The Danish Economy 2009-11

INTRODUCTION AND SUMMARY

This article reviews Danmarks Nationalbank's forecast for the Danish economy in the years 2009-11. The forecast has been produced using the macroeconometric model MONA¹ and is based on available economic statistics, including Statistics Denmark's quarterly national accounts for the 1st quarter of 2009.²

Like the international economy, the Danish economy has been hit by a severe downturn in the wake of the financial crisis. Correction of a very high capacity pressure in the pre-crisis years was already underway, and consequently the decrease in output is likely to be greater in Denmark than in many comparable countries. The slowdown has gradually inten sified, and available indicators point to the gross domestic product, GDP, being more than 5 per cent lower in the 2nd quarter of 2009 than at the end of 2007. For 2009 as a whole, GDP will be 3.2 per cent lower than in 2008, cf. Table 1. Domestic demand has declined even more, and com bined with a considerable reduction of the capacity pressure this has led to a pronounced fall in imports, exceeding the fall in exports.

In this half-year, output and domestic demand are expected to pick up somewhat following the substantial slowdown in recent quarters – this is supported by the first July indicators for retail turnover and business and consumer confidence. However, the weak economy dampens the recovery in domestic demand, which will not reach a normal growth rate until 2011, while the first signs of growth among Denmark's trading partners contribute to a small increase in exports. In spite of the earlier onset of the recession in Denmark, recovery is expected to be in line with that of the euro area and weaker than in the USA, cf. Chart 1.

Employment has shown a steady downward trend over the last year and, at 103,300 in July, unemployment has more than doubled since it bottomed out one year earlier. It is thus close to its structural level, i.e. the level that is compatible with stable development in wages and prices. In the light of the weak output growth, unemployment is expect ed to continue to rise – but at a slower pace – to a peak of around 180,000 in early 2011. Productivity, which grew by an average of 1.5 per cent p.a. from 1995 to 2006, fell by around 4 per cent in 2007-08. In the projection, productivity increases substantially, without returning to the trend, however. The short-term impact of productivity development on unemployment is elaborated on in Box 1.

ALTERNATIVE SCENARIOS	Box 1
The housing market has been weak since 2007, with falling prices and low turnover, and according to Statistics Denmark quarterly price falls for single-family houses were in the range of 6 per cent in the 4th quarter of 2008 and the 1st quarter of 2009. In the central forecast estimate, the trend reverses toward the end of this year and prices increase slightly. Exactly when the housing market will reverse is, however, subject to uncertainty, not least in a period of rising unemployment, and the following there fore considers an alternative scenario in which housing prices decrease further in the coming years. More specifically, a scenario is outlined in which housing prices fall throughout the forecast period, to a level 30 per cent below the peak in the 1st quarter of 2007 by the end of 2011, and in which residential investments are lower. This brings real cash prices, i.e. cash prices relative to construction costs, back to the level in early 2003, cf. the left-hand chart below. Productivity development is key to welfare in the longer term. In recent years, productivity in Denmark has shown a very weak trend, and in the forecast productivity is assumed to recover in the coming years. It is uncertain how rapid the recovery will be, and another alternative scenario considers the impact of a slightly slower return to the normal productivity track. In this scenario, hourly non-agricultural productivity declines relative to the baseline scenario from the 3rd quarter of 2009 onwards, to stand 1 per cent below the central estimate by the end of 2011, cf. the right-hand chart below. The drop in real cash prices in alternative scenario 1 reduces the households' housing wealth, thereby dampening consumption. Combined with lower residential investments, this will reduce GDP growth by around ½ percentage point in both 2010 and 2011, and unemployment will peak at around 190,000 in 2011, cf. the table. The lower growth in demand will boost the current-account surplus relative to the baseline scenario. Overall, the considerably weaker development in real cash prices causes unemployment to rise somewhat further. This reflects the lower residential in vestments, while the consumption effects of the lower wealth are moderate. Correspondingly, the surge in housing wealth in 2005-06 was only to a lesser extent converted into consumption.
ASSUMPTIONS OF ALTERNATIVE SCENARIOS
Note: Real cash prices are cash prices relative to the deflator for residential investments.
In alternative scenario 2, the negative shock to the supply side of the economy – the slightly weaker productivity development – has no major effect on GDP in the short term. Instead, employment rises by a good 15,000 in 2011, so that the percentage in crease in employment more or less offsets the percentage decline in productivity. The impact on unemployment of the slightly weaker increase in productivity is of the same magnitude, and the unemployment figure ends up at 163,000 in 2011, compared with 178,000 in the central estimate. The weaker productivity development in this scenario entails higher unit labour costs. This has a negative impact on competitiveness and leads to a further reduction in export market shares. Over the forecast horizon the effect is, however, modest. The reason is that output is demand-driven in the short run. The long-term effect is lower GDP and unchanged unem ployment. ALTERNATIVE SCENARIOS   Baseline scenario 1: Weaker housing market 2: Weaker productivity growth 2009 GDP, per cent year-on-year -3.2 -3.2 -3.2 Unemployment, 1,000 persons 103 103 100 Balance of payments, kr. billion 22 23 22 HICP, per cent year-on-year 1.1 1.1 1.1 2010 GDP, per cent year-on-year 0.9 0.4 0.9 Unemployment, 1,000 persons 163 168 150 Balance of payments, kr. billion 11 17 10 HICP, per cent year-on-year 1.4 1.4 1.4 2011 GDP, per cent year-on-year 1.7 1.2 1.6 Unemployment, 1,000 persons 178 191 163 Balance of payments, kr. billion 16 30 16 HICP, per cent year-on-year 1.5 1.5 1.6

Private-sector wage increases declined to 3 per cent year-on-year in the 2nd quarter. Particularly nuisance bonuses such as overtime payment have fallen, and if this item is eliminated the decline was considerably smaller. Real wages have risen substantially, and the rate of wage in crease remains somewhat higher than abroad. This indicates that pres sure on the labour market is still stronger in Denmark than in other countries, despite rising unemployment. The same pattern is seen for core inflation, i.e. the increase in consumer prices excluding energy and food, which in July was 2.3 per cent year-on-year compared to 1.3 per cent year-on-year in the euro area. Domestic market-determined infla tion, IMI, has risen to around 6 per cent year-on-year, indicating that the fall in import prices has not been fully passed on to consumers.

Notwithstanding sound growth in the households' disposable real incomes, domestic demand – and private consumption in particular – has fallen significantly over the past year. The savings ratio has thus in creased, and combined with low interest rates and release of SP savings (special pension scheme) from June onwards this strengthens the con sumption opportunities of the households. On the other hand, the weakening of the housing market and falling equity prices have reduced the households' wealth, and the weak labour market also makes many Danes more cautious. Housing prices have fallen considerably over the last year and in spite of low interest rates and higher disposable incomes for the households a reversal does not seem to be in sight. Housing prices are now estimated to be close to bottoming out, so in the projec tion the fall in cash prices makes way for a slight increase during 2010 and 2011. In view of the weak labour market, a further decline in hous ing prices does, however, pose a downside risk to the economy. This is also analysed in Box 1.

Given the current fiscal policy stance, the government budget balance is set to reverse from a surplus of approximately kr. 60 billion in 2008 to a deficit of up to kr. 100 billion in 2010, a weakening of approximately 9 per cent of GDP. This reflects a combination of strong automatic stabilisers and considerable easing of fiscal policy. Although fiscal policy is assumed to be almost neutral in 2011, a considerable deficit of almost 5 per cent of GDP is foreseen, entailing a significant increase in government debt.

Below, the changes in relation to the March 2009 forecast are out lined. This is followed by a more detailed review of the forecast, includ ing the underlying assumptions.

REVISIONS IN RELATION TO THE PREVIOUS FORECAST

In 2009 to date, output has shown a far weaker trend than forecast in March. For the year overall, GDP is now expected to decline by 3.2 per cent, cf. Table 2. The downward adjustment is to a large extent attrib utable to weaker development in the export markets, but private domestic demand has also fallen more than expected. Due to the weaker output development, unemployment reaches a higher level in this forecast.

The current-account surplus has been reduced compared with the pre vious forecast, reflecting the strength of the international downturn, including a lower surplus on trade in services. Oil prices have risen more than expected and the estimate for consumer prices in 2009 has there fore been raised a little. The economic slowdown also means that infla tion in 2010-11 has been adjusted downwards a little.

ASSUMPTIONS IN THE PROJECTION

The projection is based on number of assumptions concerning the inter national economy, financial conditions and fiscal policy.

The international economy
The international financial crisis has had a more severe impact on the real economy than expected by international organisations prior to the preparation of the March forecast. However, initial signs that the world economy is recovering have recently led the international organisations to adjust their GDP growth estimates for 2010 upwards for most coun tries, but compared with the March forecast the assessment of Danish export market growth in the current year has deteriorated substantially. The market for Danish exports is thus expected to shrink by 13.5 per cent from 2008 to 2009, cf. Table 3. This is by far the greatest annual reduc tion since 1975 when the OECD statistics began. Looking ahead, export markets are expected to recover slowly as the international economy picks up.

Global price pressures have also eased in relation to the assumptions underlying the previous forecast. Consequently, expected price increases in the export market for industrial goods and for goods competing with Danish products in the domestic market have been adjusted downwards since the previous forecast. Foreign wage increases are expected to remain low over the projection period on account of the weak interna tional economy.

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. Short-term interest rates rose from 2005 until the autumn of 2008, and then fell until the beginning of Septem ber 2009. According to market expectations, short-term interest rates will rise by a good 2 percentage points until 2011.

Bond yields have also declined since the autumn of 2008. The short-term mortgage rate is now back at low level of 2005, while the longer-term rates are slightly above the 2005 level. Bond yields are predicted gradually to increase again, to 4.7 per cent by 2011.

The krone has strengthened against the currencies of Denmark's trading partners in recent years, and at end-2008 the nominal effective exchange rate of the krone reached the highest level since 1979. Subse quently it has weakened a little. Compared with the March forecast, the effective exchange rate of the krone remains more or less unchanged, masking a strengthening vis-à-vis the dollar, but a weakening against the Swedish krona and other currencies. In the projection, the dollar rate and the effective krone rate are assumed to be unchanged from the level at the beginning of September 2009.

The price of oil dived from a level of around 135 dollars per barrel in July 2008 to just over 40 dollars in early March 2009. Since then it has risen again, to around 70 dollars per barrel at the time of the forecast. In the projection, oil prices are expected to be in line with futures prices, i.e. to rise slightly from the current level. This forecast thus operates with considerably higher oil prices than the March forecast.

Fiscal assumptions
The fiscal assumptions in the forecast reflect the fiscal-policy stance as presented in Economic Survey, August 2009. Growth in real public con sumption is expected to be 1.8 per cent in 2009 and 1.5 per cent in both 2010 and 2011. The forecast assumes a strong increase in public invest ments due to factors such as the decision to bring forward fixed local-government investments and the political agreement on transport in vestments. Growth in public consumption is assessed to be higher than estimated in Economic Survey, reflecting the tendency to exceed the tar get. The accommodative fiscal policy is expected to boost economic ac tivity, particularly in 2009 and 2010.

FORECAST FOR THE DANISH ECONOMY 2009-11

Output and employment
Output has gradually declined since the end of 2007 and is estimated to be more than 5 per cent lower in the 2nd quarter of 2009 than at the end of 2007. It is assessed to have bottomed out, and growth is expected to turn from negative to positive in the 2nd half of 2009. Overall, output is down by 3.2 per cent in 2009 compared to 2008. Looking ahead, out put will gradually rise, by 0.9 and 1.7 per cent in 2010 and 2011, respect ively, cf. Table 2.

The drop in output means that there are many spare resources in the form of unutilised labour and production capacity. This is particularly evident in the industrial sector, where data for the current quarter indicates substantial spare capacity.

Economic growth slowed at the end of 2006, while employment rose by a further 3 per cent until the beginning of 2008. Productivity thus de clined by around 1 per cent in 2007. It is not unusual for productivity growth to weaken towards the end of a boom, but this time the decline has been much greater than during recent downturns. The forecast operates with a gradual reversal of productivity, the pronounced weak ening in 2007-08 being offset by strong growth in productivity, particu larly in 2010-11 when productivity is expected to grow by 5.2 and 4.4 per cent, respectively. The reasons are that normal capacity utilisation is restored, and that employment typically reacts to output developments with a lag.

The lower productivity, together with rapidly rising wages, reduced the profit share considerably in 2007-08. In the projection, higher prod uctivity and moderate wage developments bring the profit share a little closer to its normal level.

In the forecast, employment is expected to decrease strongly from its high 2008 level. In 2009-10 it will fall by around 80,000 persons annually, cf. Table 4. The decline should be seen against the backdrop of weak growth in the projection and the strong increase in employment in the years up to 2008.

Seasonally adjusted unemployment was 103,300 persons in July 2009 and is thus close to its structural level, which is estimated to be between 100,000 and 120,000. Unemployment is expected to peak at 180,000 in early 2011.

The forecast operates with a shrinking labour force. Demographics will reduce the labour force by around 5,000 a year. Moreover, the recession lowers the participation rate. The most pronounced fall will be in 2009, when the labour force is expected to decline by 30,000. In 2010 and 2011 further reductions of 16,000 and 14,000, respectively, are foreseen.

Wages and prices
After a period of strong pressure on the labour market and high wage increases, wage inflation has declined as a result of the economic slow down. Wage developments are expected to remain weak throughout the forecast period, with annual wage increases hovering around 3 per cent, cf. Table 5.

For some time, wage increases in Denmark have been high compared with those of Denmark's trading partners. Most recently, the global downturn has reduced the rate of wage increase among Denmark's trading partners seen as one. Notwithstanding the rise in unemployment, hourly wages in industry are thus still set to grow at a faster pace in Den mark than abroad. Wage competitiveness will therefore deteriorate further over the forecast period, resulting in a moderate fall in Danish export market shares.

Hourly wage costs are projected largely to mirror the development in wages in the absence of significant changes in business enterprises' other labour costs. Following a period of negative productivity growth, the development in productivity is relatively strong in the projection. As a result, unit labour costs will fall in 2010-11 after having risen substan tially in the preceding period. The wage share will decline as labour-market pressures abate. A wage share of 68 per cent, as foreseen for 2011, is, nevertheless, still rather high compared with recent decades.

Price inflation has declined further over the summer, and in August 2009 annual consumer price inflation was 0.7 per cent measured by the Harmonised Index of Consumer prices (HICP), cf. Table 6. The strong de cline in inflation over the last year primarily reflects falling energy prices and slightly lower food prices than one year ago. Core inflation, which excludes energy and food prices, has been slightly above 2 per cent since March 2009 and was 1.9 per cent in August.

Domestic market-determined inflation, IMI, has risen considerably recently, to around 6 per cent year-on-year. This reflects the usual ten dency for IMI to increase when import and energy prices fall because the lower prices are initially not fully passed on to consumers. In the coming months, IMI is expected to remain high on account of declining import prices. Subsequently, IMI is predicted to decline substantially, and in 2010 and 2011 weak demand and receding wage inflation will gradually push IMI down below 1 per cent.

Due to the drop in commodity prices in the 2nd half of 2008, annual energy price inflation will be negative until the end of 2009. However, recent oil-price increases mean that energy prices have begun to rise quarter-on-quarter, and by 2010 annual energy price inflation is expect ed to be positive. Food price inflation has been moderate over the last year, but is expected to rise slightly more towards the end of the fore cast period. The development in energy and food prices, combined with the general slowdown, keeps consumer price inflation well below 2 per cent in the projection.

Domestic demand
Private consumption has fallen every quarter since the 1st quarter of 2008. The downward trend is assessed to have abated in the 2nd quarter of 2009, and in the current half-year consumption is expected to pick up again, reflecting factors such as rising consumer confidence and wide spread exercise of the option to withdraw SP savings. Nonetheless, con sumption is developing at a slower pace than disposable incomes so that the consumption ratio will decrease further in 2009 and 2010, cf. Table 7. In the coming years, the increase in consumption will be curbed by lower household wealth and expectations of higher unemployment.

The level of activity in the housing market is low, and prices for single-family and terraced houses fell by more than 5 per cent in the 1st quarter of 2009. Over the last few months, the number of homes for sale has, however, decreased moderately, and the decline in asking prices is slowing down. In view of these trends and a sustained low level of inter est rates, the housing market is expected gradually to stabilise during 2009 and 2010.

The decline in residential investments seen in 2008 has continued into 2009. In the projection, residential investments are expected to continue to fall in step with the lower real cash prices. In the current year they are, however, expected to be buoyed up by the agreed pool of funds for renovation of permanent residences.

The downward trend in business investments since the beginning of 2008 reflects lower investments in machinery, transport equipment and software, as well as a fall in non-residential construction. With many vacant commercial properties, more difficult financing conditions and weak prospects for output development, non-residential construction is expected to decline further in 2009 and into 2010. Machinery invest ments are now well below the level in 2006-08, when capacity pressure was strong. Towards the end of the forecast period business invest ments are expected to rise a little as output grows, but the investment ratio is expected to remain at the current low level.

Total domestic demand, excluding inventory investments, fell by 0.8 per cent in the 1st quarter of 2009. Lower private investment and a de cline in private consumption are expected to reduce demand in 2009 overall, while rising public consumption and investments will have the opposite effect. Subsequently, domestic demand will slowly pick up, driven by rising private consumption and public demand and, at a later stage, also by higher private investment.

Foreign trade and the balance of payments
Exports have fallen since the 2nd quarter of 2008 as global economic activity and world trade have contracted. In the 2nd quarter of 2009, real exports are expected to have declined by 10 per cent relative to the same quarter of 2008. The forecast assumes that exports will continue to decrease until early 2010 and will then slowly grow as the international economy recovers, cf. Table 8.

The downward trend in exports over the last year has been most pronounced for goods. Exports of industrial goods are estimated to have fallen by 18 per cent in real terms since the 2nd quarter of 2008 against the backdrop of weaker foreign demand and loss of competitiveness. In the forecast, industrial exports stabilise towards the end of 2009 and gradually begin to rise from mid-2010. Industrial exports are estimated to develop more weakly than imports of industrial goods in the major recipient countries, implying a further loss of market shares.

Oil and gas production has decreased in recent years, and this ten dency is expected to continue so that real energy exports decline in the projection. Agricultural exports are also predicted to fall in the near future due to lower exports of animal products.

Exports of services, primarily sea freight, have shown a weak trend in 2009, particularly in current prices. From the 2nd quarter of 2008 to the same quarter of 2009, exports of services are estimated to have de creased by a good 4 per cent in volume terms and approximately 23 per cent in current prices. The underlying factors are the weak development in world trade and considerable downward pressure on freight rates due to lower demand and increased freight capacity.

Import volumes have gone down since mid-2008 as domestic capacity pressure has eased and exports, which have a large import content, have weakened. In the 2nd quarter of 2009, real imports are estimated to have fallen by a good 12 per cent relative to the same quarter of 2008. Like exports, imports are expected slowly to pick up from mid-2010 on wards. Imports have declined at a faster rate than demand since the end of 2007, causing the import ratio to diminish. This indicates that pressure on production resources has eased. In the forecast, the propensity to import stabilises at the lower level and then rises slightly towards the end of the period.

According to the available national accounts, export prices fell con siderably more than import prices in the 1st quarter of 2009, implying a deterioration of the terms of trade. This reflects factors such as lower prices for Danish energy exports, as well as a much sharper price drop for service exports than for service imports. In the projection the terms of trade are restored to some degree.

The current-account surplus totalled almost kr. 22 billion in the first seven months of 2009, which is nearly kr. 4 billion higher than in the corresponding period of 2008. The improvement reflects a higher net surplus on trade in goods and investment income, while the net profit on trade in services, including sea freight, has declined. In the projec tion, the balance of payments deteriorates until mid-2010, in line with the diminishing surplus on trade in services, cf. Table 9. Subsequently, the surplus slowly increases as the global economy begins to recover, and the surplus of the balance of goods and services grows.