Denmark: Staff Report for the 2017 Article IV Consultation

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Denmark

Abstract

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Denmark

Context

1. The economy has recovered from crisis and is approaching potential. On upwardly revised national accounts data, Denmark surpassed its pre-crisis output level in 2014. Although the pace of growth in recent years has been markedly lower than it had been before the crisis, speed limits seem to be appearing on the horizon. Estimates of potential output remain surrounded by considerable uncertainty, but both staff and the authorities estimate that the remaining output gap is small and that it will close in 2017 or 2018. There are also signs that capacity constraints are already starting to bind in some sectors. The coincidence of low growth—which has been lagging peers for considerable time—and increasingly binding constraints highlights Denmark’s reduced growth potential, reflecting in particular structurally weak productivity growth and low domestic investment levels.

A01ufig1

Growth of Real and Potential GDP

(Percent)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: IMF World Economic Outlook and Fund staff calculations.

Low Growth Meets Capacity Constraints

2. Low but steady growth continues. Muted by a negative carryover from the previous year, GDP growth in 2016 is estimated at 1.3 percent—about ¼ percent lower than the two previous years—but the underlying growth momentum remained steady (Figure 1, Table 1). Supported by negative interest rates and ongoing improvements in the value of household assets, activity was driven by strong private consumption growth with increasing contributions from private investment. The contribution from net exports was negative as buoyant imports outpaced exports, which remained subdued owing to slow euro area growth.

Figure 1.
Figure 1.
Figure 1.

Denmark: Recent Developments

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Table 1.

Denmark: Selected Economic and Social Indicators, 2013–22

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Sources: Danmarks Nationalbank, Eurostat, IMF World Economic Outlook, Statistics Denmark, and Fund staff calculations.

Contribution to GDP growth.

Based on Eurostat definition.

General government.

Overall balance net of interest.

Cyclically-adjusted balance net of temporary fluctuations in some revenues (e.g., North Sea revenue, pension yield tax revenue) and one-offs.

A01ufig2

Contributions to Real Growth

(Percentage points, yoy percent change)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Statistics Denmark and Fund staff calculations.

3. The labor market is strong, and capacity constraints are starting to bind. Employment has risen steadily in recent years, supported by increases in labor participation (Figure 2). Unemployment has fallen from 7.6 percent in 2011 to 6.2 percent in 2016 and is now close to its estimated structural level. Firms increasingly report labor shortages as an impediment to production—notably in the construction sector—and the ratio of total vacancies to unemployed persons is rising. Real wage growth has also been rising in recent years, though not out of step with that elsewhere in Europe. Meanwhile, capacity utilization in the manufacturing sector is hovering around its long-time average—reinforcing the picture of an economy close to its equilibrium.

Figure 2.
Figure 2.
Figure 2.

Denmark: Labor Market

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

A01ufig3

Unemployment and Employment Rates

(Percent of labor force; percent of working age population)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Statistics Denmark, OECD, and Fund staff calculations.
A01ufig4

Capacity Utilization

(Percent)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Source: Statistics Denmark and Fund staff calculations.

4. Inflation has started to rise, albeit from a low level. With the earlier impact of oil prices gradually dissipating, headline inflation has risen, reaching 1.0 percent in April 2017. The Danish inflation rebound, however, has lagged behind recent reflation in the euro area on account of a number of idiosyncratic factors, including a one-off reduction in telecommunication tariffs owing to delayed compliance with new EU rules on roaming charges, comparatively weaker pass-through from oil, and a drop in clothing prices.

A01ufig5

HICP Headline Inflation

(Y/Y percent change)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Eurostat and Fund staff calculations.

5. House price increases continue to be rapid in urban areas and for flats. Reflecting a multitude of factors including low mortgage interest rates, rising incomes, and supply constraints, house prices have been rising steadily across Denmark with real average prices up 4 percent year-on-year in 2016 (Figure 3). For the country as a whole, levels are now reaching roughly halfway between the pre-crisis peak and the 2011 trough. Prices for flats and properties in the major metropolitan areas, however, continue to rise considerably faster than the national average and are close to their pre-crisis levels. The ratio of household debt to disposable income has edged off somewhat from its 2010 peak, but its level remains the highest in the OECD.

Figure 3.
Figure 3.
Figure 3.

Denmark: Housing and Household Debt

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

A01ufig6

Real Property Prices 1/

(Index, 2005Q1 = 100)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Association of Danish Mortgage Banks; Statistics Denmark; and IMF staff calculations.1/ Prices are deflated by CPI. National average and Copenhagen are the weighted averages of owner-occupried flats and one-family houses nationally and in Copenhagen, respectively.

6. The current account surplus has fallen, but remains large. After peaking at just over 9 percent of GDP in 2015, the current account surplus came down to about 8 percent in 2016, largely reflecting lower services exports (Figure 4, Tables 2, 3). Denmark’s recently high surplus is heavily impacted by offshore trading activities (such as merchanting trade) and high earnings on its increased stock of foreign assets. These factors reflect Danish firms’ increasing orientation toward overseas activities and integration in global value chains. The surplus also reflects high private sector savings (including due to the large, funded second pillar pension system) and a dearth of domestic investment since the global crisis. Applying the External Balance Assessment (EBA) methodology, staff assess the external position to be stronger than implied by medium-term fundamentals (Annex I). This assessment, however, is subject to important uncertainties. The current account surplus is forecast to decline over the medium term as domestic investment rebounds and net retirement savings start to taper off after population aging peaks.

Figure 4.
Figure 4.

Denmark: External Sector

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: IMF DOTS, World Bank, World Economic Forum, Haver Analytics, and Fund staff calculations.1/ Excluding DEU, FRA and NLD.
Table 2.

Denmark: Balance of Payments, 2013–22

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Sources: National Bank of Denmark, Statistics Denmark, and Fund staff calculations.
Table 3.

Denmark: Net International Investment Position, 2010–15

(In percent of GDP)

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Sources: International Financial Statistics and Fund staff calculations.
A01ufig7

Current Account and NIIP

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: IMF Balance of Payments Statistics and Staff calculations.

7. The fiscal stance has tightened and become more neutral. Recent data revisions significantly reduced the headline 2015 fiscal deficit (from 2.1 percent of GDP to 1.3 percent) and the deficit shrank moderately further in 2016 to −0.9 percent of GDP (Figure 5, Tables 4, 5). Excluding the effects of the many one-off factors that have impacted the headline fiscal balance in recent periods, the structural balance improved by 0.7 percentage point in 2016 to an estimated deficit of 0.4 percent of potential output. The authorities have thus been making good progress with unwinding the large fiscal stimulus provided during the crisis, and public finances have been moving toward a more neutral stance, in line with the pace of the recovery. Owing to many years of high surpluses prior to 2008, the public debt stock, at 40 percent of GDP, remains modest and well below the Stability and Growth Pact (SGP) benchmark. A debt sustainability analysis points to a gradually declining public debt ratio over the medium term (Annex II).

Figure 5.
Figure 5.
Figure 5.

Denmark: Fiscal Sector

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Table 4.

Denmark: Public Finances, 2013–22

(In percent of GDP)

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Sources: Statistics Denmark and Fund staff calculations.

Overall balance net of interest.

In percent of potential GDP.

One-off items relate to vehicle registration tax, pension yield tax, North Sea oil and gas revenue, net interest payments, and other special items.

Table 5.

Denmark: GFSM 2001 Statement of General Government Operations, 2013–22

(Bln. Danish Kroner)

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Sources: Statistics Denmark and Fund staff calculations.
A01ufig8

General Government Balance

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: IMF World Economic Outlook and Fund staff calculations.

8. Nominal credit growth remains weak, reflecting low demand. Following a rapid credit expansion in the 2000s, private sector credit growth decelerated sharply after the global financial crisis. And despite an environment of negative interest rates, credit growth has remained well below its long-term trend since 2012 as firms and households continue to repair their balance sheets. Aggregate private sector credit remained broadly flat also in 2016, with credit to nonfinancial corporates falling by 1.6 percent. Household credit grew modestly overall, at 1.1 percent, but with large differences between regions.

A01ufig9

Credit Gap: Actual - Trend Private Sector Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Source: BIS.
A01ufig10

Stock of Oustanding Credit

(Bln. of kroner)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Source: Danmarks Nationalbank.

A Mostly Benign Outlook, with Evolving Risks

9. The baseline outlook is for continued moderate growth and gradually rising inflation. Growth is projected at 1.5 percent in 2017, and hovering in subsequent years around 1¾ percent, or close to Denmark’s estimated medium-term growth potential. Activity is expected to be driven by strong and increasingly balanced private demand. Low interest rates and the buoyant housing market should continue to support private consumption in the short term. Investment is expected to continue its rebound, initially on rising construction activity, but gradually becoming more broad based as balance-sheet repair progresses and the need to alleviate domestic capacity constraints becomes increasingly pressing. Exports are also forecast to increase, on stronger external demand, though the contribution of net exports to growth is expected to remain small. As the economy continues to operate at a level close to capacity, inflation and wages are set to gradually rise further.

10. The outlook is subject to substantial risks (Annex III). Domestically, increasing labor shortages in the face of growing demand could constrain medium-term growth prospects and accelerate wage and price growth. On the other hand, sustained increases in labor participation could mitigate such pressures. Continued house price rises would further increase households’ exposure to shocks, including from rising interest rates. External risks include lower than expected growth in the euro area, rising political and geopolitical uncertainties with intensification of risks of fragmentation in Europe, and global trade disruptions. On the other hand, greater than expected gains in consumer and business confidence abroad could promote stronger consumption and investment, which would benefit Denmark. Sharp increases in global yields would tighten financial conditions with adverse effects on consumption, investment, the housing market, and export markets. Any sharp reversal of high house prices in Sweden, would also affect financial conditions negatively given the close linkages of the regional banking system.

Authorities’ Views

11. The authorities broadly agreed with staff’s assessment of developments and risks. They concurred that the economy is close to potential and that capacity constraints are becoming more binding, noting this could weigh on growth. Danmarks Nationalbank (DN) shared staff’s concerns about household resilience and rising house prices, though government officials were somewhat less concerned. Authorities mostly agreed on external risks but, except for the DFSA, did not see imminent risks from the Swedish housing market. The authorities agreed the current account surplus is large, but stressed this was the aggregated result of individual decisions by households and firms in a free market economy. They also pointed out that, in contrast to many other countries, Denmark does not have unfinanced pension obligations—a desirable feature which has contributed to savings. They did not see major imbalances in the economy or distortions from policies.

Policies for Sustained Growth

12. Economic policies should alleviate capacity constraints and raise potential growth. Macroeconomic policies should gradually become more neutral, in line with Denmark’s cyclical position. On fiscal policy, it would be appropriate to slow the pace of consolidation relative to earlier plans to facilitate tax cuts and new labor market reforms. Structural policies need to be strengthened to boost the growth potential of the economy, including by further raising labor supply and by promoting investment. A slowdown in fiscal consolidation and higher public and private investment would also help reduce the current account surplus. Macroprudential measures are needed to bolster household resilience to shocks and contain medium-term housing risks.

A. Macroeconomic Policies—Towards a Neutral Stance

Fiscal Policy

13. The authorities consider slowing the pace of fiscal consolidation modestly to provide room for tax cuts and possible reforms. With the 2016 deficit at 0.9 percent of GDP, faster progress has been made towards medium-term consolidation goals than earlier envisaged. For 2017, however, the authorities anticipate small increases of the headline and structural deficits, indicating a slight temporary loosening of the fiscal stance. Both the headline and the structural deficit (which is slightly lower on the authorities’ estimate than on staff’s) will, however, comply with SGP rules in 2017 and 2018, as well as with Denmark’s own budget law—which stipulates that the structural deficit should not exceed ½ percent of GDP. Beyond the near term, the government has been considering delaying meeting its zero structural balance objective by 5 years to 2025 to provide room for maneuver over the next few years. In the previous government’s “2025 plan,” presented last year, this room was intended for a combination of cuts to income taxes and reforms to boost labor supply. However, the plan was subsequently shelved and, against a backdrop of increasing reform fatigue, recent discussions suggest there is a risk that labor market reforms will be postponed.

Key Indicators for the General Government

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Source: IMF Staff calculations.

Percent of potential GDP.

14. Staff agreed that a slower pace of consolidation would be appropriate but emphasized that capacity-enhancing reforms are a priority. Denmark’s public finances are broadly sustainable and there is fiscal space. Also, the current fiscal stance appears broadly appropriate for the cyclical position of the economy and, with the structural balance expected between -½ and zero percent, it will remain broadly neutral for the foreseeable future. Against this backdrop, staff supported the government’s intention to modestly ease the fiscal consolidation path. Such a slower pace of fiscal consolidation will also be conducive to a faster adjustment of the current account. To ensure positive supply effects, however, staff stressed that it would be critical that useful tax measures— such as an earned-income tax credit for low-income earners and bonus deductions for R&D investments—are complemented by strong labor market reforms, including earlier envisaged measures to raise the retirement age faster and limit student grants to prescribed study periods. Staff also cautioned that a more countercyclical fiscal stance would be called for if growth turned out substantially faster than expected.

15. Shifts in the composition of fiscal outlays could help boost growth. Staff also observed that although Denmark’s fiscal outlays are among the highest in the OECD, spending on public investment is below that of peers—even after post-crisis increases. At the same time, international rankings indicate that the quality of specific components of public infrastructure leave room for improvement. This suggests that a shift in the composition of spending, away from consumption and transfers, to productive public investment could improve public resource allocation. Useful areas for investment include the development of housing in the larger cities and upgrading the transport infrastructure (e.g., rail and ports) in view of increasing demands. Such investments would support sustainable medium-term growth and help reduce the savings-investment gap. Making more resources available for the education of migrants could help raise labor supply. On the revenue side, efforts to reduce Denmark’s high tax rates could also help spur growth, and should be combined with a reduction—and eventual phase out—of mortgage interest deductibility (see also below).

Monetary Policy

16. Currency pressures have mostly abated as interest rates remain significantly negative. Amid strong appreciation pressures in early 2015, DN intervened heavily in the FX market and lowered its deposit policy rate to −0.75 percent to safeguard the peg of the Danish krone to the euro. Since then, easing pressures have allowed the DN to unwind its FX purchases and to narrow interest margins relative to the ECB policy rate—including by raising the deposit rate by 10bp to - 0.65 percent in January 2016. Since early 2017, likely reflecting heightened policy uncertainties in the US and Europe, the krone has strengthened somewhat against the euro, prompting some DN interventions in the FX market—for the first time since the minimal interventions post Brexit—but pressures have remained modest thus far.

A01ufig11

Policy Rate Differential with European Central Bank

(Percent)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Danmarks Nationalbank and ECB.
A01ufig12

FX interventions and the Exchange Rate

(Bln. DKK)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Haver Analytics and Fund staff calculations.

17. The DN should remain ready to defend the peg and continue to normalize rates as conditions allow. As conditions in the euro area normalize, it would be appropriate to gradually reduce spreads relative to the ECB, if market conditions permit.

Authorities’ Views

18. The authorities viewed the fiscal stance as appropriate given the current outlook. They concurred that further strong labor market reforms, complemented with tax reductions, should be a priority to help sustain growth and ease labor supply constraints over the medium term. However, they pointed to increasing resistance to reform following the major reforms in recent years, which could reduce the political feasibility of such measures. While the authorities agreed that productive public investment could help support growth, they did not see the Danish level as particularly low and noted that in practice it was hard to distinguish between public and private investment owing to public-private partnerships. On monetary policy, the central bank underscored that maintaining the peg to the euro was the exclusive policy objective.

B. Housing Policies—Containing Building Pressures

19. House prices continue to rise, particularly in regions with strong new credit creation. In a context of historically low interest rates, significant housing supply constraints, and adverse tax incentives, house prices continue their upward trend. As in recent years, the increases remain most prominent in the major metropolitan areas, such as Copenhagen (up 10 percent year-on-year in 2016), and for flats (up 7 percent in 2016). While nation-wide nominal household lending has been rising slowly at about 1 to 1½ percent per year in the last two years, a concern is that the faster property price increases overlap with the regions with relatively rapid increases in new mortgage lending. This could potentially create pockets of unstable credit expansion that chase rising property prices, for example, among first-time home buyers.

A01ufig13

House Price and Mortgage Lending Changes in Denmark

(Percent)

Citation: IMF Staff Country Reports 2017, 158; 10.5089/9781484301586.002.A001

Sources: Danmarks Nationalbank; and Association of Danish Mortgage Banks.

20. While a shock to the housing market would probably not pose an acute threat to the banking system, macroeconomic risks are substantial. High household leverage and volatile house prices have historically not posed major credit risks to lenders and recent DN stress tests suggest relatively modest risks for banks even in the most severe scenarios. However, shocks to house prices or a prolonged rise in borrowing rates could impact household consumption and affect macroeconomic stability. While Danish households have large assets (mostly in housing and pensions), these tend to be mostly illiquid and provide limited effective buffer for consumption, as was highlighted by the sharp drop in consumption following the last housing bust. Also, with current debt service ratios at their lowest level in decades, rising interest rates could have a substantial effect, especially as some 60 percent of mortgages now have floating rates. Vulnerabilities would be particularly pronounced for specific, leveraged household groups.1 Related concerns featured prominently in warnings issued by the European Systemic Risk Board last fall.

21. The authorities are considering additional macroprudential measures to curb risks. In recent years, the authorities have adopted key supervisory guidance to address rapid housing price increases, including two “diamonds” with supervisory guidance for mortgage credit institutions and banks, best practices for banks’ risk management, and a five percent down payment requirement (see 2016 Article IV report for details). The impact of these measures on lending standards, however, has been only modest and short-lived. More recently, in line with staff advice, the DN and the Danish Financial Supervisory Authority (DFSA) have begun examining additional macroprudential tools and in March the Systemic Risk Council (SRC) adopted a recommendation that the government caps the loan amount of variable-rate and interest-only loans in the Copenhagen and Aarhus areas to four times the borrowers’ income. Meanwhile, a recent, albeit small, increase in the LTV-ceiling for vacation homes from 60 to 75 percent runs counter to the efforts to reduce housing risks.

22. A recently agreed reform of property taxation is a step forward. In May, the government announced changes to the property and land tax systems to end the property valuations freeze in place since 2002. Under the new system, to be introduced in 2021, property tax amounts will again rise proportional to house price increases, thus eliminating the procyclical impact of the freeze. However, to protect homeowners from tax increases while they occupy their home, the payment of tax increases after 2021 are deferred until the home is sold, which could discourage mobility in the housing market. Another feature of the new system is that future property tax revenues above an expected structural target will be used to lower tax rates, thereby potentially creating a new element of procyclicality although specific modalities are yet to be decided.

23. Staff advocated pushing ahead with macroprudential and other policies to safeguard macrofinancial stability. Recommended measures span several policy areas.

  • Macroprudential policies. Staff reiterated its call for putting in place a DTI limit and welcomed the SRC’s proposal. It suggested, however, that a general cap should apply to all loans, irrespective of the loan terms, possibly with tighter limits for interest only and variable rate instruments. It also called for raising the down payment requirement to at least ten percent to help further shield households from excessive indebtedness. Minimum amortization requirements should also be considered. For example, Sweden requires that borrowers make annual payments of at least 1 percent of the principal for mortgages with LTV over 50 percent and 2 percent for those with LTV above 70 percent. To further reduce risks from variable interest rates, the authorities should consider tightening the guidance in the mortgage diamond by further reducing the maximum share of such loans in banks’ portfolios.

  • Mortgage interest deductibility and property tax reform. The broad housing recovery and current low interest rates provide a conducive environment for reducing the tax deductibility of mortgage interest expenses and for further lowering, beyond what is currently planned, the value of the deduction for interest payments. Homeowners in Denmark are already exempt from capital gains taxes on the sale of their primary residence, and further lowering mortgage interest deductibility—or phasing it out entirely as in Ireland, Spain and the UK—can help reduce the debt bias in the tax system. Separately, it will also be key that the tax rebate system agreed in the property tax reform is designed so as to set a high bar for future tax rate reductions.

  • Supply policies. Addressing longstanding housing supply constraints, such as strict zoning regulations, procedures for land development, and rental market regulations, can also help ease housing price pressures by improving the responsiveness of supply to housing demand.

Current Mortgage Interest Deductibility from Personal Income Taxes

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Sources: National tax and other authorities; Bourassa et al. (2013); Smidova (2016).

Authorities’ Views

24. The authorities agreed that house price increases in certain areas called for vigilance. The DN favored a further expansion of the macroprudential toolkit and strongly supported the SRC’s DTI recommendation. The government, however, had yet to take a position on the proposal and argued that several key measures (such as the best practices for bank’s risk management) had been taken in recent years and that it would be useful to evaluate their impact. The property tax reform was mostly seen as a step forward, although the DN shared staff’s concerns about reduced mobility and the procyclicality of future tax rebates. The government noted that there had been plans for reducing the mortgage interest deductibility, which could potentially still be considered at some later date.

C. Financial Sector Policies—Underpinning Stability

25. Denmark’s large financial system appears sound. The financial system is large (with assets of about 700 percent of GDP), complex, and closely intertwined with that of Nordic neighbors, but appears generally in good health. All systemic banks have capital buffers in excess of regulatory minima, with the system-wide regulatory tier 1 capital ratio currently at about 21 percent (Table 6). Short-term liquidity requirements are met comfortably, with all systemic credit institutions exceeding the current minimum liquidity coverage ratio (LCR). Despite the decline of their net interest margin, banks have also remained profitable owing to greater fee income, one-off proceeds (including divestments), charge-backs of loan-loss provisions, and cuts and efficiency improvements that have reduced operation expenses. Meanwhile, insurance firms and pension funds have been adjusting their product designs to cope with the low interest rate environment, in particular by shifting away from guaranteed-return products to market-based products. Insurance stress tests show that Danish insurance firms would be less affected in stress scenarios than their peers abroad, including because their interest-rate sensitivity is reduced by using derivatives.

Table 6.

Denmark: Financial System Indicators, 2010–16 1/

(In percent)

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Source: Danish Financial Supervisory Authority.

These may be grouped in different peer groups based on control, business lines, or group structure.

All credit institutions’ aggregated data on a parent-company basis.

Consolidated data for the five main banking groups (IFRS).