Public Information Notice No. 99/83

Public Information Notice: IMF Concludes Article IV Consultation with Denmark

August 26, 1999

On August 5, 1999, the Executive Board concluded the Article IV consultation with Denmark.¹

Background

The Danish economy continued to perform well in 1997-98. Real GDP growth of about 3 percent remained above potential and unemployment fell to 6 percent, less than half its level only five years earlier. Consumer price inflation remained subdued at slightly below 2 percent. However, capacity constraints became more evident and the external current account balance showed a deficit, for the first time since 1989, of 1.4 percent of GDP. Also, at 4½ percent, wage inflation remained higher than in the main trading partner countries.

Economic policies aimed at slowing growth in domestic demand, while sustaining a rapid pace in implementing structural reforms. Thanks to the large fiscal dividends deriving from a buoyant economy and declining structural unemployment, the general government budget balance strengthened to show a surplus of 1 percent of GDP in 1998. Meanwhile, the Danish krone resisted episodes of turbulence, although that was only possible at the cost of temporary increases in short-term interest rates and a widening of risk premia relative to euro area currencies.

Real GDP growth is projected to slow to 1.3 percent in 1999 as a result of new measures started in mid-1998 that are partly designed to dampen consumer spending and housing demand. Inflation is forecast to edge up to 2½ percent mainly because of higher environmental taxes, while the external current account deficit is expected to narrow due to the sharp slowdown of domestic demand.

Executive Board Assessment

Executive Directors commended the authorities for their sustained implementation of a strategy of fiscal discipline and structural reform, which had contributed to a prolonged economic expansion. There had been large increases in employment and business investment, and unemployment had fallen by more than half in five years. Meanwhile, inflation had remained subdued and the public finances had strengthened.

Directors observed that indicators regarding short-term prospects are mixed. On one side, the past two years had seen an acceleration of wage inflation, a surge in consumer spending and housing prices, and a weakening of the external current account. Some Directors considered that these developments suggested that particular caution was needed to preserve Denmark's external competitiveness. Other indicators, however, suggested that the inflationary pressures may already be subsiding. On balance, Directors welcomed the measures taken by the authorities to restrain demand. They considered that, partly in view of the discipline imposed by the exchange rate arrangement, the authorities should stand ready to tighten fiscal policy further, should evidence of overheating persist. At the same time, they agreed that there was scope for the automatic fiscal stabilizers to operate if activity turned out to be markedly weaker than currently foreseen.

Directors broadly welcomed the authorities' objective to sustain large structural budgetary surpluses in coming years and supported their intention to use these surpluses for a substantial reduction in debt, rather than to lower the tax burden. Lower debt, in turn, would allow the effects of longer-term demographic pressures to be accommodated without compromising the strength of public finances. Directors emphasized, however, that realization of the projected fiscal surpluses would depend crucially on expenditure restraint and on continuing structural reforms. In this context, they stressed the need to strengthen expenditure discipline, especially at the local authority level. They urged the authorities to fully exploit the potential economies of scale in the provision of public services, and to explore the scope for user fees and private service provision. Directors emphasized that the growth in demand for publicly-provided services needs to be curbed over time if goals for the fiscal balance are to be achieved without increasing Denmark's already high tax rates.

Directors welcomed Denmark's impressive progress in improving the functioning of the labor market, which had made a vital contribution to fiscal consolidation. While noting recent tax and other structural reform initiatives, Directors nevertheless considered that additional reforms to enhance incentives and flexibility in the labor market will be needed to achieve the authorities' targets for employment and participation rates on which, in turn, the achievement of fiscal goals partly depends. In this context, Directors suggested that attention should focus on further reducing incentives for early retirement and on encouraging earlier entry of young adults into the labor market. Some Directors considered that the generosity of unemployment benefits should also be reviewed.

Directors supported the authorities' long-standing commitment to exchange rate stability, which is continuing with the krone's participation in ERM2. This commitment had enhanced fiscal discipline and contributed to wage restraint. Directors noted, however, that the exchange rate arrangement at times implied the maintenance of monetary conditions that are not well attuned to Denmark's cyclical conditions. This added to the need for fiscal policy to play a major role in stabilizing demand and ensuring that external competitiveness remained adequate.

Noting that the liberalization of product markets should not fall behind that in the labor market, Directors urged the authorities to build further on their achievements in deregulating markets and easing barriers to entry in sectors where public entities have traditionally enjoyed a protected status.

Directors welcomed Denmark's excellent record in extending assistance to developing countries and its efforts to target this assistance on the poorest countries.