On December 5, 2014 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Denmark.¹

The Danish economy is recovering slowly and unevenly. The economy contracted slightly (by 0.1 percent) in 2013, but it looks likely to accelerate modestly in 2014. Growth is held down by a trend decline in North Sea oil and gas production as well as exports to euro-area partners. 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. Inflation and interest rates remain low. Domestic inflation is about 1.5 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.

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 is expected to expand in 2014 and is projected to widen further in 2015.

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.

The recovery is likely to continue but remain fragile. Annual growth is estimated at 0.7 percent in 2014, projected to increase to 1.4 percent in 2015, and trend to slightly above 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 largely close by 2018.

However, risks remain on the downside. Surges in global financial markets volatility (disorderly exit from unconventional monetary policy or other causes) that lead to a spike in market interest rates could depress consumption as households’ cash flow is diverted to higher debt service on adjustable rate mortgages. A protracted period of low euro area interest rates as the Danish economy recovers could create overheating pressures and overvalued asset prices. A drop in confidence in Danish covered bonds could depress consumption through higher debt service on adjustable rate mortgages. Last but not least, the Nordic-Baltic financial system is tightly integrated and problems elsewhere in the region would spill over into Denmark and outward spillovers from Denmark would most likely propagate through the financial system channel.

Executive Board Assessment²

The Executive Directors welcomed the rebound in economic activity, the steady decline in unemployment, and the improved housing market. Directors agreed that growth prospects are favorable, underpinned by the strong track record of prudent macroeconomic policies and financial system stability, while the exchange rate peg continues to serve the economy well. Meanwhile, vulnerabilities remain from the elevated household debt and weak growth in Denmark’s main trading partners.

Directors commended the authorities for their substantial fiscal consolidation efforts in recent years, which have kept the debt-to-GDP ratio at low levels and strengthened public finances. They agreed that the fiscal stance for 2015 is broadly appropriate, consistent with the medium-term goal of achieving a structural budgetary balance. Directors supported the authorities’ intention to start rebuilding fiscal buffers, taking due account of cyclical developments.

Directors noted that, while financial stability risks are generally contained, further efforts are needed to enhance the resilience of the financial system, in view of its large size and risks in mortgage finance. Priorities include developing macroprudential tools; strengthening prudential supervision and regulatory requirements for mortgage banks; and improving crisis management and bank resolution. Directors looked forward to continued close regional cooperation and full implementation of the recommendations of the updated Financial System Stability Assessment.

Directors emphasized the need to prevent excessive accumulation of household debt. They agreed that the new supervisory guidelines for mortgage credit institutions, the down payment requirement, and the gradual reduction in mortgage interest deductibility would go a long way in reducing risks and house price volatility. Directors noted that these initiatives could be complemented by measures to rebalance tax incentives and deregulate the rental market.

Directors encouraged the authorities to pursue additional reforms to enhance productivity growth and competitiveness. In this regard, they considered that many recommendations from the recent Productivity Commission warrant further consideration. Directors also called for continued efforts to increase labor market participation and improve the functioning of the labor market more broadly.