Public Information Notice No. 06/109

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Denmark

October 5, 2006

On September 29, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Denmark.¹

Background

The Danish economy underwent major changes over the last two decades. A macroeconomic stabilization program adopted in the mid-1980s was followed by structural reforms in the 1990s. The fixed exchange rate regime helped anchoring inflation expectations and imposed discipline on macroeconomic and structural policies, contributing to the strong fiscal performance. In recent years, fiscal policy, guided by prudent medium-term objectives, resulted in budget surpluses and a significant decline in public debt as a share of GDP. Following a decade of current account surpluses, foreign debt also fell markedly.

After a period of slow growth, the Danish economy accelerated in 2004-05, driven by domestic demand, and registered a growth rate of 3.2 percent in 2005, more than twice that of the Euro area. Private consumption was boosted by high real disposable income owing to tax reductions in 2004, low interest rates, and house price developments. Sharply rising house prices also spurred double-digit residential investment growth. Real public consumption growth decelerated slightly in 2005, but remained well above the 0.5 percent target. Exports and imports grew sharply, and the current account reached a surplus of 3 percent. Staff forecast growth of around 2¾ percent in 2006, slowing down to about 2¼ in 2007.

Inflation remains contained, but is catching up with that in the euro area. The unemployment rate fell to 4.5 percent in June 2006, the lowest level in 30 years. Strong growth and a flexible labor market contributed to a notable pickup in employment. Labor market conditions have consequently tightened, and in both the construction industry and the financial sector labor shortages appear to have emerged. Despite the decline in unemployment, the number of participants in labor market programs remains high. In June, agreement was reached on a reform of the welfare system, including future increases in retirement ages and labor supply measures.

In 2005 the fiscal surplus reached 3.9 percent, much higher than budgeted and than the surplus in 2004. This was due to strong revenue growth, largely attributable to high revenues from pension return and corporate income taxation, including revenues from the oil-and-gas related activities in the North Sea. In addition, government expenditures declined as a percentage of GDP. Given that revenue developments were mainly cyclical, the structural balance shows a smaller improvement. General government debt came down further from about 44 percent of GDP at end-2004 to 36 percent of GDP at end-2005.

Policy interest rates have followed the recent increases by the ECB. Asset prices rose rapidly in 2005 and the profitability of financial institutions is at record high. Banks and mortgage credit institutions posted record profits with a substantial contribution from fee income due to securities trading and refinancing of mortgage loans. Denmark participated in the Financial Sector Assessment Program (FSAP) in the course of 2005-06.

Executive Board Assessment

The Executive Directors commended the authorities' record of stability-oriented policies and welcomed the economy's recent strong performance, with high growth rates and low unemployment. Directors viewed that recent interest rate increases and capacity utilization constraints should contribute to a gradual slowing in growth rates in the period ahead. Continued public expenditure restraint, and measures to increase labor supply and moderate wages will reduce the risk of overheating associated with tensions in the labor market and domestic demand pressures. Directors observed that developments in the housing market should be closely monitored.

Directors emphasized that fiscal policy should continue to be guided by prudent medium-term objectives. They noted that the current framework, which aims at reaching structural surpluses of ½-1½ percent of GDP, has enabled an impressive decline in the debt-to-GDP ratio. Directors cautioned against a weakening of the framework when it is updated in the period ahead, and stressed the need for a continued strong focus on the medium-term sustainability of public finances, based on realistic assumptions about the economy and the impact of structural reforms.

Directors expressed concern that an upward revision in real public expenditure growth targets, in line with the new welfare proposals, would add to the demand pressures in the short run. They supported the authorities' intention not to introduce tax cuts in 2007, noting that the tax freeze has helped control upward pressures on taxes and expenditures, and has been a useful disciplinary device. Directors observed, however, that constrained tax flexibility has resulted in property taxation that is partially frozen in nominal terms, which has provided an unnecessary stimulus to the housing market. At the same time, high marginal personal income tax rates, which become effective at relatively low income levels, constrain labor supply. A gradual and predictable elimination of the partial nominal property tax freeze, aimed at avoiding a shock to the market, and a corresponding reduction in personal income taxes would be supportive of sustainable economic growth.

Directors agreed that Denmark's exchange regime continues to serve the country well by anchoring inflationary expectations and imposing discipline in other economic policy areas. They considered the overall level of competitiveness appropriate, and noted that the recent monetary tightening in line with the ECB would help counter cyclical pressures.

Directors emphasized the importance of continued wage moderation to temper demand pressures and maintain international competitiveness. They welcomed the willingness of social partners in recent years to agree to responsible wage increases, with an eye on international trends and competitiveness, and encouraged them to maintain this consensus during the upcoming round of wage negotiations.

Directors welcomed the welfare agreement, reached by major political parties in June, which marks an important step toward preparing Denmark for aging, and maintaining sustainable public finances in the long term. They urged the authorities to implement forcefully the agreed measures.

Directors noted that the Danish flexicurity model has worked well, contributing to Denmark's low unemployment. At the same time, they observed that it involves costly benefits and active labor market policies, which may make it less applicable to countries with high unemployment and weak public finances. Nonetheless, the model merits study by other countries, as a possible way to increase labor market flexibility.

Directors welcomed the outcome of the FSAP, which found the Danish financial system to be generally healthy and well supervised. In an environment of rapid credit growth, the authorities were advised to heighten supervisory vigilance and adopt a cautious approach toward any reduction in capital buffers. Directors underscored the importance of strengthening the supervisor's statutory and budgetary autonomy, its stress testing capacity, and efforts regarding governance in financial institutions and cross-border supervision.

Directors noted that the recent sharp increase in house prices cannot be fully explained by developments in income and interest rates. They noted that favorable tax treatment and the introduction of new financial instruments are likely to have contributed to the rise in prices. Directors recommended close monitoring of the housing market, strict application of supervisory regulations, and effective consumer information about the risks of overborrowing.

Directors commended Denmark's generous official development assistance, which amounts to the internationally impressive level of 0.8 percent of gross national income in 2006.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.