The Dutch economy is experiencing an unprecedented shock

The FINANCIAL — The Dutch economy is experiencing an unprecedented shock. Real GDP is likely to contract by some 4 percent in 2020, one percentage point less than projected in the IMF’s October 2020 WEO. The comparatively high technological penetration and digitalization of activities have helped contain the impact of the sanitary restrictions adopted to limit the spread of the virus. Like in other parts of Europe, a second wave of contagion has been in train this autumn in the Netherlands, necessitating new sanitary restrictions.

The Dutch economy is expected to contract much less in the last quarter of 2020 than it did in the second quarter of this year, owing to the lesser extent of restrictions in most of the current period, the faster adaptation of businesses, and the continued operation of global value chains. However, the recovery in the first quarter of 2021, marked by the winter, is likely to be muted and subject to continuing large risks from the pandemic. We expect that the recovery will gain momentum in the spring and that the economy will grow by around 3 percent in 2021 and 2022, with some upside risks if the vaccine’s deployment is fast or leads to strong sentiment and more spending.

Fiscal policy should continue supporting the economy until the recovery is on firm ground. The decision to extend existing policy support programs until mid-2021 is appropriate in view of continuing risks, and the early announcement of such an extension has helped to moderate uncertainty for businesses and households. The authorities should stand ready to further expand or prolong policy support to affected firms and households until activity recovers sustainably, and avoid the emergence of “policy cliffs.”

In the near term, the priority should remain the preservation of employment and businesses to prevent scarring. Telling whether certain businesses will remain viable or not is difficult. Given this difficulty, as well as the favorable prospects for administration of a vaccine in the course of 2021, the mission recommends erring on the side of providing broad support to prevent excessive or unnecessary scarring in the economy. The converse risk, that of keeping some unviable firms alive for some time or slowing the reallocation of resources across the economy, seems more limited now that there is light at the end of the tunnel. Maintaining support for vulnerable households and workers during the pandemic will also help limit the risk of increasing inequality. The government is in a strong position to continue providing broad and timely support, given that fiscal space remains ample even after considering the fiscal impact of the recession and the costs of economic support programs.

As the recovery takes hold, policies should gradually shift towards facilitating the movement of labor and capital. The government is developing training and career counselling programs to ease job transitions and the movement of workers across sectors. Measures to spur private investment (e.g. a payroll tax deduction for companies initiating new investments) are also being developed. These policies are welcome. As we recommended in the past, establishing a credit bureau for businesses would facilitate access to financing, particularly for small and medium enterprises. When the crisis is over and emergency support is lifted, the economy may experience an increase in bankruptcies, which have been suppressed in the last several months. It is important to make sure that mechanisms for corporate workouts, in court and out of court, are ready to handle a rise in caseloads.

Financial sector stresses from the pandemic remain contained. The banking system entered the pandemic with strong capital and profit ratios, although the system’s reliance on wholesale funding and high exposure to mortgage loans implied some specific vulnerabilities. But in the pandemic bank profits are being affected by the prevailing low interest rates and the need to start provisioning for potentially deteriorating asset quality. In this context, banks have benefitted from appropriate European and Dutch macroprudential and supervisory relief measures, and indirectly from government emergency programs, which protect borrowers. Strong capitalization, moreover, provides space to absorb the current and potential effects of the pandemic and continue to provide credit in the recovery. Pension funds and insurance companies are under pressure owing to continued low interest rates and, this year, depressed returns on their equity investments too, underscoring vulnerabilities that predate the pandemic. Bank and nonbank lenders’ exposures to commercial real estate warrant close monitoring, given the impact of the pandemic on this sector.

Looking beyond the pandemic, policymakers should aim to boost economic growth, foster a green recovery, and promote the resilience of economic agents—a goal that has grown in salience during this crisis. Specific policy actions should be carefully planned and timed to avoid conflict with the near-term overarching priority of maintaining the support for the economy. Areas that deserveconsideration include the following:

• Reducing debt biases to further strengthen balance sheet resilience. Regarding corporate taxation, continuing to reduce interest payments deductibility and exploring other options to discourage excessive leverage would be desirable. In the household sector, continuing to gradually reduce mortgage interest deductibility and loan-to- value limits (toward a maximum of 90 percent in the medium term), and capping debt service to income ratios across the cycle, would help reduce debt biases. Removing impediments to the growth of the housing rental market would reduce the need for borrowing, and ameliorating supply-side constraints would alleviate tightness in the housing market.

• Moderating the duality of the labor market. The pandemic highlighted the comparatively vulnerable position of the self-employed and workers with flexible contracts. While there are good reasons for these work modalities, it is important to address regulatory and tax features that that may inadvertently promote them. For example, adopting mandatory disability insurance for the self-employed, as currently planned, would be a step in the right direction. The tax credit for the self-employed may also merit examination, carefully weighing its potential unintended effects on the incidence of self-employment against the intended objectives of this provision and seeking less distortionary ways to achieve those objectives.

• Boosting potential growth. Increasing spending in education deserves consideration. This should include initiatives to facilitate life-long learning and upskilling, especially to address identified skill shortages, including in the area of digitalization. It is also worth paying attention to primary and secondary education, given the declining performance in international comparisons. Increasing public direct support to R&D and digital infrastructure and addressing impediments to full-time female labor participation would raise potential growth. Reducing labor duality may also help strengthen productivity growth by reinforcing the incentives of employers to invest in the skills of their employees.

• Fostering a greener and more sustainable economy. The recovery provides an opportunity to increase efforts to reach the country’s ambitious emissions reduction goals. Moving forward with the national climate agreement should spur innovation and the adoption of new technologies among Dutch firms, bringing about new growth opportunities. The recently launched National Investment Fund and, on a smaller scale, the Next Generation EU funds, should be mobilized to promote investment in green technologies and the energy transition. At the same time, energy transition, climate change, and related technological and policy changes at home and abroad can be sources of risk for many economic agents. The mainstreaming by the DNB of stress testing of the financial system for these types of risks is a timely innovation. • Advancing on pension reform. Going forward with the pension agreement should help strengthen the second pillar, under pressure from low interest rates, given the defined-benefit features of the occupational pension funds. The pension reform is expected to reduce intergenerational tensions, including disincentives to enroll for young individuals,and itmay contribute to reduceincentives forself-employment. It may also help smooth the response of private consumption to interest rate movements and other economic shocks. The authorities should continue with the reform and ensure a smooth transition to the new system.

The mission wishes to thank its interlocutors in government agencies, the DNB, the CPB, and the private sector for generously sharing their time and knowledge.