IMF holds consultation meeting with Netherlands

The IMF says ongoing but necessary deleveraging of household and bank balance sheets will continue to weigh on economic activity over the medium term.

A pick-up in activity is predicated on a bottoming out of the housing market and a reduction in uncertainty. Policies should be geared towards supporting growth while minimizing downside risks and allowing for an orderly adjustment of private sector balance sheets. Given this balance sheet recession, fiscal policy should maintain its focus on medium-term structural targets while allowing automatic stabilizers to operate.

The banking system should shore up its capital buffers through private sources and retained earnings to reduce its vulnerability to funding and housing market uncertainty, and to prepare for Basel III capital requirements. Structural reforms to support long term growth and reduce volatility are required, although some of these will need to be sequenced appropriately.

Balance sheet deleveraging will continue to be a drag on the recovery. Despite the nominal 20 percent correction in house prices since 2008, there remains considerable uncertainty surrounding the future path of house prices, and the adjustment of household balance sheets to lower levels of indebtedness is expected to continue. This will continue to weigh on sentiment and consumption over the medium term. The banking system still remains heavily exposed to the real estate sector and dependent on wholesale funding, and its process of balance sheet adjustment is also expected to remain in train for the foreseeable future. Exports to the rest of the euro area are expected to pick up only gradually. Overall, under the baseline we therefore expect output to contract by 0.5 percent in 2013 before gradually recovering by 1.1 percent in 2014.

The baseline outlook is subject to a number of risks that are tilted to the downside. The interaction of household and bank balance sheets linked through changes in house prices makes the outlook subject to unusually large uncertainty.

Expectations that house prices need to adjust by more than is currently assumed would restrain both household consumption and lending by banks, which could in turn lead to a continuing cycle of falling house prices and deleveraging. Should uncertainty about fiscal and structural policies persist, household spending could remain subdued, postponing the recovery.