## _cr06341 - Executive Summary

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### Executive overview and key issues
- The Danish economy has been doing very well lately but is now faced with the risk of overheating.
- Economic activity in 2005 and early 2006 was strong, driven in part by rapidly appreciating house prices, and unemployment has reached record low levels.
- Macroeconomic policy options to cool the economy are limited given ERM2 participation and the already strong fiscal position.
- Required policy mix: continued public expenditure restraint, rapid implementation of measures to increase labor supply, wage moderation, and actions to avoid unbalanced housing market developments to maintain macroeconomic and financial stability.

### Short-term outlook and growth projections
- Growth projections and assumptions:
  - Growth is expected to continue at a strong but slower pace in 2006, followed by a further moderation in 2007–08, assuming a gradual slowdown in private consumption and investment.
  - Growth is estimated to continue at a strong but slower pace in 2006 and to gradually return to its potential (around 2 percent) in 2007–08, conditional upon continued wage moderation and prudent fiscal policies.
- Recent outturns (2005):
  - Real GDP rose by 3.2 percent in 2005.
  - Real GDP growth (2000–2005 series shown): 3.5, 0.7, 0.5, 0.7, 1.9, 3.2.
  - Contributions to GDP growth, 2005: Domestic demand 3.9, Consumption 2.2, Public 0.3, Private 1.9, Fixed investment 1.9, Inventories -0.3, Net exports -0.8, Exports 3.8, Imports -4.6.
- Major projection table highlights (selected):
  - Real GDP (change in percent): 2004 1.9; 2005 (prel.) 3.2; 2006 (proj.) 2.7; 2007 (proj.) 2.3.
  - Growth returns to potential (around 2 percent) in 2008.
  - CPI (year average): 2004 2.1; 2005 (prel.) 1.8; 2006 (proj.) 1.8; 2007 (proj.) 2.0.
  - Unemployment rate (in percent): 2004 6.2; 2005 (prel.) 5.7; 2006 (proj.) 4.8; 2007 (proj.) 4.9.

### Fiscal policy: outcomes, assessment, and recommendations
- 2005 fiscal outturn and fiscal indicators:
  - A large fiscal surplus of 3.9 percent of GDP was achieved in 2005, much higher than budgeted and than the 2004 surplus of 1.7 percent of GDP.
  - Revenue growth was 6.4 percent in 2005.
  - Structural balance improved by 0.9 percentage point of GDP (source states structural balance shows a smaller improvement).
  - General government debt came down to 36 percent of GDP at end-2005.
- Revenue and expenditure details (percent of GDP, 2003–05 snapshot):
  - Total Revenues: 54.8 (2003), 56.5 (2004), 56.7 (2005), change 05-04 = 0.2
  - Personal Income Taxes: 22.3, 21.7, 21.5, change -0.2
  - Pension Return Taxes: 0.4, 1.6, 2.0, change 0.5
  - Company Taxes: 2.9, 3.2, 3.6, change 0.4
  - VAT: 9.6, 9.8, 10.0, change 0.2
  - Total Expenditures: 54.9, 54.8, 52.8, change -2.0
  - Public Consumption: 27.5, 27.6, 27.1, change -0.5
  - Transfer Incomes: 17.3, 17.2, 16.4, change -0.7
  - Interest Expenditures: 3.4, 3.1, 2.6, change -0.5
  - Balance: -0.1 (2003), 1.7 (2004), 3.9 (2005), change 2.2
  - Structural Balance: 0.7, 0.8, 1.7, change 0.9
- Fiscal policy recommendations:
  - Tight control over public expenditures is required to avoid contributing to demand pressures.
  - Authorities’ intention to abstain from further tax cuts in 2007 is welcome for cyclical reasons, but the current tax freeze is described as "unnecessarily rigid."
  - A revenue-neutral combination of a decrease in personal income taxation and an increase in real estate taxes would support labor supply and financial stability, but lacks political support.
  - Prioritize improved spending discipline; contain public consumption growth and enforce spending ceilings.

### Monetary and exchange rate policy
- Exchange-rate regime and credibility:
  - The fixed exchange rate system—the peg of the krone to the euro—continues to serve Denmark well by anchoring inflationary expectations and imposing discipline on fiscal and structural policies.
  - Denmark participates in ERM2 with margins of 2¼ percent vis-à-vis the euro; central fixed rate at DKr 746.038 per €100.
- Interest rate behavior and pass-through:
  - The DNB follows official interest rate changes by the ECB closely and intervenes only to smooth exchange rate movements.
  - The lending rate and the rate of interest for certificates of deposit were raised by 10 basis points in February due to an outflow of foreign exchange.
  - Monetary conditions index (MCI) composition: weighted averages of the 3-month interest rates and the detrended effective exchange rates, with respective weights of 0.75 and 0.25.
  - Mission noted raising rates in line with possible future ECB increases would be suitable; pass-through of changes in interest rates has become quicker with enhanced availability of adjustable rate products.

### Labor market, welfare reform, and structural policies
- Labor market outcomes and pressures:
  - Unemployment fell to 4.5 percent in June (lowest in 30 years).
  - Employment pickup of about 1 percent.
  - Labor shortages emerged in construction and the financial sector.
  - Full-time participants in active labor market programs remained high at 4.4 percent of the labor force at end-2005.
- Welfare Agreement key elements (June 20, 2006):
  - Early retirement age raised from 60 to 62 years during 2019-22.
  - Public pension age raised from 65 to 67 years during 2024-27.
  - Retirement ages indexed to the mean life expectancy of 60 year olds as of 2025.
  - More flexible early retirement scheme and measures to improve job opportunities for older workers.
  - Short-run labor supply measures: shorten educational tracks, reduce extended unemployment benefits for older workers, increase participation of immigrants, reduce restrictions on foreign workers.
- Structural policy guidance:
  - Commended reforms but advised stronger short-run labor supply measures to alleviate bottlenecks.
  - Globalization Council recommendations supported but mission cautioned against unfocused and rushed additional public spending on R&D; expenditures should be targeted and phased.
  - Continue product market deregulation and complete remaining reforms while economy is strong.

### Price developments, competitiveness, and wages
- Inflation and competitiveness:
  - Harmonized inflation rose to 2.1 percent in June; recent rise mainly attributed to transitory factors, including large increases in energy and food prices.
  - Inflation remains contained but is catching up with the euro area; core and headline inflation have shown an upward trend and the gap with the euro area almost disappeared in 2005.
  - Denmark experienced a 15 percent real appreciation of the krone during 2001–04; Denmark’s REER appreciation was more contained than the euro (25 percent) and depreciated slightly since early 2005.
  - Labor productivity growth in manufacturing lagged Germany, Sweden, and the United Kingdom in 2004-05 largely due to cyclical factors; unit labor costs rose more than in Germany and Sweden but were in line with the euro area average.
- Wage policy:
  - Broad agreement on importance of continued wage moderation to reduce overheating risks and maintain competitiveness.
  - Social partners have so far agreed on relatively moderate wage increases; upward pressures remain, notably in construction and financial sectors.

### Financial sector, housing market risks, and supervision
- Financial sector assessment:
  - FSAP indicated an overall resilient and well-supervised financial system.
  - Banks and mortgage credit institutions posted record profits in 2005; insurance companies and pension funds also performed well.
  - Life insurance and pension segments addressed past contractual problems but continue to offer products with guaranteed returns that may pose risks.
- Housing market developments and risks:
  - House prices appreciated by 21.6 percent in 2005 following an increase of 10 percent in 2004; real estate price index (1995=100): 2004 226.3; 2005 261.0.
  - Staff analysis: the acceleration of house prices is not fully explained by high income growth and falling interest rates; contributing factors include new mortgage products and the tax freeze.
  - House prices in Denmark rose by more than 20 percent in 2005, one of the highest rates worldwide.
  - Household debt and credit:
    - Low interest rates stimulated credit growth, which reached 14.6 percent in April 2006.
    - More than 60 percent of credit is extended to households.
    - Household debt is at more than 200 percent of disposable income.
    - Debt-servicing costs remain contained due to low interest rates; net debt is low.
    - Wider use of adjustable rate mortgages increased households’ exposure to changes in short-term interest rates.
- Supervisory recommendations:
  - Close monitoring of the housing market, strict application of supervisory regulations, effective consumer information about risks of overborrowing.
  - Any easing of capital requirements should be gradual; supervisors should use authority to require additional capital where appropriate.
  - Intensify DFSA stress testing capacity, entrench DFSA autonomy and accountability, consider expanding DFSA resources, upgrade internal controls guidance, broaden fit-and-proper coverage.
  - Heighten supervisory vigilance given rapid credit growth; adopt a cautious approach toward any reduction in capital buffers.

### Debt sustainability: external and public debt projections
- External debt sustainability (key projected path, external debt in percent of GDP):
  - 2001 33.7; 2002 27.1; 2003 23.1; 2004 22.6; 2005 21.2; 2006 19.4; 2007 17.8; 2008 16.4; 2009 15.0; 2010 13.5; 2011 12.1.
- Selected external-debt indicators and flows:
  - Net external debt declined from 34 percent of GDP in 2001 to 21 percent in 2005.
  - Baseline projection: net external debt declines to 12 percent of GDP in 2011.
  - Gross external financing need (in percent of GDP): 2005 8.2; 2006 7.7; 2007 6.5; 2008 6.0; 2009 5.2; 2010 4.3; 2011 3.5.
- Public sector debt sustainability (key projected path, percent of GDP):
  - Public sector debt: 2001 48.8; 2002 48.4; 2003 45.6; 2004 43.7; 2005 36.2; 2006 31.8; 2007 28.0; 2008 25.3; 2009 23.0; 2010 21.0; 2011 19.2.
- Fiscal dynamics (selected):
  - Primary deficit (percent of GDP): 2005 -6.5; 2006 -4.8; 2007 -4.5; 2008 -3.5; 2009 -3.1; 2010 -2.7; 2011 -2.5.
  - Revenue and grants (percent of GDP): 2005 56.7; 2006 54.0; 2007 53.3; 2008 52.3; 2009 52.0; 2010 51.6; 2011 51.3.
  - General government gross debt (selected projections): 2006 36.2; 2007 31.8; 2008 28.0; 2009 25.3; 2010 23.0; 2011 21.0.
- Stress-test outcomes:
  - Under relevant stress test scenarios the debt ratio reaches at most 24 percent of GDP in 2011.
  - Baseline scenario (assuming the tax freeze remains in effect): public sector debt declines to 19 percent of GDP in 2011.

### Risks, scenarios, and sensitivities
- Upside short-term risks:
  - Further reduction in an already low unemployment rate may give rise to labor market tensions.
  - Upward wage pressures, notably in construction and financial sectors; increases in fringe benefits noted.
  - Housing market has yet to show clear signs of slowdown.
  - Pressures to loosen fiscal policy given the large 2005 surplus.
- Downside risks:
  - Housing market slowdown could substantially affect growth in domestic demand through wealth effects on consumption and consumer confidence, given high household debt mostly covered by real estate collateral.
- External sensitivities:
  - Danish economy sensitive to the exchange rate, the oil price, and shipping industry performance.
  - Further appreciation of the euro might negatively affect the trade balance.
  - As a net exporter of oil, Denmark benefited from high oil prices in 2005, contributing to budget and current account surpluses.

### Executive Board assessment and policy recommendations (high level)
- Findings and outlook:
  - Directors commended stability-oriented policies and welcomed strong recent performance: high growth rates and low unemployment.
  - Staff forecast: growth around 2¾ percent in 2006, slowing to about 2¼ in 2007.
  - Inflation remains contained but is catching up with the euro area.
- Policy priorities and recommendations:
  - Continue fiscal policy guided by prudent medium-term objectives; maintain structural surpluses of ½–1½ percent of GDP.
  - Continue public expenditure restraint and avoid weakening the fiscal framework when it is updated.
  - Implement measures to increase labor supply and moderate wages.
  - Monitor housing market developments closely and maintain supervisory vigilance.
  - Support authorities’ intention not to introduce tax cuts in 2007; consider gradual and predictable elimination of the partial nominal property tax freeze accompanied by a corresponding reduction in personal income taxes.
  - Maintain Denmark’s exchange regime (euro peg) and favor gradual monetary tightening in line with the ECB where appropriate.
  - Strengthen DFSA statutory and budgetary autonomy, build up stress testing capacity, and focus on governance and cross-border supervision.

*Source: _cr06341 - Executive Summary and accompanying staff report material (IMF staff report content provided in the source PDF).*

### Executive Summary ......................................................................................................

### _cr06341 - Executive Summary

### Executive overview and key issues
- The Danish economy has been doing very well lately but is now faced with the risk of overheating.
- Economic activity in 2005 and early 2006 was strong, driven in part by rapidly appreciating house prices, and unemployment has reached record low levels.
- Macroeconomic policy options to cool the economy are limited given ERM2 participation and the already strong fiscal position.
- Required policy mix: continued public expenditure restraint, rapid implementation of measures to increase labor supply, wage moderation, and actions to avoid unbalanced housing market developments to maintain macroeconomic and financial stability.

### Short-term outlook
- Growth projections:
  - Growth is expected to continue at a strong but slower pace in 2006, followed by a further moderation in 2007-08, assuming a gradual slowdown in private consumption and investment.
  - This forecast is based on continued prudent fiscal policies and wage moderation.
- Recent outturns (2005):
  - Real GDP rose by 3.2 percent in 2005.
  - Real GDP growth (2000–2005 row): 3.5, 0.7, 0.5, 0.7, 1.9, 3.2 (table-style series shown in source).
  - Contributions to GDP growth, 2005: Domestic demand 3.9, Consumption 2.2, Public 0.3, Private 1.9, Fixed investment 1.9, Inventories -0.3, Net exports -0.8, Exports 3.8, Imports -4.6 (as reported in source table).
- Domestic demand drivers in 2005:
  - Private consumption boosted by high real disposable income (tax reductions in 2004), low interest rates, new loan types (e.g., interest-only loans), and house price developments.
  - Double-digit residential investment growth driven by rising house prices.
  - Real public consumption growth decelerated slightly but remained well above the 0.5 percent target in the fiscal framework.
  - Exports and imports grew sharply; external sector contributed negatively to growth.

### Fiscal policy findings and recommendations
- 2005 fiscal outturn:
  - A large fiscal surplus of 3.9 percent of GDP was achieved in 2005, much higher than budgeted and than the 2004 surplus of 1.7 percent of GDP.
  - Revenue growth was 6.4 percent in 2005.
  - Structural balance improved by 0.9 percentage point of GDP (source states structural balance shows a smaller improvement).
  - General government debt came down to 36 percent of GDP at end-2005.
- Revenue and expenditure details (percent of GDP, 2003–05 snapshot in source):
  - Total Revenues: 54.8 (2003), 56.5 (2004), 56.7 (2005), change 05-04 = 0.2
  - Personal Income Taxes: 22.3, 21.7, 21.5, change -0.2
  - Pension Return Taxes: 0.4, 1.6, 2.0, change 0.5
  - Company Taxes: 2.9, 3.2, 3.6, change 0.4
  - VAT: 9.6, 9.8, 10.0, change 0.2
  - Total Expenditures: 54.9, 54.8, 52.8, change -2.0
  - Public Consumption: 27.5, 27.6, 27.1, change -0.5
  - Transfer Incomes: 17.3, 17.2, 16.4, change -0.7
  - Interest Expenditures: 3.4, 3.1, 2.6, change -0.5
  - Balance: -0.1 (2003), 1.7 (2004), 3.9 (2005), change 2.2
  - Structural Balance: 0.7, 0.8, 1.7, change 0.9
- Policy recommendations and assessment:
  - Tight control over public expenditures is required to avoid contributing to demand pressures.
  - Authorities’ intention to abstain from further tax cuts in 2007 is welcome for cyclical reasons, but the current tax freeze is described as "unnecessarily rigid."
  - A revenue-neutral combination of a decrease in personal income taxation and an increase in real estate taxes would support labor supply and financial stability, but lacks political support.
  - The Fund has recommended prioritizing improved spending discipline; government efforts have reduced public consumption growth, although spending ceilings were exceeded (Box 1).

### Monetary and exchange rate policy
- The fixed exchange rate system—the peg of the krone to the euro—continues to serve Denmark well by anchoring inflationary expectations and imposing discipline on fiscal and structural policies.
- Denmark participates in ERM2 with margins of 2¼ percent vis-à-vis the euro.
- The peg is viewed as a central pillar of Denmark’s macroeconomic stability strategy (Fund view in Box 1).

### Labor market, structural policies, and welfare reform
- Labor market performance:
  - Unemployment fell to 4.5 percent in June (lowest in 30 years).
  - Employment pickup of about 1 percent.
  - Labor shortages emerged in construction and the financial sector.
  - Full-time participants in active labor market programs remained high at 4.4 percent of the labor force at end-2005 (participants in programs statistic cited).
- Structural policy developments:
  - The welfare agreement reached on June 20, 2006 marks an important step toward preparing Denmark for the implications of an aging population.
  - Measures in the agreement aimed at increasing labor supply in the short run could have been stronger.
  - Initiatives to enhance competitiveness appear generally well placed, although their costs will need to be contained.
- Fund advice (Box 1):
  - Commended strong performance of labor market and encouraged reforms to reduce incentives for early retirement to alleviate labor supply constraints and lower structural unemployment.
  - Recent welfare reform agreement includes adjustments in the retirement schemes and labor supply measures.

### Price developments and competitiveness
- Inflation:
  - Inflation remains contained but is catching up with that in the euro area.
  - Harmonized inflation rose to 2.1 percent in June (source attributes recent rise mainly to transitory factors, including large increases in energy and food prices).
  - Core and headline inflation have shown an upward trend; the gap with the euro area almost disappeared in 2005.
- Competitiveness:
  - Denmark experienced a 15 percent real appreciation of the krone during 2001–04 (source statement).
  - Denmark’s REER appreciation was more contained than the euro (25 percent) and depreciated slightly since early 2005.
  - Danish exports and export shares in world and EU markets held up well; trade and current account surpluses have been sustained.
  - Labor productivity growth in manufacturing lagged behind Germany, Sweden, and the United Kingdom in 2004-05 largely due to cyclical factors.
  - Unit labor costs in Denmark rose more than those in Germany and Sweden but were in line with the euro area average.

### Financial sector assessment and housing market risks
- Financial sector assessment (FSAP):
  - The FSAP indicated an overall resilient and well-supervised financial system.
  - Close monitoring of the housing market and continued strict adherence to supervisory rules will be required.
- Housing market:
  - Rapidly appreciating house prices have been a key driver of domestic demand and a factor in the overheating risk noted in the summary.
  - Actions to avoid unbalanced housing market developments are recommended as part of the policy mix.

### Historical context and policy framework
- Past reforms:
  - Major macroeconomic stabilization in the mid-1980s followed by structural reforms in the early 1990s improved inflation, unemployment, fiscal deficits, and current account outcomes.
  - Results: significant growth in the late 1990s, reduced structural unemployment, sizable fiscal surpluses, lower public debt-to-GDP, and improved foreign debt position.
- Policy framework:
  - Since 2001, policy emphasis on fiscal consolidation and augmenting labor supply.
  - Key elements: real public expenditure norms and a tax freeze.
  - Strong nationwide consensus on prudent economic policies and the “flexicurity” model combining labor market flexibility, an extensive social safety net, and active labor market policies.

*Source: _cr06341 - Executive Summary (IMF staff report content provided in the source PDF).*

### 9.      Policy interest rates follow those of the ECB and monetary conditions are

### 9.      Policy interest rates follow those of the ECB and monetary conditions are

### Monetary policy and interest rates
- Denmark is a long-standing member of ERM2; small spreads in interest rates vis-à-vis the euro area and narrow movements of the krone around the parity underline the credibility of the peg.
- The DNB follows official interest rate changes by the ECB closely and intervenes only to smooth exchange rate movements.
- The lending rate and the rate of interest for certificates of deposit were raised by 10 basis points in February due to an outflow of foreign exchange, inter alia as a result of Danish institutional investors’ purchases of foreign shares and securities.
- The monetary conditions index (MCI) has recently bottomed out.
  - Monetary conditions indices are calculated as weighted averages of the 3-month interest rates and the detrended effective exchange rates, with respective weights of 0.75 and 0.25.

### Credit, interest rates, and household balance sheets
- Low interest rates have stimulated credit growth, which reached 14.6 percent in April 2006.
- More than 60 percent of credit is extended to households, underpinning a significant appreciation of house prices.
- Household indebtedness:
  - Household debt is at more than 200 percent of disposable income.
  - Debt-servicing costs remain contained due to low interest rates.
  - Net debt is low.
- Wider use of adjustable rate mortgages has raised households’ exposure to changes in short-term interest rates.

### Asset prices and financial sector profitability
- The Danish stock market index went up by 37 percent in 2005; one third of the growth was attributable to the rising shares of Maersk.
  - Note: During the first half of 2006, the Danish stock price index came down by about 5 percent.
- House prices appreciated by 21.6 percent in 2005 following an increase of 10 percent in 2004.
- Banks and mortgage credit institutions posted record profits with substantial contribution from fee income due to securities trading and refinancing of mortgage loans, supported by low provisions.
- Insurance companies and pension funds performed well due to higher returns from equities, bonds, and real estate holdings.

### Developments in the Danish housing market (Box 2)
- House prices in Denmark rose by more than 20 percent in 2005, one of the highest rates worldwide.
- Drivers of house price appreciation:
  - General factors: increases in real disposable income and declines in interest rates (these fail to fully explain the recent acceleration).
  - Denmark-specific factors:
    - Housing finance market: efficient mortgage-financing system with new products (flexible-interest and interest-only loans), easy refinancing options, active mortgage-linked securities market, and low transaction costs. New products have increased amounts borrowed by lowering initial debt servicing obligations.
    - Taxation system: the tax freeze keeps underlying values for real estate tax essentially set at 2002 levels, so recent sharp increases in house prices have not resulted in a nominal increase in real estate taxes due.

### Outlook and risks (A. Outlook and Risks)
- Growth projections:
  - Growth is estimated to continue at a strong but slower pace in 2006, followed by a further moderation in 2007–08.
  - Growth is expected to gradually return to its potential (around 2 percent) in 2007–08, conditional upon continued wage moderation and prudent fiscal policies.
- Inflation and balances:
  - Inflation is projected to remain around 2 percent, supported by the exchange rate peg.
  - Current account and government balances are expected to remain in surplus, albeit less so than in 2005, helped by continued high oil prices.
- Upside short-term risks:
  - Further reduction in an already low unemployment rate may give rise to labor market tensions.
  - Upward wage pressures evident in construction and financial sectors; social partners noted increases in fringe benefits.
  - Housing market has yet to show clear signs of slowdown, though authorities indicated supply has recently increased somewhat.
  - Pressures to loosen fiscal policy in light of the large 2005 surplus.
- Downside risks:
  - Housing market slowdown could substantially affect growth in domestic demand through wealth effects on consumption and consumer confidence, given high household debt mostly covered by real estate collateral.
- External sensitivities:
  - Danish economy sensitive to the exchange rate, the oil price, and its position in international sea trade.
  - Further appreciation of the euro might negatively affect the trade balance.
  - As a net exporter of oil, Denmark benefited from recent high oil prices in 2005, contributing significantly to budget and current account surpluses.
  - The export sector is strongly affected by shipping industry performance, which is vulnerable to changing market conditions.

### Wage moderation and competitiveness
- Broad agreement on importance of continued wage moderation to reduce overheating risks and maintain competitiveness.
- Authorities noted Denmark scores highly on most indicators for external competitiveness but cautioned that significant wage increases would erode the external position.
- Social partners have so far agreed on relatively moderate wage increases, but strong upward pressures remain.

### Fiscal policy (B. Fiscal Policy)
- Fiscal framework:
  - Plan 2010 (agreed in 2001) aims at reaching a structural surplus over the medium-term of ½–1½ percent of GDP to ensure fiscal sustainability in an aging environment.
  - The framework enabled a decline in the debt-to-GDP ratio and related interest expenditures.
  - Authorities plan to update fiscal projections (Plan 2010) toward the end of this year and issue a new fiscal framework (Plan 2015) in the course of 2007.
- Expenditure pressures and tax freeze:
  - Public consumption growth exceeded expenditure norms in 2004 and 2005, largely from local governments exceeding spending limits.
  - Real public expenditure growth targets are likely to be revised upward to about 1 percent per year in line with new welfare proposals.
  - Authorities indicated there would be no proposals for tax cuts in 2007.
  - The tax freeze has been in place since 2002 to contain overall taxation and control expenditure, particularly at the local level.
  - Mission view: the tax freeze is overly rigid when "not a single tax rate can be increased—even where it would allow other, more harmful tax rates to come down."
- Mission proposal:
  - Increase real estate taxation and reduce income taxation correspondingly to support both labor supply and financial stability.
    - Rationale: current real estate taxation based on frozen below-market values provides an unnecessary and potentially damaging stimulus to the housing market; high marginal personal income tax rates that kick in at relatively low levels constrain labor supply.
  - Authorities’ concerns: increases in real estate taxation could put downward pressure on housing market and cause liquidity problems among some taxpayers; political economy concerns about “opening the box” on tax rates.
  - Mission noted process would need to be predictable and carried out responsibly; experience from other countries suggests gradual tightening need not lead to significant price pressures.
- Local government reform:
  - Ongoing reform aims to merge local governments into larger entities and more clearly assign responsibilities to improve service quality and resource efficiency.
  - Reform could help central government better control local expenditures in the medium term.
  - Mission welcomed streamlining but pointed to short-run upward pressures on expenditures; authorities said measures were in place to control these costs.

### Monetary and exchange rate policy (C. Monetary and Exchange Rate Policy)
- Agreement that the fixed exchange rate system (peg to the euro) continues to serve Denmark well by anchoring inflation expectations.
- Margins around the central rate are small, as are interest rate differentials with the euro area, reflecting market confidence in the peg.
- Authorities expressed strong commitment to the peg; mission noted the peg’s disciplinary impact on macroeconomic and structural policies.
- DNB policy stance:
  - DNB has closely followed official interest rate movements by the ECB.
  - Mission noted raising rates in line with possible future ECB increases would be suitable given Danish cyclical circumstances.
  - Pass-through of changes in interest rates on the economy has become quicker with enhanced availability of adjustable rate products, particularly in housing finance.

### Welfare reform and structural issues (D. Welfare Reform and Structural Issues)
- Main political parties reached an agreement on welfare reform aimed at preparing Denmark for an aging population; mission welcomed the agreement.
- Key elements of the welfare agreement (summary):
  - Gradual increases in age thresholds:
    - Early retirement age raised from 60 to 62 years during 2019-22;
    - Public pension age raised from 65 to 67 years during 2024-27;
    - Retirement ages indexed to the mean life expectancy of 60 year olds as of 2025.
  - More flexible early retirement scheme (e.g., opt-in until 15 years before early retirement age).
  - Adjustments in age limits related to higher retirement ages.
  - Improved job opportunities for older workers; strengthened prevention and workplace health and safety standards; abolition of age-discriminating barriers in the labor market.
  - Additional package elements: efforts to reduce unemployment (including among immigrants and descendants), measures to shorten educational tracks and promote earlier study completion, promotion of secondary education, life-long learning, research, innovation, and entrepreneurship.
- Short-run labor supply measures:
  - Measures to shorten the educational track, reduce extended length of unemployment benefits for older workers, increase participation of immigrants in the workforce, and reduce restrictions on foreign workers.
  - Authorities noted agreed short-run steps will be helpful; mission found measures insufficient to remove bottlenecks due to compromises.
  - Mission commented that adoption of Welfare Commission recommendations on taxation and introduction of user fees in health sector would have been welcome; authorities noted user fees would circumvent the tax freeze unless matched by tax reductions.
- Globalization Council report:
  - Recommends strengthening competitiveness through increased spending on education, R&D, and improving business climate.
  - Mission cautioned that unfocused and rushed additional public spending on R&D could be inefficient and unhelpful from a cyclical perspective; expenditures should be linked to clear targets and phased in carefully, with an important role for the private sector.
- Product market deregulation:
  - Progress made: further liberalization of the energy market, partial privatization of public postal services, consumers can choose gas and electricity suppliers, and prices are more market-based.
  - Mission advised using the strong economy to move ahead with remaining reforms in product and service markets.
- Flexicurity model seminar:
  - The model combines a flexible labor market, generous unemployment benefits, and active labor market policies.
  - Contributed to significant reduction in unemployment but financed in part through a large tax wedge on labor income.
  - High costs and moral hazard problems may impede effective implementation; authorities acknowledged advantages and drawbacks and stressed the historical acceptance of easy hiring and firing rules in Danish society.

*IMF staff report content as provided in the source PDF.*

### Box 4. The Danish Flexicurity Model:

### Box 4. The Danish Flexicurity Model: Can it be emulated by other European countries?

### Overview and core features
- The Danish flexicurity model combines a high degree of labor market flexibility with a high level of social protection engendered by generous unemployment benefits and active labor market policies.
- The model is associated with a low unemployment rate and a high standard of social security for the unemployed.
- Denmark finances high spending on labor market programs and unemployment benefits (more than 5 percent of GDP per year) by sustaining a high tax burden and one of the largest tax wedges on labor income among European countries.

### Historical experience and effectiveness
- Denmark traditionally combined flexible labor markets and high income protection. However, in the early 1980s Denmark experienced high and rising unemployment and inflation, chronic current account deficits, and mounting public deficits; unemployment fell only after unemployment benefits and labor market policies were tightened.
- Other countries have reduced high unemployment to low levels with different social models (examples cited: Sweden, Ireland, and the United Kingdom).

### Costs, fiscal implications, and short-run transition issues
- Implementing the Danish model elsewhere can be costly:
  - Countries starting from high unemployment will face a short-run sharp increase in the cost of unemployment benefits and active labor market policies, thereby widening the tax wedge with adverse impacts on labor demand and supply.
  - A calibrated model for France cited in the selected issues paper finds that implementation could be costly and reduction in structural unemployment during the first few years may be limited.
- The high cost reflects Denmark’s combination of generous benefits and costly active labor market programs financed by a high tax burden.

### Transferability and policy lessons
- Certain elements merit study and selective adoption:
  - The trade-off between the population’s willingness to accept labor market flexibility and the presence of a well-functioning social safety net.
  - The need to develop effective labor market policies to avoid high costs and perverse incentives.
  - The Danish government’s ongoing monitoring, analysis, and willingness to respond with policy actions.
- Examples of Danish policy responses:
  - Since the early 1980s crisis, reforms have shortened the maximum period for participation in active labor market programs and tightened eligibility criteria for unemployment benefits.

### FSAP and financial-sector-related recommendations (Box 5 and appraisal)
- FSAP findings:
  - The financial system was judged generally resilient, well supervised, and underpinned by an effective legal and financial infrastructure.
  - In 2005, banks and mortgage credit institutions posted record profits; insurance companies and pension funds also did well.
  - Life insurance and pension fund segments have addressed problems from past contracts with high guaranteed returns but continue to sell products with guaranteed returns that may cause problems.
- FSAP mission recommendations to forestall potential problems:
  - Any easing of capital requirements allowing for further expansion of credit be done gradually, and supervisors make greater use of their regulatory authority to require additional capital as appropriate in individual cases.
  - Intensify efforts to better monitor, compile information, and model the impact of various shocks through a buildup of the stress testing capacity at the DFSA.
- Additional governance and supervisory recommendations:
  - Entrench DFSA autonomy and accountability by providing a statutory basis and granting greater budgetary autonomy; consider separation of its regulatory and supervisory budget.
  - Consider expanding DFSA resources to verify banks’ internal models, undertake stress testing, and combat money laundering.
  - Upgrade the guideline on internal controls to an Executive Order and broaden fit-and-proper coverage.
- Authorities’ response:
  - Authorities agreed with the thrust of the FSAP, cautioned banks on internal capital allocation plans, and the DFSA sent a letter to financial institutions about housing-market risks.
  - Authorities planned to formalize the DFSA’s role in a statutory provision but were skeptical about prospects for formal budgetary autonomy.

### Macroeconomic appraisal and policy implications (staff appraisal highlights)
- Current risks and outlook:
  - The Danish economy has been doing very well but faces the risk of overheating driven in part by rapidly appreciating house prices and record low unemployment.
  - Growth rates are expected to come down gradually during 2006–08; growth is estimated to return to its potential (around 2 percent) in 2008, conditional on prudent fiscal policies and wage moderation.
  - Risks are on both the upside and downside: further reduction in the already low unemployment rate could cause labor market tensions and overheating; a significant slowdown in the housing market could substantially reduce domestic demand.
- Policy priorities emphasized:
  - Continued wage moderation to moderate demand pressures and maintain international competitiveness; consensus among social partners to agree on relatively modest wage increases should be maintained.
  - Fiscal policy should be guided by prudent medium-term objectives: the current framework aims at reaching structural surpluses of ½-1½ percent of GDP.
  - Containing expenditure growth is essential given cyclical pressures; local authorities found it difficult to adhere to expenditure norms with public consumption growth exceeding targets in 2004 and 2005.
  - The tax freeze is effective but rigid; it has resulted in frozen real estate values that provide an unnecessary stimulus to the housing market and high marginal personal income tax rates that become effective at relatively low income levels, constraining labor supply. Policy suggestion: increase real estate taxation and reduce personal income taxes correspondingly.
  - Denmark’s exchange regime (euro peg) continues to serve well by anchoring inflationary expectations; recent monetary tightening in line with the ECB will help counter cyclical pressures.
  - The welfare agreement reached in June (by major political parties) helps prepare Denmark for aging and maintain long-term fiscal sustainability, but measures to increase labor supply in the short run were weakened to achieve consensus and should nonetheless be implemented promptly.
- Financial stability advice:
  - Heighten supervisory vigilance and adopt a cautious approach toward any reduction in capital buffers.
  - Strengthen the DFSA’s statutory and budgetary autonomy, further build up its stress testing capacity, and focus on governance in financial institutions and cross-border supervision.
- Housing market:
  - Close monitoring required: sharp increase in house prices cannot be fully explained by income and interest-rate developments; favorable tax treatment and new financial instruments likely contributed to the rise in prices. Recommended actions include close monitoring, strict application of supervisory regulations, and effective consumer information about risks.

### Key statistics and quantitative points (preserved wording)
- Spending on labor market programs and unemployment benefits: more than 5 percent of GDP per year.
- Growth is estimated to return to its potential (around 2 percent) in 2008.
- Structural surplus target: ½-1½ percent of GDP.
- Time coverage for growth moderation: during 2006–08.

*Based on "Danish for All? Balancing Flexibility with Security: the Danish Flexicurity Model" and related FSAP and staff appraisal material included in the source document.*

### 45.      It is proposed that the next Article IV consultation be conducted on the 24-month

### _cr06341 - 45.      It is proposed that the next Article IV consultation be conducted on the 24-month

### Major macroeconomic projections and outcomes (selected)
- Real GDP (change in percent)
  - 2004: 1.9
  - 2005 (prel.): 3.2
  - 2006 (proj.): 2.7
  - 2007 (proj.): 2.3
- Domestic demand (change in percent)
  - 2004: 0.6
  - 2005 (prel.): 3.3
  - 2006 (proj.): 3.3
  - 2007 (proj.): 2.1
- Private consumption (change in percent)
  - 2004: 1.6
  - 2005 (prel.): 3.4
  - 2006 (proj.): 3.2
  - 2007 (proj.): 2.3
- Gross fixed investment (change in percent)
  - 2004: 2.0
  - 2005 (prel.): 4.5
  - 2006 (proj.): 9.4
  - 2007 (proj.): 6.5
- Net exports contribution to GDP growth (percent)
  - 2004: -1.4
  - 2005 (prel.): -0.8
  - 2006 (proj.): -0.1
  - 2007 (proj.): 0.3
- CPI (year average)
  - 2004: 2.1
  - 2005 (prel.): 1.8
  - 2006 (proj.): 1.8
  - 2007 (proj.): 2.0
- Unemployment rate (in percent)
  - 2004: 6.2
  - 2005 (prel.): 5.7
  - 2006 (proj.): 4.8
  - 2007 (proj.): 4.9
- Current account (percent of GDP)
  - 2004: 3.2
  - 2005 (prel.): 2.5
  - 2006 (proj.): 3.2
  - 2007 (proj.): 2.3

### Public finance (selected indicators, percent of GDP)
- General government revenues
  - 2004: 54.8
  - 2005 (prel.): 56.5
  - 2006 (proj.): 56.7
  - 2007 (proj.): 54.0
- General government expenditure
  - 2004: 52.8
  - 2005 (prel.): 51.4
  - 2006 (proj.): 51.4
  - 2007 (proj.): 50.8
- General government balance
  - 2004: 2.3
  - 2005 (prel.): 3.9
  - 2006 (proj.): 2.6
  - 2007 (proj.): 2.5
- General government structural balance
  - 2004: 0.7
  - 2005 (prel.): 1.1
  - 2006 (proj.): 0.4
  - 2007 (proj.): 0.7
- General government primary balance
  - 2004: 4.9
  - 2005 (prel.): 3.5
  - 2006 (proj.): 2.5
  - 2007 (proj.): 1.9
- General government gross debt
  - 2004: 45.6
  - 2005 (prel.): 43.7
  - 2006 (proj.): 36.2
  - 2007 (proj.): 31.8

### External sector and balance of payments (selected)
- Exports of goods & services (percent of GDP)
  - 2004: 45.0
  - 2005 (prel.): 48.3
  - 2006 (proj.): 49.4
  - 2007 (proj.): 48.6
- Imports of goods (percent of GDP)
  - 2004: 40.3
  - 2005 (prel.): 43.4
  - 2006 (proj.): 44.8
  - 2007 (proj.): 43.8
- Trade balance, goods and services (percent of GDP)
  - 2004: 4.9
  - 2005 (prel.): 4.9
  - 2006 (proj.): 4.7
  - 2007 (proj.): 4.8
- Net oil exports (US$ bln)
  - 2002: 1.5
  - 2003: 1.0
  - 2004: 1.4
  - 2005: 1.8
  - 2006 (proj.): 2.6
  - 2007 (proj.): 3.2
  - 2008 (proj.): 3.2
- Memorandum: Gross External Debt
  - 2002: 121.4
  - 2003: 125.6
  - 2004: 131.5
  - 2005: 146.4
  - 2006 (proj.): 151.7
  - 2011 (proj.): 184.7

### Financial sector and vulnerability indicators (selected)
- Domestic credit growth (end of year)
  - 2000: 11.5
  - 2001: 9.5
  - 2002: 5.1
  - 2003: 6.3
  - 2004: 8.9
  - 2005: 14.9
- M3 growth (end of year)
  - 2000: -5.2
  - 2001: 7.7
  - 2002: 11.9
  - 2003: 11.3
  - 2004: 2.7
  - 2005: 14.2
- 3-month short-term interest rate
  - 2000: 4.9
  - 2001: 4.6
  - 2002: 3.5
  - 2003: 2.4
  - 2004: 2.1
  - 2005: 2.2
- 10-year government bond yield
  - 2000: 5.7
  - 2001: 5.1
  - 2002: 5.1
  - 2003: 4.3
  - 2004: 4.3
  - 2005: 3.4
- Key banking sector indicators (selected)
  - Regulatory capital to risk-weighted assets (Tier 1+Tier 2)
    - 2000: 12.7
    - 2001: 12.9
    - 2002: 13.5
    - 2003: 13.9
    - 2004: 13.4
    - 2005: 13.2
  - Tier 1 capital to risk-weighted assets
    - 2000: 9.9
    - 2001: 9.6
    - 2002: 10.2
    - 2003: 10.7
    - 2004: 10.7
    - 2005: 10.2
  - Nonperforming loans to gross loans and guarantees
    - 2000: 0.5
    - 2001: 0.5
    - 2002: 0.6
    - 2003: 0.6
    - 2004: 0.5
    - 2005: 0.3
  - Credit growth (selected)
    - 2000: 14.8
    - 2001: 7.4
    - 2002: 1.5
    - 2003: 4.6
    - 2004: 14.2
    - 2005: 24.7
  - Liquidity and leverage (selected)
    - Gross loans to deposits (2000-05): 114.1; 113.8; 109.4; 103.3; 105.4; 115.3
    - Liquid assets to total assets (inclusive of interbank lending, 2000-05): 29.6; 25.0; 28.3; 29.3; 26.6; 30.2
- Real estate price index (1995=100)
  - 2000: 162.1
  - 2001: 171.5
  - 2002: 195.1
  - 2003: 190.4
  - 2004: 226.3
  - 2005: 261.0

### Medium-term staff scenario (selected projections, 2003-11)
- Real GDP (annual percent change)
  - 2006: 2.7
  - 2007: 2.3
  - 2008: 2.0
  - 2009: 2.0
  - 2010: 2.0
  - 2011: 2.0
- Current account (percent of GDP)
  - 2006: 3.2
  - 2007: 2.2
  - 2008: 2.3
  - 2009: 2.2
  - 2010: 2.4
  - 2011: 2.5
- Inflation: Consumer Prices (year average)
  - 2006: 1.8
  - 2007: 1.7
  - 2008: 1.7
  - 2009: 1.7
  - 2010: 1.7
  - 2011: 1.7
- Public finance (general government balance, percent of GDP)
  - 2006: 2.6
  - 2007: 2.5
  - 2008: 1.7
  - 2009: 1.4
  - 2010: 1.1
  - 2011: 1.0
- General government gross debt (percent of GDP)
  - 2006: 36.2
  - 2007: 31.8
  - 2008: 28.0
  - 2009: 25.3
  - 2010: 23.0
  - 2011: 21.0
- Output gap (percent of potential output)
  - 2006: 0.3
  - 2007: 1.2
  - 2008: 0.9
  - 2009: 0.5
  - 2010: 0.1
  - 2011: 0.0

### Fund relations and statistical issues
- Article IV consultation cycle
  - Denmark is on the 24-month consultation cycle.
  - The staff report for the last Article IV consultation (IMF Country Report No. 04/240) was discussed at EBM/04/76 (August 2, 2004).
- Membership and IMF financial positions (as of June 30, 2006)
  - Quota: 1,642.80 SDR Million (100.00 percent)
  - Fund holdings of currency: 1,508.20 SDR Million (91.81 percent)
  - Reserve Tranche position: 134.60 SDR Million (8.19 percent)
  - SDR Department net cumulative allocation: 178.86 SDR Million (100.00 percent); holdings: 43.47 SDR Million (24.30 percent)
  - Outstanding Purchases and Loans: None
  - Financial Arrangements: None
  - Projected Obligations to Fund: None
  - Resident Representative: None
- Exchange rate arrangements
  - Denmark participates in ERM2, maintaining 2¼ percent fluctuation margins vis-à-vis the euro with a central fixed rate at DKr 746.038 per €100.
- Statistical issues
  - The quality and timeliness of the economic database are described as very good and adequate for surveillance purposes.
  - Denmark subscribes to the Fund’s Special Data Dissemination Standard (SDDS).
  - Authorities have introduced new monetary financial institutions data conforming to ESA95 and expanded coverage to include money market funds, small banks, and cooperative banks; some financial account data derive from this enhanced source.
  - Data for the central bank and other depository corporations are reported to STA on a timely and regular basis; the ECB framework is used for reporting monetary data to STA.

*IMF staff report material as contained in the content unit.*

### Appendix III: Denmark—Debt Sustainability Analysis

### _cr06341 - Appendix III: Denmark—Debt Sustainability Analysis

### External debt sustainability
- Denmark’s external position is strong after a series of current account surpluses since 1990 (except a small deficit in 1998).
- Net investment position turned positive in 2005.
- Net external debt declined from 34 percent of GDP in 2001 to 21 percent in 2005.
- Baseline projection: net external debt declines to 12 percent of GDP in 2011.
- Alternative scenarios and bound tests: under the worst scenario (a shock to the non-interest current account) external debt rises by two percentage points of GDP relative to baseline.

Key projected external-debt path (external debt, in percent of GDP)
- 2001: 33.7
- 2002: 27.1
- 2003: 23.1
- 2004: 22.6
- 2005: 21.2
- 2006: 19.4
- 2007: 17.8
- 2008: 16.4
- 2009: 15.0
- 2010: 13.5
- 2011: 12.1

Selected external-debt indicators and flows
- Change in external debt (2005→2011): -1.5, -1.4 (annual projected changes listed in table).
- Identified external debt-creating flows (example values): 2005: -1.4; 2006: -3.5; 2007: -3.5; 2008: -3.4; 2009: -3.4; 2010: -3.5; 2011: -3.5.
- Current account deficit, excluding interest payments (percent of GDP): 2005: -3.6; 2006: -2.9; 2007: -3.1; 2008: -3.1; 2009: -3.0; 2010: -3.1; 2011: -3.1.
- External debt-to-exports ratio (in percent): 2005: 44.0; 2006: 39.3; 2007: 36.7; 2008: 33.8; 2009: 30.9; 2010: 27.9; 2011: 24.8.
- Gross external financing need (in billions of US dollars): 2005: 21.3; 2006: 21.2; 2007: 19.3; 2008: 18.6; 2009: 16.9; 2010: 14.7; 2011: 12.5.
- Gross external financing need (in percent of GDP): 2005: 8.2; 2006: 7.7; 2007: 6.5; 2008: 6.0; 2009: 5.2; 2010: 4.3; 2011: 3.5.

Key macroeconomic assumptions underlying baseline (selected)
- Real GDP growth (in percent): 2005: 3.2; 2006: 2.7; 2007: 2.3; 2008: 2.0; 2009: 2.0; 2010: 2.0; 2011: 2.0.
- GDP deflator in US dollars (change in percent): 2005: 2.6; 2006: 3.4; 2007: 5.0; 2008: 2.5; 2009: 2.4; 2010: 2.6; 2011: 2.7.
- Nominal external interest rate (in percent): 2005: 2.8; 2006: 3.6; 2007: 4.1; 2008: 4.2; 2009: 4.3; 2010: 4.4; 2011: 4.5.
- Growth of exports (US dollar terms, in percent): 2005: 12.2; 2006: 9.1; 2007: 5.7; 2008: 4.3; 2009: 4.4; 2010: 4.7; 2011: 5.4.
- Growth of imports (US dollar terms, in percent): 2005: 13.0; 2006: 10.5; 2007: 5.1; 2008: 4.3; 2009: 4.3; 2010: 4.5; 2011: 5.4.
- Current account balance, excluding interest payments (percent of GDP): 2005: 3.6; 2006: 2.9; 2007: 3.1; 2008: 3.1; 2009: 3.0; 2010: 3.1; 2011: 3.1.
- Net non-debt creating capital inflows (percent of GDP): 2005: -2.9; 2006: 0.7; 2007: 0.7; 2008: 0.7; 2009: 0.7; 2010: 0.7; 2011: 0.7.

### Public sector debt sustainability
- Fiscal surpluses over time reduced public sector debt from 49 percent of GDP in 2001 to 36 percent in 2005.
- Baseline scenario (assuming the tax freeze remains in effect): public sector debt declines to 19 percent of GDP in 2011.
- Under relevant stress test scenarios the debt ratio reaches at most 24 percent of GDP in 2011.

Key projected public-sector-debt path (public sector debt, in percent of GDP)
- 2001: 48.8
- 2002: 48.4
- 2003: 45.6
- 2004: 43.7
- 2005: 36.2
- 2006: 31.8
- 2007: 28.0
- 2008: 25.3
- 2009: 23.0
- 2010: 21.0
- 2011: 19.2

Selected public-debt dynamics and fiscal items
- Change in public sector debt (2005→2011): 2005: -7.6; 2006: -4.4; 2007: -3.8; 2008: -2.7; 2009: -2.3; 2010: -2.0; 2011: -1.8 (all percent of GDP).
- Primary deficit (percent of GDP): 2005: -6.5; 2006: -4.8; 2007: -4.5; 2008: -3.5; 2009: -3.1; 2010: -2.7; 2011: -2.5.
- Revenue and grants (percent of GDP): 2005: 56.7; 2006: 54.0; 2007: 53.3; 2008: 52.3; 2009: 52.0; 2010: 51.6; 2011: 51.3.
- Primary (noninterest) expenditure (percent of GDP): 2005: 50.2; 2006: 49.3; 2007: 48.8; 2008: 48.8; 2009: 48.9; 2010: 48.9; 2011: 48.8.
- Automatic debt dynamics (percent of GDP): 2005: 0.1; 2006: 0.3; 2007: 0.7; 2008: 0.8; 2009: 0.8; 2010: 0.7; 2011: 0.7.
- Public sector debt-to-revenue ratio (percent): 2005: 63.8; 2006: 58.8; 2007: 52.4; 2008: 48.3; 2009: 44.2; 2010: 40.7; 2011: 37.5.
- Gross financing need (in percent of GDP): 2005: -3.9; 2006: -2.6; 2007: -2.5; 2008: -1.7; 2009: -1.4; 2010: -1.1; 2011: -1.0.
- Gross financing need (in billions of U.S. dollars): 2005: -10.2; 2006: -7.2; 2007: -7.5; 2008: -5.2; 2009: -4.6; 2010: -3.8; 2011: -3.7.

Key macro-fiscal assumptions underlying baseline (selected)
- Real GDP growth (in percent): 2005: 3.2; 2006: 2.7; 2007: 2.3; 2008: 2.0; 2009: 2.0; 2010: 2.0; 2011: 2.0.
- Average nominal interest rate on public debt (in percent): 2005: 6.2; 2006: 6.3; 2007: 6.5; 2008: 6.7; 2009: 6.9; 2010: 7.0; 2011: 7.2.
- Average real interest rate (in percent): 2005: 3.6; 2006: 3.8; 2007: 4.8; 2008: 5.1; 2009: 5.3; 2010: 5.4; 2011: 5.5.
- Inflation rate (GDP deflator, in percent): 2005: 2.6; 2006: 2.5; 2007: 1.7; 2008: 1.6; 2009: 1.6; 2010: 1.6; 2011: 1.6.
- Growth of real primary spending (deflated by GDP deflator, in percent): 2005: 0.2; 2006: 0.8; 2007: 1.4; 2008: 2.0; 2009: 2.2; 2010: 2.1; 2011: 1.9.
- Primary deficit (percent of GDP): see above (2005: -6.5; 2011: -2.5).

### Executive Board assessment and policy recommendations
Findings and outlook
- Directors commended the authorities’ record of stability-oriented policies and welcomed strong recent performance: high growth rates and low unemployment.
- Staff forecast: growth around 2¾ percent in 2006, slowing to about 2¼ in 2007.
- Inflation remains contained but is catching up with the euro area.
- Unemployment fell to 4.5 percent in June 2006, the lowest level in 30 years.
- Fiscal surplus in 2005 reached 3.9 percent, much higher than budgeted; general government debt fell from about 44 percent of GDP at end-2004 to 36 percent at end-2005.
- Financial sector: asset prices rose rapidly in 2005; banks and mortgage credit institutions posted record profits. FSAP concluded the financial system is generally healthy and well supervised.

Policy recommendations and cautions
- Continue fiscal policy guided by prudent medium-term objectives; maintain strong focus on medium-term sustainability based on realistic assumptions.
- Avoid weakening the fiscal framework when it is updated; maintain discipline that aims at structural surpluses of ½–1½ percent of GDP.
- Continue public expenditure restraint; measures to increase labor supply and moderate wages to reduce overheating risks.
- Monitor housing market developments closely.
- Support authorities’ intention not to introduce tax cuts in 2007; the tax freeze has helped control upward pressures on taxes and expenditures.
- Gradual and predictable elimination of the partial nominal property tax freeze (to avoid a market shock), accompanied by a corresponding reduction in personal income taxes, would support sustainable growth.
- Maintain Denmark’s exchange regime, which anchors inflation expectations and imposes discipline.
- Emphasize continued wage moderation to temper demand pressures and maintain international competitiveness; encourage social partners to sustain responsible wage increases.
- Implement forcefully the welfare agreement (reached in June) including future increases in retirement ages and labor supply measures to prepare for aging and sustain public finances.
- In the financial sector domain:
  - Heighten supervisory vigilance given rapid credit growth.
  - Adopt a cautious approach toward any reduction in capital buffers.
  - Strengthen the supervisor’s statutory and budgetary autonomy.
  - Improve stress testing capacity, governance in financial institutions, and cross-border supervision.

### Selected contextual macro-fiscal facts from the assessment text
- Growth rate in 2005: 3.2 percent (more than twice that of the Euro area).
- Unemployment rate in June 2006: 4.5 percent.
- Fiscal surplus in 2005: 3.9 percent.
- General government debt end-2004: about 44 percent of GDP; end-2005: 36 percent of GDP.

*Appendix III: Denmark—Debt Sustainability Analysis, IMF staff report (content unit _cr06341).*

### introduction of new financial instruments are likely to have contributed to the rise in prices.

### _cr06341 - introduction of new financial instruments are likely to have contributed to the rise in prices.

### Housing market, house prices, and financial instruments
- Staff analysis: Danish house prices nominal growth rates of 9 percent in 2004 and 17 percent in 2005.
- Staff finding: The acceleration of house prices is not fully explained by high income growth and falling interest rates.
- Contributing factors identified: an effectively functioning mortgage market with a number of new products, and the tax system and the tax freeze.
- Risk assessment and recommendations:
  - Introduction of new financial instruments are likely to have contributed to the rise in prices.
  - Directors recommended close monitoring of the housing market, strict application of supervisory regulations, and effective consumer information about the risks of overborrowing.
  - Authorities note a significant increase in the supply of dwellings for sale and a slower pace of sales during the summer, indicating interest rate increases since fall 2005 have had a more visible effect.
  - Official forecast: a pronounced deceleration in the growth of housing prices is anticipated.

### Real economy and outlook
- Recent performance and projections:
  - Continued strong GDP growth of 2.7 percent in 2006 (staff and authorities).
  - GDP growth in 2005 reported as 3.6 percent.
  - 2007: GDP growth is assumed to moderate further in line with a soft landing.
- Labor market and wage pressures:
  - Unemployment rate at the lowest level in more than 30 years.
  - Wage increases accelerated slightly in 2nd quarter of 2006, exceeding 3 percent (y/y) for the first time in 2 years.
  - Strongest wage increase: 4.4 percent y/y in the construction sector.
  - Authorities emphasize continued wage moderation to reduce overheating risks.
- Domestic demand and contribution of housing:
  - Large increases in real estate prices boosted construction activity and household demand via wealth effects.

### Fiscal policy, surpluses, and Plan 2010
- Fiscal balances and debt (selected figures from table):
  - General government balance: 2001 1.2; 2002 0.2; 2003 -0.1; 2004 1.7; 2005 3.9; 2006 2.6 (percent of GDP).
  - General government structural balance: 2001 1.1; 2002 0.4; 2003 0.7; 2004 0.8; 2005 1.7; 2006 1.5 (percent of GDP).
  - General government gross debt: 2001 48.8; 2002 48.4; 2003 45.6; 2004 43.7; 2005 36.2; 2006 31.8 (percent of GDP).
- Staff concern and authorities’ stance:
  - Staff shows concern about pressures to loosen fiscal policy given large general government surplus reaching a record high of 3.9 percent of GDP in 2005.
  - Authorities understand the concern and indicate the government’s proposal for the 2007 fiscal bill points to a slight tightening if plans for a significant decline in public investments materialize.
  - Large fiscal surpluses to be used to bring down public debt consistent with the Plan 2010.
- Plan 2010 framework and commitments:
  - Plan 2010 requires yearly structural surpluses of ½-1½ percent of GDP on average.
  - Authorities intend to update the fiscal framework in 2007 covering the period up to at least 2015 and reflecting recently agreed welfare reforms.
- Welfare Agreement fiscal details:
  - Earmarked amount of DKK 2 billion in 2007 increasing to DKK 10 billion in 2012 (approximately 0.5 percent of GDP) to be invested in research, education, innovation and entrepreneurship.
  - As a consequence, real public consumption growth will exceed the assumed growth rate in Plan 2010 by 0.5 percentage point and amount to 1.0 percent in the years 2007-2010.
  - Historical context: a real growth rate of 1 percent corresponds to slightly less than the average public consumption growth in 2001-2005 and is half the average growth rates of public consumption of 2 percent per year in the 1990’s.
- Tax policy:
  - The Danish tax freeze is part of the medium term fiscal framework; staff considers it effective but unnecessarily rigid.
  - Staff preference: reduction of labor income taxation financed by increased real estate taxation.
  - Authorities' view: advantages of the tax freeze in its current form exceed the drawbacks; it is a credible and strong commitment device.

### Monetary and exchange rate policy
- Exchange rate regime: ERM2 Participant.
- Authorities’ assessment:
  - The Danish fixed-exchange rate policy (peg to the Euro) serves Denmark well and helps anchor inflationary expectations.
  - Inflation has been very stable around a level corresponding to ECB’s definition of price stability for many years.
  - Competitiveness is sound, with low unemployment and a healthy current account surplus.
- Interest rate pass-through:
  - DNB closely follows ECB interest rate movements.
  - Any future rate increases by the ECB would be welcome given cyclical circumstances in Denmark.
  - Pass-through of changes in interest rates on the economy has become quicker with more widespread use of adjustable rate products, in particular in housing finance.

### Welfare reform and structural policies
- Welfare Agreement measures:
  - Raise early retirement age from 60 to 62 years during 2019–2022.
  - Raise statutory public pension age from 65 to 67 during 2024–2027.
  - Introduce mechanism in 2015 (with effect from 2025) to adjust retirement ages in line with increases in life expectancy.
  - Measures to increase short-run labor supply: reduce unemployment among older workers and immigrants, earlier completion of education, easier access for foreign workers.
- Authorities’ view: Welfare Agreement is an important step to ensure long-term fiscal sustainability and to increase labor force participation.

### Financial sector stability and supervision
- FSAP findings:
  - Danish financial system appears resilient and well supervised, supported by effective legal and financial infrastructure.
  - Good coordination between domestic institutions responsible for financial sector stability.
- Supervisory and regulatory measures:
  - Government will consider recommendations concerning institutional set up of the Danish Financial Supervisory Authority (DFSA); budget decisions are for Parliament.
  - DFSA is allocated increased resources when given new assignments.
  - DNB’s Financial Stability Report and IMF: financial institutions remain robust; no immediate threats to financial stability identified.
  - Stress tests to be given higher priority by DNB; DFSA developing use of stress tests for monitoring soundness.
- Basel II implications and mitigation:
  - New Basel II capital requirements could imply potentially large decreases in minimum capital requirements for institutions using internal rating based approaches and advanced measurement approaches.
  - Danish regulation includes floors that set the maximum decrease in capital requirements for institutions using advanced methods in 2007, 2008 and 2009, in accordance with the EU Capital Requirement Directive.
  - DFSA can set additional capital requirements in individual cases.
- Supervisory tools and fit-and-proper:
  - DFSA will consider issuing executive orders instead of guidelines; benefits must be weighed against increased costs for supervised entities.
  - Authorities generally concur that extending “fit-and-proper” regulation to all key staff could be useful, but consider pre-approval for key staff as potentially an unnecessary burden and resource intensive for DFSA.
- Anti–money laundering:
  - Denmark at an advanced stage in implementation of the 3rd Money Laundering Directive.
  - Implementing act adopted by Parliament; parts have entered into force; remaining parts enter into force on January 1, 2007.
- Payment and securities systems:
  - FSAP confirms Danish payment and securities settlement systems are safe and efficient; DNB and DFSA will analyze recommended improvements.

### Other structural issues and public spending
- Flexicurity model:
  - Combines a flexible labor market, high unemployment benefits and active labor market policies.
  - Model has been very successful in reducing unemployment in Denmark.
  - Staff note: the model is costly and sensitive to moral hazard problems.
- Tax wedge and international comparisons:
  - Authorities argue selected diagrams may overstate the tax wedge in Denmark because social security contributions are relatively low.
  - Deducting cash benefits from the tax burden is questioned because such benefits are means tested.
  - Cross-country comparisons of such data are particularly difficult.
- Official Development Assistance:
  - Since 1978, Denmark has consistently provided development assistance of more than 0.7 percent of GNI.
  - Government will ensure Denmark’s ODA does not fall below 0.8 percent of GNI for the coming years.
- Selected economic indicator highlights (from table):
  - Real GDP (change in percent): 2001 0.7; 2002 0.5; 2003 0.7; 2004 1.9; 2005 3.2; 2006 2.7.
  - Domestic demand (change in percent): 2001 0.0; 2002 1.7; 2003 0.6; 2004 3.3; 2005 4.1; 2006 3.3.
  - CPI (change in percent, year average): 2001 2.4; 2002 2.4; 2003 2.1; 2004 1.2; 2005 1.8; 2006 1.8.
  - Unemployment rate (percent): 2001 5.2; 2002 5.2; 2003 6.2; 2004 6.4; 2005 5.7; 2006 4.8.
  - Gross national saving (percent of GDP): 2001 23.5; 2002 22.7; 2003 22.8; 2004 22.3; 2005 23.6; 2006 23.7.
  - Gross domestic investment (percent of GDP): 2001 20.4; 2002 20.4; 2003 19.6; 2004 20.2; 2005 20.8; 2006 21.5.
  - Central government balance (percent of GDP): 2001 0.2; 2002 0.2; 2003 0.4; 2004 2.0; 2005 4.3; 2006 2.6.
  - Short-term interest rate (3 month, percent): 2001 4.6; 2002 3.5; 2003 2.4; 2004 2.1; 2005 2.2.
  - Government bond yield (10 year, percent): 2001 5.1; 2002 5.1; 2003 4.3; 2004 4.3; 2005 3.4.
  - Trade balance, goods and services (percent of GDP): 2001 6.6; 2002 5.8; 2003 6.1; 2004 4.9; 2005 4.9; 2006 4.7.
  - Net oil exports (US$ bln): 2001 1.0; 2002 1.4; 2003 1.8; 2004 2.6; 2005 3.2; 2006 3.2.
  - Current account (percent of GDP): 2001 3.1; 2002 2.5; 2003 3.2; 2004 2.3; 2005 3.0; 2006 2.2.
  - FDI (net, percent of GDP): 2001 -1.2; 2002 0.5; 2003 0.7; 2004 0.0; 2005 -1.6.
  - Official reserves (US$ billion, net): 2001 17.9; 2002 24.8; 2003 34.4; 2004 36.9; 2005 35.7.
  - Gross external debt (percent of GDP): 2001 124.8; 2002 121.4; 2003 125.6; 2004 131.5; 2005 146.4.
  - International investment position (percent of GDP): 2001 16.7; 2002 17.4; 2003 13.3; 2004 9.0; 2005 -1.6.
  - Average DKr per US$ rate: 2001 8.3; 2002 7.9; 2003 6.6; 2004 6.0; 2005 6.0.
  - Nominal effective rate (2000=100, ULC based): 2001 101.5; 2002 102.7; 2003 107.4; 2004 108.9; 2005 108.4.
  - Real effective rate (2000=100, ULC based): 2001 101.3; 2002 103.7; 2003 108.1; 2004 113.9; 2005 113.7.
  - Fund position (as of June 30, 2006): Holdings of currency (in percent of quota) 91.8; Holdings of SDRs (in percent of allocation) 24.3; Quota (in millions of SDR) 1,642.8.

_Statement by Tuomas Saarenheimo, Executive Director for Denmark and Ole Hollensen, Senior Advisor to Executive Director; September 29, 2006. Sources cited in the document: National Bank of Denmark; Denmark Statistics; Eurostat; and IMF staff projections._

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06341.pdf_