Mission Concluding Statement 

Denmark: Staff Concluding Statement of the 2023 Article IV Mission

May 12, 2023

Copenhagen, Denmark – May 12, 2023:

Denmark has achieved an impressive post-pandemic recovery, with the output and employment level now well above its pre-pandemic trajectory, contributing to inflationary pressures. More recently, there are signs that economic activity has started slowing, and high inflation, tightening financial conditions, and weaker external demand will weigh on the outlook. The financial system has remained stable, although house prices have fallen. The medium-term growth outlook remains modest, reflecting well-known demographic headwinds in Denmark and lower global growth. Against this background, the policy priorities are as follows.

• Consider additional fiscal tightening to lower price pressures and provide insurance against upside inflation risks.

• Safeguard financial stability by closely monitoring risks around borrowers’ creditworthiness, commercial real estate, cross-border exposures, and liquidity while further tightening macroprudential policies targeting existing pockets of vulnerability.

• Pursue structural reforms to support high, inclusive, and sustainable growth, including in the areas of digitalization, competition, labor markets, education, and green transition.

Economic outlook and risks

1. After a strong recovery from the pandemic, growth is moderating. High inflation, weaker external demand, and tightening financial conditions weigh on activity. The economy is expected to experience a slowdown in the first half of 2023 before regaining momentum in the second half, assuming a continued moderation in energy prices, still high inflation, and an improvement in external demand. Staff expect GDP growth to slow from 3.8 percent in 2022 to ½ percent in 2023 and recover to 1½ percent in 2024. Beyond 2024, medium-term growth will stay around 1.3 percent, down from the pre-pandemic average of 1.8 percent, largely due to lower global growth and demographic headwinds.

2. Headline inflation is expected to average 4 percent in 2023, far above 2 percent, and core inflation has proven sticky. Headline inflation peaked in October 2022 and has since fallen as global energy price pressures eased. Core inflation, however, has not shown clear signs of easing. Moderating energy prices will continue to reduce headline inflation, but core inflation will decelerate only slowly as tight policies and an output gap closure take place. Staff project that headline and core inflation will remain high at around 2½—2¾ percent at the end of 2024. Collective wage bargaining resulted in wage growth of about 10 percent over the next two years, higher than in the past.

3. Risks to growth are broadly balanced, but risks to inflation are tilted to the upside. Downside growth risks include an escalation of Russia’s war in Ukraine (disrupting global trade), renewed supply shocks, and persistent tightening of global financial conditions. Domestically, house price corrections could accelerate. In contrast, an end to the war in Ukraine, stabilization of global commodity markets, and stronger external demand would lead to stronger growth than the baseline forecasts. Upside inflation risks reflect renewed supply shocks and stronger-than-expected and persistent wage pressures.

Taking a tighter fiscal stance to support disinflation

4. The Spring 2023 Budget shows that the structural balance will remain in a surplus of ¾ percent of GDP in 2023, broadly unchanged from 2022. The budget includes new discretionary spending measures to support Ukraine, temporarily relieve vulnerable segments of population hit hard by higher prices, and improve hospital services. The government also continues to provide energy-related support. These measures are mostly offset by the expiration of the remaining Covid-19 measures and the reallocation of other spending items, thus leaving the structural balance (including Covid-19 measures) broadly unchanged. The Ministry of Finance estimates that the fiscal plan would reduce output growth, taking into account the multiplier effects of discretionary fiscal measures.

5. Because of persistently elevated inflation, additional fiscal tightening should be considered to provide insurance against upside inflation risks. There is uncertainty regarding the multiplier effects of the fiscal measures, while the output gap level is expected to remain positive, and inflation too high with an upside risk in the near term. Accordingly, staff recommend that the authorities make every effort to improve the structural balance in the order of ½ percentage points of GDP in 2023 through tight spending control and saving any revenue above budget forecasts. With inflation expected to remain persistently elevated in 2024, fiscal policy should continue to support disinflation. If downside risks to growth materialize and inflation eases, automatic stabilizers should be allowed to operate fully.

6. The government should continue to recalibrate fiscal policy as needed to ensure its long-term sustainability. Over the medium term, the structural balance will weaken to a small deficit, mainly reflecting an increase in defense and age-related spending. To contain the level of the structural deficit within 0.5 percent of GDP set for 2030, the authorities are planning supply-side measures, including canceling a public holiday (approved by the parliament), tightening the duration of student grants, and strengthening early retirement rules. However, given uncertainty about population projections and the economic effect of the labor reform measures, if fiscal trends suggest the risk of breaching the structural deficit limit, the authorities might need additional fiscal adjustment measures. In this context, any changes to the indexation of statutory retirement age to life expectancy—from the current one-to-one—should safeguard long-term fiscal sustainability. Under the baseline scenario, public debt is projected to stay steadily around 30 percent of GDP over the medium term.

Safeguarding financial stability

7. The banking system is sound, with ample capital and liquidity buffers, but risks are rising given lower growth, elevated inflation, and tightening global financial conditions. Since these risks could deteriorate the debt service capacity of borrowers, close supervision is warranted to ensure the adequacy of banks’ assessment of impairment charges as economic prospects change. In addition, commercial real estate (CRE) risks, including those arising from cross-border operations in the Nordic region, should continue to be closely monitored. In this light, the authorities should continue efforts to close data gaps. An increase in risk weights on CRE exposures or the introduction of a sectoral systemic risk buffer could be considered. In addition, given the increased risk of cyberattacks on critical infrastructure and institutions, the authorities’ ongoing work on cyber security risks is welcome.

8. Further tightening of macroprudential policies to target pockets of vulnerability could be considered. Household debt has decreased but remains high at about 200 percent of net disposable income. Riskier mortgages, especially variable-rate mortgage loans with deferred amortization, have risen. In this context, the recent increase of the countercyclical capital buffer to 2.5 percent was appropriate. However, more should be considered, including (i) subjecting new mortgages extended to highly leveraged households to a lower loan-to-value limit than the current 95 percent or mandatory amortization until a minimum equity share is reached, (ii) extending the scope of the “growth area guidelines” beyond Copenhagen and Aarhus, and (iii) reviewing the risk weights of riskier mortgages. Furthermore, once house prices and inflation stabilize, the authorities are encouraged to review the high tax deductibility of mortgage interest expense and complex rental market regulations from the financial stability perspective. Staff welcome the government’s plan to link property taxes to market valuations starting in January 2024.

9. Continued supervisory vigilance in monitoring risks in the pension and life insurance sector is necessary. Danish pension and life insurance companies have ample capital buffers to withstand adverse shocks. However, if capital market volatility intensifies, their liquidity position could be adversely affected. Staff support the supervisor’s initiative to develop and launch a pilot stress test for pension and life insurance companies.

10. The authorities are encouraged to consider reforming the institutional setting of financial sector policy making in line with the 2020 Financial Sector Assessment Program. The government has yet to implement several recommendations, including in the area of systemic risk oversight, the operational independence of the Danish Financial Supervisory Authority, and the governance of the resolution authorities. Other key pending recommendations include introducing the legal basis for binding borrower-based measures.

Pursuing structural reforms

11. Continued efforts are necessary to maintain high productivity growth. The government’s commitment to further accelerate digitalization will help. This should be complemented with efforts to improve the efficiency of product markets and enhance competition. In order to support new businesses, including start-ups and high-tech firms that tend to struggle with initial losses, tax measures should be explored, in particular, relaxation of the cap on carry-forward losses, reduction of taxation of dividends (without unduly distorting personal and corporate tax integration), and introduction of corporate equity allowance to reduce the cost of capital. In addition, staff support the authorities’ initiative to reform the business support system. In this regard, a cost-benefit analysis would usefully inform a reform strategy.

12. The authorities’ strong focus on labor market reforms is welcome, given an expected decline in the working-age population in the coming years. Canceling a public holiday will help increase annual hours worked, while the proposed personal income tax reform will help improve work incentives. The government is also planning to reform the early retirement schemes to increase employment. But additional measures should be explored consistent with Denmark’s well-functioning flexicurity model. These include: (i) reviewing the structure of marginal effective tax rates, including benefits, to minimize disincentives to work and earn more, especially for lower-income households; (ii) continuing efforts to increase employment rates of immigrants; and (iii) enhancing education outcomes of students with immigrant backgrounds.

13. Denmark has made substantial progress in reducing emissions, but further measures are required to meet its ambitious climate goals. Carbon pricing should be strengthened as planned (Green Tax Reform). But given uncertainty regarding emissions reduction, complementary fiscal incentives at the sectoral level are needed, including feebates (i.e., fee and rebate schemes). In addition, more efforts will be needed to save energy, including in buildings, in line with the EU directive. The Danish Strategy for Adaptation to Climate Change (2008) should be updated to provide comprehensive guidance on the government’s adaptation initiatives.

The mission thanks the authorities and other counterparts for their accommodative flexibility, warm hospitality, and for candid and high-quality discussions. We are especially grateful to the Danmarks Nationalbank for its assistance with meeting and logistical arrangements.