Denmark: Staff Concluding Statement of the 2016 Article IV Mission

May 4, 2016

A Concluding Statement describes the preliminary findings of IMF staff at the end of an official staff visit (or ‘mission’), in most cases to a member country. Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, or as part of other staff monitoring of economic developments.

The authorities have consented to the publication of this statement. The views expressed in this statement are those of the IMF staff and do not necessarily represent the views of the IMF’s Executive Board. Based on the preliminary findings of this mission, staff will prepare a report that, subject to management approval, will be presented to the IMF Executive Board for discussion and decision.

May 4, 2016

Denmark has a longstanding track record of sound economic and social policies. It consistently scores high in international comparisons of the business climate and competitiveness, and education levels are high. In addition, the flexible labor market model and extensive active labor market policies have fostered comparatively high employment. Meanwhile, Denmark has secured excellent social outcomes and admirably low income inequality, which is the lowest in the OECD.

Yet output growth has been weak for an extended period. GDP growth has been below that of peers like Sweden and Germany for a longer time and this has continued in the aftermath of the global financial crisis—though terms of trade gains and high foreign income have mitigated some of the adverse impact. The relative underperformance partly reflects slower growth of the working age population and a trend decline in the production of Danish North Sea oil and gas. But the persistent growth gap also reflects stubbornly low productivity growth which, over time, risks eroding the basis for living standards that today are among the highest in the world.

Outlook and Risks

The ongoing recovery is expected to remain gradual and muted. Supported by low interest rates and oil prices, private consumption continues to be the main driver for growth in the short term. However, investment is projected to also pick up, reflecting the diminishing impact of firm deleveraging and the strong recovery in the housing market. Export growth is likely to remain low, in line with the weak external environment. On these trends, the economy is forecast to grow by 1.3 percent in 2016 and 1.6 percent in 2017, which will allow unemployment to fall further. Inflation is expected to rise from 2017 as the output gap narrows and the impact of recent oil price drops fades.

Risks are tilted to the downside and could derail the recovery. In particular, lower-than-projected trading partner growth would adversely affect Denmark’s outlook. Also, in view of high household debt and the sizable share of adjustable rate mortgages, volatility in global financial conditions leading to a spike in market interest rates could abruptly raise households’ debt service and depress consumption. The expected disruption of trade and financial flows that would follow a potential “Brexit” compounds these risks. Domestically, an unfettered continuation of recent rapid house price increases would raise the risk of a correction over the medium term.

Economic Policies

Policies should support the recovery, contain risks, and raise potential growth. Fiscal policy should be tuned to minimize risks to the recovery, while product market liberalization and better integration of refugees would help raise potential output. Enhancing the flexibility of housing supply and reducing adverse incentives from housing taxation, paired with readiness to implement appropriate and timely macroprudential measures, would reduce medium-term housing risks.

Macroeconomic Policy

Monetary policy should continue to focus on maintaining the peg. A normalization of rates should continue if market conditions and exchange rate pressures allow. Should a further lowering of ECB policy rates, or a change in market conditions, necessitate a renewed reduction in Danish policy rates, Danmarks Nationalbank could seek to mitigate the impact on banks by raising the limits for the current account as in 2015.

The expected gradual tightening of the fiscal stance is appropriate. Based on the projected lagged impact of recent labor market reforms, agreed ceilings for fiscal consumption, and existing public investment plans, the structural fiscal deficit is forecast to improve by 0.6 percent of GDP during 2016-20. The modest consolidation should help foster long-term sustainability and facilitate the preservation of fiscal space for future contingencies. The implied slight tightening of the fiscal stance is appropriate given the baseline projection of a gradual strengthening of the recovery.

However, uncertainties surrounding the recovery call for nimble fiscal policies. Considering that Denmark’s moderate level of public debt leaves room for maneuver, and given the absence of an independent monetary policy, fiscal policy should continue to act as the main stabilizer of cyclical fluctuations. Thus, if downside risks materialize automatic stabilizers should be allowed to operate. In addition, short-term fiscal support would be called for—for instance via higher productive public investment or by not offsetting further refugee-related spending with cuts elsewhere in the budget. Conversely, faster fiscal tightening will be needed if the recovery gathers pace faster than expected.

Housing Policies

Rapid house price increases call for vigilance. Fueled by historically-low interest rates, house prices have risen rapidly in recent periods—especially for flats and in Copenhagen. While a recent slowdown in the volume of housing transactions might herald an impending softening, the market bears close watching since a continuation of the uptrend would soon bring real house prices in these segments back to pre-crisis levels. For the moment, risks are mitigated by the localized character of the steepest price increases and the absence of an attendant rapid build-up in household debt. However, past experience suggests that bubbles can form and spread quickly. Moreover, with high shares of “interest only” and variable rate loans, households are already exposed to substantial interest rate risk.

Action across several policy areas would help contain the build-up of housing risks. We welcome the introduction of the DFSA’s “Supervisory Diamond for Mortgage Credit Institutions (MCIs),” which addresses risks related to variable rate and interest only loans. In addition, the recent establishment of the “Seven Best Practices” should strengthen risk management practices of mortgage lenders in areas with rapid house price increases. The introduction of a five percent cash down payment requirement for house purchases is also a step in the right direction. However, more can be done and early action would help the authorities stay ahead of the curve.

Additional macroprudential tools should be developed. The preparation of an adequate macroprudential “toolbox” is important to ensure that measures can be implemented without delay when needed. In particular, we would suggest considering limits on the debt-to-income ratio, which would help keep household debt and debt service capacity in check, especially in a context where house prices rise faster than incomes. The authorities should also consider raising the new minimum down payment requirement to at least 10 percent to increase households’ buffer in case of adverse house price shocks. These measures would complement the existing MCI supervisory diamond as they help protect households (as opposed to bank portfolios) and address risks from loans by commercial banks (as opposed to MCIs only). This would also help ensure that risks are not just shifted from the mortgage institutions to the banks. If regional market conditions continue to diverge, consideration could be given to applying policies with different stringency across regions.

More fundamentally, the present would be a good time to tackle longstanding housing supply issues and reduce adverse incentives from taxation. Improving zoning regulations could help alleviate supply constraints while easing Denmark’s tight rental market regulations would facilitate more efficient use of the existing housing stock. On the tax side, the procyclical valuation freezes for land and property taxes should be ended and we strongly welcome the authorities’ intention to transition to a new housing valuation system, which will be discussed in the autumn.

Financial Sector Policies

We welcome the follow up on the recommendations of the 2014 FSAP, though further work remains. With the recent implementation of EU regulations, the supervisory and resolution regimes have been strengthened. Also, the DFSA is planning to increase the frequency of on-site inspections. Furthermore, the supervisory diamond and Seven Best Practices address several key FSAP recommendations. More could be done, though, to bolster the operational independence of the DFSA, including by lengthening the terms of Board members and introducing strict fit and proper appointment criteria. An internal audit function should also be established in the DFSA to ensure integrity and consistency of supervision. We are encouraged to learn that this work is underway. Finally, it should be ensured that the DFSA continues to have adequate resources to execute its expanded set of tasks, including regarding the supervision of the pension and insurance sectors.

Strengthening regional cooperation on financial stability issues is also key. Given the interconnectedness of the Nordic banking sector, close coordination is essential and the impending branchification of Nordea only lends the issue further increased pertinence. We therefore support the ongoing work among the Nordic authorities to strengthen agreements in this context. It will be critical to reach clear understandings on robust cross-border supervisory cooperation, adequate information sharing, depositor protection, and resolution arrangements.

Structural policies

Good labor market reforms have been undertaken in recent years and further efforts are underway. The mission supports the recently agreed cap on the aggregate benefits that households can receive and it encourages the authorities to follow through with the second phase of this reform and lower taxes on low-income earners, which should further improve work incentives.

The refugee crisis highlights the challenge of better integrating migrants. Larger migrant inflows provide an opportunity to boost the labor supply, but swift integration is key. The track record is poor with only 30 percent of nonwestern immigrants employed after three years against an employment rate of 75 percent for Danes. We thus welcome the new tripartite agreement on integration that contains many promising elements, including the opportunity for migrants to enter the labor market at a reduced wage for a limited two-year period and bonus incentives for companies to employ them. Implementation needs to be closely monitored to ensure progress toward the government’s goal of raising the employment rate for migrants after three years to 50 percent. Further measures should also be considered, including lifting restrictions on accepting regular work while asylum requests are being processed and starting the new integration program earlier for asylum seekers whose requests have a high probability of success. Such measures would help limit the loss of skills and employability associated with prolonged spells of inactivity.

Reducing product market regulation could raise productivity and potential growth. The government is making gradual progress in implementing the reforms recommended by the Productivity Commission. Further reforms could usefully aim at reducing regulation in the retail and some network sectors. New firm-level evidence suggests that this could substantially increase firms’ productivity, including through sizable downstream effects on the broader economy. We thus welcome the government’s intention to liberalize the “Planning Act”—where additional gains could be realized by loosening restrictions also on the largest store sizes—as well as the ongoing work on a new strategy for selected network sectors.

The mission thanks the authorities and other counterparts for their warm hospitality and for candid and high-quality discussions.


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