## _cr10365

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### Executive summary — background, outlook, and recovery dynamics
- Denmark is recovering from a deep recession driven by a housing market correction and the global financial crisis; output is projected to expand by around 2½ percent this year.
- From peak to trough, output contracted by close to 7 percent; private consumption contracted by close to 7 percent; exports were down by 14 percent.
- The housing correction involved a decline in house prices of about 20 percent.
- The labor force survey–based unemployment rate surged by over 4 percentage points to 7.3 percent by mid-2010.
- Private consumption contracted by close to 5 percent in 2009, then rose by 1.9 percent during 2010Q1 and 0.4 percent in 2010Q2.
- Consumer confidence returned to positive territory in early 2010 but weakened again by October 2010.
- Exports: after falling by 10 percent in real terms in 2009, total exports rose by 1.4 and 3 percent during 2010Q1 and Q2, respectively; rebound led by reversal in the services account, in particular sea freight.

### Outlook and key macro risks
- Growth projections:
  - Growth is projected to reach 2.5 percent in 2010, and to decelerate to 2 percent next year.
  - Growth is projected to hover around 2 percent during 2012–15.
  - With potential growth at around 1.5 percent, the output gap will be gradually closed in this period.
- Inflation:
  - Inflation (year average) in 2009 was 1.3 percent, and is expected to remain at 2.0 percent in the near term.
- Key downside risks:
  - Public consumption growth will be capped by the fiscal consolidation package.
  - Capital formation remains weak.
  - Private consumption recovery is nascent and may be protracted following housing and banking shocks.
  - Danish interest rates are unusually low and are likely to rise with ECB rate hikes, negatively affecting housing and asset prices.
  - Highly leveraged balance sheets and variable interest rate loans leave corporates and households vulnerable to higher interest rates, with possible knock-on effects to banks and the real economy.
  - Proposed Basel III rules create uncertainties for Denmark’s mortgage bond market.
  - External uncertainties remain high, notably downside risk to euro area growth.
  - Authorities added a demography-driven drop in labor supply growth as a downside risk to medium-term growth.

### Fiscal policy, public finances, and consolidation strategy
- Crisis response and fiscal stance:
  - Fiscal policy delivered some 4 percentage points of GDP in discretionary stimulus in 2009–10; roughly two thirds implemented in 2009.
  - General government balance swung from a surplus of 3.4 percent of GDP in 2008 to a deficit of 2.8 percent of GDP in 2009; deficit projected to widen to around 5 percent of GDP in 2010.
  - Cumulative effect of counter-cyclical fiscal policy during 2009–10 estimated by the authorities at around 2¼ percentage points of GDP.
  - Widening deficits and funding of financial support to the banking sector are projected to lift the general government debt-to-GDP ratio to near 45 percent in 2010, a 17 percentage points of GDP increase since 2007.
- Consolidation objectives and measures:
  - Consensus that a credible consolidation strategy to reduce the general government deficit to below 3 percent of GDP by 2013 should anchor fiscal policy.
  - The three-year consolidation envisaged in the draft 2011 budget includes consolidation measures of some 1.5 percentage points of GDP to be implemented during 2011–13, equally divided between spending reductions and revenue increases.
  - Box 1 highlights planned measures (2011–13): public consumption growth capped, municipal spending control enhancements, central government general savings of ½ per cent per year in 2011–13, targeted central government cuts and reorientation, reform of the unemployment insurance scheme (reduction from 4 to 2 years).
  - Revenue measures in Box 1: suspension of automatic indexation of income tax thresholds (revenue ≈ 0.3 percent of GDP in 2013), deferral of planned increase in top-bracket threshold (≈ 0.1 percent of GDP per year), annual ceiling of DKK 3,000 on trade union fee deductions (≈ 0.1 percent of GDP).
- Staff cautions and recommendations:
  - Staff would have welcomed greater emphasis on limiting public consumption growth and cautioned that revenue hikes could exacerbate work disincentives from an already very high tax burden.
  - Municipalities (responsible for ~60 percent of general government employment and spending) must comply with spending ceilings; staff recommended additional monitoring and sanctions (accurate quarterly execution data, systematic monitoring of poor performers, immediate corrective actions).
  - Suggested systematic assessment/debate on desired level of welfare spending and public consumption, possibly via a regular report by an independent fiscal commission/institution.

### Key projected macro figures (selected, 2008–15)
- Real GDP: 2008: -0.9; 2009: -4.7; 2010: 2.5; 2011: 2.0; 2012: 2.0; 2013: 2.0; 2014: 1.9; 2015: 1.9
- Private consumption: 2008: -0.2; 2009: -4.6; 2010: 3.3; 2011: 3.0; 2012: 2.8; 2013: 2.7; 2014: 2.7; 2015: 2.7
- Public consumption: 2008: 1.6; 2009: 3.4; 2010: 2.6; 2011: 1.3; 2012: 0.8; 2013: 0.7; 2014: 0.6; 2015: 0.5
- Fixed investment: 2008: -4.7; 2009: -13.0; 2010: -4.0; 2011: 4.4; 2012: 2.0; 2013: 2.0; 2014: 2.0; 2015: 2.0
- Exports: 2008: 2.4; 2009: -10.2; 2010: 3.9; 2011: 3.7; 2012: 3.8; 2013: 3.9; 2014: 3.7; 2015: 3.7
- Current account (percent of GDP): 2008: 2.0; 2009: 4.1; 2010: 3.6; 2011: 3.2; 2012: 3.0; 2013: 2.9; 2014: 2.7; 2015: 2.5
- Inflation, consumer prices: 2008: 3.4; 2009: 1.3; 2010: 2.0; 2011: 2.0; 2012: 2.0; 2013: 2.0; 2014: 2.0; 2015: 2.0
- General government balance (percent of GDP): 2008: 3.4; 2009: -2.8; 2010: -5.0; 2011: -4.4; 2012: -3.4; 2013: -2.1; 2014: -1.1; 2015: 0.0
- General government gross debt (percent of GDP): 2008: 34.2; 2009: 41.4; 2010: 44.4; 2011: 47.0; 2012: 48.6; 2013: 48.8; 2014: 48.0; 2015: 46.3
- Employment (change in percent): 2008: -1.4; 2009: -1.7; 2010: -0.6; 2011: -0.4; 2012: -0.1; 2013: 0.1; 2014: 0.2; 2015: 0.2
- Average unemployment rate: 2008: 1.9; 2009: 3.6; 2010: 4.2; 2011: 4.5; 2012: 4.4; 2013: 4.0; 2014: 3.5; 2015: 3.0
- Output gap (percent of potential output): 2008: 0.5; 2009: -2.8; 2010: -2.4; 2011: -1.9; 2012: -1.4; 2013: -0.9; 2014: -0.5; 2015: 0.0

### Financial sector stability, supervision, and vulnerabilities
- Policy response:
  - Swift and strong policy actions helped stabilize the banking system and defend the peg.
  - The Danish National Bank (DNB) purchased some DKK 210 billion in foreign exchange from November 2008 to December 2009; reserve build-up continued through the first half of 2010, with reserves starting to decline in early fall 2010.
  - The DNB raised deposit rates on two occasions in October 2010—the first interest rate hikes in two years—to ease pressures on the peg.
  - Authorities provided comprehensive government support to stem pressures in the banking system, including intervention and nationalization of Roskilde Bank in July 2008.
  - Number of commercial and savings banks fell from more than 160 in mid-2006 to 125 in mid-2010.
- Supervision and macro‑prudential capacity:
  - The Financial Supervisory Authority (FSA) is responsible for micro-supervision; the DNB handles macro-prudential supervision.
  - Statutes revised to allow DNB to independently collect data for macro-prudential purposes and micro-level bank data; joint liquidity stress tests conducted.
  - Establishment of a “supervisory diamond” examining bank ratios against benchmark thresholds; recommendation to enhance enforcement and proactive response to breaches.
  - Cross-border supervision: August signing of a Nordic-Baltic cooperation agreement on cross-border financial stability, crisis management, and resolution.
- Bank vulnerabilities and resolution:
  - Some medium-size banks (Group 2) remain vulnerable and partly depend on official guarantees; authorities’ guarantees and capital injections provide a two–three year window to rebalance positions.
  - Recommendation: imperative that all banks accept the new resolution scheme; use moral suasion and supervisory capital charges to ensure participation.
- Financial indicators (selected, Group 1 and Group 2 banks):
  - Group 1 banks solvency ratio (selected years): 13; 14; 12; 14; 18; 17
  - Group 2 banks return on equity before tax (selected years): 20; 25; 17; -27; -43; -6
  - Loans and impairment losses over deposits (Group 2): 115; 139; 144; 155; 117; 118

### Labor market, flexicurity, and productivity challenges
- Flexicurity performance:
  - Denmark’s flexicurity model performed well during the crisis, combining flexible layoff arrangements with generous unemployment benefits and extensive active labor market policies (ALMP).
  - Employment fell by 5.5 percent during 2008Q4–2009Q4; registered unemployed more than doubled from a very low pre-crisis level.
  - ALMP measures refocused on upgrading skills and changing labor demand; measures included training subsidies, flexible work-sharing rules, youth unemployment packages, expanded ALMP eligibility, vocational training for low-skilled adults, strengthened employment services, a national job alert system, tightened sickness leave rules, and reorganization of the Public Employment Service.
  - A decline in the labor force (as foreign workers left) eased the impact on unemployment.
  - Official estimates showed no indication of an increase in the structural component of unemployment.
- Productivity and TFP decline:
  - Danish labor productivity (gross value added per hour worked) is relatively low and has trended downward since the mid-1990s; after adjusting for employment composition and capital, most of the decline appears linked to a fall in total factor productivity (TFP) growth.
  - Growth accounting (EU-KLEMS): TFP growth declined from 0.8 percent on average during 1981–95 to -0.7 percent in 1996–2007; the drop in TFP larger than the euro area average and significantly larger than in the U.S., Germany and Finland.
  - Sectoral TFP slowdown concentrated in financing and business services, construction and network industries.
- Empirical findings on labor market flexibility and TFP (Table 5):
  - More labor market flexibility improves TFP growth with a short lag; effect follows an inverted-U relationship.
  - Reported coefficients (OECD sample, 1987–2007): Labor market regulation t-1 (linear term): -0.093 ***; Labor market regulation t-1 (squared term): 1.097 **; Implied peak value of the Fraser variable: 5.9.
  - Denmark appears slightly to the right of the peak; TFP growth could be higher if labor markets were somewhat less flexible.
  - Mechanism: high turnover from flexibility may weaken incentives for firm-specific human capital investment, reducing TFP when flexibility is excessive.
- Policy recommendations on productivity:
  - Reforms to intensify competition and accelerate firm exit and entry, particularly in services, to aid diffusion of knowledge.
  - Measures to increase the return to education at higher skill levels to reallocate resources to more productive areas.
  - Consider phasing out early retirement schemes and reforming sickness and disability leave benefits to address looming labor supply shortages.

### Local government fiscal coordination and spending control
- Institutional features:
  - 98 municipalities (child care, primary and lower-secondary education, elderly care, preventive health care, libraries, sports and cultural activities, ALMP implementation); 5 regions (healthcare/health insurance, regional development).
  - Local government spending share of general government expenditure peaked at 64.5 percent in 2008; local government employment share > 60 percent in 2010.
  - Devolution of spending not matched by devolution of revenue assignments; regions funded entirely by central government grants after 2007 reform.
- Enforcement challenges:
  - Municipal spending growth has persistently exceeded centrally negotiated ceilings; general government spending norm missed since 1993.
  - Municipalities financed overruns with non-tax revenues such as cash reserves from asset sales.
  - 2011 measures: conditional block grant raised to DKK3 billion; new reporting requirement—half-year municipal accounts; tightened individual sanctions on tax increases effective in 2011 (remittances: 75 percent year of increase, 50 percent following year, 25 percent the year after).
- Recommendations to improve vertical coordination:
  - Strengthen negotiation framework so municipal plans align with general government balance targets and public consumption ceilings.
  - Enhance in-year reporting (quarterly cash-based revenue and spending, consumption/investment decomposition).
  - Introduce ex-post monitoring focused on expenditures and a systematic backward-looking analysis to identify “bad performers” and require adjustment plans, contingency set-asides or individual municipal spending ceilings where needed.
  - Give higher profile to central-local agreements via systematic ex-ante and ex-post assessments (regular report within existing institutional framework).

### Article IV cycle recommendation and final policy priorities
- It is recommended that the Article IV consultation with Denmark remain on the 24-month cycle.
- Directors’ and staff priorities:
  - Embed a credible consolidation strategy to reduce the general government deficit below 3 percent of GDP by 2013 and achieve structural balance in 2015.
  - Emphasize rein in public consumption growth to limit need for further tax increases given high tax burden.
  - Continue to strengthen financial sector regulation and supervision and ensure participation in resolution schemes.
  - Address productivity shortfalls through competition-enhancing reforms, higher returns to education, and labor market measures to balance flexibility with investment incentives.
  - Strengthen municipal monitoring, reporting and sanctions to control sub-national expenditure overruns.

*Source: IMF staff report excerpts from _cr10365.*

### Executive Summary

### Executive Summary

### Background and outlook
- Denmark is recovering from a deep recession driven by a housing market correction and the global financial crisis; output is projected to expand by around 2½ percent this year.
- From peak to trough, output contracted by close to 7 percent; private consumption contracted by close to 7 percent; exports were down by 14 percent.
- The housing correction involved a decline in house prices of about 20 percent.
- The labor force survey–based unemployment rate surged by over 4 percentage points to 7.3 percent by mid-2010.
- Private consumption contracted by close to 5 percent in 2009, then rose by 1.9 percent during 2010Q1 and 0.4 percent in 2010Q2.
- Consumer confidence returned to positive territory in early 2010 but weakened again by October 2010.

### Policy response and financial sector developments
- Swift and strong policy actions helped stabilize the banking system and defend the peg.
- The Danish National Bank (DNB) purchased some DKK 210 billion in foreign exchange from November 2008 to December 2009; reserve build-up continued through the first half of 2010, with reserves starting to decline in early fall 2010.
- The DNB raised deposit rates on two occasions in October 2010 to ease pressures on the peg—the first interest rate hikes in two years.
- The authorities provided comprehensive government support to stem pressures in the banking system, including intervention and nationalization of Roskilde Bank in July 2008.
- The number of commercial and savings banks fell from more than 160 in mid-2006 to 125 in mid-2010 due to failures, transfers to the state holding “Financial Stability Company,” absorptions, and cessations.
- Banking system stabilization: profits have strengthened, net interest income grew, write-downs declined, large exposures were reduced, solvency ratios improved, and liquidity strengthened; however, some medium-size banks remain vulnerable and still partly depend on official guarantees.

### Fiscal policy and public finances
- Fiscal policy delivered some 4 percentage points of GDP in discretionary stimulus in 2009–10.
- Roughly two thirds of the stimulus was implemented in 2009, focused on expenditure: higher public consumption, subsidies, transfer payments, and income tax cuts as part of a major tax reform.
- The general government balance swung from a surplus of 3.4 percent of GDP in 2008 to a deficit of 2.8 percent of GDP in 2009.
- The deficit is projected to further widen to around 5 percent of GDP in 2010.
- The cumulative effect of counter-cyclical fiscal policy during 2009–10 is estimated by the authorities at around 2¼ percentage points of GDP.
- Widening deficits and funding of financial support to the banking sector are projected to lift the general government debt-to-GDP ratio to near 45 percent in 2010, a 17 percentage points of GDP increase since 2007.
- Despite higher deficits and debt, investor sentiment remained positive and spreads vis-à-vis German Bunds remained very low.

### Labor market response and flexicurity
- Denmark’s flexicurity model performed well during the crisis, combining flexible layoff arrangements with generous unemployment benefits and extensive active labor market policies (ALMP).
- Employment fell by 5.5 percent during 2008Q4–2009Q4, with construction and industry particularly hard hit; robust public sector employment helped moderate total employment losses.
- The number of registered unemployed more than doubled (from a very low pre-crisis level).
- ALMP measures were refocused to upgrade skills and address changing labor demand; a table of crisis labor market measures in 2009–10 documents multiple initiatives (training subsidies, flexible work-sharing rules, youth unemployment packages, expanded eligibility for ALMP, vocational training for low-skilled adults, strengthened employment services, a national job alert system, tightened sickness leave rules, and reorganization of the Public Employment Service).
- A decline in the labor force (as foreign workers left) eased the impact on unemployment.
- Official estimates showed no indication of an increase in the structural component of unemployment.

### Corporate sector and recovery dynamics
- Households and corporates were highly leveraged before the crisis; recovery in these sectors has been slow.
- Corporate bankruptcies continued to rise after 2009, concentrated in small and medium-sized companies in construction, trade, and transport, which account for about ¾ of total corporate bankruptcies.
- Households have been rebuilding net financial assets; the propensity to consume has trended downwards since mid-2008 and declined further during 2010H1.

### Key challenges and policy priorities identified
- Shift policy focus from short-term crisis response to putting growth on a steady and sustainable path while further reducing vulnerabilities.
- Bring fiscal policy gradually back to a trajectory ensuring credibility of the peg and sustainability.
- Continue strengthening financial sector regulation and supervision, including responding to supranational initiatives.
- Improve allocation of resources to address sluggish labor productivity growth.
- Authorities broadly agreed with the mission’s analysis and recommendations; they were less concerned than staff about negative incentive effects from revenue hikes in their consolidation program, and differences remained in emphasis among priorities for further financial sector regulatory and supervisory reforms.

### Mission and consultations
- Consultation discussions were held in Copenhagen during October 22–November 1, 2010.
- The staff team—Mr. De Broeck (Head), Ms. Babihuga, Mr. Mehrez and Mr. Ross (all EUR)—met with the Chairman of the Board of Governors of Danmarks Nationalbank; Deputy Permanent Secretaries of the Ministry of Finance; the Deputy Director General of the Danish Financial Supervisory Authority; and other senior officials, as well as representatives of trade unions, business associations, and financial institutions.

*Source: Executive Summary of IMF staff report.*

### 9.      Exports have rebounded, led by a reversal in the services account, in particular

### 9.      Exports have rebounded, led by a reversal in the services account, in particular 

### Export and services developments
- After falling by 10 percent in real terms in 2009, total exports rose by 1.4 and 3 percent, during 2010Q1 and Q2, respectively.
- The rebound in exports has been led by a reversal in the services account, in particular sea freight.

### Recovery indicators and sectoral developments (Figures 1–5)
- Real GDP and output:
  - Real GDP contracted sharply following a period of overheating.
  - Output began to rise again in the second half of 2009, supported by private and public consumption, stock rebuilding, and a lagged rebound in exports linked to strength in German and Swedish imports.
- Property and domestic demand:
  - Property prices experienced a downward correction after the boom; single family, residential and business properties, and owner-occupied flats all showed declines.
  - Domestic demand collapsed during the sharp decline in external demand but is beginning to recover; retail and industrial production have started to improve.
- External environment and confidence:
  - Export new orders strengthened (total, capital goods, intermediate goods).
  - Business confidence steadily improved; PMI and industrial confidence indicators rose.
- Households and credit:
  - Denmark experienced a particularly steep decline in private consumption compared with peers.
  - The decline in household wealth was the largest among its peers; household indebtedness remains high relative to peers.
  - Credit growth exceeded trend during the expansion, contributing to a housing bubble followed by a bust; lending by mortgage credit institutions did not decline as bank lending fell.
  - Credit growth has started to turn around and credit conditions improved with a decline in impairments.
- Labor market:
  - Unemployment rate rose to over 7 percent (LFS and registered unemployment series shown).
  - Employment has begun to rebound in all industries except construction.
  - Long-term unemployment deteriorated; risks to the labor market remain despite improving surveys.
- Monetary and exchange rate:
  - During the crisis, uncollateralized money market rates rose above DNB policy rates; monetary policy spreads between the DNB and ECB spiked.
  - DNB policy rates were cut and margins inserted to increase money market activity.
  - With the krone under appreciation pressure, DNB intervention increased and foreign assets were fortified through government issuance of external debt.
  - Movements in cross rates suggest the krone could have appreciated by 10 to 25 percent.

### Outlook and risks (Section II)
- Growth projections and inflation:
  - Growth is projected to reach 2.5 percent in 2010, and to decelerate to 2 percent next year.
  - Growth is projected to hover around 2 percent during 2012–15.
  - With potential growth at around 1.5 percent, the output gap will be gradually closed in this period.
  - Inflation (year average) in 2009 was 1.3 percent, and is expected to remain at 2.0 percent in the near term.
- Key downside risks identified:
  - Public consumption growth will be capped by the fiscal consolidation package.
  - Capital formation remains weak.
  - Private consumption recovery is nascent and may be protracted following housing and banking shocks.
  - Danish interest rates are unusually low and are likely to rise with ECB rate hikes, negatively affecting housing and asset prices.
  - Highly leveraged balance sheets and variable interest rate loans leave corporates and households vulnerable to higher interest rates, with possible knock-on effects to banks and the real economy.
  - Proposed Basel III rules create uncertainties for Denmark’s mortgage bond market.
  - External uncertainties remain high, notably downside risk to euro area growth.
  - Authorities added a demography-driven drop in labor supply growth as a downside risk to medium-term growth.

### Policies and discussions (Section III) — overarching challenge
- Main challenge:
  - Putting growth on a steady and sustainable path while reducing vulnerabilities.
  - Withdrawal of policy support should be cautious and carefully calibrated given the uncertain durability of the recovery.
  - Priorities: strengthen resilience of the financial sector and improve labor productivity growth.

### Fiscal policy assessment and recommendations (Subsection A)
- 2009–10 fiscal stance:
  - Fiscal policy in 2009–10 has been appropriately counter-cyclical.
  - A favorable pre-crisis position (budget surplus and low debt) provided room for fiscal maneuver.
- Consolidation strategy:
  - Consensus that a credible consolidation strategy to reduce the general government deficit to below 3 percent of GDP by 2013 should anchor fiscal policy.
  - Staff argued that the widening deficit, large increase in debt, and population ageing pressures made consolidation imperative.
  - Both staff and authorities viewed further adjustment beyond 2013 as needed to achieve headline and structural balance in 2015.
- Draft 2011 budget and three-year consolidation:
  - The three-year consolidation envisaged in the draft 2011 budget is overall appropriate.
  - Consolidation measures of some 1.5 percentage points of GDP to be implemented during 2011–13 are equally divided between spending reductions and revenue increases.
  - Authorities’ calculations, which incorporate delayed multi-annual effects of the large easing in 2009–10, indicate frontloading would have near-zero net negative impact on economic activity in 2011 and gradually increase thereafter.
  - If downside risks materialize, shifting 2011 measures to outer years while keeping the overall consolidation envelope unchanged would be appropriate.
- Revenue vs. expenditure balance and labor incentives:
  - Staff would have welcomed greater emphasis on limiting public consumption growth.
  - Staff cautioned that the revenue measures in the draft 2011 budget would raise the tax burden from already very high levels and could exacerbate work disincentives.
  - Authorities noted significant personal income tax cuts from the 2009 tax reform would broadly offset revenue hikes; staff welcomed a decision to reduce the duration of unemployment benefits.
  - Reining in spending growth is the key medium-term fiscal policy challenge as public consumption as a share of GDP would continue to significantly exceed medium-term targets even after cuts.
- Municipalities and spending control:
  - Municipalities are responsible for around 60 percent of general government employment and spending and enjoy large spending and tax autonomy; they collect less than 40 percent of general government revenue and receive central government grants.
  - Yearly central-government–municipal agreements cap municipal spending, but municipal spending growth has persistently exceeded ceilings; a sizeable overrun is projected in 2010.
  - A new agreement freezes 2011 municipal welfare spending in real terms and introduces additional reporting requirements (half-year accounts) and stronger collective and individual sanctions.
  - Complying with municipal spending ceilings and meeting the general government deficit target is essential; staff welcomed improvements but cautioned they remain untested and recommended additional monitoring and sanctions (accurate quarterly execution data, systematic monitoring of poor performers, immediate corrective actions).
  - Staff recommended a broader debate on the desired level of welfare spending and public consumption, and suggested a systematic assessment and discussion before and after the budget year, possibly via a regular report prepared by an independent fiscal commission/institution; authorities were open to an independent assessment but considered it could be prepared within existing institutions.

### Key medium-term scenario figures (Table highlights, 2008–15)
- Real GDP:
  - 2008: -0.9
  - 2009: -4.7
  - 2010: 2.5
  - 2011: 2.0
  - 2012: 2.0
  - 2013: 2.0
  - 2014: 1.9
  - 2015: 1.9
- Real domestic demand:
  - 2008: -0.5
  - 2009: -6.2
  - 2010: 3.0
  - 2011: 2.8
  - 2012: 2.1
  - 2013: 2.0
  - 2014: 1.9
  - 2015: 1.9
- Private consumption:
  - 2008: -0.2
  - 2009: -4.6
  - 2010: 3.3
  - 2011: 3.0
  - 2012: 2.8
  - 2013: 2.7
  - 2014: 2.7
  - 2015: 2.7
- Public consumption:
  - 2008: 1.6
  - 2009: 3.4
  - 2010: 2.6
  - 2011: 1.3
  - 2012: 0.8
  - 2013: 0.7
  - 2014: 0.6
  - 2015: 0.5
- Fixed investment:
  - 2008: -4.7
  - 2009: -13.0
  - 2010: -4.0
  - 2011: 4.4
  - 2012: 2.0
  - 2013: 2.0
  - 2014: 2.0
  - 2015: 2.0
- Exports:
  - 2008: 2.4
  - 2009: -10.2
  - 2010: 3.9
  - 2011: 3.7
  - 2012: 3.8
  - 2013: 3.9
  - 2014: 3.7
  - 2015: 3.7
- Imports:
  - 2008: 3.3
  - 2009: -13.2
  - 2010: 3.9
  - 2011: 5.2
  - 2012: 4.0
  - 2013: 3.9
  - 2014: 3.8
  - 2015: 3.8
- Current account (percent of GDP):
  - 2008: 2.0
  - 2009: 4.1
  - 2010: 3.6
  - 2011: 3.2
  - 2012: 3.0
  - 2013: 2.9
  - 2014: 2.7
  - 2015: 2.5
- Inflation, consumer prices:
  - 2008: 3.4
  - 2009: 1.3
  - 2010: 2.0
  - 2011: 2.0
  - 2012: 2.0
  - 2013: 2.0
  - 2014: 2.0
  - 2015: 2.0
- Employment and unemployment:
  - Employment:
    - 2008: -1.4
    - 2009: -1.7
    - 2010: -0.6
    - 2011: -0.4
    - 2012: -0.1
    - 2013: 0.1
    - 2014: 0.2
    - 2015: 0.2
  - Average unemployment rate:
    - 2008: 1.9
    - 2009: 3.6
    - 2010: 4.2
    - 2011: 4.5
    - 2012: 4.4
    - 2013: 4.0
    - 2014: 3.5
    - 2015: 3.0
- Public finance:
  - General government balance (percent of GDP):
    - 2008: 3.4
    - 2009: -2.8
    - 2010: -5.0
    - 2011: -4.4
    - 2012: -3.4
    - 2013: -2.1
    - 2014: -1.1
    - 2015: 0.0
  - General government structural balance (percent of potential output):
    - 2008: 2.3
    - 2009: -0.2
    - 2010: -1.9
    - 2011: -1.0
    - 2012: -0.9
    - 2013: -0.4
    - 2014: -0.2
    - 2015: 0.0
  - General government gross debt (percent of GDP):
    - 2008: 34.2
    - 2009: 41.4
    - 2010: 44.4
    - 2011: 47.0
    - 2012: 48.6
    - 2013: 48.8
    - 2014: 48.0
    - 2015: 46.3
  - Output gap (percent of potential output):
    - 2008: 0.5
    - 2009: -2.8
    - 2010: -2.4
    - 2011: -1.9
    - 2012: -1.4
    - 2013: -0.9
    - 2014: -0.5
    - 2015: 0.0

*Source: IMF staff compilation from Danmarks Nationalbank and Statistics Denmark data in the provided content.*

### Box 1. Denmark: Planned Fiscal Consolidation

### Box 1. Denmark: Planned Fiscal Consolidation

### Consolidation objectives and context
- In May 2010, the Danish government and the main opposition party agreed on measures to consolidate public finances during 2011–13, to bring down the deficit to below 3 percent by 2013.
- Relative to previous spending plans, the package entails a budget improvement of 0.6 percent of GDP.

### Spending measures
- Public consumption growth capped (in real terms) in 2011–13.
  - Relative to previous spending plans, this entails a budget improvement of 0.6 percent of GDP.
- Enhanced mechanisms to ensure municipal spending control (taking effect in 2011).
  - The central government grant can be reduced for the municipalities as a whole if budgeted or actual spending grows more than agreed.
  - Sanctions are tightened with respect to individual municipalities that raise taxation to spend more (if and when the municipalities as a whole exceed the agreement on municipal taxes).
- Reorientation of spending priorities within a spending envelope of 0.6 percent of GDP.
  - In the municipalities, the budget for social welfare spending is kept unchanged at the 2010 budget levels in real terms.
  - In the central government, a general savings of operating costs of ½ per cent per year in 2011–13 is envisaged.
- Targeted central government spending cuts with savings redirected towards social spending.
  - Cuts include certain cultural and educational activities; capping development aid at 2010 nominal levels; and reducing child benefits.
- Reform of the unemployment insurance scheme.
  - Reduction in the duration of the benefit from 4 to 2 years.

### Revenue measures
- Suspension of automatic indexation of the thresholds for income taxes in 2011–13.
  - Applies to the basic income tax allowance, the income threshold for the top-bracket personal income tax and a number of other thresholds in the tax system.
  - The suspension is neutral from the income distribution point of view, and will provide revenue of approximately 0.3 percent of GDP in 2013.
- Deferral of the planned increase in the income threshold for the top-bracket personal income tax rate for three years.
  - This results in gross revenue of around 0.1 percent of GDP per year.
- Annual ceiling of DKK 3,000 on tax deductions for trade union fees, and limitations on tax deductions of certain employer contributions.
  - The immediate revenue is estimated at about 0.1 percent of GDP.

*Source: _cr10365 - Box 1. Denmark: Planned Fiscal Consolidation*

### 28.      The central bank and the supervisory authorities have strengthened

### _cr10365 - 28.      The central bank and the supervisory authorities have strengthened

### Financial sector supervision and macro‑prudential capacity
- The Financial Supervisory Authority (FSA) is responsible for micro-supervision; the DNB handles macro-prudential supervision.
- Government guarantees prompted increased interaction between FSA and DNB and enhanced access to bank data.
- Statutes revised to allow DNB to independently collect data for macro-prudential purposes as well as micro-level bank data.
- The authorities conduct joint liquidity stress tests.
- The FSA has sharpened the focus on assessing the viability of institutions’ business models and strengthened the transparency of its supervisory activities.
- The establishment of a “supervisory diamond”, which examines various bank ratios against benchmark thresholds, is welcomed.

### Cross-border supervision and cooperation
- Cross-border supervision enhanced among Nordic and Baltic authorities.
- In August, Denmark joined other Nordic and Baltic countries in signing a cooperation agreement on cross-border financial stability, crisis management, and resolution—the first ever implementation of a EU-wide initiative.
- Supervisory colleges have been extended to include all large banking groups.
- Recommendation: Concrete and precise arrangements regarding intervention modalities and burden sharing responsibilities should be implemented within the Nordic-Baltic cooperation agreement.

### Bank structure, vulnerabilities, and resolution
- Authorities noted some warranted consolidation of Group 2 (medium-size) banks would likely occur due to the compliance costs of Basel III.
- The authorities stressed the trend decline in the number of banks over the last few decades.
- The authorities and staff agreed that all banks should accept the new resolution scheme; it replaces a temporary arrangement introduced in response to the 2008 banking crisis and is in line with best practices.
- Legal constraints prohibit making acceptance mandatory; banks must decide at their next general shareholder meetings whether to be governed by the new scheme or remain under corporate bankruptcy procedures in the event of insolvency.
- Authorities thought most banks would join the resolution scheme voluntarily, but private market participants expressed some doubts.
- Recommendation: It is imperative that all banks accept the new resolution scheme. The authorities should use moral suasion and supervisory capital charges to ensure that all institutions opt for the scheme.
- Observation: Some medium-size banks remain vulnerable—with funding continuing to depend in part on official support. The authorities’ guarantees and capital injections provide a two–three year window in which financial institutions should rebalance positions and revise business models.

### Policy and supervisory enhancements suggested
- The supervisory diamond’s usefulness as an enforcement tool could be enhanced by a proactive response to breeches.
- DNB/FSA collaboration projects on monitoring financial sector risks could be further strengthened—notably with regard to exposures to wholesale funding.
- DNB/FSA should, in cooperation, prepare for new macro‑prudential regulation and supervision activities and requirements.

### Labor market, productivity, and competitiveness
- Denmark’s flexicurity model expected to continue to perform well; policy focus shifting to looming labor supply pressures.
- Authorities confident that the jump in conjunctural unemployment would be absorbed by the recovery.
- Labor supply is projected to decline over the medium term due to demographic developments.
- Recent policy changes noted:
  - Reduction in the duration of unemployment benefits from 4 to 2 years.
  - 2009 tax reforms expected to increase labor supply.
  - Increase in the retirement age agreed in the 2006 welfare reform will not take effect until 2019.
- Recommendation: More immediate measures are needed, including steps aimed at phasing out early retirement schemes and reforming sickness and disability leave benefits.
- Labor productivity growth in Denmark has been below the average of comparable advanced economies.
- A significant portion of the underlying decline in labor productivity appears due to inefficient resource allocation (allocation between high-productivity and low-productivity firms within the same industry).
- Recommendations to raise productivity:
  - Reforms that intensify competition and accelerate firm exit and entry, particularly in services, to help diffusion of knowledge.
  - Measures that increase the return to education, at higher skill levels in particular, to reallocate resources to more productive areas.
  - Note: Denmark’s flexible labor market supports productivity overall, but higher turnover could in some instances decrease incentives to invest in firm-specific human capital; relatively high public spending on job-related training is observed.

### External developments and export performance
- Exports of goods have been falling for some time but have been offset by rising investment and shipping service income; favorable terms of trade effects have underpinned the positive current account.
- Danish exports have lost ground in key markets (e.g., Germany and the U.K.); about a quarter of Danish exports are in sectors that are declining globally.
- The structure of exports is relatively heavily weighted toward the production of food and beverages, while limited in the manufacture of high-tech goods.
- Volume growth in the food and beverage sector has declined significantly of late.
- Unit labor cost based REER appreciated by about 10 percent during 2005–09, reflecting high wage growth and low labor productivity gains; weakness in the euro and lower labor cost growth have pushed the REER down by 5 percent over the past year.
- Staff estimates suggest the krone is broadly in line with fundamentals. On average, the individual CGER methodologies indicate a slight undervaluation of around 5 percent. The two current account based approaches (macro-balance and external sustainability) suggest slightly higher undervaluation than the equilibrium exchange rate methodology.

### Macro outlook and fiscal policy appraisal
- Recovery is taking hold following a deep and long recession.
- Real GDP is projected to grow at about 2.5 percent this year.
- Growth is projected to decelerate to 2 percent in 2011 and to hover around that rate in the following years, gradually closing the output gap.
- The Danish policy response to the dual domestic banking and global financial crisis was overall appropriate: fiscal stimulus of almost 4 percentage points of GDP and major monetary easing supported activity and limited employment losses.
- The peg to the euro continues to serve Denmark well; given the constraints of the peg, the current and foreseen monetary policy stance is appropriate. Eventual euro adoption could eliminate related costs and concerns.
- Policies need to focus on putting growth on a steady and sustainable path while reducing vulnerabilities. With the recovery under way, fiscal policy should embark on a multi-year consolidation program.
- A credible adjustment strategy to reduce the general government deficit to below 3 percent of GDP by 2013 should anchor fiscal policy.
- Further adjustment beyond 2013 will be needed to achieve structural balance in 2015.
- The three-year consolidation package includes measures of some 1.5 percentage points of GDP that aim to bring down the deficit to below 3 percent of GDP by 2013; the package is somewhat frontloaded.
- Assessment: A greater emphasis on reducing public consumption growth would have been preferable. The tax burden is already very high, raising concerns that a proposed further increase will exacerbate negative impacts on work incentives.
- Sustained efforts to rein in public consumption growth and meet the 2011 deficit targets are needed. Yearly central-municipal agreements limit public consumption growth but have not managed to eliminate persistent overruns, including in 2010.
- Recommendation: There is scope for further strengthening the monitoring of municipal budget execution and related sanctions. Consider a more systematic assessment in the form of an independently prepared regular report to give a higher profile to the agreements and generate a broader policy debate on welfare spending in Denmark.

*Source: IMF staff.*

### 49.      It is recommended that the Article IV consultation with Denmark remain on the

### It is recommended that the Article IV consultation with Denmark remain on the 24-month cycle.

### Macroeconomic output and demand (Selected indicators, 2004–11)
- Real GDP (change in percent): 2.3; 2.4; 3.4; 1.7; -0.9; -4.7; 2.5; 2.0
- Net Exports (contribution to GDP growth) 1/: -2.0; -1.1; -2.0; -0.2; -0.5; 1.7; 0.0; -0.7
- Domestic demand (change in percent): 4.3; 3.4; 5.2; 1.9; -0.5; -6.2; 3.0; 2.8
- Private Consumption (change in percent): 4.7; 3.8; 3.6; 2.4; -0.2; -4.6; 3.3; 3.0
- Gross fixed investment (change in percent): 3.9; 4.7; 14.2; 2.9; -4.7; -13.0; -4.0; 4.4
- Potential output (change in percent) 1/: 1.6; 1.2; 1.7; 1.6; 1.6; -1.5; 2.0; 1.5
- Output gap (in percent of total output): 0.0; 1.2; 2.9; 3.0; 0.5; -2.8; -2.4; -1.9

### Labor market and prices
- Labor force (change in percent): -0.2; 0.1; 1.0; 0.4; -2.3; 0.1; 0.1; -0.1
- Employment (change in percent): -0.4; 0.9; 2.2; 1.6; -1.4; -1.7; -0.6; -0.4
- Unemployment rate (in percent): 5.8; 5.1; 3.9; 2.8; 1.9; 3.6; 4.2; 4.5
- GDP deflator (change in percent): 2.3; 2.9; 2.1; 1.9; 3.6; 0.4; 2.7; 2.0
- CPI (year average, change in percent): 1.2; 1.8; 1.9; 1.7; 3.4; 1.3; 2.0; 2.0

### Public finance (percent of GDP, 2004–11; projections in table extend to 2015)
- General government revenues: 56.7; 58.0; 56.8; 55.8; 55.3; 55.6; 53.8; 53.5
- General government expenditure: 54.8; 53.0; 51.7; 51.1; 51.9; 58.5; 58.8; 57.9
- General government balance: 1.9; 5.0; 5.0; 4.8; 3.4; -2.8; -5.0; -4.4
- General government structural balance: 1.6; 1.6; 1.6; 2.1; 2.3; -0.2; -1.9; -1.0
- General government primary balance: 3.3; 6.1; 5.8; 5.2; 3.5; -2.5; -4.4; -3.7
- General government gross debt: 45.1; 37.8; 32.1; 27.4; 34.2; 41.4; 44.4; 47.0

Selected longer-run public finance projections (percent of GDP, 2012–15 shown in Table 2):
- Total Revenues (2004–15 range): 56.7 ... 53.2
- Total Expenditures (2004–15 range): 54.8 ... 53.2
- Balance (2004–15 sequence): 1.9; 5.0; 5.0; 4.8; 3.4; -2.8; -5.0; -4.4; -3.4; -2.1; -1.1; 0.0
- Primary balance (2004–15 sequence): 3.3; 6.1; 5.8; 5.2; 3.5; -2.5; -4.4; -3.7; -2.8; -1.6; -0.6; 0.5
- Gross Debt (2004–15 sequence): 45.1; 37.8; 32.1; 27.4; 34.2; 41.4; 44.4; 47.0; 48.6; 48.8; 48.0; 46.3

### Money, interest rates, and exchange rates (selected)
- Domestic credit growth (end of year): 8.9; 14.9; 14.1; 13.1; 10.9; -1.8; ......  
- M3 growth (end of year): 2.7; 14.3; 11.4; 17.0; 7.7; 5.0; ......  
- Short-term interest rate (3 month): 2.1; 2.2; 3.1; 4.3; 4.9; 1.8; ......  
- Government bond yield (10 year): 4.3; 3.4; 3.8; 4.3; 4.3; 3.6; ......  
- Average DKK per US$ rate: 6.0; 6.0; 5.9; 5.4; 5.1; 5.4; ......  
- Nominal effective rate (2000=100, ULC based): 108.9; 108.4; 108.7; 110.9; 113.9; 115.3; ......  
- Real effective rate (2000=100, ULC based): 116.4; 119.5; 120.5; 126.4; 128.8; 125.0; ......

### Balance of payments (in billions of DKr and percent of GDP, selected)
- Exports of goods & services (billions DKr): 448.9; 467.7; 545.9; 555.5; 505.0; 497.4; 469.4; 448.4
- Imports of goods & services (billions DKr): -391.4; -451.3; -520.8; -545.0; -584.7; -450.6; -477.4; -505.7
- Trade balance, goods and services (billions DKr): 55.5; 5.1; 3.9; 2.8; 2.5; 3.8; 3.3; 3.1
- Current account (billions DKr): 3.0; 4.3; 3.0; 1.5; 2.0; 4.1; 3.6; 3.2
- Current account (percent of GDP): 3.0; 4.3; 3.0; 1.5; 2.0; 4.1; 3.6; 3.2

Memorandum and structural items:
- Net oil and oil-related exports (percent of GDP): 1.2; 1.4; 1.9; 1.5; 1.3; 0.8; ..........
- Net sea transportation receipts (percent of GDP): 1.3; 2.9; 2.8; 2.7; 3.3; 1.9; ..........
- Current Account net of items above (percent of GDP): 0.5; 0.0; -1.7; -2.8; -2.6; 1.2; ..........

### Financial sector indicators (Group 1 and Group 2 banks, selected)
Group 1 Banks (selected indicators)
- Solvency ratio: 13; 14; 12; 14; 18; 17
- Core capital ratio: 9; 10; 8; 11; 14; 14
- Return on equity before tax: 22; 22; 19; 34; 3
- Return on equity after tax: 17; 18; 16; 32; 2
- Loans and impairment losses over deposits: 117; 134; 132; 138; 127; 139

Group 2 Banks (selected indicators)
- Solvency ratio: 13; 12; 11; 10; 15; 16
- Core capital ratio: 11; 9; 8; 8; 13; 13
- Return on equity before tax: 20; 25; 17; -27; -43; -6
- Return on equity after tax: 15; 19; 13; -24; -34; -6
- Loans and impairment losses over deposits: 115; 139; 144; 155; 117; 118

Note: First half 2010 results are semi-annual. Source: Denmark Financial Stability Authority.

### Spending control in a highly decentralized system (Annex I — key findings and institutional features)
- Institutional structure:
  - 98 municipalities: responsibilities include (i) child care; (ii) primary and lower-secondary education; (iii) elderly care; (iv) preventive health care; (v) libraries, sports facilities and other cultural activities; (vi) implementation of active labor market policies.
  - 5 regions: mainly responsible for healthcare and health insurance, plus regional development, growth, and specialized educational and social institutions.
  - Municipalities represented by the National Association of Municipalities (LGDK); regions represented by the association of regions.
- Rapid rise in sub-national spending:
  - Denmark’s share of local government spending in general government expenditure peaked at 64.5 percent in 2008.
  - Local government employment share in total government employment exceeded 60 percent in 2010.
  - In 1995 local government spending share was roughly 54 percent compared to Nordic and EU averages of 37 percent and 28 percent respectively.
- Revenue assignment lagging expenditure devolution:
  - Devolution of spending was not matched by devolution of revenue assignments, increasing dependency on central government grants.
  - Since 2003 a tax freeze prevents municipalities from collectively increasing the average tax rate; individual municipal increases must be offset by reductions elsewhere.
  - After a 2007 reform, regions are entirely funded through central government grants (no longer able to raise own revenue).
- Fiscal coordination and agreements:
  - Annual voluntary negotiations between central government and local organizations result in a framework agreement with an overall expenditure ceiling and tax level guidance.
  - Agreements are collective and voluntary; municipalities can deviate but deviations must be neutralized; central government may impose sanctions; LGDK can exercise moral suasion.
  - Municipal financing: tax revenues (income and real property taxes) yield roughly 60 percent of total financing; central government block grants comprise 13 percent.
- Enforcement challenges and sanctions:
  - Spending at municipal level has consistently exceeded ceilings; general government spending norm missed since 1993.
  - Municipalities have financed overruns with non-tax revenues such as cash reserves from sale of assets (land).
  - 2003 tax freeze slowed but did not eliminate tax rate drift; tax rates increased from 2007–10.
  - 2008 parliamentary measures: sanctions/incentives relevant to municipal budgets (ex ante) — excessive municipal tax revenue neutralized via reductions in collective municipal block grant; roughly DKK1 billion of block grant became conditional.
  - For 2011 agreement (responding to 2009 overruns), conditional block grant raised to DKK3 billion; both budget and outcome must comply with the ceiling; individual sanctions on tax increases instituted. These sanctions become effective in 2011 and would not have remedial impact until 2012.
  - New reporting requirements introduced: preparation of half-year municipal accounts.
- Composition and pressures:
  - Devolution focused on socially sensitive areas: health and social services account for roughly 3/4 of total sub-national spending in Denmark (compared to just over 1/2 in Sweden and 1/3 in unitary states).
  - Aging-related expenditure pressures are a major concern for local governments.
- Enforcement limitations:
  - Collective and voluntary nature of agreements undermines enforceability and central government enforcement could contravene constitutional local autonomy.
  - Individual municipality tax increases that raise the average tax rate must be remitted to the central government as follows: 75 percent of the increase remitted the year of the increase, 50 percent the following year, and 25 percent the year after.

*Source: IMF staff report content in the supplied PDF (Tables 1–4 and Annex I).*

### 10.      More broadly, the institutional vertical coordination between levels of

### 10.      More broadly, the institutional vertical coordination between levels of government has been weak.

### Vertical coordination weaknesses and fiscal divergence
- Central government has faced difficulties getting the sum of the budget of the individual municipalities to abide by a centrally negotiated target.
- Central government’s overall fiscal objective of targeting real consumption spending growth has not been well translated into individual municipal fiscal plans, as municipal agreements focus on the annual collective expenditure ceiling denominated in nominal level terms.
- Municipal budgets have until 2009 consistently diverged from agreements with the central government, reflecting a clear divergence in fiscal plans and actions between tiers of government.

### Measures to stem municipal overspending (policy recommendations)
- Improvements already made:
  - Monitoring of municipal budget execution improved.
  - Sanctions introduced in the context of the central government-municipal agreement for 2011 (noted as welcome but partly untested until 2012).
- Additional measures that could be considered:
  - Budget formulation
    - Municipal budgets include multiyear plans beyond the current budget year, but in practice have limited relevance in the annual budget preparation process. More emphasis could be put on the accuracy, quality and guiding character of multi-year plans.
  - Yearly negotiations
    - The starting point of the negotiations should be fully consistent will the general government balance targets and the ceiling on public consumption as a share of GDP (rather than taking last year’s budgets or outcomes as starting point).
  - In-year fiscal reporting
    - Introduction of half-yearly accounts is welcome, but better quarterly data to analyze developing divergences between budget plans and execution could be considered.
    - Direct reporting of quarterly cash-based revenue and spending data, including a consumption/investment decomposition, could facilitate budget execution monitoring.

### Incentives and sanctions (policy levers)
- Enhance incentives to pursue efficiency in municipal service delivery through consideration of cost savings in the allocation of central government grants.
- Ease adverse incentives to overuse benefit schemes through improving the co-financing formula for income benefit expenditure.
- Establish clearer consequences for municipalities with a track record of overspending:
  - Ex-post monitoring introduced for 2011 is welcome, but ex post monitoring on the tax side may be of limited practical consequence because municipalities typically do not change tax rates during the course of the year.
  - Ex post monitoring should therefore focus on the expenditure side, and could be enhanced through a more systematic backward looking analysis of spending and liquidity patterns to identify “bad performers.”
  - Potential additional conditions for identified bad performers:
    - a. Requirement to submit an adjustment plan to correct for past spending overruns
    - b. Requirement to set aside an unallocated contingency in the budget to offset possible spending overruns in the budget year ahead
    - c. An individual municipality spending ceiling in case the contingency under b. proves to be insufficient to prevent a spending overrun ex post

### National-local fiscal coordination (alignment and transparency)
- Ensure consistency between central-local agreements and the broader fiscal objectives at the general government level.
  - Strengthen the negotiation framework so municipalities better understand and internalize how the nominal spending ceiling and the tax freeze they agree to can contribute to broader fiscal policy objectives.
  - Better assess implications of decisions from the center on new local spending mandates and coordinate them more effectively with municipalities.
- Give a higher profile to central-local agreements and generate a broader policy discussion on their content while maintaining their non-binding legal nature.
  - Introduce a more systematic ex-ante and ex-post assessment, including analysis of their contribution from the point of view of Convergence Programme objectives.
  - This evaluation could be in the form of a regular report prepared within the existing institutional framework.

---

### ANNEX II. WHAT IS BEHIND THE DECLINE IN DANISH TFP GROWTH?

### A. Introduction — context and main messages
- Danish productivity, measured as gross value added per hour worked, is relatively low and has trended downward since the mid-1990s.
- After adjusting for employment composition and capital, most of the decline appears linked to a fall in total factor productivity (TFP) growth.
- Empirical results (noted as preliminary):
  - Danish sectoral TFP growth is significantly higher when the “technological gap” between the domestic and leading frontier economies is large, implying opportunities for convergence through technology transfer.
  - Danish TFP growth is not affected by technology developments in leading frontier economies (cutting edge innovation dynamics do not spillover into Denmark).
  - Danish labor market flexibility—perhaps combined with strong income and job search support for the unemployed—could weaken incentives for investment in firm-specific human capital through excessive job turnover.

### B. Growth accounting — quantifying the decline
- Growth accounting using EU-KLEMS decomposes labor productivity growth into capital intensity, labor quality and TFP growth.
- Key quantitative findings:
  - TFP growth declined from 0.8 percent on average during 1981–95 to -0.7 percent in 1996–2007.
  - The drop in TFP is larger than in the euro area (EA) average and significantly larger than in countries that maintained healthy productivity growth (U.S., Germany and Finland).
  - TFP slowed in most sectors, with large falls in financing and business services, construction and network industries.

### C. Links between TFP and economic policy variables
- TFP reflects innovation, adoption/diffusion of state of the art technologies, and efficiency in factor utilization.
- Growth dynamics:
  - Countries near the technology frontier grow via introduction of newer technologies; followers grow by adopting existing frontier technologies.
  - Policies that favor cost-efficient adoption of existing technologies help followers; frontier countries benefit more from policies that promote innovation (e.g., R&D and higher education spending).
  - External trade in capital goods with industry leaders is thought to stimulate technology transfers and convergence toward the frontier.

### D. Methodology and data
- Empirical framework: panel regressions for a fifteen OECD country sample at the sectoral level over the 1987–2007 period; baseline specification models industry-level TFP growth as a function of:
  - Sectoral TFP growth at the frontier economy (F)
  - Sectoral TFP gap between economy (i) and the frontier (F)
  - Sector specific and time varying R&D expenditures and trade (Z)
  - Country specific labor policy variables (L)
  - Interaction terms between the gap and Z and L
  - Other controls (e.g., real effective exchange rates)
- Data sources:
  - Productivity and TFP data from the KLEMS database.
  - Structural variables such as R&D expenditures and product market regulation from the OECD.
  - Labor market policies from the Fraser Institute labor market regulations indicator (index ranges from 0 to 10, with lower values implying anti-competitive regulations); the Fraser labor market variable suggests Denmark has a relatively flexible labor market system.
- Descriptive patterns:
  - The TFP gap between sectoral Danish TFP and the frontier is growing in many sectors (e.g., food and beverage and tobacco; electrical and optical equipment).
  - The level of the gap is relatively high in transport, chemicals, paper products and electrical equipment.
  - R&D expenditures increased mainly in chemical products (which appears to have helped close the TFP gap), and in electrical equipment and food and beverages (where it has not).

### E. Results — empirical estimates and interpretation
- Baseline specification (without policy variables):
  - For OECD countries, TFP growth is significantly higher when there is stronger TFP growth at the frontier and when the gap with the frontier is large.
  - Quantitative effects:
    - A 1 percent increase in TFP growth in the frontier economy results in a 0.05 percent increase in TFP growth.
    - A larger TFP gap one period earlier results in a less than 0.01 percent increase in TFP growth.
    - Given the size of the average TFP gap (40 percent) and the average TFP growth rate of the frontier economy (1.8 percent), the contribution of the gap is about 3 times larger.
  - For Denmark specifically:
    - The growth rate of TFP at the frontier is insignificant for Denmark, across all sectors and when focusing on market services or manufacturing.
    - The catching up effect (the gap effect) is higher than the OECD average and strongly significant, especially at the manufacturing level.
- Benchmark model with R&D expenditures included:
  - For OECD countries, lagged R&D intensity significantly adds to TFP growth at the total economy, manufacturing or market service levels.
  - For Denmark, no evidence that R&D intensity improves TFP growth or absorption capacity, consistent with the finding that growth at the frontier or new technological innovations do not appear to drive Danish TFP growth.

*Prepared by Kevin Ross and Volodymyr Tulin (both EUR) — content as provided in the source document.*

### 12.      Table 5 presents the results with the labor market variables—which are

### Table 5 presents the results with the labor market variables—which are particularly interesting.

### Main empirical findings on labor market flexibility and TFP
- More labor market flexibility improves TFP growth with a short lag.
- The effect operates through a square specification, yielding an inverted-U relationship: too much labor market flexibility limits TFP growth, but so does too little flexibility.
- Given the coefficients on lagged and squared labor market regulation, the implied maximum value of the Fraser variable is around 5.9. Values above this level start to drag down TFP growth.
- Denmark appears to be slightly to the right of the peak, so TFP growth could be higher if Danish labor markets were somewhat less flexible.

### Key numeric estimates reported in Table 5 (OECD sample, 1987–2007)
- Labor market regulation t-1 (linear term): -0.093 ***
- Labor market regulation t-1 (squared term): 1.097 **
- Implied peak value of labor market regulation: 5.9
- Labor market regulation t-1, distance from the peak: -0.332 ***
- R^2: 0.13 (columns reported with these coefficients)
- Fixed effects: country, industry, year, within-groups estimation
- Observations: 3309 (sample: 15 OECD economies, 1987-2007)
- Notes: ***, **, * indicates 1, 5, and 10 percent statistical significance, respectively. Newey-West standard errors in parenthesis.

### Robustness and caveats from accompanying notes and footnotes
- Results using product market regulation were not significant and are not reported.
- When aggregating the data over 3 or 4-year periods, the effect of the lagged labor variable becomes negative: short term effects appear to be positive but longer term effects negative. These aggregated results work well only without fixed effects, implying potential overfitting given much fewer observations; they are therefore not included.
- The implied maximum value of the Fraser variable is around 5.9; values above this level start to drag down TFP growth.

### Interpreted mechanisms for the inverted-U relationship
- Greater emphasis on flexibility may lead to higher job turnover regardless of the state of the business cycle.
- In Denmark, labor turnover is relatively high, reflecting low levels of job protection and firing and hiring costs, but also significant unemployment and retraining support.
- Frequent worker reallocation within Denmark’s “flexicurity” labor market could diminish labor search costs too much and weaken incentives for firm-specific investment in human capital, which can reduce TFP growth when flexibility is excessive.

### Policy implications and considerations
- Moderate labor market flexibility can enhance TFP growth; both insufficient and excessive flexibility can be detrimental.
- For Denmark, slightly less labor market flexibility (moving leftward from its position slightly to the right of the inferred peak) could raise TFP growth.
- Policymakers should balance flexibility with incentives for firm-specific human capital investment and consider the interaction of job protection, firing/hiring costs, unemployment support, and retraining programs to avoid weakening firm-level incentives.

*Source: IMF staff calculations and notes, Table 5 and accompanying text in the Informational Annex (Staff Report for the 2010 Article IV Consultation, November 23, 2010).*

### 3.4 percent of GDP in 2008 to a deficit of 2¾ percent of GDP in 2009, and the deficit is

### _cr10365 - 3.4 percent of GDP in 2008 to a deficit of 2¾ percent of GDP in 2009, and the deficit is

### Executive Board assessment and macro risks
- The Danish economy was hit by dual shocks: a domestic housing market correction and the global recession.
- A large discretionary fiscal stimulus, building on Denmark’s macroeconomic framework, stabilized output and the banking system and prevented an increase in structural unemployment.
- The economy has begun to recover, but policies should manage two key risks:
  - A possible worsening of growth prospects.
  - A tightening in monetary conditions exposing household and corporate vulnerabilities from highly leveraged balance sheets and variable interest rate loans.

### Fiscal position, projections, and consolidation strategy
- Fiscal outcomes and projections:
  - General government balance: surplus of 3.4 percent of GDP in 2008; deficit of 2¾ percent of GDP in 2009; projected to widen to around 5 percent of GDP in 2010—around 2 percent of GDP when excluding cyclical and temporary components.
  - Even with return by 2015 to pre-crisis budget balance targets, gross general government debt as a share of GDP will be some 30 percentages points higher than envisaged before the crisis.
  - General government revenues: 56.7 (2004), 58.0 (2005), 56.8 (2006), 55.8 (2007), 55.3 (2008), 55.6 (2009), 53.8 (2010), 53.5 (2011) percent of GDP.
  - General government expenditure: 54.8 (2004), 53.0 (2005), 51.7 (2006), 51.1 (2007), 51.9 (2008), 58.5 (2009), 58.8 (2010), 57.9 (2011) percent of GDP.
  - General government structural balance: 1.6 (2005), 1.6 (2006), 1.6 (2007), 2.1 (2008), 2.3 (2009), -0.2 (2010), -1.9 (2011), -1.0 (2011?) percent of GDP. (As presented in table.)
  - General government gross debt: 45.1 (2004), 37.8 (2005), 32.1 (2006), 27.4 (2007), 34.2 (2008), 41.4 (2009), 44.4 (2010), 47.0 (2011) percent of GDP.
- Directors’ assessment of fiscal policy and consolidation:
  - The authorities’ three-year fiscal consolidation package is an important step toward strengthening fiscal position and reaching structural balance in 2015.
  - Achieving structural balance in 2015 is key to safeguard the credibility of the peg to the euro, prepare for ageing-related pressures, and ensure fiscal sustainability.
  - The lagged effects of the large fiscal easing in 2009–10 will continue to support the recovery in 2011; some Directors saw room to slow consolidation if recovery is at risk.
  - Consolidation strategy, including frontloaded elements, was considered well designed.
  - Directors recommended stronger efforts to rein in public consumption growth to meet deficit targets and saw scope to further strengthen public expenditure management, particularly at the municipal level.
  - Containing expenditure growth would reduce the need for tax increases given Denmark’s tax burden remains high even after recent tax reform.

### Financial sector vulnerabilities and recommendations
- Directors supported strengthening financial sector supervision and commended:
  - Establishment of benchmark thresholds for various bank ratios.
  - The recently signed Nordic cooperation agreement on cross-border financial stability, crisis management and resolution.
  - Strengthened cooperation between the financial supervisory agency and the National Bank with increased focus on macro-prudential risks.
- Remaining concerns and recommendations:
  - Encourage further efforts to address vulnerabilities in some medium-size banks and risks from a resurgence of domestic real estate problems or international financial pressures.
  - Note challenges arising from implementation of Basel III rules.
- Specific staff/authorities points on liquidity and covered bonds:
  - Staff view: share of total mortgage bonds to be sold to meet liquidity requirements is 11 per cent and will have a limited price effect; alternative liquidity instruments could address disruptions.
  - Authorities’ view: off-loading of 11 per cent of all outstanding covered bonds (41 billion) could comprise around 25 per cent of the trade of covered bonds in a given year and likely result in lasting re-pricing; concerns that liquidity proposals would have significant consequences for the government bond market and could hamper liquidity and the peg.
  - Authorities note that Danmarks Nationalbank empirical findings indicate Danish covered bonds have been as liquid as Danish government bonds during periods of market stress.
  - Authorities cite IMF’s Global Financial Stability Report (October 2010) acknowledging stresses from implementing the LCR.
- Adjustable-rate mortgage (ARM) loans and funding:
  - Staff: ARM loans with maturity less than 1 year pose macro risk due to interest rate sensitivity on real estate values; welcome stable funding requirement to reduce such loans.
  - Authorities: recognize risks but note potential positive effects of ARM loans during slowdowns with falling interest rates.

### Economic outlook, activity, and labor market
- Activity and growth:
  - Real GDP: historical and projected changes in table—Real GDP: 2.3 (2004), 2.4 (2005), 3.4 (2006), 1.7 (2007), -0.9 (2008), -4.7 (2009), 2.5 (2010), 2.0 (2011) percent change.
  - With national accounts for 2010Q3, GDP growth in 2010 looks to be around 2 per cent (authorities)—less than staff expected.
  - Authorities expect GDP growth of 1¾ per cent in next year (presumably 2011).
  - Recovery drivers: fiscal easing, tax cuts, pay-out of Special Pension (SP) savings, and sharp drop in interest rates since autumn 2008.
  - Risks: substantial and primarily linked to international developments.
- Labor market:
  - Unemployment rate: 5.8 (2004), 5.1 (2005), 3.9 (2006), 2.8 (2007), 1.9 (2008), 3.6 (2009), 4.2 (2010), 4.5 (2011) percent.
  - Private employment fell markedly; labor adjustments appear to have come to an end.
  - Structural employment estimate increased by around 3¼ per cent since 2005, partly due to higher labor participation and reduced structural unemployment.
  - Wage growth has come down to around 2–2½ per cent per annum.
  - Directors noted flexicurity helped avoid increase in structural unemployment; recommended steps to increase returns on education (particularly at higher skill levels) and to step up competition in services to reallocate resources to more productive uses.
  - In view of looming labor supply shortages, reforms of early retirement schemes and sickness and disability leave benefits are a priority.
- Labor market flexibility vs. productivity:
  - Staff findings suggest high labor market flexibility may limit productivity growth by reducing firm incentives to invest in employee education and firm-specific human capital.
  - Authorities are skeptical that less flexible labor market would improve productivity and emphasize virtues of low unemployment over marginal productivity gains.

### Productivity and structural issues
- Productivity levels:
  - Danish productivity levels are somewhat below the average of comparable advanced economies and have trended downward in relative terms since the mid-1990s.
  - Underlying decline attributed to inefficient resource allocation between high- and low-productivity firms and concentration of highly educated workers in the public sector.
- Policy recommendations to raise longer-run growth:
  - Increase returns on education, particularly at higher skill levels.
  - Step up competition in the services sector to facilitate resource reallocation.
  - Reforms to intensify competition and accelerate firm exit and entry, especially in services, to help diffuse knowledge and increase productivity.
- Compensating factors for living standards:
  - Positive trend in terms-of-trade and substantial improvement in net foreign interest payments (due in part to elimination of net foreign debt), comparable to 4 per cent of GDP over a period of 10 years.

### Fiscal policy measures and local government controls
- Fiscal consolidation agreement (May 2010):
  - New initiatives of DKK 24 billion (1½ per cent of GDP) towards 2013 and a further DKK 2 billion through 2015.
  - Agreement aims to bring fiscal deficit below 3 per cent of GDP by 2013 and move toward structural balance in 2015.
  - Consolidation implemented through lower growth in public spending, higher taxes, and reform of unemployment benefit system to increase employment and growth potential through 2015.
  - Measures estimated to increase labor supply by some ⅓ per cent, including impact from higher taxes; negative impact on labor supply from tax hikes amounts to 15 per cent of labor supply gains from the most recent tax reform.
  - Welfare Agreement from 2007: 2-year rise of age thresholds for eligibility for retirement benefits taking effect in 2019 and gradual increases in line with life expectancy; reform expected to add some 8-10 per cent to employment in 2040.
- Local government expenditure:
  - Challenge to avoid local government expenditure overruns; growth in public consumption has been higher than planned almost every year since 1993.
  - Sanctions introduced in 2008 for overruns via reductions in block grants; new instruments effective from 2011 to strengthen incentives for municipal expenditure limits.
  - Fiscal bill for 2011 includes new measures: in case of overruns in 2011, 60 per cent of the reduction is deducted individually in the block grants to municipalities that spend more than budgeted and the rest of the deduction is collective.

### Monetary policy and exchange rate peg
- Authorities’ stance:
  - Long-standing exchange rate peg has anchored inflation expectations and is key to Denmark’s stability-oriented macro policy.
  - Danmarks Nationalbank intervened in fall 2008 and increased policy interest rates significantly to defend the peg; since autumn 2008 it has lowered the policy lending rate.
  - Spread between the policy lending rate in Denmark and the euro area is now five basis points.
  - Foreign exchange reserve has more than doubled since the end of October 2008; authorities argue substantial reserves are required.
- Liquidity and market measures:
  - In June 2009 Danmarks Nationalbank introduced an interest margin between the policy lending rate and the interest rate on certificates to incentivize banks to settle liquidity among themselves.
  - Normalization in euro-area money market is closely monitored; a rise in short-term money market interest rates in the euro area recently led Danmarks Nationalbank to increase the rate of interest on certificates of deposit.
- Vulnerabilities:
  - Expected tightening in monetary conditions raises vulnerabilities for households and corporations given highly leveraged balance sheets and prevalence of variable interest rate loans—with possible knock-on effects to banks and the real economy.

### Key data highlights from Selected Economic and Social Indicators (2004–11, table)
- Real GDP (change in percent): 2.3; 2.4; 3.4; 1.7; -0.9; -4.7; 2.5; 2.0 (2004–2011).
- Domestic demand (change in percent): 4.3; 3.4; 5.2; 1.9; -0.5; -6.2; 3.0; 2.8.
- Private Consumption (change in percent): 4.7; 3.8; 3.6; 2.4; -0.2; -4.6; 3.3; 3.0.
- Gross fixed investment (change in percent): 3.9; 4.7; 14.2; 2.9; -4.7; -13.0; -4.0; 4.4.
- Gross national saving (percent of GDP): 23.4; 25.2; 25.7; 24.5; 24.0; 21.5; 21.1; 21.1.
- Gross domestic investment (percent of GDP): 20.4; 20.8; 22.7; 23.0; 22.0; 17.4; 17.5; 17.9.
- Potential output (percent): 1.6; 1.2; 1.7; 1.6; 1.6; -1.5; 2.0; 1.5.
- Output gap (in percent of total output): 0.0; 1.2; 2.9; 3.0; 0.5; -2.8; -2.4; -1.9.
- Labor force (change in percent): -0.2; 0.1; 1.0; 0.4; -2.3; 0.1; 0.1; -0.1.
- Employment (change in percent): -0.4; 0.9; 2.2; 1.6; -1.4; -1.7; -0.6; -0.4.
- Unemployment rate (in percent): 5.8; 5.1; 3.9; 2.8; 1.9; 3.6; 4.2; 4.5.
- GDP deflator (change in percent): 2.3; 2.9; 2.1; 1.9; 3.6; 0.4; 2.7; 2.0.
- CPI (year average, change in percent): 1.2; 1.8; 1.9; 1.7; 3.4; 1.3; 2.0; 2.0.
- Domestic credit growth (end of year): 8.9; 14.9; 14.1; 13.1; 10.9; -1.8.
- M3 growth (end of year): 2.7; 14.3; 11.4; 17.0; 7.7; 5.0.
- Short-term interest rate (3 month): 2.1; 2.2; 3.1; 4.3; 4.9; 1.8.
- Government bond yield (10 year): 4.3; 3.4; 3.8; 4.3; 4.3; 3.6.
- Trade balance, goods and services (percent of GDP): 5.5; 5.1; 3.9; 2.8; 2.5; 3.8; 3.3; 3.1.
- Current account (percent of GDP): 3.0; 4.3; 3.0; 1.5; 2.0; 4.1; 3.6; 3.2.
- GDP per capita, PPP (2008): $36,845.
- At-risk-of-poverty rate (2008): 11.8 percent.

### Policy recommendations and priorities (as reflected in text)
- Strengthen fiscal consolidation to reach structural balance by 2015 and limit public consumption growth to meet deficit targets.
- Further strengthen public expenditure management, particularly at municipal level; implement municipal incentives from 2011 and stricter sanctioning in fiscal bill for 2011.
- Address medium-size bank vulnerabilities and risks from real estate or international pressures; implement macro-prudential supervision and crisis management cooperation.
- Consider measures to increase returns on education at higher skill levels and increase competition in services to boost productivity.
- Prioritize reforms of early retirement schemes and sickness and disability leave benefits in view of looming labor supply shortages.
- Monitor and manage liquidity requirements and Basel III implementation impacts on government and covered bond markets; assess alternative liquidity arrangements and implications for financial stability and the exchange rate peg.

*Source: IMF staff report and Public Information Notice for the 2010 Article IV Consultation with Denmark (excerpts as provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10365.pdf_