Austrian economy projected to be around 1 ½ percent in 2010 and 2011

This is a part of preliminary finding of the International Monetary Fund (IMF) mission. It says further:

Austria is facing a number of challenges. As a very open and competitive economy, Austria had benefited from strong links with dynamic neighboring countries up to the crisis, and experienced higher growth than the euro area average. However, this integration also bears risks, notably in the financial sector. This calls for a cautious fiscal policy stance, as while Austria's fiscal position remains relatively solid compared to most of its Euro area peers, market tensions may arise in case of adverse developments. This also calls for strong supervision to address remaining vulnerabilities in the financial sector. Finally, growth in some Central, Eastern and South eastern European (CESEE) countries is likely to be lower than before the crisis, while the labor force is ageing and Austria should adopt policies to strengthen its growth potential. There is no room for complacency.

In this context, main recommendations are three-fold:

- The significant increase in public debt should be reversed through steadfast consolidation at all levels of government. The general government deficit will need to be reduced from 2011 onwards, to ensure a reduction below 3 percent of GDP by 2013 and a further decrease thereafter. Comprehensive reforms, including in fiscal federalism arrangements, would produce ample room for a mostly expenditure-based consolidation with limited impact on growth.

- Financial stability should be further strengthened. Supervisory actions have stepped up significantly, and should continue to intensify, including in a cross-border context. Efforts to reduce risks in foreign currency lending, in cooperation with other supervisors, while maintaining sufficient financing in CESEE countries are welcome. A further strengthening of supervisory powers is needed to reinforce crisis prevention and early resolution.

- While the Austrian economy fares well on several grounds, notably as regards its efforts in research and development, further structural reforms would reinforce the growth potential. Making better use of its labor resources in all segments of the labor market and increasing competition in some service industries would support growth, thus facilitating the needed fiscal consolidation.

Growth outlook and policies

Austria's recession has been deep, but with limited effects on unemployment. As trade had contributed strongly to growth in the past years, its contraction was felt commensurately in 2009. Supported by tax cuts and various labor market measures, together with dynamic real wages, consumption helped cushion the recession. Investment, however, dropped by about 10 percent, largely as a consequence of depressed demand prospects. The crisis affected mainly the manufacturing sector, while domestically-oriented activities fared better. The resulting rise in unemployment by 1 percent, to 4.8 percent was muted, partly thanks to subsidized short-time working schemes and a strong increase in training programs.

A modest export-led recovery is underway. While quarterly data have been volatile, growth picked up in the second half of 2009 and leading indicators point to a continued strengthening of economic activity. GDP growth of around 1½ percent, together with a modest recovery in employment, is expected in 2010 and 2011. While in response to market pressures fiscal consolidation in some partner countries will be greater than previously expected, Austria is at this stage benefitting from the Euro effective depreciation and from low financing costs. However, uncertainties are high and mainly center on developments in the international environment and financial markets. At national level, decisive fiscal consolidation, a further strengthening of financial stability, and wage developments in line with preserving competitiveness will be key to maintaining confidence in the economy.

In the medium run, potential growth is likely to be below pre-crisis levels. Prospects may be affected by deleveraging in some CESEE countries, as a result of past excessive credit growth. Also, the population is ageing and growth in working age population is set to slow down and to turn negative after 2020. While migration can help mitigate this development, there is also a case for better using already available labor resources.

Growth could be boosted by structural reforms. In particular, while the overall participation rate in the labor market is relatively high, participation of older workers is low, unemployment incidence is high for low skilled workers, as well as for foreign-born workers, and women are very often working part-time. While reducing the tax wedge would require compensatory measures, addressing these issues would, in other cases, also contribute to reducing deficits and enhancing sustainability: for example, entry into disability schemes, at an average age of 51, is pervasive, and possibilities of entry into early and part time retirement have proved to be ill-designed. Policies should be redirected away from measures that create disincentives to female participation towards ensuring sufficient full day child care, pre-school and school options. This could also contribute to a better economic integration of foreign-born workers. In the services sector, where productivity is lagging that of the best EU performers, measures should be taken to ensure competition. An effective transposition of the EU Services Directive could help in this endeavor.

Fiscal policy

To ensure debt is put back on a downward path, the deficit should be brought below 3 percent of GDP by 2013 and continue to decrease thereafter. Austria has had more favorable deficit and debt developments than the Euro area average, with a deficit expected to be 4 ¾ percent of GDP in 2010 and debt around 70 percent. But current levels are not sustainable. While a continuing supportive stance in 2010 is appropriate to underpin the recovery, consolidation should start as planned in 2011. Given the moderate recovery and economic uncertainties, a lack of front-loading is justifiable. But the authorities should stand ready to take additional consolidation measures, if needed either to ensure that the target is respected or if market sentiment deteriorates. With a debt-to-GDP ratio expected to increase to close to 75 percent of GDP (an increase of 15 percentage points from pre-crisis level) and decrease only after 2013, a clear commitment to a lasting consolidation and sustainability should be signaled early on.

A well-designed mostly expenditure-based consolidation, with participation of all government levels, could minimize the effects on growth and enhance sustainability. Raising a few taxes that are currently low in an international comparison (property tax, oil tax) could bring additional benefits (e.g. increased local taxing power by updating tax bases of the real estate tax, environmental benefits for the tax on oil). However, the overall tax burden and taxation of labor are already high and there is little scope for tax increases. On the contrary, there is room for the vast majority of consolidation measures to consist of expenditure reductions without weighing unduly on growth, as spending is elevated in international comparison and with outcomes not always commensurate. For example, calibrating hospitals capacity to actual needs could reduce costs. Abolishing unjustified disparities and early retirement loopholes could increase sustainability and equity in the pension system. More widely, social policies should be better targeted. Cost/benefit of subsidies should also be re-examined. Reaping potential savings would be helped greatly by better aligning spending and financing powers across government levels, and reducing the current fragmentation and overlap in responsibilities for closely related public service deliveries. Failure to do so would result in a more costly consolidation.

Decisive reform of federal fiscal relations and institutions would further cement the credibility of Austria's fiscal consolidation. The definition of a medium-term expenditure framework at central government level, and moves towards outcome based budgeting, are welcome steps. But there is no effective mechanism to ensure participation of sub-national levels to consolidation. With an implicit state guarantee, market discipline plays little role and the current framework (“internal stability pact”) has proved its limitations. Key reforms would support consolidation: (1) increasing the revenue autonomy of Länder in the context of a re-negotiated fiscal equalization law; (2) renegotiating and improving the internal stability pact, to reduce its procyclicality (the agreed limits on deficit could be complemented by expenditure ceilings paralleling the framework agreed at central level); and (3) ensuring respect of the agreed rules, with reinforced sanction powers and correction mechanisms. Preventing local governments from issuing unlimited debt and guarantees would also be key to avoid unsustainable developments.

Financial Sector

The overall situation of banks has improved but challenges remain. Banks' capitalization has increased, partly as a result of public capital injections, leverage ratios have improved, and liquidity positions strengthened. Banks have also overall registered a slight recovery in profitability in 2009, in a favorable financing and market environment. Nevertheless, as non-performing loans have not yet peaked, banks and supervisors should continue to be attentive to the level of provisioning. Also, the adequacy of some business models may have to be reassessed. In this context, the authorities should closely monitor the situation of individual banks, including on the basis of stress tests results, and ensure appropriate action is taken in a timely manner.

Policy measures should be carefully designed. While a stronger financial sector is necessary for the removal of financial support, care should be taken to limit distortions by tightening access costs and conditions-as agreed at the EU level. As a result of the crisis, different measures and regulatory changes are being considered. The authorities should ensure that they enhance the resilience of the financial sector, through proper design and taking into account their combined effects.

Providing continued financing to the CESEE region, in line with the European Bank Coordination (“Vienna”) Initiative, while reducing the share of foreign exchange loans will be a key challenge. Austrian banks are subject to significant foreign exchange risk from unhedged borrowers, including those in Austria. The authorities' efforts, in coordination with other supervisors, to implement and enforce tighter fx-lending standards are welcome.

Supervision should be further strengthened. In line with past recommendations, a framework and procedures for strong cooperation have been put in place between OeNB and FMA. They have significantly stepped up supervisory resources, intensified inspection, and actively increased their cooperation with other home and host supervisors, which is welcome. However, gaps in supervisory powers should be filled. Notably, supervisors should be able to supervise non bank financial entities that may present material risks, including in a cross-border context (e.g. financial leasing companies). A system mandating early remedial action when warning signs are detected ought to be put in place and the FMA be able to intervene if needed to restructure a bank. A proper resolution framework, including a specific insolvency law for financial institutions, should be designed taking into account current EU initiatives.

Steps taken by the authorities to ensure that their financial system can not be used for unlawful purposes are welcome. Austria has taken action in response to its identification in the ICRG process and the mission has been informed by the Austrian authorities that Austria has been removed from the ICRG process in view of commitments by the authorities to further strengthen compliance with FATF recommendations. The action plan agreed by the authorities is a step in the right direction. Austria's acceptance of article 26 of the OECD model Tax convention is also welcome.