Directors welcomed the recent fiscal consolidation package and noted that Austria’s fiscal position compares favorably with that of other euro area countries. However, they considered that current plans may not be sufficient to put the debt ratio on a firm downward path and that a more ambitious fiscal adjustment is needed to cope with longer-term spending pressures and the cross-border exposure of the banking system.

Directors recommended that expenditure measures be the main element of the consolidation strategy, given an already high tax burden compared to peers. In this regard, they noted that savings could be achieved through further reforms in the pension system, health care, and government subsidies. A careful rationalization of the fiscal relations among different levels of government could also facilitate the necessary budgetary adjustment.

Directors considered that Austria’s financial sector has on the whole recovered from the global crisis but that remaining risks call for further strengthening the framework for financial stability. They noted that improved bank profitability should set the stage for upgrading their capital base and exiting government support, while the restructuring of some financial institutions provides an opportunity to address overcapacity in the sector. Directors also encouraged the authorities to monitor closely risks related to foreign-currency lending, including mortgages.

Directors welcomed the role Austrian banks have played in regional emerging markets. Noting the need to limit the domestic risks posed by this engagement, they recommended reinforcing macro-prudential measures that address cross-border credit exposure. Directors also supported ongoing steps to improve international coordination among supervisors, as well as plans to strengthen the bank resolution framework.

Directors stressed the importance of persevering with structural policies to boost Austria’s long-term growth prospects. In this regard, they encouraged the authorities to step up reforms of the labor market and the education system, with a view to increasing labor market participation and boosting skills, including of the immigrant population.

Background

With a rebound in external demand and sound fundamentals, the Austrian economy recovered rapidly from the 2009 recession. Private consumption and employment held up well during the downturn and, when external demand (especially from Germany) picked up, the stage was set for a swift recovery. GDP growth reached 2.1 percent in 2010, with a marked acceleration in the second half of the year. Strong growth performance is projected to continue in 2011, but decelerate after a strong first half as the cyclical recovery runs its course and external demand loses strength. At only slightly over 4 percent, unemployment is among the lowest in Europe.

Following food and energy price shocks, inflation has increased sharply in the first half of 2011, exceeding the euro area average by about one percentage point, in part owing to indirect tax increases at the beginning of the year. The current account registered a surplus of 2.7 percent of GDP in 2010, reflecting the competitiveness of the economy especially in the services sector. Outward FDI recovered somewhat but remains well below pre-crisis levels.

The fiscal deficit widened from 0.9 percent in 2007 to 4.6 percent of GDP in 2010, but the cyclical recovery and consolidation measures—a combination of tax increases and expenditure cuts—are projected to bring the deficit down to some 3½ percent of GDP in 2011 and to around 2 percent in the medium term. However, with the government’s current measures, and taking into account implementation risks, debt will likely remain above 70 percent of GDP even in the medium run.

In the banking system, the negative effects of the crisis on credit quality are still in evidence in Central, Eastern, and Southeastern European (CESEE) subsidiaries, where the nonperforming loans ratio continued to grow in 2010. As provisioning costs have fallen, however, profitability has recovered, and improved macroeconomic prospects in the CESE region should ease the situation further going forward, while direct exposures to Greece, Ireland, and Portugal are small. Banks have improved liquidity and capitalization, but have not exited government support yet, and conditions in the medium-sized bank segment remain challenging, with one bank in the segment failing the recent EU-wide stress tests.