Denmark: Staff Concluding Statement of the 2021 Article IV Mission
IMF News, May 11, 2021
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- Published: May 11, 2021
Mission summary and key messages
- Denmark entered the pandemic on a strong economic footing and used large policy space to navigate the crisis.
- The decline in real GDP in 2020 was mainly driven by weak private consumption and net exports; Denmark experienced one of the smallest contractions in Europe.
- Swift and sizable fiscal response cushioned the impact on activity; fiscal policy continues to support the recovery and public debt is sustainable.
- Unprecedented policy measures supported the labor market; unemployment increased only slightly.
- The current account surplus declined, mainly due to deteriorating services’ exports.
- Macrofinancial vulnerabilities stem largely from accelerating housing price growth amid high and increasing household leverage.
- Policy priorities: support the recovery, facilitate green and digital transitions, safeguard vulnerable groups, and enhance macrofinancial resilience.
Key policy recommendations
- Fiscal Policy
- Keep the fiscal framework flexible given the uncertain outlook and provide a bridge to the economy of the future.
- If the recovery falters, deploy substantive fiscal space as needed.
- Once the recovery is fully entrenched, implement a plan to return to the medium-term objective.
- Labor market
- Shift from exceptional support to strengthening “flexicurity” measures to facilitate efficient resource reallocation as recovery gains momentum.
- Continue efforts to improve employment prospects for the young, the low-skilled, and the foreign-born.
- Macrofinancial
- Targeted policies to address vulnerabilities from high household leverage amid rapid housing price increases while supporting credit extension.
- Tighten macroprudential tools in coordination with balancing tax incentives, and improve housing supply.
- Continue efforts to strengthen AML/CFT supervision.
- Green transformation
- Adopt a strategy including enhanced carbon pricing, reinforced by fiscal incentives across sectors to attain ambitious emissions goals.
- Implement incentives for green investment (Green Tax Reform Phase 1) and planned increase in public investment.
- Create further incentives for the private sector to step up green investment given sizable climate-related investment needs.
Outlook and risks
- Baseline near-term outlook: rebound in activity predicated on increased vaccine availability by the second half of the year.
- Output growth projected to rebound to 2.6 and 3.3 percent in 2021 and 2022 respectively.
- Recovery drivers: rebound of private consumption and net exports; investment momentum should strengthen in 2022 due to initiatives incentivizing green investment and digitalization.
- Labor market will continue to improve, supporting wages; negative output gap estimated to close by 2022.
- Potential growth to pick up in the medium term thanks to initiatives to raise investment and labor supply, helping limit scarring from the pandemic.
- Risks (tilted to the downside)
- Further waves of infections, new virus variants, or slower-than-expected vaccination rollout could impede recovery.
- Upside if pandemic is contained faster with quicker vaccination rollout.
- Disorderly reallocation toward a different post-pandemic economic landscape poses downside risk near-to-medium term.
- Macrofinancial vulnerabilities: rapid house price growth amid high and increasing household leverage; a domestic or regional house price correction could trigger adverse feedback loops and weigh on consumption growth.
Macroeconomic policies
- Fiscal policy
- Continue supporting the recovery while facilitating economic transformation.
- Fiscal deficit in the near term expected to deteriorate due to continued COVID crisis support and measures facilitating green and digital transformations.
- Medium-term fiscal stance envisaged to remain broadly neutral to protect buffers in view of significant future health care costs and adverse demographics.
- Maintain flexibility: allow strong automatic stabilizers to operate fully and deploy fiscal space if recovery falters; plan to return to medium-term objective once recovery is entrenched.
- Monetary policy
- Objective should remain to preserve the fixed exchange rate peg, which serves Denmark well and provides a framework for low and stable inflation.
- Central bank should be ready to deploy its toolkit to defend the peg in the event of undue pressure.
Financial sector policies
- Banking system
- Remains profitable, liquid, and highly capitalized but faces a challenging low interest rate environment.
- Banks’ setting of interest rates on deposits and loans remains a commercial decision; this preserves market efficiency.
- Large pre-pandemic buffers and low exposures to hardest-hit sectors limited initial credit risk; pandemic support measures mitigated liquidity and credit risks.
- Full release of the countercyclical capital buffer (CCyB) provided additional lending and loss-absorbing capacity.
- Impairments likely to increase once support schemes expire.
- Loose financial conditions and rapid residential real estate price growth provide ground for risk build-up; system is highly interconnected domestically and regionally.
- Prudential recommendations
- Deploy prudential tools to maintain financial stability; unless risk build-up subsides markedly or a new negative shock occurs, the CCyB should be increased with an appropriate phase-in period.
- Enhance monitoring of credit cycles across sectors.
- Consider differentiated risk weights at the sectoral level if credit is fueling overheating-prone sectors.
- Maintain guidance on dividend payouts and share buybacks as needed, consistent with ESRB and EBA guidelines.
- Use the newly implemented credit registry to develop a fully risk-based prudential framework to timely monitor risk dynamics.
- Continue advances to AML/CFT framework (recently led to a third consecutive upgrade by the Financial Action Task Force).
- Household leverage and housing market
- Tighten macroprudential tools and deploy coordinated tax and housing supply policies to address high and increasing household leverage amid rapid house price growth.
- Specific measures recommended:
- Tighten debt-to-income ratio (DTI) caps for all loans irrespective of loan-to-value ratios; allow DTI caps to be differentiated based on borrowers’ riskiness.
- Mandatory amortization for highly leveraged households, regardless of maturity and rate-type.
- Tighter limits on income-based measures for interest-only and floating-rate mortgages or increase minimum down-payment requirements.
- Reduce mortgage interest deductibility consistent with the overall tax framework.
- Relax supply constraints via streamlined zoning and planning procedures and reduced rent control.
Labor market policies
- Flexicurity model
- Flexicurity provides a powerful framework to implement and target labor market policy; was enhanced during the crisis via wage compensation and workshare schemes.
- Crisis measures helped cushion labor market impact, though unemployment among youth, the low-skilled, and the foreign-born increased disproportionately.
- Support and reform measures
- Authorities expanded incentives for vocational education of in-demand skills (VET), increased funding for upgrading skills, and extended training to include health courses and green economy jobs.
- Basic integration education (IGU) program expanded in 2020 to promote refugees’ labor market participation; a new migrant full-time activation scheme has been announced.
- As recovery takes hold, shift focus from exceptional support to facilitating matching and reallocation through upskilling and education; phase out exceptional support measures to protect flexibility.
- Policies to increase labor supply should continue: ongoing pension reform linking retirement age to life-expectancy is welcomed.
- Consider comprehensive tax reform using targeted in-work benefits, improve after-hours public childcare provision, and simplify certification of foreign degrees to attract skilled foreign labor.
Reforms to boost investment and productivity
- Green transition and investment
- Green Tax Reform Phase 1 is envisaged to have a small impact on emissions.
- Staff analysis: a strategy including enhanced carbon pricing, reinforced by fiscal incentives across sectors, would help Denmark attain its ambitious emissions goal.
- Prompt definition of the tax framework for green investment, including the level and base of carbon taxation, would reduce uncertainty and incentivize private green investment.
- Climate adaptation presents a significant opportunity to increase investment; planned increase in public investment is welcome but more is needed.
- Digitalization and ICT investment
- Denmark ranks high on digitalization but scope remains to enhance ICT investment.
- Support expansion of knowledge-intensive, typically ICT-intensive, sectors via rebalancing taxation for start-ups and high-technology firms:
- Relax cap of carry-forward losses and reduce taxation of dividends to improve investment conditions.
- Ensure provision of technical and digital skills to supply adequate human capital.
- Access to finance and corporate taxation
- Better access to equity finance would improve funding for new, small, or high-technology firms that may face credit constraints due to lack of collateral.
- Continue implementing investment vehicles for pension sector and public resources to invest in SMEs.
- Assess proper implementation of an incremental Allowance for Corporate Equity (ACE) to reduce debt bias and lower the cost of capital.
- By raising investment and productivity, and bolstering labor supply, these measures would boost potential growth and limit pandemic-induced scarring.
Staff thank the authorities and counterparts for accommodative flexibility, hospitality, and candid, high-quality discussions.