The Corporate Sector and the Households

The prospects for the Danish corporate sector are good. Earnings are high, but the low unemployment rate makes it difficult for companies to attract the necessary labour. The estimated failure rates are generally unchanged, but 1-2 years ahead the most vulnerable companies may experience increasing difficulties compared with prospects in the preceding year.

The credit institutions' expected losses on exposures to the corporate sector have increased, but remain low.

The households' real disposable incomes have risen considerably, partly because more people are in employment. The number of enforced sales is historically low. The households' exposure to changes in interest rates has diminished against the background of a slight increase in the proportion of fixed-rate loans and a higher ratio of capped adjustable-rate loans.

The development in housing prices has dampened, but no major price falls are expected for as long as the economy remains strong.

THE SIGNIFICANCE OF THE CORPORATE SECTOR AND THE HOUSEHOLDS TO FINANCIAL STABILITY

Extending credit to the corporate sector and the households is one of the primary functions of the banking institutions. In doing so, the banking institutions incur a credit risk. The finances of the corporate sector and the households and their robustness to adverse developments affect the banking institutions' earnings and capital structure, and thereby financial stability.

CORPORATE SECTOR

The Danish economy is booming. Growth in demand has outpaced production, so that imports have risen substantially. This has reduced the current-account surplus, which nonetheless remains sound. Employment is record high, and unemployment has dropped to the lowest level for more than 30 years. Despite the tightness of the labour market in recent years, wage and price increases have so far been moderate.

Since the autumn of 2006, the growth in lending to the corporate sector by banking institutions and mortgage-credit institutes has been rising. This matches the general tendency for corporate lending to increase fairly late in an economic upswing.

Corporate earnings have been good, but the low rate of unemployment makes it difficult for companies to attract the necessary labour. Combined with the high level of wages in Denmark, this has led to substantial investment by the corporate sector, particularly in machinery and software.

The pressure on capacity is strongest in the building sector, where there is a pronounced shortage of labour, and many companies have to decline new orders. In addition, the prices of certain types of building materials have risen considerably more than prices in general.

The sustained upswing has reduced the number of compulsory liquidations among Danish companies, cf. Chart 18. Recently, however, there has been a slightly rising tendency for companies to fail.

The prospects for the corporate sector are good. The growth in domestic demand is expected to remain high, albeit slightly lower than in the last few years, and forecasts still point to robust growth in the largest Danish export markets. The positive outlook for Danish companies is supported by the confidence indicators, which remain high for all sectors.

Sustained growth in Danish companies
Danmarks Nationalbank has developed a model to estimate the probability that a company fails within 1-2 years.^[1] As a new element, the model now includes two macrovariables, cf. the chapter on the failure-rate model, KIM. The macrovariables capture the impact of cyclical factors on the estimated failure rate. The results in the model with macrovariables deviate from the results in Financial stability 2006.

Chart 19 shows the distribution of the estimated failure rates for Danish companies since 1995. The estimated failure rate for the median company was unchanged in 2006 compared with the preceding years, but the weakest companies, measured by the 90th percentile, may experience increasing difficulties. One reason is that in an upswing many new companies are established, and viewed in isolation new companies are more likely to fail than established companies.

The pattern is more or less the same for all sectors, cf. Chart 20. The IT and telecom sector still shows the largest spread between strong and weak companies, and the situation of the weakest companies has deteriorated marginally from 2005. Building, a sector which is particularly exposed to cyclical fluctuations, has seen the highest increase in the return on assets since 2004, combined with a reduced solvency ratio.

The stable development in the estimated failure rate of the median company in the various sectors is e.g. attributable to the favourable economy, which is reflected in continuing sound key ratios.

Major sectoral differences in expected losses
In order to assess the significance of an individual sector to financial stability, it is necessary to relate the estimated failure rate to the size of the total debt in the relevant sector. The debt comprises loans from banking institutions and mortgage-credit institutes. Business service accounts for the largest share of the total debt, cf. Chart 21, and this share has risen from 41 per cent in 2004 to 44 per cent in 2006. Manufacturing and trade, etc. also account for large proportions of the total debt.

Losses on loans to various sectors are dependent on the distribution of lending to sound and less sound companies. If the debt of the individual company is weighted by the company's estimated failure rate, a measure of the expected loss on the company is achieved. It is taken into account that, depending on the type of debt, a creditor will seldom lose the full amount of the loan.

The calculated expected loss ratio has increased from just over 0.3 per cent in 2004 to almost 0.5 per cent in 2006. The part of the expected loss that is attributable to business service in particular is substantially lower than the sector's share of the total debt, cf. Chart 22. On the other hand, the expected loss in the IT and telecom and building sectors as a share of the total expected loss is twice as high as these sectors' debt ratios. For companies whose sector is unknown, the expected loss ratio is around 11 times higher than the debt ratio. The reason is that two thirds of the companies in this group are newly established companies that in isolated terms are more likely to fail.

The banking institutions' expected losses on corporate exposures have increased
The banking institutions' expected losses on corporate exposures can also be simulated on the basis of information from Danmarks Nationalbank's failure-rate model, KIM^[2]. Chart 23 shows the simulated distribution of the banking sector's expected losses on corporate exposures. The expected loss, given as the average, has increased from 2004 to 2006. On the other hand, the uncertainty of the expected loss, measured as the difference between the 95th percentile in the distribution and the average loss, is more or less constant. The expected loss on the banking institutions' corporate exposures in 2006 has been estimated at around 0.7 per cent of total lending to the corporate sector by the banking institutions, while the actual loss was around 0.3 per cent in 2005. Losses in this range are very low compared to losses in the early 1990s.

PROPERTY COMPANIES IN DENMARK	Box 1
In view of the activity in the Danish housing market in recent years, the debt of the property companies has increased. This Box is based partly on active Danish public and private limited liability companies grouped by Experian under " development and selling of real estate" and " buying and selling of own or leased real estate" , and partly on " Danske Ejendomsprojektudbyderes Brancheforening" . The average age of companies in this sector has dropped from around 10 years in 1995 to just under six years in 2006. In 2006, one third of the companies were less than two years old. The return on assets varies greatly among the property companies. The median company has seen a small decline over the last three years, to just over 2 per cent in 2006. The return on equity has, however, doubled since 2003, to around 20 per cent in 2006. The solvency ratio, i.e. the companies' ability to sustain losses, has declined since 2002. For the median company, it was almost 17 per cent in 2006. The weakest companies, measured by the 10th percentile, had a solvency ratio of around 0. The property companies are dependent on external financing. Short-term debt as a ratio of total assets has risen slightly to around 40 per cent for the median company in 2006. For the weakest companies, short-term debt is approaching 100 per cent of the total assets. The property companies' aggregate debt to the credit institutions was kr. 12.4 billion in 2006, so that it has more than doubled since 2002. This should be compared to the total lending by credit institutions to non-monetary financial institutions of just over kr. 1,000 billion at end-2006. The property companies' total debt to credit institutions as a ratio of their total assets provides a measure of their gearing, which has increased from 29 per cent in 2002 to 44 per cent in 2006, cf. the Chart below. Almost 10 per cent of the property companies had negative equity capital in 2006. In terms of total assets, these property companies account for a very small proportion.
GEARING OF THE PROPERTY COMPANIES, 2002-06
Source: Experian A/S and own calculations.

HOUSEHOLDS

The finances of the households have improved in recent years. Disposable real incomes have increased considerably because more people are in employment and real wages have risen. The easing of direct and indirect taxation has also contributed. Wealth has increased quickly in step with the recent surge in housing prices. The households' strong financial position is emphasised by a very low level of enforced sales. The number has dropped to less than 100 per month, which is the lowest level in the almost 30 years that this data has been compiled, cf. Chart 24.

The households' higher real disposable incomes have contributed to a substantial expansion of private consumption since 2003. Since the mid-1990s, private consumption has not increased much faster than incomes, however, and the large capital gains have thus only been converted to consumption on a limited scale. Housing investments, on the other hand, have increased considerably in the same period.

According to preliminary national accounts data, consumption growth declined little in 2006 compared with 2005, but the growth is not expected to fade away. Interest rates have risen since 2005, particularly at the short end of the yield curve, and the housing market has slowed down in recent quarters, after strong price rises in preceding years. This may curb growth in private consumption, and especially in housing construction. High job security and the prospect of further growth in real incomes create the right conditions for a sustained expansion of consumption, however. The households' sound finances are reflected in ever-increasing indebtedness.

The chapter on macro stress testing of Danish households includes an analysis of the exposure of the households to higher interest rates and increasing unemployment.

More widespread use of fixed-rate loans and capped loans
At end-2006, the households' borrowing from banking institutions and mortgage-credit institutes had increased by around 12 per cent in relation to end-2005, cf. Chart 25. The repeated tightening of monetary policy has pushed up short-term interest rates. Long-term yields have risen rather less, so that the yield curve is almost flat. This has considerably reduced the immediate financial advantages of adjustable-rate loans. Consequently, the ratio of fixed-rate loans to the households' total outstanding loans has increased slightly over the past six months, after falling for a number of years. At the same time, data from the Association of Danish Mortgage Banks shows that a growing proportion of adjustable-rate loans are capped. This reduces the households' exposure to rising interest rates.

Deferred-amortisation loans are becoming ever more popular. While these loans accounted for 30 per cent of the total outstanding volume of mortgage-credit loans to households in 2005, the figure had risen to 37 per cent in 2006. Around two thirds of the deferred-amortisation loans are at adjustable interest rates. However, fixed-rate loans account for a considerable share of the growth in deferred-amortisation loans.

Dampened price development in the housing market
Prices in the housing market have dampened during the past year, following a period of very high growth in cash prices. Price increases were modest in the 1st quarter of 2007, and the number of homes put up for sale continued to rise substantially, cf. Chart 26. In the City of Copenhagen, the prices of single-family and terraced houses were by and large unchanged during the 1st quarter of 2007, while prices of owner-occupied flats fell.

Even though the mood in the housing market has changed, there is no reason to expect a general price dive for as long as the economy remains strong. At the regional level, some downward price adjustment cannot be ruled out, however.

The slowdown in the housing market is attributable to such factors as a higher level of interest rates, primarily at the short end of the maturity range. Particularly in the Greater Copenhagen area, there also seems to have been a shift in expectations of future housing prices. In recent years a rapidly rising market has been buoyed up by expectations of further price increases in the future.

In general, the households have only mortgaged a small proportion of the capital gains on owner-occupied homes achieved in recent years. This means that the households have substantial buffers against falling prices. For the households that bought their homes when prices peaked, any price drops will naturally be less welcome, but are hardly likely to entail major losses for the banks or to jeopardise financial stability.