Denmark
2008 Article IV Consultation-Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Denmark
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International Monetary Fund
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Publication Date:
29 Dec 2008
eISBN:
9781451811230
Language:
English
Keywords:
ISCR; CR; IMF staff estimate; growth; growth prospect; maturing mortgage bond; personal income; public finance; exchange rate; government bond; current account; Fiscal stance; Labor markets; Unemployment; Global
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The key findings of Denmark’s 2008 Article IV Consultation are examined. The global liquidity crisis put the financial sector under severe stress, but most banks have weathered the crisis well owing to strong initial positions and supportive policies. The crisis accelerated a downturn that had begun in 2007 and tilted the balance of macroeconomic risk toward recession. The macroeconomic policy mix is appropriate, including higher interest rates to support the exchange rate peg and an expansionary budget to add a countercyclical thrust to the strong stabilizing effect of Denmark’s automatic stabilizers.

Abstract

The key findings of Denmark’s 2008 Article IV Consultation are examined. The global liquidity crisis put the financial sector under severe stress, but most banks have weathered the crisis well owing to strong initial positions and supportive policies. The crisis accelerated a downturn that had begun in 2007 and tilted the balance of macroeconomic risk toward recession. The macroeconomic policy mix is appropriate, including higher interest rates to support the exchange rate peg and an expansionary budget to add a countercyclical thrust to the strong stabilizing effect of Denmark’s automatic stabilizers.

I. Background

1. In Denmark, the global financial turbulence which gathered force in 2008 added fuel to a cyclical slowdown that had begun in early 2007. From the perspective of macroeconomic management, the timing of the crisis was fortuitous since the cyclical position was still strong and a slowdown was called for. From the perspective of financial stability, however, the timing was inopportune: banks with exposures to the slumping construction sector were writing down loans just when the crisis raised their funding cost and froze their foreign funding lines. Through the crisis, the authorities adhered to their macroeconomic policy framework—a euro peg and fiscal rules which allow full play to automatic stabilizers—while moving decisively to ensure banking system liquidity and reassure creditors. This report was written in the midst of the crisis. The policy discussions were held in late September, but the report also covers developments and policy responses through early November.

Implementation of Fund Policy Advice

Denmark’s policies are generally consistent with Executive Board views. Recent policy changes have been in line with some but not all the recommendations made in the 2006 Article IV consultation: the marginal tax rate on labor income is being cut, but the authorities have ruled out financing the cut by raising property taxes. Consistent with the 2006 Financial Sector Assessment Program (FSAP) recommendation, more resources have recently been announced for the financial system supervisor (DFSA) in order to facilitate more intensive risk-based supervision.

2. The slowdown began with a reversal of the factors that had fueled the 2005-07 upswing (Figure 1). The housing boom ended when mounting supply pricked the price bubble and slowed construction; ebullient consumer confidence wilted in the face of falling home values; and previously easy lending conditions tightened as interest rates rose and defaults on construction loans increased. Residential and business fixed investments declined and export growth decelerated. By late 2008 the slowdown was firmly in place but the output gap was still high and the labor market was still overheated (Figure 2).

Figure 1.
Figure 1.

Denmark: the downswing gathers pace

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Sources: Statistics Denmark and staff calculations.
Figure 2.
Figure 2.

Denmark: capacity constraints, costs, and prices, 2000-present

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Sources: Eurostat, Statistics Denmark, and staff calculations

3. The labor market responded to both upswing and downturn with a lag. Early in the boom, labor supply was expanded by structural reforms and an influx of workers from EU new member states. Consequently, the upswing had an unusually large impact on employment and an unusually small impact on wages. In mid-2007, however, wage growth finally picked up; it has remained strong despite slowing output growth, although the most recent data show some moderation. The tight labor market, a generous 2008 public sector wage agreement, and rising food and fuel prices have pushed nominal wage growth to about 4.5 percent, implying real wage growth in excess of productivity growth. The downward march of the unemployment rate ended in August but unemployment remains at a record low, well below the estimated NAIRU, and vacancy rates are high.1

4. Like wages, prices were quiescent during the first two years of the upswing and picked up only in late 2007. Inflation, kept low by wage moderation and favorable import prices, dipped below the eurozone level even as demand took off. But it accelerated to just under 5 percent in 2008, pushed up by food and energy prices and an increase in core inflation following the wage acceleration. Inflation expectations worsened starting in mid-2007, though they have since stabilized with the downturn in commodity prices and the global outlook.

5. Competitiveness is adequate, but trends in wages and productivity are unsustainable. CGER analysis suggests that the real effective exchange rate (REER) is well aligned—the three approaches show an average overvaluation of less than 2 percent (Text table). But wage competitiveness has been eroded by slower productivity growth and faster real wage growth than in trading partners (Figure 3). To date, the impact on the REER has been softened by structural shifts—a move towards higher-value added goods (sustaining profitability) and an improvement in the terms of trade (making real wages rise faster than product wages). Even so, the REER is high relative to recent norms, the external current account surplus has been narrowing, and Denmark’s share in global export markets has declined.

Figure 3.
Figure 3.

Denmark: Competitiveness Under Strain

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Sources: CGER, Direction of Trade Statistics, IFS, and World Economic Outlook.

CGER Estimates of REER Misalignment 1/

(in percent)

article image

MB: macrobalance; ERER: equilibrium real exchange rate; ES: external stability

6. The global crisis has put financial markets under strain but most banks, including the half dozen largest, have weathered it well. This reflects conservative investment strategies in a sound regulatory environment. Although mortgage lending has grown rapidly in recent years, against the background of a housing boom, credit risk management standards are high and market risk is limited because most funding is through covered bonds. Large commercial banks—accounting for about 80 percent of assets—and specialized mortgage banks are well-capitalized. But small and medium sized banks—which grew rapidly in recent years—have slim excess capital buffers (Table 7). Direct effects of the global crisis were small because exposure to U.S. subprime assets was limited and subsidiaries of foreign banks were subject to tight restrictions on intra-group exposures. Spillover risk from subsidiaries in the Baltics and Ireland was very small since they represented only about 5 percent of the parent bank’s credit portfolio and 2 percent of group profits. Instead, the main channels of contagion were increasing risk aversion and the drying-up of liquidity (Figure 4). Hardest hit were small and medium sized banks, which had increased their reliance on money market funding that now became difficult—and costly—to roll over. This gave rise to a clutch of mergers and takeovers, including a high profile central bank intervention in a midsize bank with an exceptionally weak loan portfolio. Fortunately, most banks entered the crisis with healthy capital buffers (Table 6), partly because the reduction of capital requirements under Basel II was phased in gradually.

Table 1.

Denmark: Selected Economic and Social Indicators, 2000–08

article image
Sources: IMF, World Economic Outlook; Danmarks Nationalbank; Statistics Denmark; OECD; Eurostat; and IMF staff projections.

Contribution to GDP growth.

Figures for 2007-08 reflect Ministry of Finance estimates and projections as of August 2007; pre-2007 numbers are from Danmarks Statistik.

In percent of potential GDP

Table 2.

Denmark. Medium-term Scenario, 2005–13

(Percentage change, unless otherwise indicated)

article image
Sources: Danmarks Nationalbank, Statistics Denmark, and IMF staff estimates.

Contributions to growth

In percent of GDP

In percent of potential output. Structural balance estimates differ from the Ministry of Finance owing to differences in (i) unemployment gap estimates; (ii) one-off changes to certain budget items; and (iii) accounting methodology.

Table 3.

Denmark: Balance of Payments, 2004–13

article image
Sources: Danmarks Nationalbank, Statistics Denmark, and IMF staff calculations.
Table 4.

Denmark: Net Investment Position, 2001–07

(in percent of GDP)

article image
Sources: Danmarks Nationalbank and IMF staff calculations
Table 5.

Denmark Public Finance, 2003–13

(in percent of GDP)

article image
Source: Statistics Denmark and IMF Staff calculations.

Note: The structural balance estimates differ from those of the Ministry of Finance due to: differences in (i) unemployment gap estimates; (ii) estimates of one-off, non-cyclical changes to certain budget items; and in (iii) accounting methodology.

Table 6.

Denmark: Indicators of External and Financial Vulnerability, 2003–08

article image
Sources: DFSA, Danmarks Nationalbanken, Statistics Denmark, IFS.

Shareholders’ equity to total assets.

Included in short-term liabilities are deposits available on demand and time deposits with original maturity of less than a year.

Bank external liabilities net of external assets to total liabilities.

Table 7.

Financial Soundness Indicators of major Danish banks

article image
Source: Danish Financial Supervisory Authority Notes:

Group I consists of the 5 largest banks; group II consists of the next 11 largest banks by assets. Taken together, assets held by these banks are 95 percent of banking sector assets.

Shareholders’ equity to total assets

Figure 4.
Figure 4.

Denmark: Developments in the Financial Sector

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Sources: Bloomberg, Danmarks Nationalbank, and Statistics Denmark.1/ Average of RBS, HBOS, HSBC, UBS and Barclays.2/ Difference between Non-MFI deposits and loans.

7. Denmark’s fiscal position is among the strongest in the EU (Figure 5). The expenditure ratio came down considerably during the last decade, though it is still high, reflecting the cost of the welfare state. With taxes even higher, the general government surplus is among the largest in the EU. Consequently, the debt ratio has declined to a little over 20 percent and interest rate spreads on government debt are negligible (though they have been pushed up by the financial crisis). The 4½ percentage point increase in the fiscal surplus since 2003 (Table 1, Text Chart) stemmed from cyclical factors—strong employment and reduced unemployment—as well as structural factors—rising North Sea oil and gas activities and lower net interest payments.

Figure 5.
Figure 5.

Denmark: Fiscal Developments in a European Perspective

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Source: Danmarks Nationalbank, IFS, and WEO.1/ Unweighted average.
uA01fig01

Denmark: strengthening fiscal performance,2002–07 1/

(percent of GDP)

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Source: Danish Ministry of Finance1/ Projections of actual balance (2008) and structural balances as of May 2008.

II. Outlook and Risks 2

8. The global financial crisis and downturn are clouding the outlook. Growth is expected to be weak through 2010 before reverting gradually to potential (Table 2, text table). On the domestic front, borrowing costs have risen and confidence has been shaken by falling home values, rising corporate defaults, and banking problems. Recent survey data indicate a downward slide in expectations of economic performance over the next 12 months; this should be reflected in sluggish consumption and weak investment. On the external front, export growth will be pulled down by slower growth in key export markets: Germany, Sweden, the United Kingdom, and the United States. But, assuming the global economy revives in late 2009, growth should remain in positive territory. In the near term, the slowdown in consumption will be cushioned by still high employment, rising real wages and fiscal automatic stabilizers. Over time, rising unemployment and weaker inflationary expectations should reduce wage pressures, enabling firms to rebuild profit margins and creating conditions for a pick-up in growth.

Denmark: Medium-term Outlook

(Percentage change, unless otherwise indicated)

article image
Sources: Danmarks Nationalbank, Statistics Denmark, and IMF staff estimates.

Contributions to growth

In percent of GDP

In percent of potential output. Structural balance estimates differ from the Ministry of Finance owing to differences in (i) unemployment gap estimates; (ii) one-off changes to certain budget items; and (iii) accounting methodology.

9. Considerable downside risk attends this central outlook. A more prolonged global recession could constrain export growth through 2010. Moreover, it may be difficult to reduce interest rates in the context of a flight to liquidity in global currency markets. In the immediate future, tight liquidity could push up interest rates on adjustable rate mortgages that will reset in December—which amount to 13 percent of GDP. Higher interest costs—just as unemployment starts rising—could lead to household belt-tightening, a spike in mortgage defaults, a further decrease in home values, and second-round effects on investment and employment (Box 2). This could pull the economy into a recession.

Housing and the Business Cycle

House prices overshot fundamentals during the recent boom and have yet to correct fully. 3 In these circumstances an increase in interest rates on adjustable rate mortgages combined with a rise in unemployment could trigger an abrupt adjustment. This would depress construction, drive up unemployment, and weaken the performance of real estate-related loan portfolios.

WEO estimates suggest that Danish housing prices were about 20 percent overvalued in December 2007 (text chart). Since then, prices have decreased only 2 percent, leaving them well above the level justified by fundamentals such as disposable income and construction cost.

A drop in house prices would raise unemployment significantly due to a large impact on construction. House prices have been highly correlated with residential construction; the high labor intensity of construction implies a correspondingly high impact on employment.

The impact on consumption could also be large. While the correlation between consumption and home values has been low in the past, the impact could be large when compounded by high interest costs, a collapse in share prices and rising unemployment.

The ultimate impact—magnified by a “financial accelerator”—could be protracted low growth and high unemployment. Foreclosures resulting from high interest rates on variable-rate mortgages could depress home values and undermine recovery on defaulted mortgages. Banks would make losses when balance-sheets were already damaged by rising unemployment, falling household wealth and weaker corporate balance-sheets. This could result in a longer period of tight credit and higher borrowing costs, delaying economic recovery.

uA01bx02fig01
1/ All indexes represent nominal prices.

10. Wage growth is a concern but appears to be moderating. As noted, rising wages are contributing to an erosion of competitiveness. Looking forward, however, rising unemployment, falling vacancy rates, and a trend towards more decentralized wage setting in the private sector should help break wage momentum.

III. Policies and Discussions

11. Faced with the global financial crisis, the authorities have taken steps to secure the twin anchors of their policy framework—the euro peg and fiscal automatic stabilizers. The peg stabilizes inflation by importing the ECB’s monetary stance. The authorities have reaffirmed their commitment to it and taken the steps needed—including interest rate hikes—to support foreign exchange reserves and maintain euro liquidity. Denmark’s fiscal rules have two objectives: long-term sustainability—achieved through a target range for the structural balance—and demand management—achieved via automatic stabilizers. Despite the possibly severe downturn the authorities plan to stick to this framework—relying on automatic stabilizers to cushion the slowing in demand without a discretionary fiscal impulse. Moreover, they have reduced the likelihood of a severe downturn with measures that should keep financial markets functioning and liquidity flowing.

A. Containing the Impact of the Global Financial Crisis

12. The response to the global crisis has been timely and comprehensive. The key objective has been to support confidence; the key measures have aimed to maintain liquidity and ensure that banks can honor all unsubordinated claims even if they come under stress.

13. Early efforts to alleviate liquidity shortages in the banks had mixed success, and were followed by more direct interventions. An attempt in May to revive the interbank market by introducing loan bills—usable as collateral at Danmarks Nationalbanken (DNB)—was not successful because it failed to address banks’ strong liquidity preference and aversion to counterparty risk. With small and medium sized banks frozen out of the money market, the DNB ratcheted up its response in September by broadening the set of collateral it accepts and creating a framework for uncollateralized lending to banks with excess capital. In October, in another attempt to revive the interbank market, a state guarantee was extended to interbank lending. Finally, banks’ need to service clients requesting dollar liquidity was met by a government issue of T-bills (which the US Federal Reserve accepts as collateral) and a central bank auction of funds obtained via a swap line with the Federal Reserve.

14. Foreign exchange market pressures in October have pushed up the interest rate. The market’s flight to liquidity included a shift out of krone into the deeper euro market, leading to reserve outflows. The authorities, whose monetary policy is focused tightly on sustaining the peg, responded by increasing domestic interest rates (now 175 bps higher than the euro rate), buttressing reserves with the proceeds of euro-denominated government borrowing, and arranging a currency swap with the ECB. The interest rate hike stemmed the outflow but it could push up mortgage financing costs when adjustable rates are reset in December. The episode has revived discussions of a new referendum on euro adoption, possibly in 2011.

15. In October, as the financial crisis deepened, the government and the banking sector agreed on an innovative and comprehensive framework to enhance financial stability (Box 3). The overriding objective was to build confidence. The framework embeds features aimed at normalizing the interbank market and avoiding disruptive suspensions of payments, It secures the financial participation of the private sector through a Private Contingency Association (PCA). It provides an incentive for distressed banks to seek pre-emptive private-sector solutions since shareholders of a bank wound up under the terms of the new Act lose control of it. It also promotes the consolidation of the sector by easing financial constraints that could block takeovers of distressed banks. Finally, eligibility requirements are designed to reduce domestic and cross country “beggar thy neighbor” effects. The framework has not yet been used, but some of its features—including financial participation by the PCA—were present in the resolution of Roskilde bank in July-August.

Agreement on Financial Stability

Key features of the agreement include a blanket guarantee and procedures for the orderly winding up of distressed banks. Parts of the framework are entrenched in a Financial Stability Act, that has the following key elements:

Guarantee of claims. All deposits and other unsecured claims on banks belonging to the PCA are guaranteed. 133 banks—and 99 percent of deposits—are covered.

Winding up company (WUC). Banks whose capital falls below the regulatory floor must allow a state-owned WUC to arrange for purchase or wind-up. All deposits and unsecured claims are honored but shareholders lose control of the bank.

Burden sharing. The PCA is set up as an insurance scheme. Member banks pay premia and make guarantees that, together, cover the first DKK 35 billion of losses incurred by the WUC (equivalent to 2 percent of GDP). Beyond that, losses are covered by the state, which also receives any profit earned by the WUC.

Level playing field. The guarantee covers all PCA member banks. It can cover branches abroad only if the host country has a similar guarantee. The Act also extends the coverage of the regular Deposit Guarantee Fund to Danish branches of foreign banks.

Addressing moral hazard and intensifying supervision. The Act has a framework for expelling a bank that takes on greater risk under the umbrella of the guarantee. Alternatively the DFSA may dismiss members of the board of directors or order the bank to dismiss a member of its management board.

Another key element of the agreement was an undertaking by participating banks not to pay dividends, create new redemption programs or initiate new share purchases.

16. Staff raised concern about the adequacy of the DFSA’s resources. The economic slowdown and continued pressure in global financial markets call for intensified monitoring of the financial sector. The transition to Basel II has expanded the DFSA’s supervisory mandate, and the mission—following-up on the 2006 FSAP—emphasized the need for resources to recruit and retain risk experts necessary to fulfill this mandate. The mission also pointed out that the difficulties of small banks during the downturn underscored the need to supervise them more frequently. The authorities increased the DFSA’s resources as part of the political agreement on financial stability.

17. The authorities emphasized that the introduction of the mortgage covered bond legislation in 2007 strengthens lenders’ risk management practices. The legislation tightens loan-to-value standards and provides incentives for commercial banks to strengthen market risk management by aligning securitization techniques more closely with the “balance principles” used by mortgage banks.

B. Macroeconomic Stabilization

18. Denmark’s macroeconomic framework relies to a large degree on automatic stabilizers. The peg rules out discretionary monetary policy since monetary conditions are determined by the exigencies of sustaining the peg (text chart). Under the current exceptional circumstances, this has meant raising krone interest rates despite a decline in euro rates. Discretionary fiscal policy is also tightly constrained—by fiscal rules enshrined in political agreements, by large expenditure entitlements, and by multi-year wage contracts. Denmark’s fiscal automatic stabilizers are among the strongest in Europe (text table)—reflecting high marginal tax rates and a social safety net that kicks in when unemployment rises.

uA01fig02

Monetary conditions index 1/

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Sources: Danmarks Nationalbanken, Statistics Denmark, WEO, and staff calculations.1/ Weighted average of interbank rate and detrended effective exchange rate, corrected for inflation (real index).

19. Within this framework the authorities are planning a gradual decline in the structural surplus over the next six years—a sustained moderate fiscal expansion. In part the decline reflects exogenous secular changes: a demographic shift is pushing up age-related expenditures while North Sea oil and gas revenues are declining. But there are also discretionary elements. First, a political accord (the “tax freeze”) caps tax rates, causing specific taxes—such as the real estate tax—to fall in real terms. Second, an unfinanced cut in personal income taxes, enacted in 2007, becomes fully effective in 2009. Third, a public sector wage agreement was negotiated this past spring and locks in wage increases of 12 percent over the next three years. And finally public consumption is projected to rise by 1 percentage point of GDP over the period. Taken together, these trends and policies will reduce the structural surplus from over 2 percent of GDP in 2007 to about zero by 2015.

Budgetary impact of a 1 percent change in GDP

(in percent of GDP)

article image
Source: OECD (2000)

20. For 2009, the mission and the authorities agreed in September that a close-to-neutral fiscal stance would be appropriate. While the economic slowdown was generating political pressure for fiscal stimulus, the authorities emphasized that the economy was still above capacity and unemployment was just bottoming out at an exceptionally low level. Moreover, automatic stabilizers could be expected to cushion the slowdown, and indeed a more serious recession, should it occur. Under the circumstances, they laid more emphasis on the salutary role of a slowdown in breaking wage momentum. Staff shared these views and also emphasized the need for a tight fiscal position to support long run sustainability. In the event, the adopted budget was in line with the targeted medium-term path described above, implying a fiscal injection—over and above automatic stabilizers—of about 0.6 percent of GDP.4

C. Fiscal sustainability

21. Denmark was among the first in the OECD to articulate and implement a long-term fiscal framework that addressed demographic challenges. The strategy rests on two pillars—accumulating assets while demographics and North Sea revenues are relatively favorable and implementing structural reforms to contain costs in the long run. In particular:

  • The government’s 2015 plan pre-finances old-age-related spending with structural surpluses that are targeted in a ¾ to 1¾ percent of GDP range through 2010 and above zero through 2015 (chart). This would raise net government assets to about 10 percent of GDP in 2015, after which they would start being drawn down.

  • Several waves of reforms have been implemented over the last two decades. The most important was the 2006 Welfare Agreement which will raise the age thresholds for voluntary early retirement pension—starting in 201 9—and old age pension—starting in 2024—and then index them to longevity. By reducing the old age dependency ratio (text charts), the Welfare Agreement improved the long-run structural fiscal balance by about 4 percentage points of GDP, effectively closing the long term fiscal gap.56 More recently, the 2007 Job Plan strengthened work incentives for pensioners, persons on disability, and the unemployed.

uA01fig03

Projected Fiscal Balances, 2007–15

(in percent of GDP)

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Sources: Danish Ministry of Finance and Statistics Denmark.Note: 1/ Projections through 2009 from May 2008 Budget Outlook and 2010-2015 from Convergence Program 2007
uA01fig04

Denmark: Impact of the Welfare Agreement on labor supply and the dependency ratio

Citation: IMF Staff Country Reports 2008, 379; 10.5089/9781451811230.002.A001

Source: Staff calculations.

22. Nevertheless, the authorities recognize that further measures are now needed. The tax freeze through 2015, the personal income tax cuts effective in 2009, and the government’s energy strategy, among other factors create a sustainability gap that would be filled by a permanent increase in the structural balance by 0.8 percent of GDP (text table). A Tax Commission (due to report in February 2009) and a Labor Market Commission (which issued a preliminary report in September 2008) have been established to come up with proposals:

Denmark: Fiscal Sustainability Gap

article image
Source: Ministry of Finance and IMF staff calculations

  • The mandate of the Tax Commission is to improve work incentives by lowering marginal tax rates on labor income. The commission is free, in principle, to propose compensating increases in other taxes—a welcome temporary thaw in the six year “tax freeze”. But its ability to strengthen medium-term sustainability is limited. First, the commission is required to present a revenue-neutral overall package. Second, real estate taxes are off the table—the commission does not have the mandate to reverse the decline in the effective tax rate caused by the freeze in assessed property values.

  • In contrast, the Labor Market Commission’s mandate is to improve long-term public finances. The Commission recently released a number of proposals—accelerate the Welfare Agreement’s program to raise the pension age, reduce the duration of unemployment benefits, shift the focus of active labor market programs from education to on-the-job training, and improve the recruitment of foreign labor. While these proposals would go a long way toward improving fiscal sustainability, the public reaction has been overwhelmingly negative, based on the view that it is too soon to re-negotiate the terms of the 2006 Welfare Agreement.

23. The mission discussed challenges and risks to closing the longer-term fiscal gap. First the fiscal benefits of the Welfare Agreement—and the cost to retirees—are back-loaded to 2019. While this allows ample time for planning; it also entails some risk that the political commitment may falter as implementation draws nearer. Second, policy measures to achieve the targets of the 2015 plan have not yet been identified. Third, there is a great deal of uncertainty regarding the fiscal costs of ageing, especially with respect to health and old-age care. Analysis by staff and by independent researchers suggests that the authorities’ assumptions might too optimistic. Fourth, Denmark will need to open its borders to the EU New Member States at end-2010. While most studies show that inward migration from these states is likely to have an insignificant effect on public finances, there are concerns that fiscal sustainability could be weakened by individuals gaming the eligibility rules. Finally, there are uncertainties associated with sustaining fiscal discipline at the local government level—though in this area some recent reforms look promising.

IV. Staff Appraisal

24. Denmark has weathered the global crisis well so far but conditions are still fragile. The economy is still cyclically strong but the weakening global outlook has increased the risk of a severe downturn. Financial markets’ shift towards risk-free liquid assets has put pressure on the exchange rate peg and widened interest rate spreads—between krone and euro as well as between government bonds and mortgage bonds. Against this background, policies need to address three challenges—find the right balance in steering the economy to a soft landing; support financial stability; and ensure that a decade-long effort to strengthen fiscal sustainability does not stall.

25. Macroeconomic policies need to be set in light of the exchange rate peg. The peg has served Denmark well—anchoring inflationary expectations and keeping interest rates within narrow spreads relative to the euro zone. The authorities’ supportive policy stance—a steady hand on fiscal policy through the crisis and a readiness to raise interest rates in the face of reserve outflows—is thus welcome.

26. The proposed 2009 budget strikes a good balance between allowing growth to slow and cushioning it from a severe recession. The 2007 cyclical slowdown was welcome given record low unemployment and fast rising wages, but the global crisis has increased the risk of a hard landing. Given the deterioration in the global outlook, the authorities’ 2009 budget proposal—which adds a discretionary positive impulse to the automatic stabilizers—is appropriate notwithstanding concerns about medium term sustainability.

27. The authorities’ responses to the financial crisis were innovative, forceful, and timely. The new liquidity facilities are comprehensive and the collaborative approach to resolving problem banks facilitated prompt decision-making and prevented contagion during a period of exceptionally fragile confidence.

28. The new financial stability act establishes clear rules and sound incentives. The main features of the agreement—a blanket guarantee and a transparent procedure for pre-emptive resolution should help secure creditor confidence. The burden-sharing rule protects the taxpayer but has contributed to a decline in banks’ share values. Other measures—intrusive but temporary—improve incentives for prudent behavior: the dividend moratorium will strengthen capital buffers; the greater powers extended to the DFSA punish risk-taking; and the elimination of shareholder control in a wound-up bank creates an incentive for preemptive private sector solutions. Also welcome are provisions that level the playing field in cross-border banking operations.

29. Current conditions underscore the importance of intensifying financial sector surveillance and supervision. The DFSA’s initiative to monitor liquidity risk more frequently and comprehensively is welcome. Although financial stability work is well established, there is scope for further strengthening, and it is important to ensure that the DFSA has the resources to recruit and retain appropriate staff in light of their expanded mandate under Basel II—the recently agreed increase is welcome.

30. Competitiveness is adequate, but recent trends are unsustainable. The REER is well aligned, but wages are rising faster than in trading partners while productivity is rising slower. Wage growth needs to slow if firms are to rebuild profitability and stem the decline in Denmark’s export share. Otherwise firms will be stressed by a simultaneous increase in costs and slowdown in demand.

31. Upfront action is needed to ensure fiscal sustainability. The achievements of the past two decades have been remarkable, but they do not close the long-term fiscal gap.

Difficult choices are required in order to make the welfare state compatible with labor market incentives and long term fiscal balance.

  • Tax reform needs to be more comprehensive. A broader set of measures should be considered, including user fees, the indexation of the tax on residential property and reducing the deductibility of mortgage interest.

  • On the expenditure side, the proposals recently presented by the Labor Market Commission deserve careful consideration.

32. Denmark’s continued generous provision of foreign aid is welcome. Denmark is committed to maintaining development assistance at the internationally high level of 0.8 percent of gross national income.

33. Staff recommends that Denmark remain on the 24-month consultation cycle.

1

See the Selected Issues paper “Labor market reforms, changing demographics, and the Danish NAIRU” by Jay Surti.

2

The near-term outlook has deteriorated since the discussions. Growth projections for 2008-10 have been revised downward by 0.2-0.4 percentage points since September and the output gap, which was projected to gradually decline towards zero is now projected to be negative in 2009–12.

3

See International Monetary Fund (2008) World Economic Outlook, April, Chapter 3.

4

This corresponds to a 0.4 percentage point change in the authorities’ estimate of the structural balance as of August 2008.

5

It also covers the EC Ageing Working Group’s 2005 estimate of long-run ageing costs of 3.6 percent of GDP.

6

See the selected issues paper “Demographic Changes and Fiscal Sustainability in Denmark” by Allan D. Brunner.

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Cover IMF Staff Country Reports
Denmark: 2008 Article IV Consultation-Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Denmark
Author:
International Monetary Fund
Volume/Issue:
Volume 2008: Issue 379
Publisher:
International Monetary Fund
ISBN:
9781451811230
ISSN:
1934-7685
Pages:
42
DOI:
https://doi.org/10.5089/9781451811230.002
Figure 1.

Denmark: the downswing gathers pace
Figure 2.

Denmark: capacity constraints, costs, and prices, 2000-present
Figure 3.

Denmark: Competitiveness Under Strain
Figure 4.

Denmark: Developments in the Financial Sector
Figure 5.

Denmark: Fiscal Developments in a European Perspective

Denmark: strengthening fiscal performance,2002–07 1/

(percent of GDP)

Monetary conditions index 1/

Projected Fiscal Balances, 2007–15

(in percent of GDP)

Denmark: Impact of the Welfare Agreement on labor supply and the dependency ratio