Copenhagen, Denmark: The strength of the economic recovery bodes well for the rebound in activity to persist, but uncertainty remains high due to the war in Ukraine and the pandemic, with the balance of risks tilted to the downside. Labor market pressures have increased. Surging energy prices have propelled inflation to historic highs. The current account surplus remains large. While house prices appear to be stabilizing at elevated levels, high household debt is a source of risk.
Key Policy Recommendations:
Fiscal Policy. Due to the strong rebound, the planned fiscal tightening —by unwinding pandemic-related measures—is appropriate. Yet, given the uncertain outlook, the authorities should stand ready to recalibrate fiscal policy if either downside or upside risks materialize. Fiscal policy should continue supporting the economic transformation, including through green and digital initiatives.
Macrofinancial. The financial sector remains vulnerable to high household leverage and an increasing share of risky mortgages. Focus should lie on tightening income-based macroprudential tools as well as improving tax incentives and housing supply. The authorities should continue to strengthen anti-money laundering supervision.
Labor market . The clearing of the labor market should be supported by the wage bargaining framework, labor inflows and planned fiscal tightening. Flexicurity allowed to operate at full force will facilitate efficient reallocation. Efforts to improve labor supply should continue, including additional activation policies that target the young, the low skilled and the foreign born.
Green transformation. Current carbon taxation proposals are welcome. A prompt decision on carbon pricing, reinforced by fiscal incentives across sectors, would catalyze private investment to complement the planned increase in public investment. Carbon tax revenues should be used to address leakages and secure a just transition.
Outlook and Risks
The outlook is for the rebound in activity to continue. Given Denmark’s small direct exposures to Russia and Ukraine, the impact of the war is expected to be limited. Amid the lifting of all pandemic-related restrictions, near-term growth—led by private consumption and investment—is projected to be strong, around 3.2 and 1.5 percent in 2022 and 2023, respectively. Lower demand from main trading partners—notably Germany—will weigh on Danish exports. Public consumption is projected to decline as COVID-support measures are unwound. Headline inflation is projected to rise appreciably this year—close to 5 percent—mainly due to surging energy prices. The planned fiscal tightening will help ease labor market pressures.
But risks remain high amid the war in Ukraine and pandemic-related uncertainty. A further escalation of the war remains a key downside risk, additionally weighing on activity and lifting inflation. Continued supply chain bottlenecks could result in higher and more persistent inflation. Pandemic-related risks are still high given the possibility of new variants. However, labor market pressures stemming from a stronger-than-expected rebound present a key upside risk. Amid high uncertainty, the balance of risks is tilted to the downside. Macrofinancial vulnerabilities remain elevated. Following a prolonged period of low interest rates, high debt, combined with illiquid housing and pension assets, exposes households to price and interest rate shocks that can spill over to aggregate demand. Furthermore, many households have recently opted for interest-only mortgages with options for lenders to request amortization if housing prices fall, which could amplify adverse shocks. In addition, homeowners are increasingly taking out variable-rate mortgage loans and repaying fixed-rate loans which naturally increases the interest-rate sensitivity of homeowners.
The fiscal stance in the baseline is appropriate, but fiscal policy should remain flexible given the uncertain outlook. Fiscal policy is planned to be tightened in 2022 as the unwinding of pandemic-related measures more than offsets war-related spending. Compensation for higher energy prices (“heat checks“) is small, temporary, and targeted. Designed as direct transfers, it is also less distortionary than measures taken in other countries. Defense and humanitarian spending is projected to persist beyond this year. Amid the strong cyclical position, the planned fiscal tightening would suitably dampen aggregate demand. Going forward, any additional compensation measures should be well targeted and fiscally neutral. Fiscal policy must be adapted to new priorities such as compensation packages, military spending, and energy transition—if necessary, by alleviating capacity pressure elsewhere in the economy. Given the uncertain outlook, fiscal policy should remain flexible, and be recalibrated as needed if either downside or upside risks materialize.
To support Denmark’s emissions targets, the authorities should adopt a comprehensive strategy. Fiscal policy is appropriately supporting the green and digital transitions. The proposed strengthening of carbon pricing is welcome. But given uncertainties regarding emissions reduction and acceptability of higher carbon prices, complementary fiscal incentives at the sectoral level should be considered, including the use of feebates. A prompt decision on the tax framework—including the proposed models in the Green Tax Reform and forthcoming proposals for agriculture and transportation—would catalyze green private investment.
Staff welcome the recent review of the Budget Law. Over the long term, the planned relaxation of the structural deficit limit would allow policy to respond to spending priorities while also providing more flexibility to deal with cyclical challenges should it be needed.
The exchange rate peg has served Denmark well. The central bank should continue to use interventions for short-term exchange rate fluctuations and interest rate adjustments for more persistent movements.
Financial Sector Policies
The banking system remains profitable, liquid, and well capitalized. Banks’ liquidity ratios are comfortably above minimum requirements and risk-weighted capital ratios were stable in 2021 as dividend payments resumed. Stress tests show that both systemic and non-systemic banks can withstand losses in the event of a severe recession. Staff welcome the recommendation of the Systemic Risk Council to increase the countercyclical capital buffer to 2.5 percent from 31 March 2023 and the Government’s decision to follow the recommendation.
But prudential tools could be further improved . A sectoral systemic risk buffer requirement would create buffers for specific risk exposures, while a fully risk-based prudential framework would allow timely monitoring of risk dynamics for individual exposures and facilitate calibrating macroprudential tools. The financial supervisory authority has adopted a new AML/CFT institutional risk assessment model. It should continue intensifying AML/CFT on-site inspections of higher-risk financial institutions.
High household leverage and an increasing share of risky mortgages warrant macroprudential tightening together with tax and housing supply reforms. Staff recommend that new mortgages extended to highly-leveraged households be subject to increased minimum down-payment requirements or mandatory amortization until a minimum equity share is reached, regardless of maturity and type of interest rate fixation. The limits applying to these borrowers should become binding if either the debt-to income or loan-to-value (LTV) threshold is breached, instead of the current joint requirement. Based on borrowers’ riskiness, differentiated caps on income-based measures and LTVs for interest-only and floating-rate mortgages should also be considered. In an environment of increasing mortgage rates, the “growth area guidelines” should be extended across Denmark and debt-service-to-income caps should be considered to protect against liquidity shocks. Mortgage interest deductibility should be reduced, and the property tax reform should be prioritized. Incentives for the adequate supply of housing should be reviewed and once inflationary pressures abate rent controls relaxed. National legislation should include borrower-based tools in the policy toolkit.
Labor Market Policies
Labor market clearing is supported by specific features of the Danish system. Amid the planned fiscal tightening, flexicurity being allowed to operate at full force will facilitate matching and efficient reallocation. The clearing of the labor market should also be supported by labor inflows and the wage bargaining framework, which allows wage flexibility over and above the collectively-negotiated wages.
Efforts to improve labor supply should continue, including additional activation policies that target the young, the low skilled and the foreign born. During the pandemic, the authorities expanded incentives by increasing unemployment benefits if the unemployed began vocational education (VET). They also provided more funds for upskilling and training. To further promote labor market participation of refugees, the government expanded the basic integration education program and extended it to 2023. These efforts are welcome and should continue. The new law that grants Ukrainian refugees quicker access to the labor market under the Special Act is welcome.
The long-term sustainability of the Danish economy relies on increasing labor supply. The current pension reform that defines the indexation of the statutory retirement age (SRA) to life-expectancy is key to maintain labor supply and underpins long-term fiscal sustainability. Any changes to the indexation that might result from the ongoing review should ensure that long-term fiscal sustainability is kept. Staff welcome the agreement “Denmark Can Do More I” (DCDM I) to strengthen structural employment by 2025. To further raise labor supply, high marginal and participation tax rates should be reduced. The adequacy of routes to early retirement should be reviewed to ensure that incentives for remaining in the labor market are maintained. By making the positive list forward looking the supply of labor with adequate skills could be increased. A more equal split of parental leave and improvements to the provision of after-hours public childcare could further decrease the gender gap and increase productivity. Simplifying the certification of foreign degrees, permanently lowering the threshold under the pay-limit scheme and reviewing its link to the unemployment rate would help attract skilled foreign labor.
Reforms to boost investment and productivity
Denmark is turning the pandemic into an opportunity to raise investment, productivity growth, and embrace the economy of the future. Policies implemented before and throughout the pandemic have contributed to Denmark’s top rankings in the EU’s Digital Economy and Society Index and the Climate Change Performance Index.
Denmark’s green and digital transformation offers an opportunity to further boost investment, raise productivity, and lower the savings-investment gap. Estimated investment needs for climate mitigation and adaptation are significant. Over the long term, fiscal space should be used to raise green and digital public investment as much as efficiently possible, while being compliant with the new Budget Law and the medium-term objective. A prompt decision on carbon pricing would further incentivize the private sector to step up green investment.
Additional policies to increase productivity growth and overall investment should be considered. Entrepreneurship can be supported by rebalancing taxation for start-ups and high-technology firms through adjustments to carry-forward losses and dividend taxation. The implementation of an incremental Allowance for Corporate Equity should also be considered. Innovation could be fostered by ensuring that incentives for R&D expenditure remain adequate for a broad spectrum of firms, including SMEs, and by promoting more collaboration between universities and businesses. Better access to equity finance would improve funding options for small or high-technology firms that might be subject to credit constraints due to a lack of collateral. Pension fund regulation should be reviewed to improve investment incentives while ensuring adequate risk practices. Also, continuing with the implementation of investment vehicles through which pension funds and public resources are invested in SMEs remains relevant. As agreed in DCDM I, the authorities should foster an environment to provide accelerator capital for companies that are in the scale-up phase. The institutional framework for competition should be enhanced by a market investigation tool and a system to scrutinize mergers. Evaluation of sectoral regulations is suggested to ensure they are conducive to adequate competition.