Mission Concluding Statements
Denmark and the IMF
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1. Denmark is weathering the global economic slowdown well. In 2001, growth slowed but unemployment nonetheless continued to fall to 5 percent, its lowest level in 25 years. Inflation was contained at around 2 percent and aggregate supply and demand were better balanced than they had been in preceding years. Overall, economic developments have been consistent with a remarkably successful soft landing since signs of overheating emerged in 1998. Sound macroeconomic policies—as reflected in sizable budget and external current account surpluses—and relatively flexible labor markets have contributed to the economy's resilience.
2. Growth is likely to remain sluggish in the period immediately ahead, but an expected recovery in the global economy toward the middle of the year, plus the effects of interest rate cuts during 2001, should boost growth in the second half of this year. On average, growth for 2002 is projected to be in the range 1 to 1½ percent and unemployment is expected to rise moderately. The balance of risks suggests that growth could well be in the lower half of that range. From a domestic perspective, the downturn in investment could be more prolonged than anticipated and consumers might remain cautious. From an external perspective, the global recovery is not yet assured, even though recent signs have been promising, and a bounce back in the euro against the dollar could hurt competitiveness.
3. Nonetheless, the downside risks are not sufficiently large to warrant a policy response. Monetary conditions are already providing support to growth. Moreover, some strains from the period of high capacity utilization, including relatively strong wage growth and high house prices, have not fully abated. Any further stimulus from a relaxation of fiscal policy would be unnecessary and unwise.
4. All-in-all, the government's stated intention to maintain a broadly neutral budget in 2002 is appropriate. Neutrality is interpreted as no significant change in the underlying surplus—that is, subtracting the effects of the economic cycle and transitory factors on the budget position. By this standard, the initial budget proposal from last year was on the loose side as it combined modest tax cuts with some slippage once again from the public consumption growth target. The new government has proposed a tax freeze and additional spending on priority items. At the very least, therefore, it should fully compensate for the cost of these measures by expenditure savings elsewhere. In implementing the budget, the automatic stabilizers should be allowed to operate in the event that economic growth deviates from the projected path for 2002. Given that output is projected to dip below potential this year, the surplus could fall below the 2 percent of GDP floor of the medium-term target, especially if receipts from the pension yield tax do not recover. This would not by itself be a cause for alarm, but it could mean that some tightening of fiscal policy will be necessary after this year to keep the surplus within the targeted range if the loss in pension yield tax receipts proves more permanent.
5. Wage negotiators can do their part to support sustainable growth. Overall external competitiveness appears to be sound, in large part because of the weakness of the euro, but relatively rapid wage growth in the last few years has led to some loss of market share in continental Europe. Moderation of wage demands would help to prevent further losses of competitiveness with the euro area and keep the economy on the soft landing path, especially if the euro were to appreciate. It would also help to maintain low inflation and a healthy surplus in the balance of payments.
6. The exchange rate arrangement whereby the krone is kept broadly stable against the euro continues to provide a valuable anchor of stability as well as discipline for domestic economic policies. As testimony to the durability and widespread acceptance of the anchor, the system easily coped with market uncertainties associated with the September 2000 referendum on adopting the euro. As Denmark's cyclical position has become more closely aligned with that of the euro area in this past year, monetary conditions have become more attuned to Denmark's domestic needs, although they still lean to the loose side.
7. Looking beyond the near term, policy makers should continue to focus on providing a stable macroeconomic framework that prepares for the longer-term effects of ageing, and on structural reforms to alleviate constraints to economic growth.
8. On the macroeconomic framework, Denmark is setting an admirable example internationally by its forward-looking fiscal policy. To meet the challenges of an ageing population and the associated longer-term strains on the welfare system, Denmark has been running sizable surpluses and paying down the public debt. Targeting surpluses of 2 to 3 percent of GDP through 2010 should continue.
9. To sustain budget surpluses, the mixed record on expenditure discipline will need to be improved. In the last 7-8 years, the ratio of public spending to GDP has fallen sharply. However, favorable growth conditions, falling interest rates, and steep declines in unemployment have been important contributory factors; meanwhile, the public consumption growth target has been missed in most years. The economic environment in coming years is likely to be considerably less favorable to shrinking the public expenditure ratio; even containing it will require more serious spending discipline. At a minimum, the target for real public consumption growth of 1 percent a year should be observed. The new government's tax freeze can help provide a measure of new discipline. But there is a need to find additional control mechanisms. The authorities should continue to build consensus for the aggregate spending target across all levels of government; strengthen incentives for local governments to stick to agreed budgets; explore where contracting out can contribute to more efficient delivery of public services; and investigate where user charges might be introduced.
10. The new government's greater emphasis on reducing the high tax burden is well placed, but significant tax cuts would require a more ambitious public spending growth target to maintain the desired surpluses. The high tax burden is at best not conducive to increasing labor supply and could become a constraint on economic growth. In any case, the tax burden might not be sustainable in the face of tax competition from abroad. For these reasons, there is a good case for building more room into medium-term plans for tax cuts. Overall public spending would not need to be cut; rather, real spending growth would need to be slowed more than envisaged. For example, extending the 1 percent annual target for real public consumption growth to all of public spending could provide as much as 0.5 percentage points of GDP a year for tax reductions. Meeting a more stringent expenditure target while accommodating higher spending in priority areas would require a critical review of other areas, including social transfers, where spending is relatively high by international standards. The most pressing area for tax reform is to reduce high income tax rates and raise upper tax thresholds. In this regard, while the government's tax freeze is providing a useful focus for the debate on taxes, its literal application to taxes that typically move in line with inflation (excises and property taxes, for example) will, over time, eat into the room for more needed income tax reform.
11. On structural reforms, measures to alleviate labor supply constraints remain high on the agenda. There is still scope to increase the participation of older workers in the labor market. Previous reforms to early retirement schemes have had a positive effect, but their longer-term impact is likely to prove less than hoped for. Further initiatives will be needed, but ultimately these will require lower pension benefits for early retirees. Greater efforts to better integrate immigrants into the active workforce are overdue. Recent proposals focus on strengthening incentives to accept jobs via reducing social benefits for newcomers. The measures risk driving immigrants' economic activity into the informal sector, especially with relatively high minimum wages. Welfare traps are not solely an immigrant issue and should be addressed through a general review of the structure of benefits. This, plus better-tailored training programs, including more on-the-job training opportunities, would help raise employment in the formal sector.
12. Efficient product markets are important for the potential growth of the economy. Based on concentration and price indicators, Denmark still experiences competition problems in a number of industries and services. The Competition Act provides a sound framework for addressing these problems and should be supported by tougher penalties for anti-competitive behavior. The government has plans to pursue deregulation and privatization in the network industries. This is welcome. However, such plans require careful design of the post-privatization regulatory framework to ensure adequate competition. Denmark is taking the lead in environmental protection, setting an example for the international community. However, the design of environmental policies should avoid unnecessary distortions in product markets as for example is occurring in the electricity market.
13. Danish banks are generally in good shape following several years of solid growth in the economy, which has enabled them to build up capital, lower provisions, and provide shareholders with a healthy return. However, as the economy has slowed, some deterioration in the credit quality of borrowers has started to become evident, prompting increased provisions. The capital buffer is large, suggesting at this stage that banks should be able to handle potential losses comfortably. As regards other financial institutions, some insurance companies and pension funds with fixed nominal interest rate guarantees were put under pressure when stock markets fell last year. While the problems in the industry were limited in scope, they partly derived from the effects of a low-interest rate environment. More generally, the shrinking availability of traditional fixed-rate products and movement into more risky and complex securities increases the importance of better risk management within insurance companies and pension funds and poses new challenges for supervisors. With the increasing importance of financial conglomerates, the proposal to integrate the various supervisory acts into one uniform set of regulations will help to close potential loopholes in the supervision and regulation of financial entities. The proposed new anti-money laundering law, with its added emphasis on combating the financing of terrorism, is a welcome initiative. Legislators are urged to pass the new law expeditiously.
14. Denmark has an outstanding record in providing assistance to developing countries of about 1 percent of GDP. It is hoped that this record is maintained and that ODA is exempted from efforts to meet public spending restraint targets.
January 23, 2002
IMF EXTERNAL RELATIONS DEPARTMENT