The Danish Economy 2008-10

INTRODUCTION AND SUMMARY

This article reviews Danmarks Nationalbank's forecast for the Danish economy in the years 2008-10. The forecast has been made using the macroeconometric model Mona^[1]and is based on available economic statistics, including Statistics Denmark's quarterly national accounts for the 4th quarter of 2007^[2].

Economic growth in Denmark was lower in 2007 than in the preceding three years. After weak development in the 1st half of 2007, growth picked up again in the 2nd half, resulting in an overall increase in GDP by 1.8 per cent in 2007 compared with 2006. The slowdown in growth – primarily attributable to supply-side factors such as labour shortage and pressure on the capital stock – is expected to continue in the coming years. Growth is estimated to be 1.9 per cent in 2008, partly buoyed up by the strong growth in the 2nd half of 2007, and to decline to 1.0 per cent in 2009 and 0.4 per cent in 2010, cf. Table 1.

The growth estimate for 2008 is generally in line with the prospects for the USA and the euro area, cf. Chart 1. The slowdown in the Danish economy thus mirrors the dampening of international growth, particularly in the affluent Western economies. Denmark has been ahead of the euro area, but behind the USA in the economic cycle. The capacity pressure is lower in the latter two economic regions, paving the way for some recovery in 2009, while growth in Denmark is expected to decline in the coming years. The increase in domestic demand is expected to be close to zero in 2010.

As a result of recent years' economic growth, employment has risen to a record-high level, and unemployment has fallen steadily to the lowest level for more than 30 years. Despite the inflow of foreign labour and an increasing participation rate, the pressure on the Danish labour market is severe, and the unemployment rate is well below the level that is compatible with wage and price stability. There is a large output gap, i.e. the gap between actual GDP and GDP in a scenario with normal utilisation of production resources.

Growth in demand fell in 2007 from the high level in the preceding years. The decrease reflected weak development in the 1st half of 2007 and a subsequent recovery in the 2nd half. The trend was most pronounced in exports, although growth in domestic demand also declined. The projection assumes continued dampening, especially of domestic demand, but also reduced export growth as a result of lower growth in export markets and weaker competitiveness. Consequently, the output gap is expected to narrow in 2009 and 2010, but to remain positive.

Recent years' strong capacity pressure has resulted in a higher import ratio and weakened the balance of payments. Both the rate of wage increase and price inflation rose during 2007. In accordance with the normal pattern, this has taken place late in the economic cycle. The lag also emphasises that wage and price pressures and the consequent deterioration of competitiveness may continue for some time after a cyclical reversal. The weaker international cyclical position, which dampens export-market growth, will make higher demands on competitiveness. At the same time, the risk associated with the international cyclical development is assessed to be asymmetrical, with the possibility of a more pronounced slowdown in the USA and a stronger spill-over effect on Europe and the rest of the world, cf. Box 1.

RISKS	Box 1
The capacity pressure on the Danish economy remains strong. GDP growth declined in 2007, but since it did not fall below the rate of potential growth, the output gap has not narrowed. The pressure on the labour market is sustained and employment has fallen month by month to a very low level. The risk of high wage increases that are not related to productivity growth, but to labour shortage, thus persists. The implication is further weakening of competitiveness, which will result in weaker export development. This will imply a longer adjustment period with unemployment above the structural level, wage moderation and recovery of competitiveness. The international economic outlook has weakened since the previous forecast in September. At the same time, the risk outlook is assessed to be asymmetrical – the risk of a severe downturn is greater than the prospect of economic growth correspondingly above the estimate. More specifically, there is a risk of stronger-than-expected slowdown in the USA and more pronounced spill-over effects on Europe and the rest of the world. This scenario clearly implies weaker growth in Denmark's export markets. Lower market growth will diminish export growth and lead to deterioration of the balance of payments. The extent of the negative effect on GDP growth in Denmark and the increase in unemployment will depend on the scale of the international downturn. I view of the normally lagged wage adjustment process, competitiveness will remain weak. Together with low or negative export-market growth, this will be an unfortunate combination that may entail unemployment above the structural level for a prolonged period. The lessons learned by the Netherlands after the boom in the 2nd half of the 1990s can illustrate the risk. The rate of wage increase in the Netherlands rose significantly in 1998, cf. Chart 2 (left), when unemployment had dropped to around 4 per cent. The strong wage dynamics in the following years were not sufficiently supported by productivity increases, which caused unit labour costs to rise by around 20 per cent from 1997 to 2002, cf. Chart 2 (right).
WAGE DEVELOPMENT, DENMARK AND THE NETHERLANDS	Chart 5
Source: OECD, Economic Outlook, no. 82, December 2007.
Competitiveness in the Netherlands had thus weakened when the international economic slowdown occurred after the millennium rollover. The Dutch economy was hard hit by the recession, and unemployment rose by around 2.5 percentage points from 2001 to 2004. For comparison, unemployment in Denmark rose by 1 percentage point in the same period, also measured in terms of the EU-harmonised definition. Wages in the Netherlands responded to the unemployment growth with a lag – the rate of wage increase grew to more than 6 per cent in 2002, but subsequently decreased. In 2005 the rate of wage increase was zero, corresponding to a drop in real wages. As a result of the low rate of wage increase in recent years, unit labour costs have been virtually unchanged since 2003. In Denmark, unit labour costs have risen generally every year since 1997, and, according to OECD observations, Denmark and the Netherlands overall showed similar levels of growth in costs, i.e. 25 per cent, for the last decade.

The revisions of the forecast compared with the September 2007 forecast are described below, followed by a more detailed review of the forecast, including its underlying assumptions.

REVISIONS IN RELATION TO THE PREVIOUS FORECAST

The estimates of GDP growth in 2008 and 2009 have been adjusted downwards slightly compared with the September 2007 forecast, cf. Table 2. This reflects weaker development in exports as a result of lower market growth and the appreciation of the effective krone rate. At the same time, domestic demand declines at a slightly faster pace due to such factors as reduced growth in real disposable incomes as a result of consumer price inflation. Recent months have seen a stronger-than-expected drop in unemployment, which has led to slightly higher pressure on the labour market at the outset of the forecast period, but this projection also operates with rising unemployment from the 2nd half of 2008. The current-account surplus has been adjusted downwards in the light of the stronger-than-expected deterioration towards the end of 2007, and weaker export growth.

The estimate of consumer prices in 2008 has been increased substantially, reflecting recent months' surging prices, not least food and energy prices. The projection maintains the current higher price level, but the forward-looking rates of increase are almost the same as in the previous projection.

ASSUMPTIONS IN THE PROJECTION

The projection is based on a number of assumptions concerning the international economy, the financial conditions and fiscal policy, cf. Table 3.

The international economy
After several years of high global economic growth, a slowdown was observed, especially in the West, at the end of 2007. The slowdown can be attributed to e.g. the real-economic spill-over effect of the turmoil in the financial markets. The pace of the US economy has slackened, and there are several signs that the economic cycle has peaked in the euro area. Overall, the growth prospects for Denmark's largest export markets have deteriorated. Consequently, export-market growth in the projection has been revised downwards from the previous forecast, to a level close to the long-term average. The price increases on the Industrial export markets are expected to gain momentum, but remain modest in the forecast. This also applies to foreign price and wage increases.

Interest rates, exchange rates and oil prices
In the forecast, the development in short-term and long-term interest rates is based on the expectations that can be derived from the yield curves in the financial markets. In the projection the short-term interest rate will fall by approximately 0.75 percentage point until the beginning of 2009, and then rise a little. The forecast assumes a modest increase in the long-term interest rate from the current level.

For a number of years, the krone has strengthened gradually in relation to the currencies of Denmark's trading partners, particularly the dollar, entailing an increase in the nominal effective exchange rate of the krone. This trend has continued since the autumn of 2007, resulting in a higher initial effective exchange rate than in the previous forecast. In the projection, the dollar rate and the effective krone rate are assumed to be unchanged from the level at the end of February 2008.

The prices for oil and other commodities have increased, and at the end of February the oil price climbed to approximately 100 dollars per barrel. In the projection the oil price is assumed to follow futures prices, which are expected to decline a little from the current high level. As a result, the oil price is almost 35 per cent higher than in the September forecast.

Fiscal assumptions
The fiscal assumptions are based on the Finance Bill 2008 as presented in Economic Survey, February 2008, and in the recently concluded job-plan agreements. Growth in public consumption is expected to be 2.3 per cent in 2008, driven by higher expenditure for procurement of goods and services and more modest increases in the public sector's own production and employment. Growth in public consumption is higher than the estimate in Economic Survey, reflecting the normal tendency to exceed the target. Annual growth in public investments is expected to be 6 per cent on average in the forecast period. Overall, fiscal policy is expected to stimulate economic activity in 2008-10.

FORECAST FOR THE DANISH ECONOMY 2008-10

Output and employment
Output grew by 1.8 per cent in 2007, in spite of the strong development in the 2nd half. This is the lowest annual output growth since 2003, and it is expected to dampen further in the forecast period. The dampening can be viewed as a natural reaction after recent years' output expansion. The current low level of unemployment and high capacity utilisation makes it difficult to maintain output growth. The capacity pressure is expected to peak this year and then ease a little as growth in demand recedes.

One of the signs of labour-market pressure is that unemployment is considerably lower than the structural level, cf. Box 2 on p.19. The forecast operates with a further decrease in unemployment in the coming months, albeit smaller than the monthly average of just over 2,000 persons observed in recent years. After the summer of 2008, unemployment will begin to rise slowly in response to the declining growth in demand. However, the unemployment rate will remain lower than the structural level until 2010. This underscores the very strong initial pressure, which is assumed to subside only slowly.

As a result of the demographic development, the supply of labour is assumed to fall by approximately 5,000 persons per year in 2008 and 2009 and slightly less in 2010. This contributes to sustaining the pressure on the labour market. The labour force has grown since 2005, despite the negative contribution from the demographic development. The reason is that favourable employment opportunities have attracted more people to the Danish labour market, including foreign labour. The positive contribution from favourable employment opportunities is nevertheless expected to decline, and the forecast operates with a fall in the labour force by 14,000 people in total from 2007 to 2010, cf. Table 4.

In view of the low rate of unemployment and declining labour force, productivity growth will be the determining factor for output growth in Denmark over the next few years. Productivity, measured as output per employee, rose by 0.2 per cent from 2006 to 2007, according to the available national accounts. In the projection, annual productivity growth is expected to rise again and approach the average level observed since 1990, i.e. approximately 1.8 per cent.

The underlying development in the labour force and productivity points towards annual potential GDP growth of 1.6 per cent. Since actual GDP growth is expected to be lower than potential GDP growth in 2009 and 2010, the capacity pressure will subside.

The expected productivity growth masks a decrease in the number of employees and a small increase in output. Employment is assumed to fall by a total of 32,000 persons from 2007 to 2010 as the capacity pressure gradually subsides and business enterprises begin to adjust the number of employees to the lower growth in demand.

Wages and prices
The very low and decreasing unemployment rate entailed higher wage increases throughout 2007, and the rate of wage increase is expected to rise further in 2008. This is supported by the 3-year collective agreements concluded in the central government area, parts of the local and regional government areas and the financial sector, in February and March 2008. The pressure on the labour market is expected to subside towards the end of the forecast period, and annual wage increases in the manufacturing sector will fall to around 4 per cent, cf. Table 5.

Wage increases in the euro area are expected to rise, albeit modestly, in the light of falling unemployment, and wage developments in Denmark's trading partner countries taken as one are expected to remain subdued in the coming years. Consequently, growth in hourly wages in industry will remain higher in Denmark than in other countries. In the projection this entails further deterioration of competitiveness and falling Danish export market shares.

Hourly wage costs are expected to mirror the development in wages. After weak growth in 2007 and 2008, productivity, measured as output per hour worked, is expected to grow by 1.5-2 per cent annually in 2009 and 2010. Since growth in hourly productivity is lower than growth in hourly wage costs, unit labour costs increase in the projection.

The increase in unit labour costs is not fully offset by higher prices for manufactured goods. The tendency in recent years towards a higher wage share thus continues in the forecast. A higher wage-earner share of total value added is normal when the pressure on the labour market is strong.

Price inflation has increased since the autumn of 2007, and in January 2008 annual consumer price inflation was 3.0 per cent in terms of HICP. The higher consumer price inflation is primarily attributable to a significant increase in energy and food prices. Domestic market-determined inflation, IMI, on the other hand, has been almost constant at around 1.3-1.4 per cent since October 2007, after increasing since the end of 2004. The development in IMI is normally weak when import and energy prices are rising because price increases are not fully passed on to consumers. Moreover, it should be noted that the calculated IMI fails to capture food price inflation if it is caused by rising wages and profits, as food prices are not included in IMI.

Notwithstanding the fact that the tendency towards rising domestic market-determined inflation has recently been curbed, the high payroll costs in combination with rapidly increasing wholesale prices for Danish goods and rising sales prices in industry, indicate a continued domestic price pressure.

In the coming months price inflation is expected to remain high on account of sustained high energy and food prices and higher price increases for imported goods and administered prices, cf. Table 6. The reduction of day-care institution tariffs in 2007 no longer impacts the calculation, which explains a part of the increase in annual price inflation for administered prices. In the 3rd quarter of 2008 the annual increases in the index of net retail prices are expected to exceed 4 per cent.

Energy price inflation is expected to be only modest in 2009 and 2010, assuming virtually unchanged oil prices, cf. Table 3. At the same time, annual food price inflation will recede somewhat. On the other hand, the higher wage increases are expected to lead to an increase in domestic market-determined inflation as from the 2nd half of 2008. Towards the end of the forecast period, inflation will fall back to around 2 per cent.

Domestic demand
Growth in private consumption gained momentum in the 2nd half of 2007 after weak development in the preceding months. Consequently, consumption grew by 2.7 per cent in 2007 compared with 2006. This is somewhat below the annual growth rates of 4-5 per cent observed in the period 2004-06, and consumption growth declines over the projection period. Disposable incomes are pushed up by the high wage increases, income-tax cuts and the reduction of the indirect tax burden as a result of the tax freeze, but this effect is partly offset by high price increases for many consumer goods. The development entails only a modest decrease in the consumption ratio despite a notable drop in the wealth ratio. The consumption ratio has been relatively stable for a prolonged period, notwithstanding the higher wealth ratio.

At national level, the prices for single-family houses were almost unchanged in 2007, while the prices for owner-occupied flats declined. Housing prices have especially decreased  in the areas that had seen the strongest price increases until 2006, and where prices had reached the highest levels. In other areas, housing prices continued to rise steadily in 2007. The projection operates with a modest fall in cash prices in nominal terms, cf. Table 7, corresponding to a price drop in real terms.

Residential investments levelled off in 2007, after a continually increasing trend since the beginning of the 1990s. In the projection, residential investments gradually decline from the current high level, in line with the decrease in cash prices. The most recent drop in interest rates and the continued growth in households' disposable income contribute to the sustained high level of residential investments.

Business investments rose by more than 10 per cent in 2007, i.e. a slightly lower growth rate than the strong growth in 2006. Construction investments have responded relatively late to the upswing and have risen from a low level in 2005. Growth in construction investments is expected to continue at a measured pace in the projection. Investments in plant and equipment rose considerably in 2007 in continuation of the rising trend observed since 2003, and the investment ratio has been pushed up in recent years on account of sound earnings for the business enterprises and strong capacity pressure.

In the projection the investment ratio is reduced from a high level as output growth subsides. However, the reduction is small, and at the end of the forecast period the investment ratio is still at the level seen during the upswing in the 1990s. The high investment ratio reflects both a more pronounced need for reinvestment, as a result of the quick replacement rate for high-tech capital, and higher capital per employee. The growing capital intensity reflects the difficulties in attracting labour.

Total domestic demand excluding inventory investments grew by 3.3 per cent in 2007, i.e. a lower growth rate than in the preceding three years, but clearly above the long-tem average. In the projection, growth in demand dampens to around zero in 2010. Growth in private consumption decreases to 0.8 per cent in 2010, and investments subside in 2009 and 2010. Recent years' tendency for growth in domestic demand in Denmark to exceed growth abroad reverses in the projection.

Foreign trade and the balance of payments
The fast pace of Danish import growth continued in 2007, particularly in the latter part of the year. Import growth for 2007 as a whole was 6.1 per cent compared with 2006, which is a lower growth rate than in the preceding three years. However, in view of the strong domestic capacity pressure, a considerable share of demand will continue to be covered by foreign production, also in the near future. The import ratio is expected to increase in the projection, albeit not at the strong pace observed in 2004-06. Total imports are expected to grow by 5.5 per cent in 2008, cf. Table 8, and import growth will then decline as growth in demand subsides.

Annual export growth was just under 7 per cent on average in 2004-06, a period of favourable sales opportunities in major export markets. Danish exports grew by 3.7 per cent in 2007, and total exports are estimated to increase by approximately 3 per cent annually in 2008-10. The decrease in export growth can be attributed to the weaker international cyclical position and the deterioration of wage competitiveness.

The manufacturing sector's assessment of export order books has been declining for the last six months against the background of the weaker international cyclical position. The forecast operates with lower growth in Denmark's industrial export volumes compared with growth in industrial import volumes in the recipient countries, entailing loss of market shares for the manufacturing sector. Oil and gas production has diminished in recent years, a trend which is expected to continue. In the projection, energy exports are thus expected to fall. Agricultural exports are estimated to increase in the light of the strong global demand for food.

In 2007 price increases were higher on the import side than on the export side, resulting in deterioration in Denmark's terms of trade. The terms of trade are expected to improve in 2008 due to such factors as the high prices for oil and agricultural exports.

In view of the high capacity pressure, the current-account surplus has gradually declined in recent years. The deterioration is mainly attributable to the balance of goods. In 2008 the current-account surplus is expected to decrease further to approximately kr. 1.8 billion, cf. Table 9. The surplus is expected to rise again to kr. 19.2 billion in 2010, corresponding to 1 per cent of GDP. This reflects an improvement in the balance of goods as economic growth abroad will outperform that of Denmark. At the same time, the surpluses on sea freight and investment income will be maintained, while the tourist balance continues to show a deficit.