The Danish Economy

In 2005, Denmark achieved the highest economic growth for a number of years. Especially domestic demand made a substantial contribution to growth. At the same time, exports and imports increased considerably, and the current-account surplus remained high. Employment rose, unemployment fell, and the labour market tightened. The rate of wage increase remained subdued, while inflation was pushed up by higher energy prices.

The favourable economic development, combined with extraordinarily high revenue from the taxation of pension yields and from oil and gas activities in the North Sea, resulted in a large government surplus.

The strong demand entails a risk of the economy overheating. If the positive development is to be maintained, it is essential that fiscal policy does not contribute to increasing demand. The strong economy gives scope to expand the workforce, but without labour-market reforms it will be hard to achieve a sustained increase in employment.

INTERNATIONAL BACKGROUND^[1]

The upswing in the global economy continued in 2005, although at a lower rate than in the preceding year, cf. Chart 1. Growth in the USA and Japan was sound, while the euro area did not begin to pick up until the 2nd half-year.

The high global growth increased demand for oil, and at end-2005 the oil price in dollar terms was 50 per cent above the level one year before. The oil price increase exerted upward pressure on global inflation, but this was not fully reflected in prices for other products or in wages, and inflation expectations also remained firm at a low level.

The USA saw a stable upswing in 2005 and GDP grew by 3.5 per cent. As in the preceding years, growth was driven primarily by sound expansion of private consumption and investments. Private consumption, stimulated by job growth and higher housing prices, rose more than real disposable incomes, and the households' savings ratio was negative. The high energy prices did not significantly affect consumption, and car sales rose strongly over the summer. The hurricanes in the autumn only briefly dampened activity. Employment continued to rise, and unemployment fell. Wage increases remained subdued.

Inflation, measured by the Consumer Price Index, CPI, accelerated as a result of rising oil prices. In 2005, inflation was 3.4 per cent, against 2.7 per cent in 2004. Core inflation, defined as CPI excluding energy and food, declined marginally during the year and was 2.2 per cent in 2005.

The Federal Reserve continued to raise the fed funds target rate in increments of 0.25 percentage points, from 2.25 per cent in January 2005 to 4.25 per cent at the end of the year, and further to 4.5 per cent in January 2006. The tightening of monetary policy contributed to the dollar's strengthening.

Government finances improved in 2005, and the deficit was 3.7 per cent of GDP, compared to 4.7 per cent in 2004. The main underlying factor was higher tax revenue as a consequence of the favourable economic development. Government debt remained unchanged at around 64 per cent of GDP.

Imports were boosted by the strong domestic demand, and the total current-account deficit increased to almost 6.5 per cent of GDP in 2005. Strong demand for dollar-denominated financial assets, particularly from countries in eastern Asia and from oil-producing countries, more than compensated for the downward pressure on the dollar from the balance-of-payments deficit and contributed to low long-term yields.

Growth is expected to continue in the USA in 2006. Risks in relation to the sustainability of the upswing mainly concern the housing market and the imbalances in the US economy. The current balance-of-payments deficit reflects low savings, both in the public sector and for households. A slowdown in the rate of increase in housing prices may reduce consumption growth, thereby contributing to improvement in the balance of payments.

In Japan, economic activity continued to pick up after many years of stagnation. GDP growth of 2.8 per cent in 2005 was especially attributable to higher domestic demand. Rising employment underpinned private consumption, and business investments increased as a result of sound business earnings. Price pressure was modest, and inflation was ‑0.3 per cent in 2005. In the 4th quarter, core inflation became marginally positive. The Bank of Japan maintained its zero-interest-rate policy. The government deficit remained by and large unchanged at 6.5 per cent of GDP, and the debt rose to 170 per cent of GDP. As in many other countries, the population of Japan is ageing, and in the longer term it will be necessary to tighten fiscal policy.

In China, GDP grew by 9.9 per cent in 2005. The strong growth was primarily driven by exports and investments and among other factors reflects China's integration into the global economy. The high investment level was set off by even higher savings, resulting in a large current-account surplus. At the same time there was a substantial capital inflow, e.g. as direct investments. In recent years, the People's Bank of China has purchased US dollars in order to maintain a fixed exchange rate vis-à-vis the dollar. In July, the fixed-exchange-rate policy was adjusted in favour of a managed float based on a basket of currencies, cf. Box 4 on p. 46. Subsequently, the renminbi strengthened slightly against the dollar. In the long term, a stronger exchange rate may improve the households' purchasing power and increase the contribution to China's growth from private consumption.

Viewed over the full year 2005, growth in the euro area was moderate, and GDP increased by 1.3 per cent. In the 1st half-year, the weak economic development seen in 2004 continued, but growth picked up during the 2nd half-year, primarily driven by exports and investments. Exports were underpinned by sound growth in the global economy and weakening of the effective euro rate.

Unemployment fell by 0.4 percentage points during 2005, to 8.4 per cent at the end of the year, and employment rose. The high unemployment in the euro area dampens household consumption.

Inflation, measured by the EU Harmonised Index of Consumer Prices, HICP, was pushed up by the rising oil prices and remained above 2 per cent for most of 2005, and thus above the medium-term target of below 2 per cent set by the European Central Bank, ECB. Core inflation, determined as HICP excluding energy and food, was stable at around 1.5 per cent all year. In December 2005 and in March 2006 the ECB raised its key interest rate by 0.25 percentage points to 2.50 per cent in the light of expectations of higher future inflationary pressure.

The government deficit in the euro area overall was 2.9 per cent of GDP in 2005. In many member states, fiscal-policy consolidation is not sufficiently strong – particularly since the sustainability of fiscal policy is under pressure in view of the ageing populations. According to the European Commission, for the fourth consecutive year France and Germany exceeded the 3-per-cent limit stipulated in the EU Treaty, cf. p. 79.

At the beginning of 2006, the euro area's economy is recovering, but the strength of the domestic demand is uncertain. Rising consumer and business confidence in e.g. Germany and Italy indicate that the upswing in consumption and investments will gain momentum. Structural reforms are still required, and it is uncertain whether there will be any significant increase in employment.

In the UK, GDP grew by 1.8 per cent in 2005, which was less than in the preceding years. The tightening of monetary policy in 2004 brought down the rate of increase in housing prices from a very high level and thus dampened consumption growth. Against this background, the Bank of England in August 2005 lowered its base rate from 4.75 per cent to 4.50 per cent. The government deficit was 3.1 per cent of GDP. The labour market remained tight, and inflation excluding energy rose to 1.6 per cent in 2005, from 1.1 per cent in the preceding year.

The upswing in Sweden continued in 2005. GDP grew by 2.7 per cent, driven mainly by strong domestic demand. Exports increased during the 2nd half-year. In spite of the solid level of activity, employment rose only slightly, wage increases were subdued and inflation was low. In June 2005, Sveriges Riksbank lowered its repo rate from 2.00 per cent to 1.50 per cent. The easing of monetary policy contributed to a weakening of the Swedish krona. The repo rate was raised to 1.75 per cent in January 2006, and to 2.00 per cent in February 2006.

In Norway, GDP growth was 2.4 per cent in 2005. Growth was mainly domestically driven, but the growth in employment was moderate. Core inflation was stable at around 1 per cent throughout the year which is below the inflation target of 2.5 per cent. Referring to sound economic growth and expectations of higher inflation, Norges Bank raised its sight deposit rate from 1.75 per cent to 2.25 per cent in the 2nd half-year.

THE DANISH ECONOMY

The economic upswing in Denmark that set in during 2003 became even stronger in 2005. Compared with the euro area, Denmark is further into the economic cycle.

GDP grew by 3.4 per cent, cf. Table 1. Domestic demand made the largest contribution to economic growth, cf. Chart 2. Private consumption was driven by higher disposable incomes, low interest rates, new loan products and accelerating housing prices. Car sales almost reached the record high of 1998. As a result of the consumption growth, the private-sector savings ratio fell. Consumer confidence expanded to a higher level in the autumn than during the upswing in the mid-1990s. Housing prices rose by 22 per cent over the year. This stimulated residential investments, which grew by 13.7 per cent. Equivalent increases in housing prices have been seen in other countries, cf. Box 1.

Business investments rose in step with the expansion of capacity utilisation. The growth was especially related to investments in equipment, while the decline in non-residential construction seen in recent years ceased. The private savings surplus declined to 0.1 per cent of GDP in 2005.

The government surplus rose from 1.7 per cent of GDP in 2004 to 3.3 per cent in 2005. The large surplus reflects the favourable economic development, and not least the extraordinarily high revenue from taxation of pension yields and from oil and gas activities in the North Sea. Since the surplus is partly of a temporary nature, and as there are increasing capacity problems in the labour market, the surplus should be used solely to reduce government debt. Growth in government consumption diminished, but at 1.3 per cent still exceeded the government's objective. The implementation of the local-government reform in 2006 will require further management of expenditure if the target for government consumption is to be met.

Growth in both exports and imports was substantial. Particularly manufactured exports rose significantly. In contrast to 2004, the surplus on trade in goods excluding energy did not decline in 2005. Improved competitiveness, cf. p. 24, is presumably one factor behind Denmark's gaining market shares in 2005. Import growth was fuelled by strong domestic demand, but also by the considerable imported element in manufactured exports.

The current-account surplus totalled kr. 53 billion in 2005, which is kr. 19 billion higher than in 2004, cf. Chart 3. The surplus has been less sensitive to domestic capacity issues than previously, e.g. as a result of the improved terms of trade and rising exports in the shipping sector. The balance-of-payments statistics were restructured at the beginning of 2005, making comparisons with previous years subject to some uncertainty. The large current-account surpluses seen in recent years have reduced the external debt, which amounted to 5 per cent of GDP at the end of the 3rd quarter of 2005.

The growth in employment that set in at the beginning of 2004 continued throughout 2005, and the labour market came under pressure. Private-sector employment rose by 20,000, while public-sector employment diminished a little, cf. Table 2. The demand for labour was particularly strong in the service and construction sectors, while employment in manufacturing industry continued to recede. Unemployment fell from 6.4 per cent in 2004 to 5.7 per cent in 2005 and by the end of the year was back at the low level seen in 2001.

WAGE AND PRICE TRENDS

Seen in relation to the cyclical development, the development in wages was subdued. The rate of wage increase in the private sector was 2.9 per cent for the full year. Since the 2nd quarter of 2004, annual wage increases have been in the range of 3 per cent, compared to around 4 per cent in 1995-2003. Wage increases in manufacturing industry, which is the sector most exposed to competition, were higher than in the euro area for the 10th consecutive year, cf. Chart 4.

Danish hourly wage costs are currently among the highest in the world. If Danish enterprises are to be competitive, their product structure must differ from that of low-wage countries, and e.g. be more knowledge-intensive, so that Danish goods and services do not compete directly with output from such countries.

A decrease in the effective krone rate improved competitiveness. The krone weakened vis-à-vis a number of currencies, including the US dollar, the pound sterling and the Norwegian krone, but strengthened against the Swedish krona. At the end of 2005, the effective krone rate was approximately 3 per cent below the level at the end of the preceding year, cf. Chart 5.

The oil price increases were reflected in inflation in Denmark, which, in HICP terms, was 1.7 per cent in 2005, compared to 0.9 per cent in 2004, cf. Chart 6. Domestic market-determined inflation (IMI), which expresses the development in business enterprises' payroll expenditure and profits, was negative, since the higher prices for energy and certain other raw materials were not fully passed on to consumer prices.

CREDIT EXPANSION

Total lending by banks and mortgage-credit institutes increased in 2005, cf. Chart 7 . In December, the annual growth was 15 per cent, against 9 per cent in December 2004. This is not quite as high as the growth in lending seen during the strong upswing in the mid-1980s, but inflation was higher then than today. The increase in lending has gone hand in hand with higher deposits. This is reflected in the development in the money stock, M2, which rose by 15 per cent in 2005 relative to 2004. M2 primarily comprises the deposits with banks of private individuals and business enterprises, as well as their holdings of banknotes and coins.

Lending to households grew substantially in 2005 against the background of the escalating housing prices and the low level of interest rates. In recent years the households' interest expenditure has become more sensitive to changes in short-term interest rates as a consequence of the increasing popularity of adjustable-rate loans and bank loans, cf. Chart 8 . A proportion of the adjustable-rate loans are capped-rate loans, however, and this type of loan protects borrowers against excessive increases in interest rates. At the end of 2005, the value of outstanding capped-rate bonds was equivalent to approximately 26 per cent of the total lending at adjustable interest rates by the mortgage-credit institutes.

ECONOMIC PROSPECTS

The cyclical upswing is set to continue in 2006. Growth in private consumption will probably be high and if property prices continue to rise consumption will be stimulated further. The level of residential and business investments will be high, and exports will be stimulated by sound expansion on export markets. However, Danmarks Nationalbank's interest-rate increases in recent months may to some extent dampen demand.

Unemployment is expected to decline further, reaching the lowest level for 30 years. In the construction industry and the financial sector there is already a considerable shortage of labour, and the labour market councils expect more bottlenecks in 2006. So far, accelerating wage increases have not been registered, but the labour market should be monitored closely.

The strong economy gives scope to get more people into employment, but without labour-market reforms, including measures that take rapid effect, it will be hard to achieve a sustained increase in employment. A solution would be to employ labour from e.g. eastern Europe and Germany. This has helped to ease the pressure on the labour markets in countries such as Ireland, the UK and Norway. Increasing the supply of labour can ease the pressure on the labour market and maintain Denmark's competitiveness.

The situation does not warrant any easing of fiscal policy. Experience from other countries, including the Netherlands, shows that procyclical fiscal policy may lead to a protracted recession. Consequently, extremely tight management of government expenditure is required. Since the large government budget surplus is partly of a temporary nature, and as there are increasing capacity problems in the labour market, the surplus should only be used to reduce government debt.