Denmark: Concluding Statement for the 2017 Article IV Consultation

May 10, 2017

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.

1. The Danish economy has recovered from crisis and is approaching potential. While recent growth has been markedly slower than before the crisis, the remaining output gap is small and capacity constraints are emerging, exemplified by tightening labor market conditions in some sectors. Meanwhile, house prices continue to rise rapidly in urban areas, even as general price and wage pressures remain subdued. The coincidence of low growth and increasingly binding constraints highlights Denmark’s reduced growth potential, reflecting structurally weak productivity gains and low domestic investment levels.

Outlook and Risks

2. The outlook is for continued moderate growth. The mission projects growth will increase to 1½ percent in 2017 and hover around 1¾ percent during 2018-22. Activity will be driven by increasingly balanced private demand, with steady consumption growth and a gradual further recovery in investment. The contribution of exports to growth is expected to remain small. Inflation should rise as the economy continues to operate close to capacity.

3. Risk are substantial. Domestic risks are becoming more prominent as increasing labor shortages could constrain growth and push up prices. Sustained increases in labor participation, however, would mitigate such pressures. Continued house price inflation could further increase households’ vulnerability, including to rising interest rates. Several external risks also remain, including lower-than-expected euro-area growth and political uncertainties.

Policy Challenges

4. Economic policies should alleviate demand pressures and raise potential growth. Macroeconomic policies should gradually become more neutral, in line with the cyclical position. Provided that strong new labor market reforms are agreed to enhance medium-term growth prospects, it would be appropriate to slow the pace of consolidation somewhat to facilitate tax reductions. Structural policies need to be strengthened to boost the growth potential of the economy, including by further raising labor supply and promoting investment. Macroprudential measures are needed to bolster household resilience.

Macroeconomic Policies

5. The fiscal stance has become more neutral. Denmark’s public finances are broadly sustainable and there is fiscal space. The current fiscal stance appears broadly appropriate for the cyclical position of the economy and remaining long-term consolidation needs are relatively small. This provides room for maneuver, though a tighter fiscal stance could be called for if growth turned out substantially faster than expected.

6. Capacity-enhancing reforms are now a priority. The government’s earlier “2025 plan” to modestly ease the fiscal consolidation path to facilitate reductions in the high tax burden and introduce new reforms to boost labor supply remains sensible. To ensure positive supply effects, it is critical that useful tax measures—such as the earned-income tax credit for low-income earners and bonus deductions for R&D investments—are complemented by strong labor market reforms, including the envisaged faster increase in the retirement age and limiting student grants to prescribed study periods. Additional measures are discussed below.

7. Shifts in the composition of fiscal outlays could help support growth. Although Denmark’s overall level of public expenditure is among the highest in the OECD, spending on public investment is below that of peers—even after post-crisis increases. A durable shift in the composition of spending away from consumption and transfers toward productive public investment could improve resource allocation and help raise growth potential. Useful areas for investment include the development of additional housing in the larger cities and upgrading of the transport infrastructure (e.g., rail and ports) in view of increasing demands.

8. The central bank should remain ready to defend the peg and continue to normalize rates as conditions allow. As conditions in the euro area normalize, it would be appropriate to gradually reduce spreads relative to the ECB, if market conditions permit.

Housing Policies

9. Ongoing house price increases in urban areas are a concern. With high debt levels and still high shares of interest-only and variable-rate mortgages, households are vulnerable. Unchecked further price increases, especially in areas with high lending growth, would raise risks. DFSA guidance to banks via a mortgage diamond and 7 best practices has helped avoid slippage of lending standards. Last week’s agreement on property taxation reform is also welcome and should reduce the procyclical impact of the current valuation freezes from 2021. However, the reform could reduce mobility and the agreed option of tax cuts in case of sustained revenue growth introduces a new element of procyclicality. The recent increase in the LTV-ceiling for vacation homes runs counter to the efforts to reduce housing risks.

10. Further macroprudential tools are needed to ensure stability. The mission strongly welcomes the Systemic Risk Council’s recent recommendation to cap the maximum loan amount of variable-rate and interest-only loans in the Copenhagen and Aarhus areas and urges the government to adopt it. The mission believes the measure could be strengthened further by applying a general cap to all loans, irrespective of loan terms, with tighter limits for riskier instruments. Introducing amortization requirements and raising the existing down payment requirement to at least ten percent would also help contain indebtedness.

11. Tax and housing supply policies should also contribute. The housing recovery and current low interest rates provide a conducive environment for reducing the tax deductibility of mortgage interest expenses. This would reduce the debt bias in the tax system and could also help restore balance in housing taxation following the permanent reduction of effective rates in the property tax reform. Easing housing supply constraints, such as strict zoning regulations, land development procedures, and rental market regulations, also remains key.

Financial Sector Policies

12. Good progress is being made with upgrading the regulatory framework. The mission welcomes the progress with implementing EU regulations, including those related to CRD IV/CRR, Solvency II, and the Bank Recovery and Resolution Directive, which address several recommendations made by the 2014 Financial Sector Assessment (FSAP). The memoranda of understanding (MOUs) with Nordic neighbors on systemic branches are also important progress in view of the interlinkages of the regional banking system and ongoing “branchification” in key systemic banking groups.

13. The mission encourages further implementation of FSAP advice. This includes a swift introduction of the minimum requirement for own funds and eligible liabilities (MREL) and the net stable funding ratio (NSFR). Following the recent early change of the chairman of the DFSA board, the mission continues to urge strengthening the operational independence of the DFSA, including by lengthening the terms of board members. To ensure integrity and consistency of its supervisory work, it is also important that the DFSA’s independent internal audit function is made operational soon. The MOUs with other Nordics should be implemented and their effectiveness should be evaluated after one year.

Labor Market Policies

14. Further raising labor supply is a key challenge. Past reforms of pensions and unemployment benefits are paying off in rising participation rates and some further positive impact is to be expected over the next few years. Nonetheless, labor supply constraints appear to be an increasing bottleneck for growth.

15. The mission welcomes initiatives to incentivize work and reduce poverty traps. Jobreform has introduced a cap on the total amount of benefits households can receive and a requirement to work 225 hours per year to maintain full eligibility for social assistance. The temporary bonus for long-term unemployed who accept work is also welcome. Last year’s tripartite agreement offers useful apprenticeships and training for migrants.

16. But more needs to be done. To further promote labor participation among the young and the old, following through on the education and pension reforms in the 2025 plan is key. In addition, eliminating the availability of unemployment benefits to graduates would help promote faster labor market entry. International experience suggests that more training and education for migrants would raise their employment prospects. Also, improving the validation of foreign degrees would help migrants with good qualifications find work faster. Lifting restrictions on work by asylum seekers and starting integration programs earlier would also speed up integration and reduce risks from prolonged inactivity.

Structural Reform

17. Policies to boost investment could help raise productivity growth. In particular, introducing an incremental Allowance for Corporate Equity (ACE) would reduce the debt bias in the tax system and increase firms’ willingness and ability to invest. Also, policies to promote knowledge-based investment, e.g., by increasing direct funding for or the tax deductibility of knowledge-related expenses, would help boost innovation and productivity. Such policies could also bolster the investment response to improved economic activity.

18. Product market reforms also remain needed. The mission strongly supports the liberalization of the Planning Act and initiatives to boost competition in the construction and utilities sectors. Relaxing strict regulations in some network sectors—e.g., passenger rail and post—would also help increase competition and productivity growth.

External Sector

19. Denmark’s current account surplus is high. This reflects corporates’ increasing operations abroad and low investment at home. High pension savings are also important. While it is not clear that there are significant domestic policy distortions causing the surplus, recommended policies to slow fiscal consolidation and raise private and public investment would help reduce the imbalance.

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

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