International Monetary Cooperation

The process to ratify the Constitutional Treaty for the EU was suspended after the Treaty was rejected by referenda in France and the Netherlands in the early summer of 2005.

Cyprus , Latvia , Malta and Slovakia joined ERM II in 2005, so that seven of the ten new EU member states are now ERM II participants.

The Accession Treaty with Bulgaria and Romania was signed in April 2005 with a view to EU membership in 2007. In October, accession negotiations were opened with Turkey and Croatia .

In March 2005, the EU member states agreed on a reform of the Stability and Growth Pact. According to estimates by the European Commission 11 member states, including five euro area member states, exceeded the Treaty's 3-per-cent limit for government budget deficits in 2005.

The IMF adopted guidelines for 100 per cent debt relief to Heavily Indebted Poor Countries. The total lending by the IMF was halved as a result of premature redemptions by the largest borrowers.

By agreement with Denmark , the IMF began an assessment of the Danish financial sector (FSAP), equivalent to the assessments performed in many other member countries.

PERIOD OF REFLECTION IN THE EU

After a number of years when the EU moved forward, with the establishment of EMU, accession of many new member states, and preparation of a Constitutional Treaty, 2005 was characterised by uncertainty and a slowdown in development. Agreement was reached on a reform of the Stability and Growth Pact, and after intense negotiations the EU heads of state or government, at the meeting of the European Council on 15-16 December 2005, agreed on the long-term framework for the EU's budget, i.e. the Financial Perspectives 2007-13. However, the process to ratify the Constitutional Treaty, which had been adopted at the meeting of the European Council in June 2004 after several years' preparatory work, was suspended after rejection of the Constitutional Treaty in two referenda, in France and the Netherlands, in respectively May and June 2005. At the subsequent meeting of the European Council on 16-17 June 2005 the heads of state or government therefore declared a period of reflection. The pause for reflection is to be used for a broad debate on the future of Europe . Against this background, the European Council will decide in the 1st half of 2006 how to proceed. The Constitutional Treaty cannot enter into force until ratified by all EU member states. A few member states chose to continue the ratification process after the declaration of the period of reflection, while a number of member states – including Denmark – postponed ratification indefinitely.

The Constitutional Treaty would have only a limited impact on economic and monetary policy in the EU since the existing framework for economic policy cooperation is by and large maintained.^[1]

NON-EMU MEMBER STATES

The ten member states that joined the EU in May 2004 have an obligation to adopt the euro at some time in the future. During 2005, several of these member states made progress towards complying with the EU Treaty's convergence criteria, which are the conditions for adopting the euro.

The convergence criteria include a requirement to participate in the EU's Exchange-Rate Mechanism, ERM II, without serious tensions for at least two years. Seven of the ten new EU member states are now ERM II participants. Estonia , Lithuania and Slovenia joined ERM II in June 2004, Latvia , Malta and Cyprus in May 2005 and, most recently, Slovakia in November 2005, cf. Box 10.

All these member states have agreed on standard fluctuation bands for their respective currencies of +/- 15 per cent around the central rate. Denmark , which has participated in ERM II since 1999, has a special agreement on a narrower fluctuation band of +/- 2.25 per cent. The fluctuation bands and central rates have in all cases been determined by agreement between the applicant and the euro area member states, the European Central Bank (ECB) and the non-euro area member states already participating in ERM II. Latvia has made a unilateral commitment to a narrower fluctuation band, Malta a commitment to keep the lira at its central rate, and Lithuania and Estonia have maintained their currency boards^[2] as unilateral obligations within the framework of ERM II, cf. Box 10 . For most of the member states, joining ERM II has not entailed significant changes in their exchange-rate policies, and their participation in ERM II has been without tensions.

In addition to participating in ERM II for two years, member states wishing to adopt the euro must meet the requirements concerning the government budget deficit, government debt, inflation and long-term interest rates.^[3] At least biennially the European Commission and the ECB prepare convergence reports to assess compliance with the criteria by 11 of the 13 member states that have not adopted the euro. Denmark and the UK have treaty-bound derogations and need therefore only be assessed at their own request. The next convergence reports are to be prepared in 2006. These reports will show whether Estonia, Lithuania and Slovenia, all of which will have participated in ERM II for two years at the end of June 2006, fulfil the criteria and can thus join the euro area as planned on 1 January 2007, cf. Box 10. Compliance with the inflation criterion may prove to be difficult, particularly for Estonia . In 2005, inflation in Estonia was 4.1 per cent, e.g. as a consequence of high oil prices. In Estonia , as in most of the other new EU member states, energy is relatively important in the calculation of inflation. The other economic convergence criteria are expected to be met by the three member states.

Most of the new EU member states plan to introduce euro banknotes and coins when they join the euro area. In this respect they differ from the existing euro area member states, which did not introduce euro banknotes and coins until January 2002, after a three-year transitional period in which the euro only existed as a unit of account.^[4] As regards practical preparations, the new EU member states are at different stages. In November 2005, the European Commission assessed that there was a general need to speed up preparations if the member states are to introduce the euro as planned.

FUTURE ENLARGEMENTS OF THE EU

The Accession Treaty with Bulgaria and Romania was signed in April 2005, with a view to the two member states' EU membership in 2007. In its report from October 2005, the European Commission assessed that the two countries had made substantial progress during the preceding year, but that a number of challenges still lie ahead if they are to be ready to join the EU in 2007 as planned. EU membership may therefore be postponed until 2008. The EU's relations with the candidate countries Turkey and Croatia entered a new phase in October 2005 when accession negotiations were opened. The negotiations are likely to be protracted, particularly those with Turkey . Negotiations with Turkey are not expected to be concluded until approximately ten years after their opening, at the earliest. Macedonia became an official candidate country in December 2005, but no date has yet been set for the opening of accession negotiations.

THE STABILITY AND GROWTH PACT

In recent years, fiscal-policy cooperation within the EU has been characterised by the member states' difficulties in fulfilling the provisions of the EU Treaty and the Stability and Growth Pact relating to government budget deficits and debt. The problems culminated in 2004, when the European Commission brought an action before the European Court of Justice following the decision by the Ecofin Council concerning the excessive deficits of Germany and France . In practice this decision meant that the excessive deficit procedure was held in abeyance for these two member states.^[5] This left fiscal-policy cooperation in a deadlock and triggered a debate on a reform of the Pact.

In March 2005, agreement was reached on adjustment of the rules of the Stability and Growth Pact. The reform appears to have paved the way for resolving the deadlock and for the rules again to be enforced with sufficient political support. The necessity of this is emphasised by the European Commission's autumn forecast, which paints a dismal picture of the budgetary situation in Europe.

2005 reform of the Stability and Growth Pact
The rules of the Treaty establishing the European Community, including its key prohibition of "excessive deficits" have not been changed with the reform of the Pact.^[6] In principle, a deficit exceeding 3 per cent of GDP is defined as excessive. The Stability and Growth Pact expands and specifies these fundamental rules under the Treaty. The purpose is to contribute to preventing excessive deficits, and also to lay down a more detailed procedure for correcting excessive deficits.

The 2005 reform was a compromise, mainly aimed at strengthening the preventive elements of the Pact and increasing flexibility in the excessive deficit procedure, particularly in low-growth situations, cf. Box 11.

In terms of the preventive arm of the Pact, the reform has entailed tightening of the requirement to pursue a medium-term objective of government budgets that are close to balance or in surplus. In the event of low potential growth and high government debt, the requirement of the medium-term objective is increased. In principle, member states that diverge from their medium-term objectives must adjust their cyclically adjusted deficit by at least 0.5 per cent of GDP per annum.^[7] This will entail enhanced consolidation of the nominal budget balance during upswings, and more limited consolidation when economic growth is below potential. In addition, major structural reforms may be taken into account if they improve the long-term sustainability of the fiscal policy. Such measures include costs of pension reforms.

The reform of the corrective arm of the Stability and Growth Pact has facilitated access to exemptions from the excessive deficit procedure in the event that the 3-per-cent limit has been exceeded. Under the Treaty's excessive deficit procedure, a member state's budget deficit may exceed the 3-per-cent limit, provided that the circumstances are exceptional and temporary and the deficit remains close to the 3-per-cent limit. Under the reform, a breach is exceptional when GDP growth is negative or has been below its potential level for a protracted period. Previously, the requirement was an annual decrease in GDP of at least 0.75 per cent. The reform entails that a balanced overall economic assessment must be performed, taking into account all relevant factors related to exceeding the 3-per-cent limit. As a new element, "all other relevant factors" have been specified, and the member state in question may point to factors to be considered. Consequently, a number of country-specific factors such as potential growth, fiscal-policy consolidation efforts, structural-policy measures, etc, may be included in the assessment.

The duration of the excessive deficit procedure has also become more flexible since the deadline for correction of an excessive deficit may in special circumstances be extended from one to two years. In addition, the deadlines given may be extended in the event of unforeseen adverse economic events, provided that the member state in question has introduced fiscal-policy tightening measures as recommended.

The significance of the reform of the Pact in 2005 cannot be assessed yet, since it will depend on how the new rules are applied in practice. However, the rules have become more complex, which marks a departure from the original concept of a simple set of rules. The increased access to exemptions can impede strict enforcement of the excessive deficit procedure.

The budget situation 2005 – status
According to the European Commission's autumn forecast from November 2005, the budget deficit in the euro area is expected to increase to 2.9 per cent, from 2.7 per cent in 2004. For the EU overall, an increase from 2.6 to 2.7 per cent is expected.

The European Commission expects 11 member states to exceed the Treaty's 3-per-cent limit in 2005, cf. Chart 28, including five euro area member states – France , Greece , Italy , Portugal and Germany – all of which are subject to the excessive deficit procedure. The procedure was initiated for Italy and Portugal in 2005, in both cases under the rules of the reformed Stability and Growth Pact. The European Commission regarded neither Italy 's nor Portugal 's deficit as temporary or exceptional, and "other relevant factors" were therefore not included in the assessment of the excessive deficit. For Italy , 2007 was set as the deadline for correction of the deficit, while Portugal has been given until 2008. Greece was the first member state to be given notice to take measures to reduce its budget deficit. The deadline was postponed by one year until 2006. The excessive deficit in the Netherlands was corrected in 2004, one year ahead of the deadline. The excessive deficit procedure was therefore abrogated in 2005 when the budget deficit for 2004 was found to have been 2.3 per cent of GDP. For Germany and France , 2005 was the deadline for correction of their excessive deficits. According to the European Commission's autumn forecast, both member states still exceeded the 3-per-cent limit in 2005, and consequently the procedure is expected to be resumed for these two member states in 2006.

Among the new member states, Cyprus brought its deficit below the 3-per-cent limit in 2005, while Hungary on the other hand adjusted its budget deficit for 2005 substantially upwards. As a result, the Ecofin Council decided in November 2005 that Hungary had not lived up to the Council decisions from March to improve the budget.^[8]

DISCUSSION OF THE IMF' S FUTURE DEVELOPMENT

The strategic development of the International Monetary Fund, IMF, was a major topic at the meetings of the International Monetary and Financial Committee, IMFC^[9], in the spring and autumn of 2005. The objective was to specify the role of the IMF in a globalised world with increasing capital flows and growing economic influence among the emerging economies, and in relation to the efforts of the poorest member countries to reach the UN's millennium development targets by 2015^[10], cf. Box 12 . One of the focus areas is to increase the influence of some of the Asian emerging economies in the IMF, since their economic progress has not been reflected in correspondingly greater influence. Unless this is ensured, there is a risk that the countries will view IMF membership as less relevant. At the same time, a number of countries wish to strengthen the influence of the developing countries.

DEBT RELIEF FROM IMF TO POOR COUNTRIES

In November, the Executive Board of the IMF adopted the implementation modalities for the Multilateral Debt Relief Initiative to cancel 100 per cent of the claims on a number of poor countries, cf. Box 13 . The Initiative is to be seen as part of the efforts to reach the UN's millennium development targets and was initially prompted by a proposal made by the G8 finance ministers in June 2005.

In addition, the IMF has adopted two new facilities for low-income countries at the initiative of the G8 countries. Poor countries with balance-of-payments problems as a result of sudden external events can now raise loans with concessional financing, the Exogenous Shocks Facility, ESF. Finally, a new type of programme with no attached lending facility, the Policy Support Instrument, PSI, has been created. Approval of a two-year PSI for Nigeria in October enabled the achievement of a debt rescheduling agreement that Nigeria had concluded with the Paris Club group of western creditor countries.

LENDING BY THE IMF

During the past year, the IMF's total lending has been more than halved, cf. Chart 29. Two of the three largest creditor countries – Argentina and Brazil – have paid off their remaining debt to the IMF ahead of schedule, while the third country, Turkey , has redeemed SDR 3.6 billion. Finally, Russia has settled its account with the IMF.

The IMF's outstanding claims under general resources totalled kr. 257 billion (approximately SDR 28 billion) at end-2005, of which Denmark 's contribution to financing the loans was kr. 1.9 billion. This outstanding represented approximately 13 per cent of the members' total quotas, which is the lowest level for 25 years. The premature redemptions of the remaining debt reduce the IMF's income from interest, which accentuates the problem concerning the IMF's future income basis, cf. Box 12 .

Argentina 's government decided to use an increase in its foreign-exchange reserve to redeem the remainder of its IMF debt of SDR 6.9 billion (approximately 10 billion dollars). The increase in the foreign-exchange reserve is attributable to e.g. higher commodity prices and a competitive export sector, factors which have contributed to rising export revenue. The relationship between the IMF and Argentina has been strained and the Argentinean authorities have threatened to stop servicing Argentina 's debt to the IMF.

In Brazil an increasing foreign-exchange reserve has enabled premature redemption of its debt to the IMF after the expiry of the borrowing programme in March. The development in the foreign-exchange reserve is e.g. attributable to an increasing surplus on the current account of the balance of payments, as well as stability-oriented macroeconomic policy, which has contributed to restoring confidence in the economy. In July, Brazil paid off the fourth of its debt that accrued interest at the highest rate, while the remaining SDR 10.8 billion (approximately 16 billion dollars) was repaid in December. The last redemptions were scheduled for 2007.

With annual growth of approximately 5 per cent, the economic restoration of Turkey continued in 2005, but a current-account deficit of approximately 6 per cent of GDP entails that the external balance is still fragile. In May a new 3-year stand-by agreement for SDR 6.7 billion (approximately 10 billion dollars) was concluded. At the core of the new programme is continuation of the tight fiscal policy, as well as intentions to introduce a number of structural reforms, including a new banking act with strengthened supervision, further measures in preparation for privatisation, and increased flexibility in the labour market.

The oil price increases in recent years enabled premature redemption by Russia – one of the world's major oil exporters – of the remaining approximately SDR 2 billion (approximately 3 billion dollars) of its debt to the IMF in January 2005. The last instalment was not due until 2008. In addition, in the summer of 2005 Russia paid off 15 billion dollars of its debt to the Paris Club.

Iraq has concluded a stand-by agreement with the IMF
In December 2005, Iraq concluded a stand-by agreement with the IMF for SDR 475.4 million (approximately 685 million dollars). This agreement is to be viewed as a continuation of the post-conflict assistance that was adopted in September 2004 as a prerequisite for the implementation of phase two of the Paris Club agreement on debt relief to Iraq .^[11] Economic growth in Iraq in 2005 is estimated at approximately 2.5 per cent. As a result of the rise in oil prices, the budget deficit is lower than expected, and the foreign-exchange reserve has been increasing. In general, the Iraqi authorities have succeeded in promoting overall macroeconomic stability in the face of extremely difficult conditions. A number of the reforms agreed with the IMF have, however, been implemented at a slower rate than envisaged.

THE IMF' S MACROECONOMIC AND FINANCIAL SURVEILLANCE OF DENMARK

Traditionally, the IMF has focused on macroeconomic surveillance, but in recent years financial surveillance has been given higher priority in view of the financial crises in Asia in 1997-98. At the core of financial surveillance is the Financial Sector Assessment Program, FSAP^[12]. The Program is voluntary, but most IMF members, including Denmark , have announced that they would like an FSAP.

Normally, the IMF sends a mission to Denmark every other year, but during 2005 and 2006 the IMF is expected to visit Denmark seven times in all, since this time its surveillance also includes FSAP. An extensive FSAP mission in November 2005 included almost 100 meetings between the IMF and relevant Danish authorities, organisations and financial institutions to give the IMF an overview of the financial sector. The FSAP seeks to disclose strengths and weaknesses in the financial systems in order to assess financial stability. In this context Danmarks Nationalbank performs stress tests to show how macroeconomic shocks affect the financial systems.^[13] The Danish Financial Supervisory Authority and specific financial institutions also participate in the stress tests. The IMF furthermore reviews international standards in four areas. The Danish Financial Supervisory Authority holds the main responsibility for the standards relating to banking supervision, insurance, and anti-money laundering and combating the financing of terrorism, while Danmarks Nationalbank holds the main responsibility for the standard relating to payment and securities settlement systems.

The IMF conducts its FSAP up to an Article IV consultation, which is the key element of the IMF's surveillance of macroeconomic conditions in member countries. The next Article IV consultation in Denmark is expected to take place in June 2006, when the conclusions of the FSAP will also be discussed. The schedules for the FSAP and the Article IV consultation are outlined in Box 14 . The conclusions are expected to be published in autumn 2006.