Mission Concluding Statement 

Denmark: Concluding Statement for the 2018 Article IV Consultation

May 16, 2018

1. The Danish economy is performing well. Last year’s growth was the highest in a decade and the output gap seemingly closed for the first time since the global financial crisis. The labor market has strengthened and capacity constraints are emerging in some sectors. Wage growth is aligned with productivity, while inflation remains subdued. The fiscal position continues to improve and public debt is sustainable. Urban property prices are rising swiftly and household debt remains elevated despite recent deleveraging. Denmark’s reduced growth potential reflects the post-crisis investment slowdown and weak productivity growth.

2. Denmark’s current account surplus remains large. In recent years, the surplus is increasingly driven by exports of goods produced abroad, reflecting Danish firms’ increased integration in global value chains, and investment income. High household savings and the post-crisis investment slowdown are also important factors.

Outlook and Risks

3. The outlook is for continued robust growth and gradually rising inflation. Output is projected to grow beyond its trend in the near-term, reaching 2 percent in 2018 and decelerating to 1.7 percent during 2019-2023. Consumption and investment will be supported by low interest rates, employment gains and higher asset prices. Exports are projected to remain robust due to favorable external growth, but the contribution from net exports is expected to stay neutral, as stronger consumption boosts imports. Inflation is anticipated to rebound from its current low level, as capacity pressures intensify.

4. Risks are broadly balanced. Stronger than expected consumption growth could lead to widespread labor shortages, potentially intensifying wage pressures, eroding competitiveness, and hindering medium-term growth prospects. Higher than expected foreign demand could aggravate wage pressures. Conversely, international trade tensions and significant tightening of financial conditions, due to uncertainty surrounding monetary policy normalization by major central banks, could restrain the upswing.

Policy Challenges

5. Policies should target higher potential growth and reinforce financial resilience. Fiscal space should be used to facilitate capacity-enhancing reforms. Structural policies need to continue supporting potential growth, including by increasing labor supply, investment, competition and productivity gains. Importantly, investment-enhancing policies would help rebalance the current account surplus. Macro-financial policies should be strengthened to address vulnerabilities associated with elevated leverage and rising house prices.

Macroeconomic Policies

6. Public finances remain sustainable with considerable fiscal space. Fiscal policy remains anchored at the medium-term objective, despite the temporary deficit pressures in 2018-20 to accommodate the one-off costs of past reforms. Last year’s fiscal balance was stronger than anticipated amid healthy revenues and underspending.

7. Fiscal space should help facilitate growth-enhancing reforms “while the sun is shining”. The authorities’ ambitious medium-term plan to boost output calls for reforms to expand labor supply and strengthen productivity growth. Thus, existing fiscal space should be used to raise productive investment, which would also help reduce the current account surplus. Reducing labor taxes for low-income earners would increase the incentives to switch from social benefits to employment. As detailed below, changes in corporate taxation could foster private business investment. Upgrading public and transport infrastructure — especially around inner-city areas experiencing strong house price growth — would help boost productivity and mitigate house prices pressures. However, a tighter fiscal stance may be called for in case of excessive demand pressures.

8. The central bank should remain ready to defend the peg and continue to normalize interest rates as conditions allow. The recent lack of foreign exchange intervention is in contrast with previous years, and reflects the absence of currency pressures. If market conditions permit, the spread relative to the ECB could be reduced gradually.

Financial Sector Policies

9. The financial system is robust despite signs of increased risk-taking in parts of the banking system. Banks remain profitable despite low interest rates and modest credit growth. Credit standards have been relaxed by lenders, while property prices keep rising. Households remain highly indebted, notwithstanding large net asset positions. Banks are adequately capitalized and comfortably meeting their liquidity requirements. The mission welcomes the government’s recent approval of the countercyclical capital buffer of 0.5 percent of risk-weighted assets from March 2019. Additional regulatory changes, such as Basel III and parts of the Banking Recovery and Resolution Directive, are set to be implemented in due time. An updated Memorandum of Understanding with Nordic counterparts agreed in February 2018 lays out necessary principles for the exchange of information and resolution issues.

10. The mission welcomes the rapid implementation of the regulatory agenda. The authorities should continue the dialogue regarding the debt buffer for mortgage credit institutions to ensure the credibility and feasibility of resolution plans. If risks continue to build up, additional increases of the countercyclical capital buffer would be important to enhance financial resilience. Staff recommend the continuing development of key indicators to assess systemic risk, possibly including macroprudential stress tests. The operational independence of the Financial Supervisory Authority should be strengthened and adequate resources should be ensured for its continued effectiveness.

Macro-Financial Policies

11. Corrective measures have been implemented to address vulnerabilities arising from the combination of rising house prices and elevated household debt. Highly indebted households may restrain consumption further — from the historically low current levels — in the event of house price and interest rate shocks. This includes some low-income households that are already overburdened by large mortgage payments. Staff welcome important policy measures implemented by the authorities in recent years, including supervisory guidance for mortgage credit institutions and banks, macroprudential regulation, and the property tax reform. Other macroprudential instruments have been added to the toolbox, notably by changing consumer protection rules to limit lending via interest-only and floating-rate mortgages to highly indebted households.

12. Complementary policies are needed to strengthen macro-financial resilience. Existing macroprudential measures should be tightened further to protect households against house price declines and higher interest rates. This includes restricting leverage further, higher down payment requirements, and stricter amortization. A further than envisaged reduction in mortgage interest deductibility would reduce the impact on homeowners, given the current low interest rates. Restrictions on the size of new apartments should be relaxed in urban areas where demand-supply imbalances appear to have been a factor pushing valuations higher. Rent controls should be reduced to incentivize the rental market and alleviate demand for housing.

Labor Market Policies

13. The labor market has continued to recover with the economic upswing, and labor shortages have appeared in parts of the economy. The employment rate has risen from its 2014 lows to almost 75 percent, while the unemployment rate has declined to around 5 percent—the lowest post-crisis level. Wage growth is in line with its fundamental drivers.

14. Previous pension and unemployment benefit reforms continue to drive the participation rate higher. Past measures, such as Phase I of JobReform, a job-premium program for the long-term unemployed, and others, have attempted to improve skills, incentivize people to join the workforce earlier, and participate longer. The mission welcomes the launch of a technology pact that could enhance digital skills.

15. Participation rates of the young and migrants can be increased further. Lowering taxes on labor and improving vocational and education training opportunities can reduce inactivity traps. Programs focusing on improving skills would help the labor force benefit from technological advances. Reducing the duration of student grants and eliminating graduates’ access to unemployment insurance can incentivize higher youth participation in the labor market. The integration of migrants could be facilitated by expediting the validation of foreign degrees. Restrictions on employment rules for refugees can be relaxed by allowing asylum seekers with high probability of obtaining residency to start earlier their integration programs. Lowering the minimum remuneration requirement or granting more exceptions to the pay limit scheme for residency permits may also attract new migrants and boost labor supply.

Reforms to boost investment and productivity

16. Investment slowed since the crisis, while productivity growth remains subdued. Weak investment, albeit from an elevated pre-crisis level, suppressed the accumulation of capital, weighing on labor productivity growth. Sectoral breakdown points at weaknesses in productivity growth rates of domestically-oriented service industries and the utility sector.

17. Measures have been taken to boost investment and productivity. Following the recommendations of the Productivity Commission, the authorities have amended the Planning and Taxi Acts to reduce regulatory burdens in the retail trade and taxi sectors. However, these measures have fallen short of the recommendations of the Productivity Commission. Initiatives implemented to improve cooperation between businesses and universities should stimulate knowledge transfer and R&D investment. Similarly, the R&D super-deduction is being increased. The Strategy for Denmark’s Digital Growth launched recently includes important public-private initiatives to improve digitalization.

18. Product market deregulation efforts should continue to boost competition and lift productivity growth. Competition in the services sector could be improved further by enhancing the powers of the Competition Council. The Planning and Taxi Acts could be liberalized further to reduce the regulatory burden. Staff supports the Strategy for Denmark’s Digital Growth, which will allow more effective use of capital and reduce operating costs. There is scope to use public resources to improve digital infrastructure, including broadband access in rural areas, to distribute digitalization benefits more widely.

19. Further measures are needed to stimulate investment. Corporate income tax reforms, such as the introduction of an Allowance for Corporate Equity, would increase incentives to invest and reduce the debt bias for both established firms and startups. In case a corporate tax reform is not carried out, investment by startups and high-technology firms could be supported by (i) relaxing the restrictions on the use of losses carried forward, (ii) alleviating the burden of the municipal tax on business property other than land (iii) making the R&D super-deduction refundable, and (iv) reducing the taxation of dividends. Investment by established firms could be supported by reducing restrictions on the deductibility of business expansion costs. In implementing these measures, safeguards should be taken to reduce the risk of revenue leakages.

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