The Danish Economy

The Danish economy continued to boom in 2006. The high growth was driven by strong domestic demand, with large increases in private consumption, residential construction and business investments. Exports rose strongly, but far less than imports, and the current-account surplus was reduced by one third of the previous year's level.

Although unemployment fell significantly to the lowest level since the first part of the 1970s, wage and price increases remained low, albeit rising, despite the marked shortage of labour.

The buoyant economy and the extraordinarily high revenue from North Sea oil and gas activities were reflected in a large government surplus.

The risk of an overheating with detrimental future consequences for the Danish economy increased in 2006.

INTERNATIONAL BACKGROUND^[1]

The global economy remained strong in 2006. Global GDP grew by 5 per cent, and world trade also expanded. The rising activity was broadly based, with increasing growth in Europe, sustained growth in the USA and Japan, and high growth in China and India. In the assessment of the International Monetary Fund, IMF, Russia, Africa and the Middle East also made economic progress. Although there were indications of stronger inflationary pressure in several countries, the level of inflation remained low.

In the USA, GDP rose by 3.3 per cent in 2006, which is at the level of the preceding year, cf. Chart 1. However, there were signs of a curbing of growth after several years' upswing. The slowdown was particularly apparent in the housing market, where investments fell and prices stagnated. Private consumption still contributed significantly to the increase in output, although the growth rate diminished a little to 3.2 per cent. The employment situation was favourable, and rising employment in the service sector more than offset the decline in industry. Against the background of mounting capacity pressure, the strong expansion of business investments continued.

The robust development in domestic demand was also reflected in a significant upturn for imports. The growth in exports was equally strong, and the current-account deficit of 6.6 per cent of GDP was equivalent to the preceding year's high level.

Wage increases rose as unemployment fell during the year. In the autumn, core inflation measured as the index of consumer prices excluding energy and food reached 2.9 per cent year-on-year, but then receded a little. In December 2006, consumer prices were 2.5 per cent higher than in December 2005.

In the 1st half-year the Federal Reserve continued the tightening of monetary policy that it begun in mid-2004. The fed funds target rate was raised by a total of 1 percentage point in four increments, cf. Chart 2, reaching 5.25 per cent on the most recent increase in June 2006. The decision not to raise the fed funds target rate further was based on the receding growth and expectations that inflationary pressure would gradually subside.

Euro area growth picked up in 2006, and GDP rose by 2.6 per cent. The upswing was based on rising domestic demand. Growth in investments increased, and private consumption expanded, rising by 1.8 per cent against the previous year. Unemployment declined further over the year to 7.5 per cent in December.

Core inflation in the euro area was stable at around 1.5 per cent year-on-year in 2006. Inflation measured by the EU Harmonised Index of Consumer Prices, HICP, fell to around the same level in the late summer after energy prices dived. Inflation was just below 2 per cent towards the end of the year. The European Central Bank, ECB, raised its key interest rate in five increments to 3.5 per cent in the course of 2006. The interest rate was raised further to 3.75 per cent in March 2007. The ECB cited the risk of higher inflation as the basis for tightening its monetary policy, cf. p. 32.

In Asia, the economic upswing continued, with high growth in China in particular. As in previous years, China's GDP rose by around 10 per cent in 2006, with strong growth in exports and investments. Investment growth was, however, moderated to a degree by a tightening of monetary policy, combined with administrative measures. The current-account surplus is estimated to have reached 8 per cent of GDP, and the People's Bank of China allowed a certain gradual strengthening of the renminbi against the dollar. The effective exchange rate of the renminbi did not appreciate in 2006, however.

The upswing in Japan continued in 2006, and GDP rose by 2.2 per cent. Private consumption did not increase quite as much as the year before, but did contribute to the upswing in activity, together with strong export growth and expansion of business investments. Consumer prices rose only slightly, and core inflation remained negative. In view of the sustained upswing in the Japanese economy, the Bank of Japan abandoned its zero-interest-rate policy and in July 2006 raised its official interest rate to 0.25 per cent, and then to 0.5 per cent in February 2007.

In the UK, GDP growth was 2.7 per cent in 2006, driven by robust expansion of domestic demand. Rising employment helped to underpin private consumption. After weak development the year before, the housing market picked up again in 2006 with house-price increases of almost 10 per cent. As a result of higher immigration and a rising participation rate, the labour force grew more than employment, and unemployment rose a little to 5.5 per cent. The rate of wage increase edged down, while the increase in HICP rose to 3.0 per cent year-on-year in December. The official bank rate was raised in August and November 2006, and again in January 2007, by a total of 0.75 percentage points to 5.25 per cent.

Sweden saw strong economic expansion in 2006, with high growth in private consumption and investments. The higher activity in recent years led to a marked increase in employment in 2006. Stronger domestic price pressure nudged up inflation from its low level. Sveriges Riksbank tightened its monetary policy during 2006, raising the repo rate from 1.50 per cent to 3 per cent, and to a further 3.25 per cent in February 2007.

In Norway, domestic demand increased strongly in 2006 and GDP grew by 2.9 per cent. Pressure on the labour market intensified, and unemployment fell to 2.8 per cent in December. Consumer price inflation was edging up, while core inflation remained around 1 per cent year-on-year. In 2006 Norges Bank raised the sight deposit rate by a total of 1.25 percentage points to 3.50 per cent, and to a further 3.75 per cent in January 2007.

In the 1st half-year, 10-year yields increased in both the USA and Germany. Subsequently, the long-term yields were generally falling until December, with the biggest decline in the USA. The narrowing of the long-term yield spread between the USA and Germany reflected, among other things, that the tightening of US monetary policy had ended, while further tightening was still expected in the euro area. During the year the euro strengthened considerably vis-à-vis the dollar and the yen.

The strong oil price rises of recent years continued until August, when the price of Brent oil exceeded 75 dollars per barrel. The oil price then fell back to the level of around 60 dollars per barrel from the beginning of 2006. The oil price was underpinned by the strong global demand in 2006. Factors contributing to the significant price fluctuations included intermittent uncertainty of supply, including unrest in Nigeria and the Middle East, combined with limited spare production capacity. The high global growth rate was also reflected in considerable price increases for other commodities, especially industrial metals, during the year.

THE DANISH ECONOMY

The economy continued to boom in 2006, with GDP growth at the same level as in 2005, cf. Table 1. Employment rose significantly, and unemployment fell by 34,000 to the lowest level since the first part of the 1970s, cf. Chart 3. Increasing reports of bottlenecks in many sectors and regions indicated that the increase in employment did not fully match the demand for labour. Particularly the construction and service sectors had many vacancies.

The labour force grew by 15,000 in 2006, cf. Table 2. The cyclically driven influx to the labour force thereby exceeded the decline in current years attributable to the ageing of the population. The influx of foreign labour numbered around 7,000.

The strong pressure in the labour market led to slightly higher wage increases in 2006 than in 2005. The tendency for higher wage increases was seen in most sectors, especially those where unemployment was lowest. For the private sector overall, the rate of wage increase reached 3.1 per cent year-on-year in the 4th quarter. Wage growth in Denmark in 2006 was higher than in the euro area and among Denmark's other trading partners, cf. Chart 4. The higher Danish wage increases reflect that Denmark's labour market has been tighter than the euro area's for a number of years, cf. Box 1. 

Core inflation, compiled exclusive of energy and food, was rising. Domestic market-determined inflation, IMI, i.e. the development in prices that are determined on market terms in Denmark, also showed a distinct increase in 2006, cf. Chart 5. The increased pressure on domestic prices was related to wage costs, and to the restoration of business profit margins, which had been rather squeezed by the high energy and import prices in recent years. The increase in the overall EU Harmonised Index of Consumer Prices, HICP, was 1.9 per cent for the full year. Inflation diminished in the autumn as energy prices reverted to around the level at the beginning of the year.

Fiscal policy has been expansionary in recent years, although total government consumption increased less in 2006 than in 2005. Government investments in building and construction rose, among other things as a result of building projects prior to the local government structural reforms.

Private consumption, which has been the principal driver of the upswing in the Danish economy, increased by 3.0 per cent in 2006. Private residential construction also continued to rise. The expansion of consumption especially reflected the growth in disposable incomes, while the substantial increases in housing wealth were only converted to consumption to a small degree.

The housing market remained buoyant, but towards the end of the year the price increases had subsided. The lower rate of price increase inter alia reflects the increase in interest rates, especially at the short end of the yield curve. The number of homes for sale rose substantially during the year and the housing market became more of a buyer's market. Growth in the households' borrowing from banks and mortgage-credit institutes remained high, but receded a little during the year, to 12 per cent year-on-year in December, cf. Chart 6. In particular, more deferred-amortisation loans were raised by households, and these loans accounted for just over one third of the households' total mortgage-credit loans at end-2006.

Business investments in machinery and other plant and equipment rose considerably. The expansion of the production capacity via capital investment should be viewed in the light of the tight labour market. The high propensity to invest furthermore reflected the sustained low level of interest rates. Business investments in building and construction also rose in 2006, following several years of weak development. The growth in the corporate sectors' borrowing from banks and mortgage-credit institutes increased, and borrowing in December 2006 was 19 per cent higher than in December 2005.

As in previous booms, the strong growth in domestic demand exerted considerable upward pressure on imports. One underlying reason for the growth in imports by 14 per cent was that the Danish economy was close to its capacity limit in 2006, making it difficult to increase production further. Imports of both consumer goods and goods for the business sector, including raw materials and semi-manufactures for production, increased.

Exports rose by 10 per cent, which was remarkable in view of the pressure on domestic production capacity. Sales to abroad benefited from high or increasing growth among Denmark's principal trading partners. Market shares for manufactured exports are estimated to be by and large unchanged from 2005 to 2006. The positive export trend indicates that the competitiveness of Danish enterprises is still high, cf. Box 1.

The nominal effective krone rate strengthened by 1 per cent during 2006, primarily due to the euro's appreciation against the dollar, cf. Chart 7. The real effective krone rate based on consumer prices strengthened equivalently, since price increases in Denmark were at the level of the weighted average of price increases abroad. Due to the stronger wage development in Denmark, the real effective krone rate based on hourly wages strengthened a little more. The strengthening of the real effective krone rate indicates a slight deterioration in competitiveness in 2006.

The trade surplus declined in 2006 as a consequence of the strong growth in imports, cf. Chart 8. The terms of trade were more or less unchanged compared with 2005, although the high oil prices during the summer led to a temporary improvement. The balance of payments continued to show a sound surplus of 2.4 per cent of GDP. The absence of previous times' large interest payments on the external debt has helped to maintain the current-account surplus in recent years.

The favourable economic development was reflected in a government surplus of 4.3 per cent of GDP, attributable to high revenue from direct and indirect taxes, as well as low expenditure on e.g. unemployment benefits. In addition, the high energy prices led to especially high tax revenue from North Sea oil and gas production.

The demographic changes in the coming decades will put a strain on government finances in the future. In 2006, a welfare reform was adopted in order to make the Danish economy more robust towards these changes. The primary objective was to increase the retirement age by raising the eligible ages for early retirement benefit and state retirement pension by two years. The reform will be phased in gradually from 2019. In the longer term it is envisaged that the retirement age will be adjusted further as life expectancy changes.

ECONOMIC PROSPECTS

The favourable economic development is set to continue in 2007. A slower increase in domestic demand is, however, to be expected after the strong growth in 2006 as a consequence of the interest-rate increases since the end of 2005 and the dampening of the housing market. Private consumption is foreseen to more or less match the increase in disposable incomes. The large increases in housing wealth of previous years have only been converted to consumption on a small scale. There is thus no reason to believe that the slowdown in the property market will dampen consumption to any significant degree. As a consequence of the high level of domestic activity it will hardly be possible to fully retain market shares in the export markets. On the other hand, exports will benefit if the expectations of high growth among Denmark's trading partners are fulfilled.

Subject to these conditions, the capacity pressure in the Danish economy will increase further. The shortage of labour is also expected to make its mark in 2007 and will dampen output growth. The demographic changes in themselves entail a reduction of the labour force. This can be countered by continuing to increase the labour-market participation rate, or by importing labour.

In the autumn of 2006 Danmarks Nationalbank recommended that fiscal policy for 2007 should curtail the increase in overall demand. The government's position was to adopt a wait-and-see approach, with a fiscal-policy stance that entails a neutral impact on GDP growth in 2007.