The economy is gradually approaching a situation with normal capacity utilization

The Danish economy is experiencing stable growth and increasing employment. The foundation for growth is assessed to be solid, and the upswing is expected to continue. Private domestic demand and exports are the largest contributors to growth in 2017 and 2018, whereas growth in public demand is expected to be more modest.

The economy is close to a situation with normal capacity utilization. The overall outlook is positive, due to several reforms, especially the 2011 Early Retirement Reform, which will continue to increase labor supply in the coming years. But the increase in demand for labor may turn out to be stronger, leading to further wage pressure. This calls for additional reforms as also assessed by staff. New reforms, which increase labor supply, may help curb capacity pressures and sustain the upswing in the Danish economy. Production capacity also depends on productivity growth, which has been weak for a sustained period. Productivity is expected to increase in 2017 and 2018, but at a relatively slow pace in line with historical developments.

There is still considerable uncertainty attached to the international economic outlook, among other things due to Brexit as well as economic policy uncertainty in the US. Monetary policy in the euro area is expected to remain extraordinarily expansionary for some time. The Danish business cycle is slightly ahead of the euro area, and the interest rate level could be too low for the Danish economy. This underscores the important role of other policies in supporting economic stability and increasing the economic supply.

Fiscal policies shall contribute to balanced growth

The expected closing of the output gap next year implies that the ongoing gradual tightening of fiscal policy should continue to promote balanced and sustainable growth.

The structural fiscal balance is planned to improve from a deficit of 0.5 percent of GDP in 2017 to a deficit of 0.3 percent of GDP in 2018. The deficit limit in the Danish Budget Law is 0.5 percent of GDP except in cases of, e.g., severe economic downturns.

In the government’s 2025-plan (presented in May 2017) the key medium-term target is to assure structural fiscal balance in 2025. The pace of consolidation is marginally slower than in the previous plan, with the 2020-target reduced from 0 to −0.1 percent of GDP. The modest improvement in the structural balance masks larger fiscal efforts, but declines in oil and gas revenues and adverse demographics weigh on the structural improvement. The slower consolidation path should be seen in the light of an improved long term fiscal outlook and still leaves the projected path in balance or surplus in 2021-2025.

Apart from increased public investment spending in 2021-25, the 2025-plan aims to reduce both tax and government spending levels relative to GDP, notably through further reform initiatives to be agreed on over coming years. In the same vein, the 2025-plan sets a key objective of increasing potential growth by an additional ½ percentage point per year through new reform initiatives, c.f. below.

Monetary policy – maintaining the peg to the euro is the sole policy objective

The authorities welcome staff’s assessment that Danmarks Nationalbank should remain ready to defend the peg. Maintaining the peg to the euro is the exclusive policy objective and hence, monetary policy rates are adjusted solely to keep the krone stable against the euro. Other considerations – such as cyclical developments in Denmark – are not taken into account when setting monetary policy rates.

Negative interest rates are now in widespread use for e.g. financial corporations, including insurance and pension companies, whereas banks have been hesitant to pass on the negative rate of interest to households and small firms. Banks’ net interest income has come under pressure as lending rates, to a higher degree than deposit rates, have followed the decline in monetary policy rates. To some extent, the decline in banks’ net interest income has been compensated for by higher fee income. On the expenditure side, there has been focus on increasing efficiency and reducing costs.

Financial sector and housing policies

The authorities assess that the recent developments in the housing market, including the higher price increases in the largest cities, to some extent should be seen in light of developments in fundamentals, e.g. low mortgage rates, rising disposable incomes, and urbanization – and a large house price decrease in 2009.

However, highly leveraged households are vulnerable to interest rate hikes and developments in Copenhagen and Aarhus call for continued close monitoring. The Danish Financial Supervisory Authority (FSA) has already adopted measures to provide guidance to credit institutions. The government is currently assessing the DTI recommendation from the Systemic Risk Council, and the response is expected later in June. The authorities would like to stress that the aim of recent measures is not to address rapid house price increases as stated in the staff report, but to ensure robustness of borrowers and credit institutions.

Overall, the authorities share staff’s assessment that the financial system in Denmark is sound, and is in a process of implementing the remaining recommendations from the FSAP.

The authorities assess that the recent property taxation reform (May 2017) will contribute to dampen house price fluctuations, since property taxes from 2021 will be fully linked to house prices. Thereby, the property taxation reform will contribute to dampening fluctuations in household consumption and through that GDP.

The property taxation reform also includes a scheme for deferring property tax increases. The deferred payment of tax increase is a loan and, according to the government, will not in itself discourage mobility in the housing market primarily, because home owners have to pay a market based interest rate on the deferred taxes.

It is the government’s view that the clause in the tax reform concerning repayment to the home owners of future tax revenue increases does not create a procyclical element, as tax reductions only occur if revenue increases structurally and permanently on a national level beyond predefined structural property tax level increases. Property taxes will therefore not be reduced during and because of a cyclical house price boom.

Productivity and structural reforms

Denmark experienced relatively low productivity growth over several decades, particularly in domestically oriented services. Increasing the growth potential of the Danish economy is a top priority for the government.

The government has an ongoing focus on securing efficient regulation with the aim of making it easier to operate and lowering the costs of production in Denmark. This will also allow new entrants to more easily enter the markets and increase competition. Several initiatives have already been implemented, e.g. the liberalization of the “Planning Act” and removal of the PSO-tariff as examples.

As noted by staff, the low level of domestic investments could be a contributing factor to recent slow productivity growth. As a small, open economy it is important that the taxation is internationally competitive and as noted by staff, policies such as introducing an incremental Allowance for Corporate Equity (ACE), as suggested by the former government, could support investments. At the same time, it is important to uphold the overall administrative simplicity of the tax system for both the private firms and the tax authorities. Furthermore, the government prioritizes an increased public investment spending in 2021-2025, which inter alia would provide new opportunities for investments in transport infrastructure. As noted by staff, such investments could support sustainable medium-term growth.

Technological progress is a key driver of productivity growth. Digitization and new technologies such as intelligent robots and Internet of Things can contribute to further productivity growth. Therefore, the government also focuses on providing good framework conditions so Danish companies can continue to exploit efficiency potentials through the opportunities of digitization and new technologies. As part of the effort to increase productivity, the government will present a strategy for Denmark’s digital growth, which will support Denmark’s position as digital frontrunner.

In the fall, the government will launch further initiatives aiming at increasing the productivity growth in Denmark.

Labor market policies aimed at increasing labor supply

The authorities are fully aware of the challenges regarding labor supply constraints. The government’s new 2025 plan lays out the need of new reforms that increase labor market participation and productivity to prolong the recovery of the Danish economy and increase growth potential in the long run. The structural reforms implemented in the recent decade are showing clear effects. Reforms since 2008 have raised employment with more than 125,000 persons and the productive potential by 5½ percent by 2025. The new 2025-plan addresses the need for an increased labor supply in several ways, including proposals for earlier entry, stronger incentives through lower income taxes, measures aimed at attracting more workers from abroad, and further improvements in integrating refugees to the labor market.

On labor market integration of refugees the guiding principle is ‘work from day one’. This calls for improved, more systematic and earlier screening of refugees’ competencies, combining employment and language classes, matching refugees’ placement to job opportunities, and for enhancing flexibility in provided housing. The previous government introduced an integration benefit to secure faster integration. The employment effort has been further strengthened with the latest amendments of the Integration Act, which came into effect on July 1, 2016. The overall goal of the amendments was to get refugees quickly into work after they were granted asylum.

External Sector Assessment - high net savings in preparation for demographic changes

The authorities agree that the current account surplus is high. A current account surplus is not a policy objective, but a result of individual decisions by households and corporations. The high current account surplus partially reflects that Denmark from early on has had a focus on the challenges of future demographic changes and tried to prepare for an aging population through the build-up of labor market pensions, resulting in a private sector savings surplus. Likewise, public finances are designed to be sustainable in the long run. To some extent, the surplus also reflects the cyclical position of the economy with low investment and consumption ratios. The authorities agree with staff that the real effective exchange rate is broadly in line with fundamentals.