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THE ECONOMY OF NORWAY

AND A PREDICTION OF THE

NEXT STEP IN ITS MONETARY

POLICY

Case Study

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Abstract

This case study discusses the Norwegian economy and show that the

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Table of content

INTRODUCTION ... 4

CENTRAL BANK POLICY SINCE GFC... 5

CURRENT SITUATION IN NORWAY ... 6

BALANCE OF PAYMENTS ... 8

OIL PRICE ... 10

EXCHANGE RATE AND INTEREST RATE DIFFERENTIALS ... 12

ECONOMETRIC ANALYSIS ... 13

GROWTH AND PROSPECTS INTERNATIONALLY ... 14

WHAT IS NEXT? ... 14

APPENDIX ... 15

1.1 EVIEWS OUTPUT ... 15

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Introduction

The glo al fi a ial isis i GFC had u a gua l a ig egati e i pa t o the o ld’s

economy. The results that followed were rising unemployment, slower growth, huge

movements in exchange rates and debt ratios going the wrong way. The central banks were subject to huge challenges regarding monetary measures and the way of implementing

poli ies to help the e o o ies a k up. This ase stud ill shed light o No a ’s e o o

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Central Bank policy since GFC

The financial crisis in 2008 gave us a reminder that low and stable inflation does not come with guarantees for financial stability. However, inflation targeting as the main mandate has been an efficient tool for low and stable inflation (chart 1.2). That has also been the

mandate of Norges Bank since 2001, but not without challenges. In the aftermath of the GFC, Norway experienced a rising figure of unemployment as indicated in chart (1.1) below.

(1.1)

Source: FRED ECONOMIC DATA and Norges Bank

Although the mandate of Norges Bank is to keep the inflation close to 2.5%, they also have to consider the whole economic picture. Macroeconomic figures as unemployment, rising housing prices and accumulation of debt will eventually affect the inflation, which is illustrated in chart (1.2) below. Apart from the monetary policy, regulation in the banking system and macroprudential policy measures are the main tools for preventing financial instability. Drastic cuts in the policy rate was also the case in Norway as with other big economies hit by the GFC. This is sharp decline in the policy rate, which was a response to the rising unemployment and other macroeconomic factors is illustrated in the chart1 above.

1 The policy rate is represented in the left axis and unemployment on the inverted left axis.

Both measured in percentage points. Policy rate data is from Norges Bank and unemployment data is from FRED ECONOMIC DATA.

0.000000000

01:01:07 01:01:08 01:01:09 01:01:10 01:01:11 01:01:12 01:01:13 01:01:14 01:01:15

Policy rate and Unemployment

Policy rate Unemployment

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(1.2)

Source: FRED ECONOMIC DATA

Current situation in Norway

Extraordinarily low rates have been prominent across the world after the GFC and the case has not been otherwise in Norway. Fast increase in public debt the last couple of years due to low rates and increasing housing prices as indicated in chart (1.3.2) should, and have been great concerns to Norges Bank lately.

(1.3.2)

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As see f o g aph . . , No a ’s households have a large debt to income ratio

compared to other countries. A further decrease in the policy rate would probably boost the developments in housing prices and household debt, and may eventually lead to financial instability. However, Olsen (2016) argues in the Monetary Policy Report that the impact of a monetary stimulus in a low interest rate environment is restricted. An increase in the policy

ate o the othe ha d, ete is pa i us, ould lead to huge i ala es i a ks’ ala e

sheets if borrowers were to default on their loans. Therefore, precautions have to be taken either way, regarding the fast increase in debt and housing prices.

(1.3.1)

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(1.3.3)

Balance of payments

As seen in table (1.4), there has been a shift in the current account balance. Balance of income and current transfers exceeded the balance of goods and services for the first three quarters of 2016. This shift in the CAB is illustrated in chart (1.4.2) as well, where the CAB as a percentage of GDP has fallen sharply the last three years. A reasonable explanation for this shift might be the decline in the price of oil (illustrated in chart 1.5), which is the largest and most important commodity for Norway in terms of exports.

(1.4)

Source: Statistics Norway

2015 2014 2013

Operating profit margin. Per cent 11,45 18,93 22,74

Operating margin. Per cent 9,19 6,03 27,2

Return on total assets. Per cent 7,4 11,57 14,47

Return on equity. Per cent 0,06 -4,83 10,2

Equity ratio. Per cent 44,75 48,25 51,2

Current ratio 1,02 1 1

Ratio of fixed assets to long term capital 1 1 1

Debt-to-equity ratio 1,23 1,07 0,95

Source: Statistics Norway

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(1.4.1)

2 Statistics Norway is the national statistical institution of Norway (SSB)

Balance of Payments, Norway, annual, 2007-2016

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Current account balance 287436 408286 258198 282704 344901 368586 314225 346018 270001 152232

Current account balance, % of GDP 12,2 15,7 10,6 10,9 12,4 12,4 10,2 11,0 8,7 4,9

Gross domestic product, market values 2349861 2605380 2429698 2590089 2791973 2965208 3071134 3140371 3117433 3111773

Balance of goods and services 315222 441747 274576 290867 358545 383302 328201 279595 169139 38584

Balance of income and current transfers -27786 -33461 -16378 -8163 -13644 -14716 -13976 66423 100862 113648

Capital transfers to abroad, net 971 1138 1120 1268 1499 1279 1377 1123 870 822

Net lending, current account 286436 407123 256784 281143 343127 367276 312817 344776 269083 151362

Direct investment -992 70526 14015 50746 12957 -316 55752 141707 114464 171432

Portofolio investment 113957 646345 6998 87479 234973 297774 350823 154590 284828 34339

Other investments -5689 -317554 296242 101457 214211 -21859 -125098 60070 -261467 33085

Reserve assets (IMF breakdown) 8546 19950 -68184 21011 -19437 4462 14178 37972 -47990 29630

Net lending, financial account 115822 419267 249071 260693 442704 280061 295655 394339 89835 268486

Net errors and omissions 170614 -12144 7713 20450 -99577 87215 17162 -49563 179248 -117124

Net errors and omissions, % of GDP 7,26 0,47 0,32 0,79 3,57 2,94 0,56 1,58 5,75 3,76

0.0

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

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Source: FRED ECONOMIC DATA

Oil price

In the summer of 2014, the price of oil started its way down. As indicated in chart (1.6), this caused huge movements and a sharp depreciation of the Norwegian Krone and a shift in the current account balance as discussed above. Although the exchange rate NOK/USD

illustrated in the graph is affected by other factors as well, it clearly shows that there is some correlation. The rate of unemployment also got to feel this sharp decline in the price of oil, as thousands of workers in the North Sea had to quit their jobs due to restructuring in the sector.

0.00 20.00 40.00 60.00 80.00 100.00 120.00 140.00

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(1.6)3

Source: Norges Bank and FRED ECONOMIC DATA

3 TWE-axis is inverted to illustrate a depreciation of the Norwegian Krone. TWE denotes the

Trade Weighted Exchange Rate and is de i ed f o a geo et i a e age usi g OECD’s t ade

Trade Weighted Exchange Rate Oil price Oil

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Exchange rate and interest rate differentials

The sharp depreciation of the currency illustrated in chart (1.5) has with little doubt had a positive impact on the economy and certainly a factor Norges Bank has appreciated. The reason for this, and what the following econometric analysis will show, is mostly explained in the sharp decline in oil price and further cuts in the policy rate (1.6). Higher prices on

imports has put a pressure on inflation upwards, and higher demand for exports has been a result of this depreciation. However, the central bank of Norway has had to look at the developments in the currency markets with great caution. Too high inflation and slow domestic growth is not a good combination, as they both argues for a policy rate in two different directions.

As Galati, Heath and McGuire (2007) argues, the interest rate differential can have a great impact on the exchange rate movements. The policy rate in Norway has the last decade more or less followed the rates in US, EU and UK. This has contributed to a stable exchange rate as the interest differentials have been moderate. Although the exchange rate is not mentioned in the mandate, it has definitely been an important tool for Norges Bank in adjusting the economy to meet its requirements.

(1.7)4

Source: Norges Bank

4 TWE on the left axis (inverted) denotes the Trade Weighted Exchange Rate and PR on the

right axis denotes the Policy Rate.

0.00

Trade Weighted Exchange Rate Policy rate

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Econometric analysis

To strengthen the arguments discussed above, the following econometric regression analysis will show some factors driving the exchange rate. I have constructed a model which tries to explain the movements in NOK/USD. Theory suggest that developments in interest rate differentials and the price of oil can have a big impact on the exchange rate and for that reason, the log-linear regression will include those as independent variables and can be written as:

log(ER)= + oil + �� � + IRUSD 5

Where log(ER) is the log of NOK/USD, (oil) is the oil price and (IRNOK) and (IRUSD) denotes the 3-month interest rates in Norway and USA respectively. A tabulate summarising the results can be found below.6

Data source: FRED ECONOMIC DATA

As the dependent variable is NOK/USD, a decrease in this variable would imply an

appreciation of the Norwegian Krone relative to the US dollar. Hence, a one-dollar increase in the price of oil will according to this model lead to a 0.29% appreciation of the Norwegian Krone relative to the dollar, holding all other variables constant. Similarly, a 1% increase in the Norwegian interest rate leads to a 1.7% appreciation of the Krone. Both of these

observations are in line with empirical evidence and economic theory. The former supports the findings of Akram and Mumtaz (2016) which argues that long run correlation between the price of oil and changes in the exchange rate has increased. The latter support the research of Galati, Heath and McGuire (2007), who states that interest rate differentials can have a big impact on movements in the exchange rate. It is also providing evidence that the well-known theory of uncovered interest parity does not hold.

5 Note: a more complicated version of this regression will be used in my dissertation; Covered

Interest Parity, Uncovered Interest Parity and Carry Trade, 2017.

6 The observed results should not be taken as completely valid, as the model may suffer from

misspecifications and spurious correlation. But, it can provide a good picture of the developments in the exchange rate NOK/USD, which has been an efficient tool for the central bank of Norway to control the macroeconomic figures of concern.

Variable Coefficient Std. Error t-statistic Prob.

C 2.106898 0.023583 89.33849 0.0000

OIL -0.002855 0.000237 -12.06278 0.0000

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Growth and prospects internationally

As mentioned, Norway is a big exporter of oil. That means that its economy does not only rely on what happens domestically, but also outside its borders. The global picture both politically and economically has the last year changed drastically. Brexit changed the outlook for the European economy as a whole and made the pound sterling fall hard, but there is still uncertainty regarding the outcome of this matter. The presidential election in US has also had its impact on the financial markets. All-time highs on the stock exchange and more government spending seems to be the immediate effect of this, given that the president will go through with his promises. The FED has approached the monetary policy with a clearly hawkish attitude, saying that a further raise in the policy rate is very likely in the near future. Then there are also new elections in Europe in the year to come. Together with a heavily indebted Greece and Italy, this has ise uestio s a out the Eu opea U io ’s futu e.

What is next?

A further increase in the price of oil is not something that I see as unlikely in the near future, given that OPEC fulfils its statements that it will cut the production drastically. This will boost the Norwegian economy domestically but will probably be slowed down by a stronger currency. As mentioned, a dovish monetary approach has been prominent in the presentations from Norges Bank.

Faster growth in Europe and the US with increasing rates is an argument for higher rates in Norway as well, but uncertainty regarding the political developments both in Europe and in the US argues for great caution when setting the policy rate. Considering that the NOK is still weak seen from a historical perspective, rising public debt domestically, low rates globally and dovish comments in earlier presentations, this leads to my informal prediction of the

e t step i No ges Ba ks’ o eta poli , namely that the rate will stay at the current level of 50 basis points after the meeting on 16th of March 2017, given that the variables

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APPENDIX

1.1 Eviews output

Dependent Variable: LNOKUSD Method: Least Squares

Date: 02/10/17 Time: 12:51 Sample: 2007M02 2015M03 Included observations: 98

Variable Coefficient Std. Error t-Statistic Prob.

C 2.106898 0.023583 89.33849 0.0000

OIL -0.002855 0.000237 -12.06278 0.0000

IRNOK -0.016608 0.005719 -2.903807 0.0046

IRUSD -0.007798 0.005544 -1.406470 0.1629

R-squared 0.677608 Mean dependent var 1.784807

Adjusted R-squared 0.667319 S.D. dependent var 0.086454

S.E. of regression 0.049866 Akaike info criterion -3.119010

Sum squared resid 0.233738 Schwarz criterion -3.013501

Log likelihood 156.8315 Hannan-Quinn criter. -3.076334

F-statistic 65.85696 Durbin-Watson stat 0.182866

Prob(F-statistic) 0.000000

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References

Akram, F. and Mumtaz, H. (2016). The role of oil prices and monetary policy in the Norwegian economy since the 1980's. [online] 1. Available at: http://static.norges-bank.no/pages/104571/Working_Paper_01_16.pdf?v=2/2/201642937PM&ft=.pdf [Accessed 13 Feb. 2017].

Ec. europa.eu. (2017). Home - Eurostat. [online] Available at: http://ec.europa.eu/eurostat/ [Accessed 13 Feb. 2017].

Fred.stlouisfed.org. (2017). LIBOR Rates | FRED | St. Louis Fed. [online] Available at: https://fred.stlouisfed.org/categories/33003 [Accessed 12 Feb. 2017].

Galati, G., Heath, A. and McGuire, P. (2007). Evidence of carry trade activity. BIS Quarterly Review. [online] Available at:

http://www.bis.org/publ/qtrpdf/r_qt0709e.pdf [Accessed 12 Jan. 2017].

Norges-bank.no. (2017). Exchange rates. [online] Available at: http://www.norges-bank.no/en/Statistics/exchange_rates/ [Accessed 14 Feb. 2017].

Olsen, Ø. (2017). Monetary Policy Report. [online] http://www.norges-bank.no/en/. Available at:

http://static.norges-bank.no/pages/105894/MPR_4_2016.pdf?v=12/15/201622042PM&ft=.pdf [Accessed 13 Feb. 2017].

Ssb.no/en. (2017). External economy. [online] Available at:

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