Mission Concluding Statement 

Denmark: Concluding Statement of the 2014 Article IV Mission

September 26, 2014

09/26/2014

The Danish economy is slowly recovering, supported mostly by improving domestic demand. The exchange rate peg to the euro has kept inflation at levels similar to the euro area, while unemployment has continued to decline over the past years. Fiscal policy is broadly appropriate, but a slightly tighter fiscal stance in 2015 would be consistent with the closing output gap. Reducing distortions to the housing market would also be welcome. Financial stability risks are contained, but high household debt remains an underlying vulnerability for the real economy.

Fostering a Fragile Recovery

1. The economy is recovering slowly and unevenly. Both GDP and export growth have been weak but positive. Both are held down by a trend decline in North Sea oil and gas production that lowered GDP growth by nearly half a percent per year but has little effect on the broader economy. At the same time, private domestic demand and non-oil exports are supporting growth. Employment has increased and unemployment has been trending downward slightly over the past year.

2. The exchange rate peg to the euro has kept inflation low without deflation. Domestic inflation is about 1½ percent although lower inflation in imports holds down the broader indices. Wage growth is also moderate. Deposit and lending rates remain very low, while government bond rates are negative out to two year maturities. After exiting a period of negative central bank interest rates earlier in 2014, the Nationalbank once again set one of the policy rates to a very slight negative value following the ECB decision to implement its negative policy rate.

3. Fiscal policy turned slightly supportive in 2014 after a substantial consolidation in 2013. While the 2013 consolidation was sufficient to exit from the Excessive Deficit Procedure, the headline deficit expanded in 2014 and is projected to widen further in 2015 as one-off revenue measures expire.

4. Financial system profitability is still low, in line with weak credit growth, but capitalization has improved. For commercial banks as a whole, already-high capital ratios have risen further and liquid assets as a share of total assets have also increased. At mortgage credit institutions, capital ratios are also high. However, weaknesses in some non-systemic banks warrant close monitoring and may require intervention.

5. The recovery is likely to continue but remain fragile. Growth should pick up in the second half of this year. However, annual growth is likely to be below one percent in 2014, increase to about 1½ percent in 2015, and trend towards 2 percent thereafter. Domestic demand and exports to non euro-area countries should support the recovery. As the recovery continues at a modest pace, the output gap is expected to close towards the end of the decade.

6. Risks are substantial and mostly tilted to the downside. Lower growth in advanced economies and emerging markets could slow the recovery by depressing Denmark’s geographically-dispersed exports of goods and services. A substantial interest rate rise as a result of either global financial market volatility or a rise in mortgage bond interest rates could depress consumption through higher debt service on adjustable rate mortgages or renewed decline in house prices. Alternatively, overheating pressures and overvalued asset prices could emerge if a Danish recovery is accompanied by protracted low interest rates in the euro area.

The right policies will help Denmark through the fragile recovery

Monetary and exchange rate policy

7. The very tight peg to the euro has served Denmark well. The peg has allowed Denmark to anchor inflation and minimize exchange rate volatility vis-à-vis most of Europe.

Fiscal policy

8. Fiscal policy for 2015 and the medium term is broadly appropriate, but a slightly tighter fiscal stance would be welcome. Structural and headline deficits look likely to be at or above 0.5 and 3.0 percent of GDP respectively with current budget plans and our macroeconomic projections. The fiscal impulse appears somewhat neutral or only slightly contractionary where more consolidation would be appropriate. A somewhat tighter fiscal position in 2015 (e.g., by ¼ percent of GDP) would start building buffers in the case of a down-turn and provide some margin for maneuver in the event of other negative fiscal shocks. This is particularly important given the inherent uncertainty of some revenue items, particularly pension taxation.

9. The government has made several reforms to control spending and increase efficiency in local governments. After repeated spending overruns, a new system of sanctions has brought spending under budgeted limits from 2011. The government has also created incentives to increase local government efficiency by rewarding local tax cuts. It has also streamlined regulations on municipalities. The mission welcomes these initiatives and would encourage independent evaluation of the local experience and sharing of best practice results.

Financial sector policy

10. Stress tests conducted as part of the IMF Financial Sector Assessment Program (FSAP) update found that financial stability risks are contained.¹ The authorities have taken steps to enhance financial system resilience since the global financial crisis, including: (i) a new bank resolution framework entailing bail-in of creditors; (ii) a new institutional framework for macro-prudential policy; (iii) the introduction of capital surcharges on systemically important banks; and (iv) the recent legislation requiring maturity extension of covered bonds in stress situations to manage refinancing risks in the mortgage finance system.

11. Important policy actions have helped to safeguard financial stability but the large size and high domestic interconnectedness of the financial system require even greater resilience. The mission recommends further measures to reduce risks. Specifically:

• Mortgage banks and covered bonds market. To mitigate risks introduced by recent product innovation, use regulatory policies to encourage longer bond maturities, ensure that interest-rate risk is better reflected in loan pricing and approvals, and increase buffers in loans with interest-only periods, for example, by reducing the loan-to-value ceiling. The proposal for a supervisory diamond for mortgage credit institutions goes in the right direction.

• Macroprudential policy. Explore new instruments capable of addressing time-varying systemic risk, such as limits on LTV and debt service to income ratios. Review the experience with institutional arrangements, especially the appointment of the government as the designated macro-prudential authority. The proposed requirement that home buyers make a down payment of at least 5 percent is welcome.

• Prudential supervision. Reduce the length of examination cycles for banks and insurance companies through the use of additional resources, and ensure the operational independence of the Danish Financial Supervisory Authority.

• Crisis management and bank resolution. Continue to implement early resolution triggers and strengthen funding arrangements as well as the resolution toolkit, prepare resolution plans and resolvability assessments, and enhance the deposit guarantee scheme. Formalize the framework for emergency liquidity support.

12. Denmark’s consideration as to whether to join the Banking Union is still ongoing. The mission notes the government’s view that there are still some unsettled issues, in particular regarding the outcome of the Comprehensive Assessment.

House prices and household debt

13. High household debt is an underlying vulnerability and house price volatility has consequences for the real economy. Some features of tax, rental market, and financial sector policy should be reconsidered in order to limit house price volatility and to prevent excessive debt accumulation in the future. The freeze on real estate valuations at 2002 levels leads to a pro-cyclical impulse. This valuation freeze creates a bias in the tax system towards owner-occupied dwellings relative to other investment. And also a bias will arise as interest rates normalize. Tight rent control also contributes to increased price volatility in owner-occupied dwellings, and may push households with limited financial buffers into premature home ownership. Finally, interest only loans limit the build-up of home equity and increase the exposure of households to shocks. The latter is also the case for adjustable rate loans. The proposals for a mortgage credit institution supervisory diamond and 5 percent down payment requirement should be complemented by reduced tax preferences for housing and less rigid rental market regulations.

Productivity and labor market reforms

14. Productivity in Denmark has grown only modestly in the past decade. The Productivity Commission has released its recommendations, many of which are in areas where the government has been making gradual reforms over time. Further reforms were included in the Growth Plan 2014 as a first response to the recommendations. Some have been rejected (e.g., restrictions on large retail establishments), and the mission urges continued consideration of reforms, including all of the remaining recommendations by the Commission.

15. Labor market challenges persist, but we welcome recent actions to address them. Increasing labor market participation is a high priority given the fiscal burden of an aging population. Building on previous measures to increase the retirement age, reforms to disability, sickness, and unemployment benefits as well as other active labor market policies and social assistance have been put in place. These share the common theme of restricting eligibility or the length of benefits and using the resources saved to provide greater support services for beneficiaries.

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We are grateful for the very warm welcome extended to us by the Danish authorities and representatives of private sector, labor, and financial institutions for the very constructive discussions.

¹ In-depth analysis and recommendations to strengthen the financial sector will be covered in the forthcoming Financial System Stability Assessment, which summarizes the findings of the FSAP, and will accompany this year's Article IV consultation staff report.