Denmark -- Concluding Statement of the 2008 IMF Mission
IMF News, October 2, 2008
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- Published: October 2, 2008
Initial assessment and policy priorities
- Strong initial conditions, sound policies, and solid institutions position the Danish economy well to face significant challenges.
- Main policy priorities:
- Contain spillovers from the global financial crisis.
- Manage the cyclical slowdown.
- Strengthen fiscal sustainability.
- The global financial crisis increases the premium on making liquidity available to sound banks; Danish banks have small exposures to US subprime assets, but contagion has come through increased risk aversion and a dry-up of liquidity.
- Temporary liquidity facilities established by Danmarks Nationalbank are welcome.
- The ongoing slowdown is a necessary adjustment to allow wage and price pressures to ease; despite negative growth at the turn of the year, output remains above potential, unemployment is exceptionally low, and wages are rising too fast.
- Liquidity crisis likely to sharpen the slowdown but does not justify loosening fiscal policy.
- Upfront action is needed to ensure fiscal sustainability due to significant demographic changes and an already high tax burden; recent proposals by the labor market commission would help.
Macroeconomic outlook and risks
- Central outlook (assuming global liquidity crisis abates):
- Growth to slow during 2008-10 and then rise back to potential once unemployment reaches a sustainable level.
- Confidence shaken by higher interest rates and inflation, a turnaround in the property market, and the worsening global crisis.
- Consumption and investment growth expected to remain sluggish; exports constrained by high labor costs and weak export markets.
- Wage growth expected to slow over time, allowing firms to rebuild profit margins and create conditions for sustainable growth.
- GDP growth projections: slightly less than one percent this year and slightly less than half a percent in 2009-10, with a pickup in 2011.
- External current account balance projected to strengthen slightly owing to contraction in domestic demand.
- Inflation, anchored by the peg to the euro, should decline as wage growth slows and global commodity price increases abate.
- Main risks:
- Significant worsening of the external environment: a protracted global liquidity squeeze could compound banking stresses, curtail bank credit and domestic demand, and be magnified by a sharp drop in housing prices.
- Momentum in recent high wage growth: nominal wage growth pushed to nearly 5 percent by tight labor market conditions, the generous 2008 public sector wage agreement, and rising food and fuel prices; real wages have grown faster than productivity. If wage growth does not slow, firms' profitability could be undermined, possibly leading to a protracted period of high unemployment.
- Competitiveness assessment:
- Real effective exchange rate assessed as well aligned.
- Denmark's productivity growth is slower than that of its trading partners while real wage growth has been faster, eroding wage competitiveness.
- Export market share has eroded; improvements in terms-of-trade have mitigated price competitiveness effects but cannot be relied on indefinitely.
- Future alternatives: a sufficiently strong wage adjustment or weaker competitiveness leading to higher unemployment.
Banking sector
- Overall sector entered the crisis from a position of strength, but the global liquidity shortfall has exposed pockets of vulnerability.
- Capitalization and asset quality:
- Sector is well capitalized, though buffers have been slimmed with the phasing-in of Basel II and IFRS.
- Loan portfolios and mortgages currently performing well, but deterioration in asset quality in real estate development and construction sectors due to end of the property boom.
- Vulnerabilities:
- Some small and medium-sized banks that rapidly increased lending during the boom and relied on wholesale deposits and money market funding are particularly vulnerable.
- Liquidity crisis combined with cyclical slowdown has put such banks under severe pressure and could reinforce merger trends at a time when finding partners may be more difficult.
- Authorities' responses and facilities:
- Preemptive bank resolution approach has worked well: contingency facility established by the Danish Bankers Association in 2007; used in August 2008 to facilitate purchase of Roskilde Bank; Danmarks Nationalbank intervened in a small bank with liquidity and asset quality problems; some small banks purchased by larger institutions.
- Danmarks Nationalbank initiatives to enhance liquidity include:
- Temporary secured lending facility based on "loan bills".
- Temporary credit facility offering banks credit on basis of their excess capital adequacy.
- Expanded collateral base for borrowing by banks.
- Extraordinary auction of treasury bills acceptable as collateral for borrowing from the US Federal Reserve.
- Auction of funds obtained through swap lines with the US Federal Reserve to address dollar shortage.
- Surveillance and supervision:
- Current conditions underscore importance of intensifying financial sector surveillance and supervision.
- DFSA's initiatives to sharpen focus on liquidity are welcome.
- Scope exists to further strengthen financial stability work and ensure DFSA has resources to recruit and retain staff, especially given expanded mandate under Basel II.
Stabilization policy
- Recommended near-term stance: neutral fiscal stance given the macro outlook and high wage growth.
- Demand management goal: allow economy to slow until output returns to capacity, labor market pressures ease, and wage growth decelerates to a sustainable rate.
- Risk of "hard landing" considered small; early phases cushioned by high employment and wage inertia and later by strong automatic stabilizers.
- Case for fiscal easing at present judged weak; fiscal sustainability concerns argue for keeping fiscal position as tight as possible.
- Authorities should resist pressure to relax fiscal stance in 2009, aiming instead for a fiscal effect of approximately zero.
- Exchange rate policy:
- Fixed exchange rate policy (peg to the euro) supported: anchors inflation expectations, disciplines macroeconomic and structural policy frameworks, contributed to strong fiscal policy.
- Peg implies Denmark effectively imports euro area monetary posture; appropriate while Denmark and euro area face similar financial market challenges.
- Peg has not come under pressure during months of the financial crisis, reflecting market confidence.
Fiscal sustainability and structural policies
- Achievements and remaining gap:
- Significant fiscal achievements over past two decades: expenditure ratio declined, general government surplus among highest in EU, debt ratio declined to a little over 20 percent.
- Generous social welfare system and unfavorable demographic outlook pose a significant long-term fiscal challenge.
- Long-term framework:
- Denmark articulated and implemented a long-term fiscal sustainability framework resting on two pillars:
- Accumulating assets in good times (favorable demographics and North Sea oil revenues).
- Implementing structural reforms to strengthen work incentives and increase the labor force.
- First pillar set out in the 2015 plan targeting fiscal surpluses during next several years to increase net government assets to about 10 percent of GDP.
- Second pillar includes reforms to increase retirement age starting in 2019 and index it to longevity, strengthen work incentives, and reduce tax wedge on wages.
- Recommendations and measures:
- Further reforms of social benefits will be needed; mission strongly endorses recent proposals by the Labor Market Commission.
- Bringing forward the increase in the retirement age to 2009 and reducing the duration of unemployment benefits would reduce budget expenditures and raise revenues by boosting structural employment.
- Measures to increase revenue may be needed to close long-term fiscal gap; consider introduction of user fees, indexation of tax on residential property, and reducing deductibility of mortgage interest.
- Work of the Tax Commission provides a window to improve taxation structure and address fiscal sustainability; regrettable that the Commission's mandate requires a revenue-neutral package and excludes taxation on residential property; authorities urged to consider a more ambitious package.
- Development assistance:
- Denmark committed to maintaining development assistance at internationally high level of 0.8 percent of gross national income.
Denmark -- Concluding Statement of the 2008 IMF Mission, October 2, 2008.