERAL EXCHANGE RATES 1/

Citation: IMF Staff Country Reports 1996, 015; 10.5089/9781451829624.002.A002

Sourcrs: IMF, International Financial Statistics; Treasurer’s Department.1/ An upward movement indicates an appreciation.
Table 2.1.

Percent Deviation from the Pre-Float ECU Central Rate

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The picture against the U.S. dollar is somewhat similar with the markka--and to a lesser extent the krona--showing more volatility with respect to the US dollar than the krone (Chart 2.4, Table 2.2). However, in this case, the krone-dollar bilateral rate has fluctuated considerably more than the exchange rate against the ECU. This is not surprising given that exchange rate policy in Norway has been oriented towards maintaining a stable exchange rate against the ECU.

Table 2.2.

Bilateral Rates Against the U.S. Dollar

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The relative stability of the krone following the delinking can also be attributed to Norway’s substantial petroleum resources. Real GDP growth--which includes shipping as well as oil and gas--has been brisk through the 1990s, and has helped sustain Norway’s current account surpluses (Table 2.3). 1/ Sweden and Finland, on the other hand, were in recession in the early 1990s and ran current account deficits for several years. The turnaround for both these countries occurred only in 1994. Norway has also managed to keep inflation comparatively lower although both Sweden and Finland have successfully reduced inflation to less than 3 percent. On the fiscal side, Norway again compares favorably to its neighboring countries. Its fiscal outlook is more positive with surpluses projected for both 1995 and 1996 in contrast to the continued negative balance for Sweden. 2/ However, both Finland and Sweden have taken steps to address their large imbalances which peaked in 1993, at 8 percent and 13 percent of GDP, respectively. As a result their exchange rates have strengthened substantially.

Table 2.3.

Selected Economic Indicators

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Source: Official and staff estimates.

Mainland GDP in parenthesis.

The maintenance of sound fundamentals has significantly enhanced the credibility of Norway’s exchange rate and monetary policy. 3/ This, in turn, has ensured a stable exchange rate for the krone, a gradual narrowing of interest rate differentials vis-à-vis European currencies, and low inflation.

4. Conclusion

So far, the current exchange rate and monetary policy has worked well for Norway even in the face of turbulence in the financial markets in Europe. The krone has been quite stable against the ECU over the life of its float, in contrast to the experience of markka and krona, and inflation has stayed low at about 2 percent over the past three years. Looking forward, the challenge will be to maintain this performance as the upswing continues.

1/

Prepared by Cheng Hoon Lim.

2/

After the devaluation in 1986, the Government made a firm commitment to maintaining a stable exchange rate.

1/

The ERM bands were widened to 15 percent either way of the central rate.

1/

The recent revision in the national accounts, however, indicate that cost competitiveness (for the manufacturing industry) improved by a smaller margin between 1988 and 1993 than previously estimated as a result of weaker productivity growth and higher wage growth. The rise in unit labor costs for the manufacturing industry is now estimated at 14 percent during this period against earlier estimates of 6 percent. Hence cost competitiveness improved by an annual average of 0.7 percent between 1988-93 as opposed to previous estimates of 2.7 percent.

1/

These developments fueled fears of a renewed period of debt-financed consumption. However, in real terms, current growth rates are still relatively moderate compared to the 10-15 percent growth rates in the mid-1980s. Hence, the growth in domestic credit so far does not indicate a strong build-up of debt in the private sector.

1/

The Finnish peg was abandoned on September 8, 1992 and the Swedish peg on November 19, 1992. Previously, the markka was temporarily floated on November 14, 1991 but was repegged the following day with a depreciation of 12.3 percent.

2/

The stated objective of monetary policy in both Sweden and Finland is inflation targeting. The Riksbank has an inflation target of 2 percent, with a tolerance range of 1 percent. The Bank of Finland aims to keep underlying inflation to 2 percent, on average.

3/

The krona and markka hit their post-float lows in April 1995 and February 1993, respectively.

1/

Oil and gas production now contributes about 13 percent of GDP and are third of Norway’s exports.

2/

The net financial asset position in Norway is also positive, in contrast to the other two countries.

3/

It is worth noting that the complete recovery of the 1992 banking crisis has also contributed to increasing the credibility of Norway’s exchange rate and monetary policy.

Norway: Background Paper
Author: International Monetary Fund