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 produced using the macroeconometric model MONA¹ and is based on available economic statistics, including Statistics Denmark's quarterly national accounts for the 2nd quarter of 2008².

The Danish economy has shifted to a lower gear over the past year after some years of high growth. Higher interest rates and weaker de velopment in the housing market have contributed to dampening resi dential investments and private consumption, while the pace of global economic growth has slackened due to the turmoil in the financial mar kets and high commodity prices. The moderation of economic growth in Denmark is expected to continue in the coming years. The forecast oper ates with a gradual decline in annual GDP growth from 1.7 per cent in 2007 to 0.5 per cent in 2010, cf. Table 1.

Following the period of high growth since 2003, capacity pressures in the Danish economy have built up to a higher level than in the euro area and the USA, which points to a more pronounced slowdown in Denmark. In 2008, as in 2007, GDP growth is expected to underperform that of the euro area and the USA, cf. Chart 1. The growth estimates for 2009 are almost on a par, but while growth is expected to bottom out in the euro area and the USA in 2009, growth in the Danish economy is expected to remain low in 2010.

So far, the slowdown has had no effect on the labour market. Recent years' strong growth has brought employment to a record-high level, and unemployment has declined steadily to well below the level that is compatible with wage and price stability without any signs of reversal as yet. The labour shortage has eased in certain sectors, e.g. construction and manufacturing, but it is still pronounced in many services, including the public sector. As a result, capacity pressures remain strong. The out put gap, calculated as the difference between actual GDP and GDP on normal resource utilisation, peaked in 2007, but is forecast to remain wider in 2008 than in the most recent booms.

Recent quarters have seen weak development in domestic demand after high growth rates for a number of years. Both consumption and investment in the private sector have declined in the 1st half of 2008, whereas exports have shown substantial growth. The projection shows continued moderate development in domestic demand as well as lower export growth against the backdrop of competitive pressures and a weak economic outlook for Denmark's trading partners. This results in a gradual narrowing of the output gap and a considerable dampening of import growth.

Wage inflation has picked up in recent years due to the tight labour market. Wage inflation is considerably higher than in most of Denmark's trading partners, and productivity growth has been weak, causing com petitive pressures to intensify. This trend is expected to continue in the next few years as the pressure on the labour market will ease only grad ually. Consumer price inflation has increased rapidly since the 3rd quarter of 2007, primarily driven by surging energy and food prices, but dampened by domestic market-determined inflation, IMI, which reflects the development in wages and profit margins. Against this background, it is by no means certain that recent months' moderate price falls from a high level in the international commodity markets will substantially dampen consumer price inflation in Denmark. This is described in more detail in Box 1, which reviews the risk of wage and price pressures remaining high, as well as the risk of a stronger downturn in the event of a more pronounced decline in private consumption, investment or the inter national economy.

The revisions of the forecast compared with the March 2008 forecast are outlined below, followed by a more detailed review of the forecast, including its underlying assumptions.

REVISIONS IN RELATION TO THE PREVIOUS FORECAST

The estimate of GDP growth in 2008 has been adjusted downwards compared with the March 2008 forecast, cf. Table 2. The downward ad justment is mainly attributable to weaker-than-expected growth in the first quarters of 2008, according to the available national accounts, in cluding a setback in domestic demand. In a forward-looking perspective, the differences diminish. In recent months, unemployment has fallen more than expected, resulting in a slight tightening of the labour mar ket at the outset, and the reversal is now expected in the 4th quarter of 2008. The current-account surplus has been adjusted upwards partly in view of the upward revision of the balance in the last quarters of 2007 and the development in the current year.

Since the spring, consumer price inflation has been stronger than pre dicted in the March 2008 forecast. Consequently, the estimates for 2008 and 2009 have been adjusted upwards. The longer-term estimates are close to the March forecast.

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 a period of high global economic growth, a slowdown has been observed over the past year. This can be attributed to higher commodity prices, weaker housing markets in several countries and effects of the turmoil in the financial markets. So far, the slowdown has been most pronounced in the USA, but it has also affected several other countries that are among Denmark's major trading partners. The growth outlook for Denmark's major trading partners overall has deteriorated since the March forecast. Consequently, export market growth has been revised downwards in the projection to a level below the long-term average.

Price increases for imported goods are expected to gain momentum in the near future in response to the higher commodity prices. This also ap plies to price increases in the industrial export markets. Foreign wage increases are expected to peak in the current year and then to decline in the light of lower economic growth.

Interest rates, exchange rates and oil prices
In the forecast, developments in short-term and long-term interest rates are based on the expectations that can be derived from the yield curves in the financial markets. The projection assumes a slight decrease in the short-term interest rate, which has shown a rising trend since the end of 2005. The long-term interest rate has also increased since 2005, reaching just over 5 per cent in the 2nd quarter of 2008. In the projection, the long-term interest rate remains close to this level.

Recent years have seen considerable strengthening of the krone vis-à-vis the currencies of Denmark's trading partners, particularly the dollar, entailing an increase in the nominal effective exchange rate of the krone. At the end of August, the effective krone rate had returned to a level close to that of the March forecast, having been slightly higher from mid-March to the beginning of August. In the projection, the dol lar rate and the effective krone rate are assumed to be unchanged from the level at end-August.

Oil prices fell from a high level from July to end-August, to stand at approximately 112 dollars per barrel. In the projection, oil prices are as sumed to follow futures prices, which rise a little from the current level. The oil price is approximately 20 per cent higher in this forecast than in the March forecast.³

Fiscal assumptions
The fiscal assumptions in the forecast reflect the fiscal-policy stance as presented in Economic Survey, August 2008. Real growth in public con sumption is expected to be 1.8 per cent in 2008, 1.6 per cent in 2009 and 1.4 per cent in 2010. The forecast growth in public consumption can be attributed primarily to increased expenditure for goods and services. The reduction in public-sector employment in 2008 can be explained by the strikes in the 2nd quarter. Growth in public consumption is higher than the estimate in Economic Survey, reflecting the normal tendency to ex ceed the target. Average annual growth in public investments is expect ed to be approximately 3 per cent 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 growth has slowed down from its annual average of almost 3 per cent in 2004-06. The growth rate fell to 1.7 per cent in 2007 and is expected to dampen further in the forecast period. This is a normal reac tion after a period of high growth and mounting wage and price pres sures.

The strong growth in 2004-06 has entailed intensified pressure on re sources and the build-up of a substantial output gap. In view of the di minishing pace of both external and domestic demand, the pressure will ease in the near future, and the output gap is expected to close towards the end of the forecast period.

The strong capacity pressures at the outset are emphasised by the con tinued decline in unemployment to well below the level that is compat ible with price and wage stability in the medium term. Unemployment is projected to bottom out in 2008, followed by an increase as businesses adjust the number of employees to the weaker demand development. Unemployment will stay below its structural level until 2010, implying that the labour market will remain tight for some time to come.

The forecast operates with a reduction of the labour force by 9,000 people, cf. Table 4, reflecting fewer persons in the prime age groups and an increased outflow from the labour force due to poorer employment opportunities. This implies a lower participation rate. The favourable employment opportunities in recent years have led to an increase in the labour force, and the expected fall can be regarded as a return to a more normal level.

In view of the low unemployment rate and shrinking labour force, productivity growth will be the determining factor for output growth in the next few years. Productivity, measured as output per employee, fell in the 1st half of 2008 according to the available national accounts. This masks a continued increase in employment and a reduction in output. In the forecast, the slower pace of economic growth is expected gradually to spill over into the labour market, and employment is expected to fall by 56,000, or 2 per cent, from 2008 to 2010. Since output is projected to grow a little over the same period, annual growth in productivity will pick up and rise to around the average level observed since 1990, i.e. ap proximately 1.8 per cent.

Wages and prices
The decline in unemployment to a very low level has led to a significant upturn in wage inflation since 2005. Against the backdrop of sustained pressure on the labour market and high consumer price inflation, annual wage inflation in industry is expected to exceed 4.5 per cent in both 2008 and 2009. Towards the end of the forecast period, with unemploy ment approaching its structural level, wage inflation is expected to de cline to around 4 per cent, cf. Table 5.

In the euro area, wage inflation seems to have gained considerable mo mentum in 2008, without reaching the Danish level, however. In the projection, the economic slowdown contributes to sustaining a moder ate pace of wage development in the euro area and Denmark's trading partners taken as one. Growth in hourly wages in industry is thus likely to remain stronger in Denmark than abroad. Wage competitiveness is expected to deteriorate further in the forecast period, accompanied by declining export market shares for Denmark.

Hourly wage costs are projected to mirror the development in wages in the absence of significant changes in business enterprises' other la bour costs. Unit labour costs are projected to increase due to the lower rate of growth in hourly productivity than in hourly wage costs.

In 2008 and 2009, expected price increases for manufactured goods will not fully counterbalance the growth in unit labour costs, resulting in a further rise in the wage share. A higher wage share is normal when the labour market is tight. The wage share is expected to recede a little in the final year of the forecast when the pressure has subsided.

Price increases have picked up considerably since last autumn. In August 2008, annual HICP inflation was 4.8 per cent. The higher price inflation is primarily attributable to surging energy and food prices. At the same time, prices for imported goods and rent have shown stronger trends.

Domestic market-determined inflation, IMI, has been low in 2008, re flecting the normal pattern of weak IMI development in a situation with accelerating import and energy prices since business enterprises do not fully pass on price increases to consumers, cf. Box 5, p. 28. In a forward-looking perspective, profit margins are expected to recover, which will contribute to reinforcing domestic price pressures. The latter are expect ed to be significant as a result of higher payroll costs and rapidly in creasing wholesale prices.

The substantial price inflation is expected to continue in the coming months due to the high energy and food prices and accelerating price increases for imported goods as well as higher IMI, cf. Table 6. Annual price inflation will then decline somewhat as the hikes in energy and food prices in the autumn of 2007 are eliminated from the calculation.

Energy price inflation is projected to be notably weaker in 2009 and 2010 than this year due to virtually unchanged oil prices, among other factors, cf. Table 3, while a clear slowdown in food price inflation is also expected. On the other hand, the recovery of profit margins and higher wage inflation are expected to entail an increase in IMI, and the rate of growth in the overall consumer-price index is projected to decline only gradually. Inflation will fall back to below 2 per cent towards the end of the forecast period.

Domestic demand
Growth in private consumption was weak in the 1st half of 2008. For the full year, growth is expected to be 1.8 per cent year-on-year, which is somewhat lower than the annual growth rates of 4-5 per cent observed in the period 2004-06. In 2009 and 2010, consumption growth is expect ed to moderate further, and the consumption-to-income ratio is expect ed to decline due to slower growth in private consumption than in household disposable income. The lower consumption-to-income ratio reflects the reduction in household wealth as a result of the weakening of the housing market.

House prices have fallen in Denmark over the past year, and ex pectations of further price drops may have led home buyers to exert extra caution. The weakening of the housing market is also reflected in the increased supply of homes for sale, the lower number of transactions and the higher number of enforced sales. Consequently, the projection also operates with falling house prices, cf. Table 7, although they are cushioned by robust growth in real incomes, a moderate level of interest rates and a continued low unemployment rate.

Residential investments have levelled off since 2006 after an almost continuous rising trend since the beginning of the 1990s. In the pro jection, residential investments decline a little from the current highs predominantly as a result of falling cash prices and high construction costs.

After remaining strong for a few years, growth in business investments has abated since the 1st half of 2007. Construction investments have re acted to the upswing with a considerable lag, having risen over the last few years from a low level. The growth in construction investments is ex pected to continue at a moderate pace until 2010. Investments in plant and equipment grew at a brisk pace in 2003-07 against the backdrop of sound corporate earnings and substantial capacity pressures. The result is a considerably higher investment ratio. In the projection, the invest ment ratio is reduced to a more normal level as output growth and capacity pressures subside.

Total domestic demand excluding inventory investments fell by 0.6 per cent in the 1st half of 2008, reflecting dampened growth in demand compared to recent years. The forecast operates with a further slow down, and in 2010 growth in private-sector domestic demand is expect ed to be close to zero.

Foreign trade and the balance of payments
Denmark has seen a decline in import growth since 2006, which can be attributed to more subdued growth in demand. In the projection, an nual import growth is 1.7 per cent on average, cf. Table 8. In compari son, annual import growth was more than 10 per cent on average in 2004-06. As a result of the high growth in demand and strong domestic capacity pressures, an increasing share of demand was met by imports, causing the import ratio to climb to a high level. In the near future, the propensity to import is expected to stabilise at the elevated level as capacity pressures ease.

Annual export growth was almost 7 per cent on average in 2004-06, a period of favourable conditions in Denmark's major export markets. In 2007, export growth was 1.9 per cent at constant prices, and in 2008-10 annual growth in real exports is expected to be just under 2 per cent. Export growth will subside in response to the slowdown in the global economy and the deterioration of Denmark's wage competitiveness.

In recent years, the strong growth in Denmark's export markets has benefited industrial exports. However, growth in industrial exports has declined since 2006 and is expected to remain moderate in the near fu ture in light of the weaker international cyclical position. The forecast operates with slower growth in Danish industrial exports than in total imports of industrial goods from the recipient countries, which implies a loss of market shares for the industrial sector.

Oil and gas production has diminished in recent years; a trend that is expected to continue. Consequently, the projection operates with falling energy exports. In the projection, agricultural exports are growing at a steady pace since grain production is expected to increase due to the surging grain prices in recent years and the abolition this year of com pulsory set-aside.

Denmark's terms of trade have improved over a number of years. In 2007, however, import prices tended to rise more than export prices, causing the terms of trade to deteriorate. In the forecast period, the terms of trade are expected to remain at the high level.

The current-account surplus declined from 2005 to 2007 primarily as a result of lower trade surpluses. The trade balance for goods has improved since then, and the improvement continues as other countries outperform Denmark in terms of economic growth. At the same time, the surpluses on sea freight and investment income will be maintained, resulting in an increasing current-account surplus in the forecast, cf. Table 9.