Denmark's Wage Competitiveness

Erik Haller Pedersen and Johanne Dinesen Riishøj, Economics

INTRODUCTION AND SUMMARY

Analyses of the development in competitiveness often focus on growth in labour costs per hour or per output unit (unit labour costs) in Denmark relative to abroad. If this measure is applied, Denmark's competitiveness has deteriorated over a number of years since hourly wages have risen more rapidly, and productivity growth has been lower, in Denmark than in competitor countries.

The underlying assumption in this simple measure of wage competitiveness is that Denmark produces the same types of goods and services as its competitors using the same technology. Over a long period Danish business enterprises have, however, been good at specialising in products that sell at very high prices in the global market. One of the main reasons is that Denmark has succeeded in creating good economic fundamentals for these business enterprises.

The countries that have seen the strongest overall increase in productivity, and thus the most favourable development in competitiveness in a narrow sense, have also experienced the greatest downward pressure on sales prices. This reflects how productivity gains have extensively been passed on to consumers by way of lower prices. Danish consumers and business enterprises benefit from this development to the extent that imported finished and intermediate goods become less expensive. Consequently, Denmark's terms of trade have improved on an ongoing basis.

Income generation in an economy is the product of productivity and terms of trade. The combination of lower productivity growth in Denmark and a higher rate of wage increase than in many other countries has to a large degree been set off by high sales prices for Danish goods and services.

For the individual business enterprise and product, high productivity, and thus the ability to compete with foreign enterprises, is essential. Foreign productivity rates for products not manufactured in Denmark are less relevant.

This line of argumentation does not mean that wage development is of no significance. Naturally there are narrow limits to the price at which a product will sell and thereby how high the production costs can be if sales volumes and margins are to be maintained. The requirements for the competitiveness of Danish business enterprises in a broad sense have increased recently. The strength of the krone, expressed as the effective krone rate, is at a 25-year peak, and the gap between Danish and foreign wage growth has widened with the latest collective agreements. At the same time, the terms of trade have flattened out in the last couple of years. There is thus a considerable risk that Denmark may be overreaching itself with the current wage development.

DENMARK'S COMPETITIVENESS

Foreign trade is important to Denmark
Denmark's international competitiveness^[1] indicates the ability of Danish business enterprises to sell products and services in the domestic and export markets in competition with foreign enterprises. Competitiveness depends on factors such as the quality and innovative skills of the labour force, economic framework conditions, economic policy, etc. This article focuses narrowly on wage competitiveness, i.e. the relationship between Danish and foreign enterprises' costs, e.g. measured using the real effective exchange rates published by Danmarks Nationalbank. Wage competitiveness is key to the links between demand, employment and balance of payments. Denmark has become an increasingly open economy, cf. Table 1, and therefore wage competitiveness is important.

The share of output that is exported is highest for agricultural and manufactured products, while services are primarily sold in the domestic market. Some services, such as personal care and hairdressing, are difficult to export, but for a number of services the share exported has become considerable.

Development in the strength of the krone
The international strength of the krone can be derived from the effective exchange rate, which is a weighted measure of its strength vis-à-vis the currencies of 27 of Denmark's largest trading partners.

Due to Denmark's fixed-exchange-rate policy, the krone is stable against the euro. The euro area accounts for approximately half of Denmark's foreign trade. Since 2000 the krone has, however, strengthened vis-à-vis a number of non-euro currencies, and in early 2008 it was at its strongest level for more than 25 years, cf. Chart 1. Viewed in isolation, this means that Danish goods and services are more expensive in the export markets and that foreign goods and services are less expensive in the Danish market. At the same time profits margins are squeezed in the short term.

Wage developments in Denmark and in competitor countries
Since the mid-1990s, hourly wages in the manufacturing sector have almost constantly increased more rapidly in Denmark than in competitor countries, cf. Chart 2. In recent years, Danish wages have accelerated. With the rate of wage increase agreed in the most recent collective agreements, no significant narrowing of the gap is envisaged in the coming years.

The development in Denmark's wage competitiveness is indicated by the relationship between hourly wages abroad and in Denmark converted into the same currency using the effective exchange rate of the krone. This index of relative hourly wages has declined over the past many years, cf. Chart 3. Denmark has thus lost market shares and wage competitiveness. The correlation between the two is clear in the 1970s and 1980s, while both have shown a downward trend over the past 15 years.

The loss of market shares is attributable not only to the level of costs in Denmark, but also to the increasing integration of large medium-income countries such as China and India into the global economy in this period. Consequently, the "old" industrialised countries must make do with a smaller share of the export markets.

The development in productivity and unit labour costs
The development in wages and productivity in Denmark compared with abroad can be summarised as relative labour costs per unit stated in the same currency, i.e. relative unit labour costs, cf. Box 1. Measured in this way, the decline in competitiveness in recent years is more pronounced than when measured by relative hourly wages, cf. Chart 3. This is attributable to relatively weak productivity development in Denmark.^[2]

In relation to individual products productivity is important, but for society overall productivity is not necessarily equal to competitiveness. There are two reasons for this. Firstly, the product composition differs from country to country. Secondly, there is a negative correlation between productivity growth and sales prices, cf. below.   

Product composition
Productivity growth varies considerably from sector to sector, cf. Table 2, and is typically below average in sectors that primarily produce services. In contrast, an area such as electronics has seen productivity growth above the average for the economy overall. The same pattern is seen in all countries.

It is important to emphasise that the data (EU-KLEMS) is sometimes revised substantially from one release to the next and that uncertainty is particularly great at subsector level.

A large part of Denmark's output lies within sectors with low productivity growth (such as services), while the share of sectors with high productivity growth (e.g. electronics) is smaller. This means that overall productivity growth tends to be lower in Denmark than in countries with more focus on high-productivity-growth sectors. Achieving the same output with less input is a clear competitive advantage, provided that the goods or services produced are the same. However, it matters less how productive foreign enterprises are when it comes to products not manufactured in Denmark – such as mobile phones.

A standard calculation shows that if Denmark's output structure had been identical to that of Finland, average productivity growth in Denmark would have been 0.1 per cent p.a. higher in the period 1995-2005. Different sector structures can thus by no means explain the entire gap between productivity growth in Denmark and abroad.  

Productivity and the economic cycle
The development in productivity in a country depends on many factors. One of the reasons why productivity growth in Denmark has been lower than in other countries taken as one since the mid-1990s could be that strong growth in employment in Denmark, combined with a widespread shortage of labour in recent years, has brought people into work who, initially at any rate, have been less productive than the average employee. However, the euro area has also seen low productivity growth without equivalently strong growth in employment. As regards Sweden and Finland, where productivity growth has been particularly strong in the last decade, both countries recovered from a deep economic crisis in the mid-1990s. The starting point for output was therefore extraordinarily low.

Over time a global elimination race takes place, in which the business enterprises that can produce goods or services at the lowest cost will oust those with higher costs for the same product. A geographical production split will thus be seen as a consequence of globalisation^[3].

Productivity growth and more subdued price rises
High productivity growth is an advantage for a country if the remuneration of production factors, be it labour or capital, increases. This is by no means always the case, as the gain from higher productivity in a competitive market is to a large extent passed on to consumers by way of lower prices, thereby squeezing profit margins. In areas with lower overall productivity growth, downward pressure on sales prices is less pronounced, cf. Chart 4. The Chart shows the correlation for Denmark, but the same pattern is seen internationally.

Danish business enterprises have been good at specialising in products that sell at high prices in the global market. Good sales prices for Danish products and receding prices for goods and services imported into Denmark are reflected in improved terms of trade for Denmark over time, cf. Chart 5. In contrast, countries with extensive production of e.g. electronics have seen prices fall – to the benefit of Danish consumers and business enterprises.

The improved terms of trade over the last decade have boosted GDP in market terms by 0.7 per cent. Over the same period, annual productivity growth in Denmark has been 0.9 per cent below the average for a number of Denmark's major competitors. The improved terms of trade have thus more or less offset the weaker productivity development.

Prices, costs and corporate earnings
Corporate earnings are determined by the development in prices and costs. A downward trend in costs by way of lower unit labour costs does not automatically increase profits if this development goes hand in hand with lower sales prices.

Danish business enterprises have posted sound earnings in the last ten years without profit ratios being squeezed too much, cf. Chart 6. At the same time, employment has increased. Within their respective niche areas, Danish business enterprises have generally been successful, and Danish employees and business enterprises have gained from productivity growth abroad in terms of lower prices for a wide range of finished and intermediate goods. There is thus no direct equation between weaker productivity development and deteriorating competitiveness. Relative unit labour costs for the economy overall tend to overestimate the deterioration of Denmark's competitiveness. In addition to wage and productivity, other relevant factors to be taken into account when assessing overall competitiveness are employment, the government budget balance and the balance of payments.

IS DENMARK SUFFICIENTLY COMPETITIVE?

Often competitiveness and balance of payments are correlated. Denmark is competitive if the balance of payments is in equilibrium in a situation with full employment. The equilibrium of the balance of payments gives an indication of whether full employment is sustainable. The explanation why loss of Danish market shares has not exerted greater pressure on the current account of the balance of payments lies in factors such as high growth in Denmark's export markets, a strong increase in the value of North Sea oil and gas production and a considerable expansion of the merchant fleet. Particularly the latter two have improved the balance of payments with little input of domestic production resources.

Since the latest upswing began in 2003, the balance of payments has deteriorated substantially. The reason is that the balance of payments is affected not only by the development in competitiveness, but also by the relationship between demand in Denmark and abroad. Weak demand in Denmark and strong demand abroad is reflected in an improvement of the balance of payments. That was the case in connection with the dampening of the Danish economy in the wake of the fiscal-policy tightening in 1998 (the "Whitsun Package"). Conversely, the strong Danish economy since 2003, coupled with deteriorating wage competitiveness, has reduced the current-account surplus considerably, cf. Chart 7.

In addition to a balance of payments in equilibrium competitiveness requires sustainable fiscal policy in a situation with full employment. In other words, private-sector production must be sufficient to ensure full employment without any kind of "life support" via economic policy.

A single figure cannot provide an exhaustive description of competitiveness, since many factors play a role, each of which can worsen or improve wage competitiveness. The latter is, however, still an important indicator as there are limits to the price at which a product will sell. Furthermore, wage competitiveness affects the rate of manufacturing relocation to low-wage countries.

Recent developments have made it even more imperative for Danish business enterprises to remain competitive in a broad sense. The terms of trade have been flat for the last couple of years, but it is still too early to say whether this is a temporary or sustained development. Unchanged terms of trade and weak productivity growth combined with relatively high wage increases is a dangerous cocktail, particularly for a very open economy such as the Danish one.