Report of the Board of Governors 2007

INTERNATIONAL BACKGROUND TO THE DANISH ECONOMY

The strong momentum in the global economy continued in 2007, primarily driven by very high growth in a number of emerging market economies, including China and India. The cyclical position in Europe remained favourable, while growth in the USA declined.

Strong global demand entailed higher commodity prices – particularly for oil. The price of Brent oil rose from 57 dollars per barrel at the beginning of 2007 to 94 dollars at year-end. Food prices also increased as a result of higher grain prices. The latter reflected poor harvests and low inventory levels, as well as growing demand for crops for e.g. biofuel.

The slowdown in the US economy was mainly attributable to the housing market, where investments and prices continued to fall. Growth was low at the beginning of 2007 and declined further towards the end of the year, when unemployment began to rise. US GDP rose by 2.2 per cent in 2007, compared with 2.9 per cent in 2006.

In the euro area growth was 2.7 per cent, which was slightly lower than in 2006, but still above the level seen in previous years. Growth was highest at the beginning of the year, but then slowed down a little, while unemployment continued to fall. GDP growth was evenly distributed over the large euro area member states, primarily driven by domestic demand, and in Germany also by rising exports.

Since the summer of 2007, the financial markets in the USA and Europe have been characterised by considerable turmoil stemming from losses on US subprime mortgages. Long-term uncollateralised money-market interest rates have risen on account of the financial turmoil, and the spread between uncollateralised and collateralised money-market interest rates has widened as a result of the increased uncertainty. From the onset of the financial turmoil a number of banks and financial institutions experienced difficulties in sourcing sufficient liquidity due to the uncertainty that had arisen in the financial markets. Both the Federal Reserve System (Fed) and the European Central Bank (ECB) have provided additional liquidity to the markets on several occasions. As a result of the turmoil, banks in both the USA and Europe have tightened their credit standards.

In the international financial markets, the yield on the benchmark US 10-year government bond fell from 4.7 per cent at the beginning of 2007 to 4.1 per cent at year-end. The fall was observed in the 2nd half of the year and was driven by the financial turmoil and the slowdown of the US economy, which led to expectations of lower inflation. US inflation, excluding energy and food, declined over the year, but towards the end of the year core inflation rose. As a result of considerably higher energy and food prices, the overall consumer price index was 4.1 per cent higher in December 2007 than one year earlier. Beginning in the autumn, the Fed lowered its target rate on three occasions, by a total of 1 percentage point, to 4.25 per cent. In January 2008 the Fed cut the target rate by a further 1.25 percentage points in two stages, inter alia citing a need for preventive measures against increasing downside risks for the US economy owing to the financial turmoil.

In the euro area the yield on the benchmark German 10-year government bond increased from 3.9 per cent at the beginning of 2007 to 4.3 per cent at year-end. The decoupling of the development in European and US long-term interest rates should be viewed in the light of Europe's relatively better cyclical position and the resulting differences in the expected interest-rate behaviour of the central banks during the year.

In 2007 the US dollar reached an all-time low against the euro, standing at 1.49 dollars per euro at end-November. At the end of December the dollar had depreciated by 10.5 per cent vis-à-vis the euro, compared with the exchange rate at the beginning of the year. After further weakening in February 2008, the dollar fell below 1.50 dollar per euro, and the exchange rate vis-à-vis the Danish krone was below 5 kroner – the lowest level since late 1978.

The global stock markets rose in the 1st half of 2007, but from the summer onwards they became more volatile with a downward trend. The benchmark stock indices in the USA, Europe and the emerging market economies ended the year slightly higher than they had begun it, while the Japanese index had fallen a little.

THE DANISH ECONOMY

Recent years' strong boom in the Danish economy continued in 2007, with the economy reaching its capacity limit. Employment rose to an all-time high, and unemployment fell to less than 58,000 at year-end, equivalent to 2.1 per cent of the labour force. This is the lowest unemployment rate since the early 1970s. Extensive pressure on the labour market meant that many industries, as well as the public sector, had difficulties in recruiting the required labour.

Real GDP growth was 1.8 per cent in 2007, compared with 3.9 per cent in 2006, cf. Table 1. Economic activity in 2007 was to a large extent curbed by labour shortage and high capacity utilisation. Productivity fell as growth in both employment and the number of hours worked exceeded output growth. This development is to some extent attributable to the fact that more people with limited work experience entered the labour market.

The rate of wage increase showed an upward trend over the year, reflecting the tight labour market. For the private sector overall, the annual rate of wage increase was 4.3 per cent in the 4th quarter of 2007, up from 3.1 per cent in the same quarter of 2006. The rising Danish wages had a negative impact on Denmark's external wage competitiveness.

Measured by the increase in the Harmonised Index of Consumer Prices, HICP, inflation averaged 1.7 per cent in Denmark in 2007. Towards the end of the year, inflation rose to approximately 2.4 per cent due to large price increases on energy and food. Domestic market-determined inflation, IMI, which describes the development in prices determined on market terms in Denmark, picked up from a low level, but remained moderate in the context of the cyclical position. In December, IMI was 1.4 per cent. Large price increases on e.g. Danish wholesale goods, industrial products and building materials, however, indicated strong underlying price pressure at the start of 2008.

The yield on the benchmark Danish 10-year government bond increased from approximately 3.9 per cent at the beginning of 2007 to approximately 4.4 per cent at year-end. The nominal effective krone rate rose as the krone strengthened vis-à-vis a number of currencies. At end-2007, the nominal effective krone rate was almost 3 per cent higher than the level one year earlier, thereby contributing to the weakening of competitiveness.

Growth in domestic demand was sound and broad-based in 2007, albeit more subdued than earlier on in the upswing. Despite the slowdown in the housing market, private consumption increased by 2.7 per cent, supported by strong income growth, high employment and the households' sound net worth.

Business investments increased by 10.8 per cent, following strong growth in the preceding year. The high level of investment reflects the shortage of labour, which has led to substitution by way of capital.

Import growth declined in 2007 after strong acceleration in 2004-06. The capacity pressure underpinned considerable growth in imports of goods, while imports of services grew only marginally. On the export side, sales benefited from high growth among Denmark's key trading partners.

The balance of payments has deteriorated since early 2006, and in 2007 the current-account surplus fell to kr. 17 billion. 2007 saw a growing deficit on the income account due to increased payments to foreign labour.

Government finances showed a surplus of 4.5 per cent of GDP in 2007, reflecting high income from direct and indirect taxes, as well as low expenditure on e.g. unemployment benefits. Government consumption rose by 1.3 per cent, and in overall terms fiscal policy was broadly neutral in relation to economic activity.

MONETARY AND FOREIGN-EXCHANGE POLICY

Throughout 2007, the Danish krone was stable at a level close to its central rate, cf. Chart 1. Danish monetary and foreign-exchange policy is aimed at keeping the krone stable vis-à-vis the euro. Due to the euro area's low-inflation policy, this creates a framework for low and stable inflation in Denmark.

The formal framework for Denmark's fixed-exchange-rate policy is the European Exchange Rate Mechanism, ERM II. Denmark participates with a central rate of kr. 7.46038 per euro and a fluctuation band of +/- 2.25 per cent in relation to the central rate.

Inflation excluding energy and food prices was stable on the low side of 2 per cent in the euro area throughout 2007. Due to increases in energy and food prices, the annual increase in the Harmonised Index of Consumer Prices (HICP) was 3.1 per cent in December 2007. The ECB's monetary-policy target is to keep inflation in the euro area below, but close to, 2 per cent in the medium term.

On 8 March and 6 June 2007 the ECB decided to raise the minimum bid rate by 0.25 percentage points. After the June increase, the minimum bid rate reached 4 per cent. The interest-rate decisions were motivated by increasing inflation risk, primarily due to the favourable economic prospects for the euro area. The ECB kept its interest rates unchanged for the rest of the year since the continued financial turmoil increased the uncertainty surrounding real economic development.

The ECB's interest-rate increases were followed by equivalent increases in Danmarks Nationalbank's interest rates, which were raised by 0.25 percentage points in March and June 2007, respectively. The fixed-exchange-rate policy means that Danmarks Nationalbank's monetary-policy interest rates are purely used to keep the krone close to its central rate. Consequently, Danmarks Nationalbank's interest rates normally mirror those fixed by the ECB for the euro area. After the June increase, Danmarks Nationalbank's lending rate was 4.25 per cent, while the discount and current-account rates were 4 per cent.

Capital flows and interventions
Portfolio investments usually constitute the most important cross-border capital flows that influence short-term fluctuations in the krone rate. For 2007, portfolio investments resulted in net capital outflows totalling kr. 67 billion. The main reason is that the structural tendency in recent years for institutional investors to buy foreign shares and bonds continued in 2007. Overall, net capital exports totalling kr. 44 billion were registered, which should be seen in the light of a current-account surplus.

In 2007 Danmarks Nationalbank sold foreign exchange net for approximately kr. 2 billion in connection with intervention to stabilise the krone. At end-2007 the foreign-exchange reserve was kr. 169 billion.

Money market
There have not been any indications that the international financial turmoil has significantly affected day-to-day money-market interest rates in Denmark. However, the long-term uncollateralised money-market interest rates rose and the spread between uncollateralised and collateralised money-market interest rates widened on account of the financial turmoil. At the beginning of 2008 the spread narrowed somewhat again.

It has not been necessary for Danmarks Nationalbank to provide extraordinary krone liquidity in connection with the financial turmoil. There have been some indications of a shortage of dollar liquidity, reflecting the fact that the USA was the source of the turmoil. Shortage of dollar liquidity is an international, not a purely Danish, phenomenon.

Other central banks have provided extraordinary liquidity in their own currencies against collateral, as banks in a number of countries have shown restraint in exchanging liquidity in the money market. In addition, the ECB and the Swiss National Bank have provided dollar liquidity under agreements with the Fed.

Monetary-policy instruments
On 3 May 2007, the maturity of Danmarks Nationalbank's monetary-policy loans and certificates of deposit was changed from 14 to 7 days in order to cushion the considerable fluctuations in the day-to-day interest rate when interest-rate increases are expected. The transition was smooth, and no major fluctuations were seen in the day-to-day interest rate around the time when the monetary-policy interest rates were raised in June. The other monetary- and foreign-exchange-policy instruments remained unchanged in 2007.

The net position of the banks and mortgage-credit institutes vis-à-vis Danmarks Nationalbank was reduced by kr. 25 billion during 2007. This is primarily attributable to a negative liquidity impact from the government finances, which in the latter part of the year developed ahead of expectations.

THE DOMESTIC FINANCIAL SYSTEM

Banks and mortgage-credit institutes
The turmoil in the international financial markets has had only a limited impact on the Danish banks, which still recorded sound profits in 2007. This reflected the favourable cyclical position in Denmark and high lending growth. The banks' lending to residents totalled kr. 1,334 billion at the end of 2007, up from kr. 1,124 billion at end-2006.

The performance of the mortgage-credit institutes remained sound in 2007. Total mortgage-credit lending by the mortgage-credit institutes to domestic households and business enterprises amounted to kr. 2,012 billion at end-2007, against kr. 1,833 billion at end-2006. Deferred-amortisation loans account for an increasing share of mortgage-credit loans, reaching 41 per cent of total lending (excluding index-linked loans) by the end of 2007, up from 34 per cent at the end of 2006. Over the last year, the share of deferred-amortisation adjustable-rate loans has remained more or less unchanged, whereas the share of deferred-amortisation fixed-rate loans has increased from 12 to 20 per cent of total mortgage-credit lending (excluding index-linked loans). Fixed-rate loans with amortisation are still the prevailing loan type.

Financial sector continuity planning
In 2006, a working group was set up to prepare a report assessing the need for national continuity planning for the financial sector in the event of a major operational disruption. The report was submitted for consultation in June 2007. A road map for the further work has been prepared and a response team set up at Danmarks Nationalbank to undertake the current operation of the continuity measures, as well as a coordination committee to coordinate the sector's overall response to any major operational disruption, such as acts of terrorism, major epidemics, natural disasters, etc. that jeopardise the functioning of the financial system.

Transition to Basel II
On 1 January 2007, new capital-adequacy rules, known as the Basel II Accord, entered into force. The new rules imply an up-to-date approach to capital requirements for credit institutions, under which the capital requirements more accurately reflect the risks incurred by each individual credit institution.

Payment systems
Settlement of payments in the Kronos, Sumclearing, CLS and Target systems continues to increase. The value of transactions settled via Danmarks Nationalbank's system, Kronos, increased by 6 per cent in 2007, to kr. 70,273 billion. In the Danish retail payment settlement system, the Sumclearing, the value of transactions in kroner rose by 7.5 per cent to kr. 5,750 billion. In VP Settlement the value of transactions in kroner declined from kr. 23,581 billion in 2006 to kr. 23,172 billion in 2007, while the number of transactions increased by 32 percent. This is attributable to a further decline in the trading of Danish bonds, which was not offset by the increase in equities trading. Moreover, settlement of transactions in euro in the Danish systems showed high growth in 2007.

The value of foreign-exchange transactions in kroner in CLS increased by 6 per cent to kr. 50,446 billion, while the number of transactions rose by 26 per cent. In November 2007, CLS was expanded to include settlement of payments in connection with trade in credit derivatives in the five largest currencies (US dollars, euro, yen, pounds sterling and Swiss francs).

Securities settlement
Danmarks Nationalbank has participated in the work to increase the sanction options in VP Securities Services. The new rules are expected to enter into force in 2008, the aim being to strengthen settlement discipline so that as many transactions as possible are settled in a timely manner. In 2007, Danmarks Nationalbank also began to investigate whether there is a need to introduce a central counterparty in the Danish securities market.^[1] 

The first bonds for financing of mortgage loans were issued in Mexico in December 2007 via the Danish central securities depository. Danmarks Nationalbank has provided advisory services through VP Securities Services in connection with the introduction of the Danish mortgage-credit model in Mexico.

Collateralisation
Danmarks Nationalbank grants loans to banks and mortgage-credit institutes against certain securities with a high credit quality as collateral. On 2 July 2007, the list of eligible securities was expanded to include covered bonds issued by financial institutions comprised by the Danish Financial Business Act.

Danmarks Nationalbank has an obligation to align its collateralisation rules concerning intraday credit in euro with those of the ECB. On 1 January 2008, Danmarks Nationalbank therefore introduced the ECB's requirements for the credit rating of securities pledged as collateral for intraday credit in euro.

Payment Services Directive and SEPA
The Payment Services Directive of the European Commission was adopted in 2007, constituting the legal basis at EU level for the European banks' work to establish a Single Euro Payments Area (SEPA). Subsequently, the Directive must be transposed into national legislation. Danmarks Nationalbank monitors the sector's progress with SEPA and has participated actively in the preparation of the Directive.

In addition, Danmarks Nationalbank is working with the Association of Local Banks, Savings Banks and Cooperative Banks in Denmark, the Danish Regional Bankers Association and PBS to establish a solution for settlement of payments using the new SEPA product for direct debit in euro. The SEPA direct-debit product is comparable to Betalingsservice in Denmark. The solution will be available to all banks in Denmark and is expected to be introduced in the autumn of 2009.

Target2 and Target2-Securities
The development of a new trans-European payment system, Target2, for settlement of payments in euro continued in 2007. The first group of EU member states migrated to Target2 in November 2007, and Denmark will connect to Target2 in May 2008.

Target2-Securities is the Eurosystem's proposal for a single European settlement platform for securities issued in euro. Settlement of securities in other European currencies will also be possible. In 2007 the project was in the user requirements phase, and in Denmark, as in most other EU member states, a national user group has been set up with representatives from all parts of the sector. Danmarks Nationalbank and VP Securities Services jointly coordinate the work of this group. In 2007 the user group prepared consultation responses on the draft user requirements, focusing on special Danish interests such as single-investor accounts. The fully articulated user requirements for the settlement platform were presented at the end of the year and have been submitted for public consultation until the beginning of April 2008. The Governing Council of the ECB is expected to reach a final decision on the project in June 2008.

INTERNATIONAL MONETARY COOPERATION

Enlargement of the euro area
On 1 January 2008, Cyprus and Malta joined the euro area and introduced the euro as their currency. The euro area thus comprises 15 EU member states. On introduction of the euro as their currency, Cyprus and Malta left the European Exchange Rate Mechanism, ERM II. The remaining ERM II participants are: Denmark, Estonia, Latvia, Lithuania and Slovakia. The change in the group of participants does not entail any adjustment of the terms for the Danish krone in ERM II.

The Lisbon Treaty and the Danish opt-outs
The new EU treaty, the Lisbon Treaty, was signed by the EU heads of state and government on 13 December 2007. With respect to Economic and Monetary Union, the Lisbon Treaty mainly introduces procedural changes in relation to previous treaties. For example, the Eurogroup, the informal meeting forum for the finance ministers of the euro area member states, now appears in a protocol.

The Danish Government Platform from November 2007 states that the government wishes the voters to have the opportunity to decide on the Danish opt-outs by referendum.

The International Monetary Fund, IMF
In recent years, the IMF has worked to adjust the quotas and voice of its 185 member countries, so that they better reflect their relative weight in the global economy. Negotiations are in progress about e.g. the quota formula, which is of key importance to the voting power of each country. During 2008 the negotiations are expected to lead to an adjustment of the quota formula, to be followed up by ad-hoc increases in the quotas, i.e. the member countries' contributions to the IMF.

In 2007, the IMF also continued its debt-relief efforts for the poorest and most indebted countries, and agreement was reached on debt relief for Liberia. Denmark has contributed kr. 31 million to the IMF's debt relief for Liberia financed via the Danish development assistance.

On 1 November 2007, Dominique Strauss-Kahn, former French minister for finance, assumed office as the Managing Director of the IMF. Since then he has worked to continue the reforms in progress, not least the IMF budget reforms, since a substantial decline in IMF lending to its member countries has reduced interest income and the IMF is estimated to have a budget shortfall of approximately USD 400 million yearly. It is expected that the shortfall will be covered via new sources of income, and by reducing the IMF's expenditures.

BANKNOTES AND COINS

Cash circulation increased from kr. 59.1 billion in 2006 to kr. 61.0 billion in 2007, an increase by 3.2 per cent^[2]. The increase in the cash circulation declined in 2007 compared with recent years, possibly reflecting dampening of private consumption. The number of banknotes in circulation rose from 156 million in 2006 to 161 million in 2007, i.e. by 3.2 per cent.

501 counterfeit banknotes were removed from circulation in 2007. This is an increase from 344 in the preceding year. In an international context, counterfeiting of Danish banknotes is still limited.

New banknote series
On 14 May 2007, Danmarks Nationalbank announced that the draft proposal from the artist Karin Birgitte Lund will form the basis for the next Danish banknote series. The design of the new series was initiated as a result of the development of new security features.

In cooperation with the artist, the Banknote Printing Works at Danmarks Nationalbank has worked on the original draft proposal, which shows five selected bridges in Denmark. The artistic expression of the banknotes has also been elaborated on in order to meet the security requirements and technical requirements. The final proposal is expected to be submitted for approval by the Ministry of Economic and Business Affairs in the spring of 2008. The first banknote is scheduled for production in 2009 and issue at the end of the same year, while the last banknote in the series is to be issued in 2012.

Faroe Islands and Greenland
As Denmark's central bank, Danmarks Nationalbank also supplies the Faroe Islands and Greenland with cash. Since 1951 the Faroe Islands have had their own banknotes. In 2006 a bill was introduced for separate Greenlandic banknotes, and the Act on Banknotes in Greenland entered into force on 1 June 2007. The Danish krone will remain the currency of Greenland, and Danish coins will still be used. Like the Faroese banknotes, the Greenlandic ones will be of the same sizes and denominations as the Danish banknotes.

The Greenland Home Rule Government has chosen the Danish/Greenlandic artist Naja Abelsen to illustrate the Greenlandic banknotes. The Banknote Printing Works at Danmarks Nationalbank and Naja Abelsen are working on a draft proposal, which is expected to be presented to the Home Rule Government before the summer of 2008.

The Royal Mint
In 2007, The Royal Mint's website, which was launched in 2006, was expanded to include a payment module, whereby collector's coins can be ordered and purchased online. The launch of The Royal Mint's own website has boosted interest in Danish collector's coins considerably.

The growing interest in collector's coins and the development in the circulation of coins have lead to an increase in the production of coins in recent years.

At the beginning of 2008, Danmarks Nationalbank contacted the Ministry of Economic and Business Affairs with a view to abolishing the 25-øre coin as the coin no longer has self-supporting purchasing power.

STATISTICS

Transition to Statistikbanken.dk
On 1 October 2007, Danmarks Nationalbank started publishing financial statistics via StatBank Denmark at Statistics Denmark. The transfer of Danmarks Nationalbank's financial statistics to StatBank Denmark is an advantage for users, who can now download all major economic and financial time series produced in Denmark from one single source.

Cooperation with the Danish Financial Supervisory Authority on reporting by investment associations
In 2007, Danmarks Nationalbank and the Danish Financial Supervisory Authority initiated a project to develop a new, common reporting system for investment associations. With the new reporting system, all reporting by investment associations will be collected at Danmarks Nationalbank, which will in turn forward data to the Danish Financial Supervisory Authority, thereby eliminating duplicate reporting as a result of overlapping reporting requirements. This will streamline administration by the authorities and reduce the investment associations' reporting burden.