The Netherlands' EU Stability Pact Dilemma

1. This message was jointly drafted by Embassy The Hague
(Econ-Schultz), USEU Brussels (Econ-Brown), and ConGen
Frankfurt (Treasury-Wallar)



2. Summary. The Netherlands' proposed EU stability program
to be considered by the Ecofin Council July 14-15 is based
on outdated numbers and presents a more optimistic outlook
than more current forecasts. Finance minister Gerrit Zalm
will have to confront slow growth and a growing deficit over
the next two years that risk breaching the EU Stability and
Growth Pact, jeopardizing the EU's "close to balance" target
for 2007, and spotlighting Zalm's reputation as the
Council's hard man on fiscal deficits. Self-imposed EMU
deficit targets agreed in the Dutch government's coalition
accord commit the center-right coalition to take measures
when these targets are breached. In view of rapidly
deteriorating economic growth prospects, budget
retrenchments needed to redress the deficit problem seem
unavoidable unless the deficit targets in the coalition
accord are abandoned. Finance Minister Gerrit Zalm held
fast to his principles at the June Ecofin in objecting to
lenient treatment for France under the Pact's excessive
deficit procedure. He will find it difficult to be as tough
on the dutch government budget performance if the Dutch
economy hits the skids predicted by these current forecasts.
End summary.



3. New forecasts conflict with the assumptions underlying
the Netherlands' revised EU stability program, due to be
considered by member state finance ministers at the July 14-
15 Ecofin Council. The numbers threaten to confront Finance
Minister Gerrit Zalm with a dilemma he never had to face
during eight years of economic upturn: slow growth and a
rapidly growing deficit.



4. The revised Netherlands' economic outlook for 2003-2004

2003 2004
(y/y percentage change)
GDP 0 1.25
Consumption 0.5 1
Investment -3.5 -0.5
Exports 0.5 5
Inflation 2.25 1.25
Unemployment 5.5 6.75
(percent of GDP)
EMU-Deficit -1.9 -2.6



5. The Hague Economic Officers and Senior Economic Adviser
discussed the Dutch program with European Commission and
Dutch permrep officials June 19 in Brussels. The European
Commission's assessment of the Dutch proposal, the final
country report in the EU's annual stability/convergence
program exercise, forecast improving growth and a falling
deficit. It is based on assumptions of 0.75 per cent GDP
growth in 2003 increasing to 2.5 percent in 2007, leading to
a nominal general government deficit of 1.6 per cent of GDP
in 2003, 1.7 percent of GDP in 2004, and a 0.5 percent
"close to balance" deficit target for 2007.



6. However, Council consideration of the report has been
delayed because of the Dutch May 2003 general elections and
the following change in government. Not surprising, the
growth assumptions on which it is based have been overtaken
by events. In the interim, a bleaker than expected outlook
for a recovery of world trade growth has led to recent
downward revisions of GDP growth forecasts varying from
stagnation (official Bureau for Economic Policy Analysis
(CPB) and major commercial banks) to a 0.4 percent fall in
GDP in 2003 followed by 1.25 percent growth in 2004 (recent
Netherlands Central Bank forecast). The leaked, but yet
unconfirmed, CPB scenario predicts a drop in tax revenues to
catapult the nominal deficit to 1.9 per cent (10 billion
euros) in 2003 and to 2.6 per cent (13 billion euros) in


2004. As a result, the budget deficit in 2007 increases to
0.9 percent of GDP, well away from the EU's 0.5 percent
"close to balance" target.



7. The growing deficit forecast could lead to two serious
consequences by the end of 2004:

o A fiscal deficit only 0.4 percentage points below the 3
per cent ceiling mandated by the EU Stability and Growth
Pact; and

o Exceeding the 2.5 per cent self-imposed EMU deficit
ceiling contained in the recently-published Government
Coalition Accord.



8. Zalm's options appear to be limited. He can:

o Let the deficit run its course, stick to the hefty 13.1
billion euro consolidation package announced in the
Coalition Accord and avoid the negative effects on GDP
growth of further spending cuts or tax increases; or

o Propose further measures (spending cuts and/or tax
increases) to steer the deficit away from the government-
accord and Stability Pact deficit ceilings and thus cause a
drag on growth



9. Under the first option, the Netherlands risks joining
Portugal, Germany and France in the Stability Pact's "sin
bin", the excessive deficit procedure. This could dent
Zalm's reputation among his fellow finance ministers as "Il
Duro" (the tough one). If, on the other hand, economic
recovery in 2004 would help steer the deficit back on course
towards balance, Zalm would not have to react immediately.
He would, however, be prepared for additional deficit
reduction should economic recovery not take hold in the
second half of 2003.



10. Under the second option, Zalm would have to propose
cutting spending by another 0.1 percentage point of GDP (0.5
billion euro on top of the 13.1 billion euro consolidation
package already agreed) in order to reduce the deficit in
2004 from 2.6 to the self-imposed 2.5 percent deficit target
in the coalition accord. But should the coalition-
government stick to its goal to reduce the deficit during
the next four-year period by an accumulated 1.8 percent of
GDP to reach the EU's close-to-balance criteria in 2007,
Zalm would have to take extra measures to the tune of at
least 4 billion euro (0.4 percent of GDP). This would risk
putting a damper on public spending and investment, serving
as a possible drag on economic recovery. Raising taxes to
bring the budget towards balance does not seem an option at
the moment. It would strike at the roots of one of the
objectives in the coalition accord of reducing the general
(tax) burden to help raise the Netherlands' long-term growth
potential.



11. Dutch PM Jan-Peter Balkenende admitted June 28 that
extra measures to keep the deficit increase at bay, should
the bleaker economic outlook hold, are unavoidable.
Balkenende remained vague about the magnitude or the nature
of additional budget measures. Although the Dutch PM
agreed that sticking to the coalition accord deficit
reduction target would require draconian spending cuts, he
did not want to speculate about the possibility of
abandoning the target. Finance Minister Gerrit Zalm held
fast to his principles at the June Ecofin in objecting to
lenient treatment for France under the Pact's excessive
deficit procedure (reftel). He will find it difficult to be
as tough on the Dutch government's budget performance if the
Dutch economy hits the skids predicted by these current
forecasts.



12. Since additional cuts in spending are hard to find or
are politically sensitive, pressure on labor unions to
observe wage moderation, as an alternative means to cut
spending, is likely to increase. Wage moderation is seen as
having double benefits: reducing the wage bill in the public
sector would narrow the deficit gap, and reducing it in the
private sector would help to restore the seriously eroded
Dutch competitive position. Whichever route the center-
right coalition chooses to go to meet its EU and EMU budget
commitments it is likely to create political unrest and
affect business and consumer sentiment. Recent surveys show
that public anxiety about the deterioration of public
finances and opposition to the proposed spending cuts is
rapidly growing.

SOBEL