Denmark: Staff Concluding Statement of the 2021 Article IV Mission

May 11, 2021

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.

Washington, DC: Denmark entered the pandemic on a strong economic footing. The authorities decisively utilized Denmark’s large policy space built over time to successfully navigate the crisis and lay the ground for a strong recovery. With one of the smallest contractions in Europe, the decline in real GDP in 2020 was mainly driven by weak private consumption and net exports. The 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; thus, unemployment increased only slightly. The current account surplus declined, mainly due to deteriorating services’ exports. A comprehensive financial policy package—together with measures to support households and corporates helped mitigate financial stability risks. Macrofinancial vulnerabilities stem largely from accelerating housing price growth amid high and increasing household leverage. Policies should support the recovery, facilitate the green and digital transitions, safeguard the most vulnerable groups, and enhance macrofinancial resilience.

Key Policy Recommendations:

  • Fiscal Policy. The fiscal framework should remain flexible given the uncertain outlook and provide a bridge to the economy of the future. If the recovery falters, Denmark should deploy its substantial fiscal space as needed. Once the recovery is fully entrenched, a plan to return to the medium-term objective remains appropriate.
  • Labor market. As the recovery gains momentum, policies should shift from exceptional support to continue strengthening “flexicurity” measures to facilitate efficient resource reallocation. Efforts to improve employment prospects for the young, the low-skilled, and the foreign-born should continue.
  • Macrofinancial. Targeted policies are required to address vulnerabilities due to high household leverage amid rapid housing price increases while supporting the extension of credit to facilitate the recovery. These include tightening macroprudential tools in coordination with balancing tax incentives, and improving housing supply. Efforts to further strengthen anti-money laundering and combating the financing of terrorism (AML/CFT) supervision should continue.
  • Green transformation. A strategy including enhanced carbon pricing, reinforced by fiscal incentives across different sectors would help Denmark attain its ambitious emissions goal. Incentives for green investment (Green Tax Reform Phase 1) and the planned increase in public investment are welcome. But given Denmark’s sizable climate-related investment needs, more needs to be done, including creating further incentives for the private sector to step up green investment.

Outlook and Risks

The near-term outlook is for a rebound in activity. This is predicated on the continued rollout and increased availability of the vaccine by the second half of the year. With the expected lifting of restrictions, output growth is projected to rebound to 2.6 and 3.3 percent in 2021 and 2022 respectively. Activity will be supported by a recovery of private consumption and net exports. The momentum in investment should strengthen in 2022 on the back of various initiatives that incentivize green investment and digitalization. The labor market will continue to improve, supporting wages. With the projected recovery, the negative output gap is estimated to close by 2022. Thanks to various initiatives to raise investment and labor supply, potential growth will pick up in the medium term, thus helping to limit scarring from the pandemic.

Amid high uncertainty, risks are tilted to the downside. The recovery could be impeded by further waves of infections, including new virus variants, and a slower-than-expected vaccination roll out. On the upside, the pandemic could be contained faster than expected with a quicker vaccination rollout. A disorderly reallocation towards a different post-pandemic economic landscape poses a downside risk in the near-to-medium term. Macrofinancial vulnerabilities remain elevated as housing prices rose sharply during the pandemic amid high and increasing household leverage. A domestic or regional house price correction, triggered possibly by a reassessment of fundamentals or tighter global conditions, could ignite adverse feedback loops and weigh on consumption growth.

Macroeconomic Policies

Fiscal policy should keep on supporting the recovery while facilitating the economic transformation. The fiscal deficit this year is expected to deteriorate on the back of continued COVID crisis support and measures that facilitate the green and digital transformations. In the medium term, the fiscal stance is envisaged to remain broadly neutral. This seems appropriate, as in the near term, fiscal policy should support lives and livelihoods until the recovery is well-entrenched, facilitate reallocation, and back reforms for the economic transformation. The broadly neutral stance in the medium term would help protect buffers—in view of significant future health care costs and adverse demographics.

Importantly, given the uncertain outlook, fiscal policy should remain flexible. If the recovery falters, Denmark should deploy its substantial fiscal space and allow its strong automatic stabilizers to operate fully with further discretionary loosening as needed. Once the recovery is fully entrenched, a plan to return to the medium-term objective remains appropriate.

The fixed exchange rate policy continues to serve Denmark well, therefore the objective of monetary policy should remain to preserve the peg. The policy provides a framework for low and stable inflation in Denmark. The central bank should stand ready to deploy its toolkit to defend the peg in the event of undue pressure.

Financial Sector Policies

The banking system remains profitable, liquid, and highly capitalized, though in a challenging environment. Bank profitability is challenged by the low interest rate environment in Denmark and globally. Setting interest rates on deposits and loans remains the banks’ commercial decision. This is an essential market mechanism to preserve the efficiency of the financial system. Amid large buffers before the pandemic, exposures to sectors hit hardest by the pandemic were low. As the crisis unfolded, measures to support households and corporates mitigated liquidity and credit risks. The full release of the countercyclical capital buffer (CCyB) provided additional lending and loss-absorbing capacity. However, impairments are likely to increase once support schemes expire. Moreover, the current outlook with very loose financial conditions, increasing asset prices—with rapid and significant growth in residential real estate prices—and prospects for a rapid recovery provides ground for risk build-up. The financial system is highly interconnected within Denmark and regionally, exposing banks to domestic and regional spillovers.

Prudential tools should be deployed to maintain financial stability. Unless the risk build-up subsides markedly or there is a new negative shock to the economy, the CCyB should be increased with an appropriate phase-in period. Enhanced monitoring of credit cycles in different sectors would be appropriate. If credit is identified as fueling overheating-prone sectors, differentiated risk weights at the sectoral level could be considered to ensure that capital buffers remain consistent with the higher risk in such sectors. Staff also recommend that guidance on dividend payouts and share buybacks remain in place as needed, consistent with ESRB and EBA guidelines to protect capital buffers. The newly implemented credit registry offers a unique opportunity to develop a fully risk-based prudential framework to timely monitor risk dynamics. Staff welcome advances to the AML/CFT framework, which led to a third consecutive upgrade by the Financial Action Task Force.

High and increasing household leverage amid rapid house price growth warrant tightening macroprudential tools and deploying coordinated tax and housing supply policies. The authorities should tighten debt-to-income ratio (DTI) caps for all loans irrespective of loan-to-value ratios. DTI caps could be differentiated based on borrowers’ riskiness. Highly leveraged households should be subject to mandatory amortization, regardless of maturity and rate-type. Also, tighter limits on income-based measures for interest-only and floating-rate mortgages or increasing minimum down-payment requirements should be considered. Mortgage interest deductibility should be reduced in a manner consistent with the overall tax framework. Supply constraints should be relaxed further with streamlined zoning and planning procedures and reduced rent control.

Labor Market Policies

The flexicurity model equips Denmark with a powerful framework to effectively implement and target labor market policy. Flexicurity was enhanced and complemented during the crisis through wage compensation and workshare schemes. This helped cushion the impact of the pandemic on the labor market. However, past labor market issues were exacerbated as unemployment among the youth, the low-skilled, and the foreign-born increased disproportionately, albeit similarly to peer countries.

Efforts to improve employment prospects for the young, low-skilled, and foreign-born are welcome. It is encouraging that the 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. To continue promoting labor market participation of refugees, the basic integration education (IGU) program was expanded in 2020. Also, a new migrant full-time activation scheme has been announced.

As the recovery gains traction, policies should be fine-tuned, shifting emphasis from exceptional support to other measures embedded in flexicurity. Once the recovery is entrenched and lockdown restrictions lifted, more focus should be given to facilitate matching and, as demand for jobs firms up, facilitate the reallocation of labor from contracting to expanding sectors through upskilling and education. Simultaneously, exceptional support measures should be phased out to protect the flexibility of the system.

Policies to increase labor supply, which is critical for the long-term sustainability of the system, should continue. Staff welcome the ongoing pension reform that links retirement age to life-expectancy. Other measures, that would increase labor supply and alleviate inactivity traps should be considered, including a comprehensive tax reform that uses targeted in-work benefits. Improvements to the provision of after-hours public childcare should be pursued. Simplifying the certification of foreign degrees would help attract skilled foreign labor.

Reforms to boost investment and productivity

Denmark’s transformation to a greener and more digital economy provides an opportunity to lift investment. Green Tax Reform Phase 1 is envisaged to have a small impact on emissions. Staff analysis indicates that a strategy including enhanced carbon pricing, reinforced by fiscal incentives across different sectors would help Denmark attain its ambitious emissions goal. A prompt definition of the tax framework for green investment, including the level and base of carbon taxation would reduce uncertainty, and provide further incentives for the private sector to scale up green investment. Climate adaptation will also offer an opportunity to significantly increase investment. While Denmark already ranks high on digitalization, there is scope to enhance information and communication technology (ICT) investment. This can be achieved by policies that support the expansion of knowledge-intensive sectors, which are typically ICT-intensive. Such policies include rebalancing taxation for start-ups and high-technology firms—including relaxing the cap of carry-forward losses and reducing the taxation of dividends—to improve conditions for investment and ensuring the provision of technical and digital skills to nurture an adequate supply of human capital.

Better access to equity finance would improve funding options for new, small, or high-technology firms. These types of firms might be subject to credit constraints due to lack of collateral. Hence, continuing with the implementation of investment vehicles by which pension sector and public resources are invested in SMEs remains relevant. Assessing how to properly implement an incremental Allowance for Corporate Equity (ACE) should be considered, as ACE would reduce the debt bias and the cost of capital. By raising investment and productivity, along with policies to bolster labor supply, these measures would also boost potential growth, limiting the pandemic-induced scarring.

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

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