## Annex V. Authorities’ Response to Past IMF Policy Recommendations (cr18177)

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### Recent developments and macro indicators
- Growth and output:
  - GDP growth in 2017 was 2.2 percent.
  - Average growth over 2010–15 was 1.3 percent.
  - The output gap is estimated to have closed in 2017.
- Labor market:
  - Employment rate close to 75 percent.
  - Unemployment around 5 percent (lowest post-crisis level).
  - Labor force expanded to 80 percent of the working-age population.
  - Employment gains since 2013 roughly evenly split among people 60+ years old, foreigners employed in high-skilled jobs, and refugees and migrants.
- Inflation and wages:
  - 2017 average inflation edged to 1.1 percent.
  - March 2018 HICP declined to 0.5 percent.
  - Services inflation averaged over 2 percent in the last six months (to March 2018).
  - Goods inflation at -0.7 percent yoy.
  - Krone appreciation by about 3 percent on an effective basis over the last year.
- Fiscal and public debt:
  - Headline fiscal balance estimated at 1.0 percent of GDP in 2017.
  - Structural balance projected to decrease from 0.2 to 0.1 percent of potential GDP between 2017–18.
  - Public debt stock estimated at 35.5 percent of GDP in 2017.
- Housing and credit:
  - Property prices averaged 4.6 percent growth in the first three quarters of 2017.
  - Copenhagen property prices rose by almost 11 percent in the first three quarters of 2017.
  - Nominal private sector credit grew by 2 percent in 2017.
  - Credit to households grew by 3 percent in 2017 and rose to 136 percent of GDP.
  - Nonfinancial corporate credit rose by 1 percent in 2017 to 104 percent of GDP.
  - Household debt to disposable income at 272 percent.
- External sector:
  - Current account surplus of 7.6 percent of GDP in 2017.
  - Foreign asset accumulation reached 317 percent of GDP in 2017.
  - Net international investment position rose to 54 percent of GDP in 2017.
  - Net exports of goods accounted for 5.8 out of 6.6 percent of GDP trade surplus in 2017.
  - Net capital outflows in 2017 reflected a reduction in debt liabilities (¾ percent of GDP) and an increase of outward direct investment (almost 5 percent of GDP).

### Outlook and risks
- Baseline projections:
  - Growth projected to hover around 2 percent in 2018–19, before gradually decelerating to estimated potential in the medium term.
  - Inflation and wages expected to gradually rise further as unemployment remains low.
  - Current account surplus expected to gradually decline over time.
  - Public debt ratio projected to decline gradually over the medium term.
- Key upside risks:
  - Consumption overshooting amid buoyant financial conditions and rising asset prices.
  - Stronger than expected global growth supporting demand for Danish goods.
  - Widespread labor shortages and capacity constraints intensifying wage pressures, weakening competitiveness.
- Key downside risks:
  - Uncertainty in Denmark’s main trading partners (including Brexit, global trade disruptions, protectionism).
  - Faster-than-anticipated normalization of monetary policy by major central banks tightening financial conditions.
  - Macroeconomic shocks transmitted via Nordic financial integration or constrained regional financing.
- Macro-financial vulnerabilities:
  - Continued increases in high house prices combined with high gross household debt could raise vulnerabilities.
  - Highly-levered households may restrain consumption in the event of house price and interest rate shocks.
  - Some low-income households already overburdened by large mortgage payments.

### Fiscal policy — staff findings and recommendations
- Recent fiscal stance and plans:
  - 2017 headline surplus at 1.0 percent of GDP.
  - Government spending projected to accelerate in 2018 driven by low base effects.
  - 2018–2020 fiscal deficits pushed up to accommodate reform costs (e.g., tax-free withdrawal of early retirement contributions; payback of property taxes during transition to new real estate valuation system).
  - Structural deficit in the near term projected to comply with SGP rules and Denmark’s budget law (½ percent of GDP).
  - Authorities plan gradual fiscal consolidation aiming for a balanced budget in the medium term.
- Staff advice:
  - Use fiscal space to pursue growth-friendly policies to boost potential output; fiscal accommodation may be warranted to facilitate structural reforms ("while the sun is shining").
  - Recommended growth-enhancing public spending areas: upgrade infrastructure; improve broadband access in rural areas; strengthen digital skills to benefit from AI and automation.
  - Revenue-side recommendations: reduction of distortionary labor taxation to boost labor supply; changes in corporate taxation to foster private investment.
  - Be prepared to arrest excessive demand pressures if needed; rely on automatic stabilizers and gradual improvement in underlying fiscal position as first line of defense.

### Monetary policy — stance and guidance
- Current stance and recent behavior:
  - Monetary conditions remain accommodative.
  - Krone broadly stable against the euro; edged above central parity but oscillating within a narrow range; no significant FX interventions since 2016:Q2.
  - Leading spread between Danmarks Nationalbank (DN) and ECB policy rate unchanged at -0.25 percent since March 2016.
  - Negative differential between money market interest rates in Denmark and the euro area has widened slightly.
- Staff recommendation:
  - Central bank should remain ready to defend the peg.
  - Continue to normalize rates as conditions allow.
  - Gradual reduction of Danish monetary policy spreads relative to the ECB should continue as market conditions permit.
- Risk factor:
  - US interest rates expected to rise further vis-à-vis euro rates, which could weigh against the euro and the krone in the short term.

### Macro-financial policies, housing vulnerabilities, and recommendations
- Financial sector health and risks:
  - Credit institutions maintained strong profitability despite slow credit growth and low interest margins.
  - Systemwide nonperforming loans are low; arrears for medium-sized banks higher than for SIFIs.
  - Liquidity requirements (e.g., liquidity coverage ratio) comfortably met.
  - DFSA issued a public warning against excessively low IRB risk weights for mortgages in high growth areas.
  - Central bank stress-test scenario: a severe three-year recession with 5 percent output contraction and nearly 20 percent property price decline; tests reveal potential for capital shortfalls for some SIFIs.
- Capital, resolution, and regulatory developments:
  - Countercyclical capital buffer activated to ½ percent of risk-weighted assets from March 2019.
  - Implementation of Basel III minimum risk weights estimated to increase capital requirements for Danish SIFIs by DKK 78 bn (almost 5 percent of total risk-weighted assets) or 34 percent higher than previously-planned fully-loaded capital (expert report).
  - DFSA completed final stage of BRRD by setting MREL and resolution strategy from July 1, 2019.
  - Single-point-of-entry resolution for SIFI groups granted; MCIs remain exempt from bail-in central resolution tool and MREL.
  - SIFIs subject to debt buffer requirement in line with SRB recommendation for a minimum 8 percent of Total Liabilities and Own Funds (TLOF).
  - Outstanding: finalize the debt buffer requirement and resolution strategies for Nykredit and DLR Kredit.
  - DFSA establishing an independent audit function; new MoU with Nordic counterparts signed February 2018.
- Staff macroprudential guidance:
  - Treatment of mortgage covered bonds for NSFR should be consistent with long-term funding stability.
  - Continue dialogue on the debt buffer for MCIs to ensure resolution credibility.
  - DFSA’s budget should not be subject to central government cuts; consider lengthening DFSA board member terms to maintain policy continuity.
  - Support Systemic Risk Council’s broad information approach and further development of systemic risk indicators and macroprudential stress tests.
  - If risks build, additional increases of the countercyclical capital buffer would be important.
- Housing-specific recommendations:
  - Tighten existing macroprudential measures further (examples below); consider reducing mortgage interest deductibility more than currently planned.
  - Strengthen housing supply via relaxing restrictions on size of new apartments in urban areas; simplify zoning and planning; reduce rent controls; upgrade public and transport infrastructure around inner-city areas.
- Suggested granular macroprudential and tax measures:
  - Lower LTV limit from 95 to 90 percent.
    - Estimated impact: lower aggregate consumption by about 1.5 percentage points one year after introduction, but increase it by 0.2 percentage points in a new steady-state because of lower debt-servicing costs.
  - Strengthen DTI restrictions for all loans irrespective of LTV.
  - Consider tighter DTI limits for interest-only and adjustable-rate mortgages.
  - Mandate amortization for highly-leveraged households—with debt-to-income above 400 percent.
  - Calibrate DTI limit to reflect lower risk for fixed–rate mortgage financing.
  - Reduce MID (mortgage interest deductibility) further than currently planned; use fiscal savings to reduce labor tax burden during transition.

### Authorities’ views and responses
- General stance:
  - Authorities broadly concurred with staff’s assessment of the outlook and risks; expect expansion to continue and agreed output gap has seemingly closed.
  - They observed capacity constraints becoming more binding and viewed risks as broadly balanced.
- Fiscal policy stance:
  - Authorities highlighted complications with using fiscal instruments to smooth output; structural reforms would not warrant short-term fiscal easing.
  - Legislative and implementation lags constrain discretionary fiscal policy effectiveness.
  - Expenditure rules cover a large part of the budget; discretionary expenditure limited to capital spending and active labor market policies.
  - Conservative expenditure growth in medium-term budget plan intended to help dampen demand pressures.
  - Government considered it unlikely MID will be reduced beyond the planned gradual decline ending next year.
- Monetary policy objective:
  - Authorities reiterated that the exclusive objective of monetary policy is to maintain the peg.
- Financial sector and housing:
  - Authorities view the financial system as profitable and resilient and expect credit institutions to meet Basel III capital requirements and maintain adequate funding.
  - Government agreed on importance of strong bank supervision but did not see need to lengthen DFSA board terms.
  - DN sees scope for tighter LTV limit, higher countercyclical capital buffer, amortization requirements, and reduction of variable-rate loans if risks continue to build.

### Structural policies: labor market, investment, and productivity
- Labor market findings:
  - Recent 3-year public sector wage agreement resulted in a nominal wage increase of 8.1 percent.
  - Unemployment rates for foreign-born people are 2 to 3 times higher than for native-born people.
  - Employment rate of male refugees about 45 percent; employment rate of female refugees about 13 percent.
- Staff recommendations to boost participation:
  - Reduce taxes on labor by increasing the ceiling for tax brackets for low- (up to around DKK 50,000/year) and middle-income (up to around DKK 520,000/year) groups.
  - Expand vocational and education training (VET) opportunities and reconsider the 2 percent annual reduction of the VET budget.
  - Improve access to digital skills; continue the Technology Pact.
  - Use transfers more efficiently (e.g., reducing duration of student grants and graduates’ access to unemployment insurance).
  - Renew the IGU program which is set to lapse in 2019 upon review.
  - Remove restrictions on employment rules for asylum seekers and allow participation in activation programs as early as possible.
  - Intensify efforts to improve integration of female refugees.
  - Increase flexibility to attract new migrants, e.g., lowering the minimum remuneration requirement (DKK 417,794/year) or granting more exceptions to the pay limit scheme for residency permits under the positive list scheme.
- Investment and productivity measures:
  - Product market deregulation in retail, taxi, and utility sectors recommended to boost competition and encourage investment.
  - Support private investment via tax measures: reduce taxation of dividends; relax restrictions on losses carried forward; make R&D super-deduction refundable; consider an incremental Allowance for Corporate Equity (ACE) to reduce debt bias.
  - Safeguards needed to reduce revenue leakage risks from tax changes.
  - Regulatory changes enacted: Planning Act amendments; Taxi Act changes; Management Commission established; R&D super-deduction being phased in; Strategy for Denmark’s Digital Growth launched.

### External balance assessment (Annex I) — findings and implications
- Key metrics:
  - Current account surplus in 2017 was 7.6 percent of GDP.
  - EBA model cyclically-adjusted current account position at 7.9 percent of GDP for 2017.
  - Current account norm of 4.0 percent of GDP.
  - Staff assess the current account gap at around 3.9 percent (percent of GDP).
  - REER model estimates: Level REER overvaluation about 11.4 percent; Index REER overvaluation about 12.5 percent.
  - Translation to exchange rate gap: assuming 0.52 semi-elasticity, translates into an exchange rate gap of about 5½–9 ½ percent.
- Drivers:
  - Offshore trading activity and investment income are significant drivers of the surplus.
  - Increasing share of trade surplus produced outside Denmark: 4.6 percent of GDP in 2017 (from less than 1 percent ten years earlier).
- Sectoral savings and investment:
  - Private sector firms have the highest net savings; households increased their net contribution to the current account surplus.
  - Nonfinancial firms reduced investment and deleveraged, contributing to a sizable increase in net lending.
- Uncertainties and policy implications:
  - Large pension contributions and measurement issues related to merchanting and offshore processing trade create Denmark-specific uncertainties.
  - EBA model does not identify domestic policy gaps that explain most of the excess current account surplus.
  - Structural policies that raise investment and scope for higher wage growth could help reduce the surplus.

*Source: cr18177 — Annex V. Authorities’ Response to Past IMF Policy Recommendations; extracted IMF staff report content.*

### Annex V. Authorities’ Response to Past IMF Policy Recommendations ___________________________ 43

### Annex V. Authorities’ Response to Past IMF Policy Recommendations

### Recent Developments
- The Danish economy: solid growth and job creation; inflation subdued; wage growth aligned with productivity; fiscal position improving; house prices trending upward with emerging signs of overvaluation in urban areas; credit growth modest; household leverage and current account surplus elevated.
- GDP growth and output gap:
  - GDP growth in 2017 was 2.2 percent.
  - Average growth over 2010–15 was 1.3 percent.
  - The output gap is estimated to have closed in 2017.
- Labor market:
  - Employment rate close to 75 percent.
  - Unemployment around 5 percent (lowest post-crisis level).
  - Labor force expanded to 80 percent of the working-age population.
  - Employment gains since 2013 roughly evenly split among people 60+ years old, foreigners employed in high-skilled jobs, and refugees and migrants.
  - Job vacancies upward; wage growth aligned with productivity growth, albeit subdued.
- Inflation:
  - 2017 average inflation edged to 1.1 percent.
  - March 2018 HICP declined to 0.5 percent.
  - Services inflation averaged over 2 percent in the last six months (to March 2018).
  - Goods inflation at -0.7 percent yoy.
  - Krone appreciation by about 3 percent on an effective basis over the last year.
- Fiscal position and public debt:
  - Headline fiscal balance estimated at 1.0 percent of GDP in 2017.
  - Structural balance projected to decrease from 0.2 to 0.1 percent of potential GDP between 2017–18.
  - Public debt stock estimated at 35.5 percent of GDP in 2017.
  - One-off payment of early retirement contributions affected the projected fiscal deficit.
- Housing and credit:
  - Property prices averaged 4.6 percent growth in the first three quarters of 2017.
  - Copenhagen property prices rose by almost 11 percent in the first three quarters of 2017.
  - Nominal private sector credit grew by 2 percent in 2017.
  - Credit to households grew by 3 percent in 2017 and rose to 136 percent of GDP.
  - Nonfinancial corporate credit rose by 1 percent in 2017 to 104 percent of GDP.
  - Household debt to disposable income at 272 percent (fallen from 2010 peak but remains highest in the OECD).
- External sector:
  - Current account surplus of 7.6 percent of GDP.
  - Surplus driven by strong net exports and robust primary income.
  - External position assessed by staff as stronger than implied by medium-term fundamentals (subject to uncertainties).

### Outlook and Risks
- Baseline projections:
  - Growth projected to hover around 2 percent in 2018–19, before gradually decelerating to estimated potential in the medium term.
  - Inflation and wages expected to gradually rise further as unemployment remains low.
  - Current account surplus expected to gradually decline over time.
  - Public debt ratio projected to decline gradually over the medium term (see Annex III referenced).
- Key upside risks:
  - Consumption overshooting amid buoyant financial conditions and rising asset prices.
  - Stronger than expected global growth supporting demand for Danish goods.
  - Widespread labor shortages and capacity constraints intensifying wage pressures, weakening competitiveness.
- Key downside risks:
  - Uncertainty in Denmark’s main trading partners (including Brexit, global trade disruptions, protectionism).
  - Faster-than-anticipated normalization of monetary policy by major central banks tightening financial conditions.
  - Macroeconomic shocks transmitted via Nordic financial integration or constrained regional financing.
- Macro-financial vulnerabilities:
  - Continued increases in high house prices combined with high gross household debt could raise vulnerabilities.
  - Highly-levered households may restrain consumption in the event of house price and interest rate shocks.
  - Some low-income households already overburdened by large mortgage payments.

### Policies for Sustained Growth — Macroeconomic Policies
- Policy objective: boost growth and enhance macro-financial stability while remaining vigilant against demand pressures; use economic upswing and fiscal space to pursue capacity-enhancing reforms (productivity, investment, labor supply); tighten macroprudential tools; reform tax and housing supply policies.

Fiscal Policy
- Recent developments and plans:
  - 2017 headline surplus at 1.0 percent of GDP; faster-than-envisaged consolidation due to stronger revenues and under-spending.
  - Government spending projected to accelerate in 2018 driven by low base effects.
  - 2018–2020 fiscal deficits pushed up to accommodate reform costs (e.g., tax-free withdrawal of early retirement contributions; payback of property taxes during transition to new real estate valuation system).
  - Structural deficit in the near term projected to comply with SGP rules and Denmark’s budget law (½ percent of GDP).
  - Authorities plan gradual fiscal consolidation aiming for a balanced budget in the medium term.
- Staff advice:
  - Use fiscal space to pursue growth-friendly policies to boost potential output.
  - Fiscal accommodation may be warranted to facilitate structural reforms ("while the sun is shining").
  - Recommended growth-enhancing public spending areas: upgrade infrastructure; improve broadband access in rural areas; strengthen digital skills to benefit from AI and automation.
  - Revenue-side recommendations: reduction of distortionary labor taxation to boost labor supply; changes in corporate taxation to foster private investment.
  - Be prepared to arrest excessive demand pressures if needed; rely on automatic stabilizers and gradual improvement in underlying fiscal position as first line of defense.

Monetary Policy
- Current stance and recent behavior:
  - Monetary conditions remain accommodative.
  - Krone broadly stable against the euro; edged above central parity but oscillating within a narrow range; no significant FX interventions since 2016:Q2.
  - Leading spread between Danmarks Nationalbank (DN) and ECB policy rate unchanged at -0.25 percent since March 2016.
  - Negative differential between money market interest rates in Denmark and the euro area has widened slightly.
- Staff recommendation:
  - Central bank should remain ready to defend the peg.
  - Continue to normalize rates as conditions allow.
  - Gradual reduction of Danish monetary policy spreads relative to the ECB should continue as market conditions permit.
- Risk factor:
  - US interest rates expected to rise further vis-à-vis euro rates, which could weigh against the euro and the krone in the short term.

### Authorities’ Views
- General concordance:
  - Authorities broadly concurred with staff’s assessment of the outlook and risks; expect expansion to continue and agreed output gap has seemingly closed.
  - They observed capacity constraints becoming more binding and viewed risks as broadly balanced.
- Specific concerns and positions:
  - Downside risks highlighted: sudden increases in interest rates and international trade tensions.
  - Upside risks noted: more buoyant household and corporate spending behavior.
  - Shared staff concerns about household vulnerabilities from rising house prices and elevated leverage.
  - Considered the current account surplus as temporary and did not see major imbalances or policy distortions.
- Fiscal policy stance:
  - Authorities highlighted complications with using fiscal instruments to smooth output fluctuations; structural reforms would not warrant short-term fiscal easing.
  - Legislative and implementation lags constrain effectiveness of discretionary fiscal policy as a demand management tool.
  - Expenditure rules cover a large part of the budget; discretionary expenditure limited to capital spending and active labor market policies.
  - Conservative expenditure growth in the medium-term budget plan intended to help dampen demand pressures.
  - Authorities viewed temporary fiscal expansion to incentivize structural reforms as potentially procyclical at the current juncture.
  - Some reforms can be implemented through regulatory changes without fiscal easing.
  - Many reforms already enacted; sustainable fiscal position and strong employment reduce appetite for major new reforms.
- Monetary policy objective:
  - Authorities reiterated that the exclusive objective of monetary policy is to maintain the peg.

### Macro-Financial Policies (Financial Sector)
- Policy focus:
  - Macro-financial vulnerabilities should be tackled through tightening macroprudential tools, combined with tax and housing supply policies.
- Financial sector indicators (selected):
  - Private sector credit levels and growth:
    - Private sector credit growth was 2 percent in 2017.
    - Household sector credit rose to 136 percent of GDP.
    - Nonfinancial corporate sector credit rose to 104 percent of GDP.
    - Household sector credit growth (y/y) in 2017 was 3 percent; nonfinancial corporate sector credit growth (y/y) in 2017 was 1 percent.
  - Household leverage:
    - Household debt to disposable income at 272 percent.
  - External vulnerabilities and Nordic financial integration noted as transmission channels for regional shocks.

*Source: cr18177 - Annex V. Authorities’ Response to Past IMF Policy Recommendations*

### 17.      The financial system is robust and signs of increased risk-taking have emerged. Despite

### 17.      The financial system is robust and signs of increased risk-taking have emerged. Despite

### Financial system health and risk-taking
- Credit institutions maintained strong profitability, including via greater fee income, despite slow credit growth and low interest margins.
- Systemwide nonperforming loans are low, although arrears for medium-sized banks are considerably higher than for Systemically Important Financial Institutions (SIFIs).
- Liquidity requirements, such as the liquidity coverage ratio, are comfortably met.
- A proposal is under negotiation to treat mortgage credit institutions’ (MCIs) covered bonds as stable funding for purposes of the Net Stable Funding Ratio (NSFR).
- Lending surveys suggest rising appetite from medium-sized banks to relax credit standards; persistent easing could encourage excessive risk-taking amid elevated financial and real asset prices.
- Banks are adequately capitalized, but in early 2018 the Danish Financial Supervisory Authority (DFSA) issued a public warning against excessively low IRB risk weights for mortgages in high growth areas.
- Recent stress tests by the central bank reveal the potential for a capital shortfall for some SIFIs.
  - Stress-test scenario: a severe three-year recession with 5 percent output contraction and nearly 20 percent property price decline.

### Capital, resolution, and regulation developments
- Additional capital and resolution buffer requirements are set to take effect in the next few years.
- The government approved activation of the countercyclical capital buffer to ½ percent of risk-weighted assets from March 2019.
  - The buffer is not currently binding given banks’ high capital levels but signals intent to guard against vulnerabilities.
- Implementation of Basel III minimum risk weights is estimated to increase capital requirements for Danish SIFIs by DKK 78 bn (almost 5 percent of total risk-weighted assets) or 34 percent higher than the previously-planned fully-loaded capital (expert report by the Ministry of Industry, Business and Financial Affairs).
- DFSA completed final stage of BRRD by setting MREL and resolution strategy for all financial institutions from July 1, 2019.
- Single-point-of-entry resolution for SIFI groups was granted; MCIs continue to be exempt from the bail-in central resolution tool and MREL.
- SIFIs are subject to a debt buffer requirement in line with the Single Resolution Board’s recommendation for a minimum 8 percent of Total Liabilities and Own Funds (TLOF).
  - Outstanding item: finalize the debt buffer requirement and resolution strategies for Nykredit and DLR Kredit.
- DFSA is establishing an independent audit function following an FSAP recommendation.
- A new Memorandum of Understanding with Nordic counterparts was signed in February 2018 for coordination and information exchange on resolution issues.

### Staff recommendations and macroprudential guidance
- Treatment of mortgage covered bonds for NSFR should be consistent with long-term funding stability, irrespective of market access.
- Continue dialogue regarding the debt buffer for MCIs to ensure credibility and feasibility of resolution plans.
- Regulator budget: DFSA’s budget should not be subject to central government cuts; adequate budget needed to ensure continued effectiveness.
- Consider lengthening the term of DFSA board members to help maintain policy continuity.
- Staff supports the Systemic Risk Council’s broad information approach to assess systemic risk and set the countercyclical capital buffer.
- If risks continue to build up, additional increases of the countercyclical capital buffer would be important to enhance financial resilience.
- Continue developing key indicators to assess systemic risk, possibly including macroprudential stress tests to quantify losses due to systemic risk amplification via cross-sectoral and/or regional contagion.

### Macro-financial linkages: housing, household leverage, and vulnerabilities
- Housing is central to the Danish economy:
  - Housing is a major household asset alongside pensions.
  - MCIs issue covered bonds to fund mortgages, transferring part of mortgage risks to investors (pension funds and insurance companies).
  - High real estate valuations and low interest rates mean house purchases typically require large mortgage multiples relative to disposable income.
- Danish households’ debt-to-income ratios are among the highest in advanced economies; consumption is sensitive to house price developments.
- Vulnerable household groups if shocks occur:
  - Low-income households who spend more than 40 percent of their disposable income on housing.
  - Households that purchased in highly appreciating urban areas (e.g., Copenhagen) where LTI ratios and credit growth are noticeably higher.
- Vulnerabilities are compounded by the large proportion of variable-rate and interest-only mortgages.

### Policy measures addressing housing vulnerabilities (recent and recommended)
- Authorities implemented an extensive package of policies, including macroprudential measures, supervisory guidance, and property tax reform.
- Following the March 2017 Systemic Risk Council recommendation, authorities introduced LTV restrictions effective from 2018 and changes to consumer protection rules limiting interest-only and floating-rate mortgages for highly indebted households.
  - Lending restrictions for households with DTI greater than 4 times and LTV greater than 60 percent:
    - Interest-rate fixation of floating-rate mortgages must be at least 5 years.
    - Deferred amortization is only applicable on 30-year fixed-rate loans.
- Staff policy recommendations:
  - Tighten existing macroprudential measures further.
    - Lower LTV limit from 95 to 90 percent.
      - Estimated impact: lower aggregate consumption by about 1.5 percentage points one year after introduction, but increase it by 0.2 percentage points in a new steady-state because of lower debt-servicing costs.
    - Strengthen DTI restrictions for all loans irrespective of LTV.
    - Consider tighter DTI limits for interest-only and adjustable-rate mortgages.
    - Mandate amortization for highly-leveraged households—with debt-to -income above 400 percent.
    - Calibrate DTI limit to reflect lower risk for fixed–rate mortgage financing.
  - Tax policy: reduce mortgage interest deductibility (MID) further than currently planned; during the transition, the low rate environment would mitigate adverse impact and fiscal savings could reduce labor tax burden.
  - Housing supply and regulatory reform:
    - Relax restrictions on size of new apartments in urban areas.
    - Simplify and streamline zoning and planning processes.
    - Reduce rent controls (among the highest in the EU) to incentivize rental supply and alleviate demand for purchase.
    - Upgrade public and transport infrastructure around inner-city areas experiencing strong house price growth.

### Authorities’ views on risks and measures
- Authorities view the financial system as profitable and resilient to shocks and expect credit institutions to meet Basel III capital requirements and maintain adequate funding.
- Government agreed on importance of strong bank supervision but did not see need to lengthen DFSA board terms.
- Authorities reviewed MOUs with Nordic-Baltic counterparts to promote effective oversight of systemic banking groups.
- The DN (central bank) sees scope for tighter LTV limit, higher countercyclical capital buffer, amortization requirements, and reduction of variable-rate loans if risks continue to build.
- The government considers it unlikely that MID will be reduced beyond the planned gradual decline ending next year and noted MID should consider balances towards other capital taxation rates.

### Structural policies — labor market findings and recommendations
- Labor market continues to improve: employment and labor force participation rates have increased, unemployment dropped.
- Wage formation is responsive to domestic and external conditions; wage growth aligns with long- and short-term determinants.
  - Recent 3-year public sector wage agreement resulted in a nominal wage increase of 8.1 percent.
- Ongoing labor market initiatives: Phase I of JobReform, job-premium program for long-term unemployed, basic education, training, skill-upgrading, and active labor market policies.
- Remaining untapped labor resources: few remaining pools for gains involving young and migrants; youth inactivity increased since the crisis.
- Integration and migrant labor market issues:
  - Unemployment rates for foreign-born people are 2 to 3 times higher than for native-born people.
  - Employment rate of male refugees about 45 percent; employment rate of female refugees about 13 percent.
- Staff recommendations to boost participation:
  - Reduce taxes on labor by increasing the ceiling for tax brackets of low- (up to around DKK 50,000/year) and middle-income (up to around DKK 520,000/year) groups to reduce inactivity traps.
  - Expand vocational and education training (VET) opportunities and reconsider the 2 percent annual reduction of the VET budget.
  - Improve access to digital skills and continue the Technology Pact to align education with private sector needs.
  - Use transfers more efficiently to incentivize earlier and higher youth participation (e.g., reducing duration of student grants and graduates’ access to unemployment insurance).
  - Renew the IGU program which is set to lapse in 2019 upon review.
  - Remove restrictions on employment rules for asylum seekers and allow participation in activation programs as early as possible.
  - Intensify efforts to improve integration of female refugees.
  - Increase flexibility to attract new migrants, for instance by lowering the minimum remuneration requirement (DKK 417,794/year) or granting more exceptions to the pay limit scheme for residency permits under the positive list scheme.

*Source: cr18177 — IMF staff report (extracted content).*

### 29.      Raising labor supply further remains a priority for the authorities. The government

### 29–43: Raising labor supply, boosting investment and productivity, and staff appraisal

### Labor supply and labor market participation
- Raising labor supply remains a priority for the authorities.
- The government continues to see scope for incentivizing later retirement.
- Ongoing work aims at underpinning the labor participation of young people and deterring the formation of long-term unemployed.
- Programs for refugee integration are providing encouraging signals, but lagging employment of female refugees behind their male counterparts remains a concern.
- The government considers policies to shrink the gender gap important.
- Staff recommendation (related points):
  - Incentives to switch from social benefits to employment would support labor supply.
  - Higher youth participation could be achieved by reducing the duration of student grants and graduates’ access to unemployment insurance.
  - Integration of migrants could be facilitated by improving the accreditation of foreign degrees, relaxing restrictions on employment rules for asylum seekers, lowering the minimum remuneration requirement, and granting more exceptions to the pay limit scheme for residency permits.

### Productivity trends and diagnosis
- Productivity growth is subdued and investment remains below its pre-crisis level.
- The decline in labor productivity has mimicked developments in other advanced economies.
- Weak investment following the crisis contributed to the decline in capital-to-labor ratio, suppressing labor productivity growth.
- Sectoral breakdown points at weaknesses in productivity growth rates of domestically-oriented service industries and the utility sector, which together comprise about 30 percent of gross value added in the economy.
- Weak investment also contributed to the recent widening of the current account surplus.

### Reforms undertaken to boost productivity and investment
- Legislative and regulatory changes:
  - The Planning Act amended to relax retail trade regulations, removing size caps for non-grocery stores and raising them for grocery stores.
  - Changes in the Taxi Act removed several restrictions and geographical constraints and took effect in 2018.
  - A Management Commission was established in 2017 to provide recommendations on improving the quality of public management.
  - Proposed reallocating funding to higher education institutions to target degrees with relatively better employment prospects.
- Innovation and digitalization:
  - Progress on incentivizing cooperation between businesses and universities to stimulate knowledge transfer and investment in R&D.
  - A new R&D super-deduction is being phased in.
  - The Strategy for Denmark’s Digital Growth launched beginning of 2018 includes public-private initiatives such as the Technology Pact, SME Digital, and Digital Hub and calls for an agile regulatory framework to support dynamic developments.
- Areas identified for further reform in the Danish National Council inaugural report:
  - Enhance powers of the Competition Council regarding companies breaching regulations and exploiting dominant market positions.
  - Further relax the Planning and Taxi Acts to allow construction of hypermarkets, ease size restrictions on retail shops in cities and towns, and reduce barriers to utilizing digital technologies (e.g., ride hailing services).
  - Remove ownership restrictions in some parts of the healthcare sector and legal industry.
  - Make it easier to make fixed-term commercial lease agreements.
  - Improve performance on digitalization despite strong European rankings; the Strategy for Denmark’s Digital Growth is an important driver of productivity growth.

### Policy measures to increase investment (detailed)
- Competition:
  - Further liberalization of planning restrictions in the retail sector and building regulations in the construction sector would encourage more investment and could alleviate housing pressures.
  - Enhance collaboration between public research institutions and businesses to expand utilization of university research and encourage investment in R&D.
  - Scope for further deregulation of the utilities sector.
- Taxation (measures suggested to support investment):
  - Investment by startups and high-technology firms could be supported by (i) reducing the taxation of dividends, (ii) relaxing the restrictions on the use of losses carried forward, and (iii) making the R&D super-deduction refundable.
  - Investment by established firms could be supported by reducing restrictions on the deductibility of business expansion costs.
  - Corporate income tax reforms, such as the introduction of an incremental Allowance for Corporate Equity (ACE), would increase incentives to invest and reduce the debt bias.
  - In implementing these measures, safeguards should be taken to reduce the risks of revenue leakages.

### Authorities’ views
- The authorities believe the level of investment is in line with the cyclical position but concurred on the merits of boosting productivity.
- The post-crisis investment slowdown is largely explained by cyclical factors and reflects the reduction of real estate activities from unsustainably high pre-crisis levels and a higher share of less investment-intensive sectors, such as services.
- The improved macroeconomic environment and emerging capacity constraints will provide impetus to private investment going forward.
- Diverging views on use of tax policy to stimulate investment:
  - Authorities took note of recommendations on tax reforms that would benefit small and high-technology firms but raised concerns about effects and implementation risks, including the need to prevent tax avoidance by owner-run businesses.
  - Authorities agreed on potential advantages of introducing an incremental ACE to reduce debt-bias and support investment but noted the need for detailed analysis before implementing an ACE and the already intense demands on the tax administration.
- The authorities concur that the ongoing transformation in the global economy calls for innovative strategies to foster efficiency gains provided by digitalization.

### Staff appraisal — key findings and recommendations
- Key findings:
  - The economy is performing well but potential growth remains weak.
  - The output gap has seemingly closed and there are emerging signs of capacity constraints.
  - Labor shortages and rising house prices coupled with elevated debt level are important domestic risks.
  - External environment is favorable but involves risks.
  - Benign macroeconomic environment provides conditions for renewing efforts aimed at raising potential growth and bolstering financial resilience.
- Fiscal policy recommendations:
  - Fiscal policy should draw on existing fiscal space to support growth-enhancing reforms while remaining anchored on the medium-term objective.
  - Fiscal space should be used to incentivize private investment through corporate tax reforms.
  - Increase growth-enhancing public spending to improve broadband access in rural areas, strengthen digital skills, and upgrade public and transport infrastructure—especially around inner-city areas experiencing strong house price growth—to boost productivity and mitigate house price pressures.
  - A tighter fiscal stance may be called for in case of excessive demand pressures.
- Monetary policy recommendation:
  - Monetary policy should focus on maintaining the peg.
  - Gradual reduction of Danish monetary policy spreads relative to the ECB would be desirable if market conditions permit.
- Financial stability and housing:
  - House price pressures in urban areas coupled with elevated household debt call for coordinated policy action.
  - Tightening of existing macroprudential measures would better protect families from house price declines and higher interest rates.
  - Consider a further than envisaged reduction of mortgage interest rate deductibility while interest rates are low.
  - Reduction of rent controls and relaxation of zoning restrictions would encourage more housing supply and alleviate demand for housing.
  - Banks are well-capitalized and progress was made with upgrading the regulatory framework; additional increases of the countercyclical capital buffer may be warranted if risks continue building up.
  - Strengthen the operational independence of the DFSA and ensure adequate resources for continued effectiveness.
- Employment and integration:
  - Employment rates continue rising on the back of past reforms, but there are untapped resources involving mainly young and migrants.
  - Measures to improve labor supply and migrant integration are reiterated (see Labor supply subsection).
- Investment and productivity:
  - Incentivizing private investment to boost productivity is a key challenge.
  - Product market deregulation in retail, taxi, and utility sectors would boost competition and encourage more investment.
  - Ongoing digitalization initiatives are important.
  - Capital income tax reforms in dividend taxation, losses carried forward, R&D deductions, business asset taxation, and an allowance for corporate equity would support investment and reduce the debt bias.
- External position:
  - The external position is stronger than implied by fundamentals, though this assessment is subject to large uncertainties.
  - The surplus is increasingly driven by offshore trading activities and investment income.
  - While the EBA model does not identify policy gaps that explain most of the excess current account surplus, structural policies that raise investment would help reduce the surplus.
- Procedural recommendation:
  - It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

*Source: cr18177 — Extract from IMF staff report (Denmark).*

### Box 1. Tax Reform Options

### Box 1. Tax Reform Options

### Boosting investment in startups and high-tech firms
- Various measures could be taken to decrease disincentives for investment by small and high-technology companies. Most importantly:
  - The tax rate on dividends could be reduced, as the high taxation of dividends discourages equity investments in startups. Listed firms are less affected, as their marginal shareholders are likely to be pension funds or foreign investors. For small investors with little collateral, there is no alternative to equity funding, which implies a very high cost of capital for them. Lower dividend tax rates would also increase the attractiveness of profit distributions and could thereby lower corporate savings.
  - The limitations on the use of losses carried forward could be relaxed. The limitation poses a challenge for cash-constraint startups who tend to be initially loss making.
  - The treatment of the R&D deduction could be made more generous, as currently only part of it is refundable.

### Improving the neutrality toward investment and the debt-equity choice
- As in most countries, the current Danish corporate income tax system entails a tax preference for debt over equity, because interest on debt is deductible.
- The introduction of an Allowance for Corporate Equity, which allows a similar deduction on equity finance, would improve efficiency, by greatly reducing the debt bias and by reducing the cost of capital so that the corporate income tax does not discourage investment. In other words, the required pre-tax rate of return would be lowered.
- Such a reform would be very promising, but a careful study of administrative data to assess the long-term revenue implications is needed, as later abolition should be avoided in the interest of tax certainty.

### Protecting tax bases and preventing profit shifting
- As Danish anti-avoidance legislation is already very strong, only minor technical changes will be needed in response to recent international initiatives aimed at reducing profit shifting.
- Specifically, one of the Danish interest deduction limitation rules will need to be changed from EBIT to EBITDA to be aligned with the requirements. The practical implication is likely to be limited, as for most firms the more binding limitation is the restriction in terms of assets, which is not affected.
- In general, there is little need for further tightening of anti-avoidance rules, which are already stronger than in most countries. However, as new avoidance strategies keep being developed, vigilance in this area is always warranted.
- Digitalization poses another major challenge that may ultimately require fundamental reform, but should not lead to rushed measures or a ring-fenced approach.
- Moreover, international tax developments, including reforms at the European Union level could affect Denmark, and their implications should be carefully studied.

*See Selected Issues Chapter “Capital Income Tax Reform Options in Denmark” for details.*

### Annex I. External Balance Assessment

### Annex I. External Balance Assessment

### Key findings and overview
- The current account surplus in 2017 was 7.6 percent of GDP, close to its post-crisis average.
- Foreign asset accumulation reached 317 percent of GDP in 2017.
- Net international investment position (NIIP) rose to 54 percent of GDP in 2017; of the nearly 54 percentage points of GDP NIIP increase since 2009, 23 percentage points of GDP was due to revaluations and other adjustments related to asset prices increases, according to staff estimates.
- Central bank analysis finds that about half (some DKK 3 trillion) of Danes’ foreign assets are interest-rate or equity-price sensitive in 2016, up from 41 percent in 2005.

### Drivers of the current account surplus
- Offshore trading activity of Danish multinational corporations and investment income are significant drivers of the current account surplus.
- Net exports of goods account for most of the trade surplus: 5.8 out of 6.6 percent of GDP in 2017.
- An increasing share of that trade surplus is produced outside Denmark: 4.6 percent of GDP in 2017 (from less than 1 percent ten years earlier), reflecting merchanting and processing trade by multinational firms.
- Net capital outflows in 2017 reflected a reduction in debt liabilities (¾ percent of GDP in 2017) and an increase of outward direct investment (almost 5 percent of GDP in 2017).

### Savings, investment, and sectoral contributions
- Private sector firms have the highest net savings; households have increased their net contribution to the current account surplus in recent years.
- Savings and investment both declined after the global financial crisis, but savings recovered quickly while investment recovered more slowly.
- Nonfinancial firms reduced investment and deleveraged, contributing to a sizeable increase in the net lending position (saving—investment) of nonfinancial firms.
- Households, after a large housing price decline, sought to repay debt and increase savings.

### EBA results, staff assessment, and uncertainties
- EBA model estimates:
  - Cyclically-adjusted current account position at 7.9 percent of GDP for 2017.
  - Current account norm of 4.0 percent of GDP.
  - Staff assess the current account gap at around 3.9 percent (percent of GDP), indicating the external position is stronger than the level consistent with medium-term fundamentals.
- Table excerpt (as presented):
  - Methodology — Current account gap (percent of GDP): EBA current account analysis 3.9
  - Staff assessment 3.9 (+/- 1) -7.5 (REER gap percent)
  - Index REER analysis - 12.5
  - Level REER analysis - 11.4
  - (Minus signs for the REER gaps indicate undervaluation.)
- Translation to exchange rate gap: assuming 0.52 semi-elasticity of the current account with respect to the real effective exchange rate, this translates into an exchange rate gap of about 5½–9 ½ percent.
- Important Denmark-specific uncertainties affecting the assessment:
  - Large pension contributions from the transition to a fully-funded retirement system create significant structural savings; the net effect on national savings is debated.
  - Measurement issues related to merchanting and offshore processing trade may lead to a slight overestimation of the current account surplus. Research indicates current account balances for merchanting-characteristic countries (including Denmark) are on average 3 percentage points of GDP higher than other countries.

### REER models, competitiveness indicators, and alternative assessments
- REER model estimates:
  - Level REER model estimates the krone is overvalued by about 11.4 percent.
  - Index REER model estimates the krone is overvalued by about 12.5 percent.
- REER indices based on inflation and unit labor costs have hovered around their 20-year average levels in recent periods, recovering from periods of undervaluation.
- Competitiveness indicators:
  - Denmark’s unit labor cost has risen faster than in major competitors (e.g., the Euro area) over the past two decades.
  - An increase in Denmark’s terms of trade over the same period partly offsets the unit labor cost increase, reflecting improved Danish export prices in high-value industries such as pharmaceuticals.
- The differing signals from the EBA current account model and REER/competitiveness indicators reinforce uncertainties and difficulties in arriving at an overall external assessment.

### Policy implications and recommendations
- The EBA model does not identify domestic policy gaps that explain most of the excess current account surplus.
- Structural policies that raise investment would help reduce the current account surplus.
- There is scope for higher wage growth; part of the resulting increased demand could be met via higher imports, supporting a reduction in the current account surplus.

*Source: Annex I. External Balance Assessment (Denmark), IMF staff report.*

### 4. Structurally weak

### 4. Structurally weak

### Major risks: growth in key advanced economies and trade partners
- Denmark’s exports are tightly linked to the euro area markets, other Nordic countries, the U.S, and China.
- Slower growth in those economies for an extended period would weaken exports and lower domestic demand, which has a negative impact on growth.
- Relative likelihood: Medium

### Major risks: retreat from cross border integration / protectionism
- Rising trade tensions would have a negative impact on Denmark, being a small globally-integrated open economy with positive trade balance.
- Relative likelihood: Medium/ High

### Risk Assessment Matrix (RAM) framing
- The RAM shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent).
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.
- Non-mutually exclusive risks may interact and materialize jointly.
- “Short term” and “medium term” are meant to indicate that the risk could materialize within one year and three years, respectively.

### Policy recommendations (to address growth and trade risks)
- Allow automatic stabilizers to operate and adjust the pace of fiscal consolidation.
- Move ahead with structural reforms to increase labor supply and reform product markets.
- Proceed with structural reforms to increase labor supply and reform product markets (recommended in the context of rising trade tensions).

### Authorities’ response to past IMF policy recommendations
Fiscal Policy
- Past recommendation: A slower pace of consolidation may be appropriate, but with capacity-enhancing reforms in mind, such as earned-income tax credit for low-income earners and bonus deductions for R&D investment. A change in the composition of fiscal spending and revenues was also recommended. These includes shift from consumption and transfers to productive public investment (spending), and from high personal income tax rate reduction to cuts in the mortgage interest deductibility (revenue).
- Authorities’ actions: Due to higher-than-expected revenue and some underspending the fiscal position showed faster-than-anticipated consolidation in 2017, partially reflecting a stronger growth outturn. Political constraints limited the chances for large tax cuts in the 2018 budget negotiation, but 2018–2020 fiscal deficits will be pushed up to accommodate costs of past structural reforms. This includes a tax-free withdrawal of early retirement contributions and payback of property taxes during transition to a new real estate valuation system.

Housing Market
- Past recommendation: Introduce a debt-to-income limit, end the procyclical valuation freezes for land and property taxes, eliminate mortgage interest deductibility, and address supply constraints.
- Authorities’ actions: A long-planned property and land tax reform took place in 2017, ending the property valuation freezes and ensuring that housing tax burden will be tied to housing price developments. A modified version of the debt-to-income limit went into effect in 2018.

Financial Sector
- Past recommendation: Complete the upgrade of the regulatory framework on CRR and BRRD, strengthen the operational independence of the DFSA, enhance regional cooperation on financial stability issues, including through the agreed MOUs.
- Authorities’ actions: The resolution framework is largely in place with the final specification of the resolution buffers for SIFIs underway. An agreement on the inclusion of covered bonds in the NSFR definition for MCIs is ongoing as well. A process to establish an internal audit office at the DFSA is underway. A new set of MOUs was agreed upon in early 2018 within the Nordic-Baltic Stability Group covering resolution collaboration practices.

Structural Reforms
- Past recommendation: Enact product market reforms, such as liberalizing the Planning Act, improving competition in the construction and utilities sectors, and promoting further deregulation in retail trade. Provide greater incentives to benefit recipients to participate in the labor force and reduce inactivity traps, intensify integration programs for migrations.
- Authorities’ actions: Amendments to the Planning and Taxi Acts relaxed regulations. Phase I of JobReform set ceilings on social assistance and provided incentives to inactive people to participate in the workforce. Phase II of JobReform is under consideration. A tripartite agreement allows greater participation of migrants in the workforce, albeit temporarily.

*Source: cr18177 - 4. Structurally weak (PDF).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18177.pdf_