The Danish Economy 2007-09

INTRODUCTION AND SUMMARY

This article reviews Danmarks Nationalbank's forecast for the Danish economy in the years 2007-09. The forecast has been made using the macroeconometric model Mona^[1] and is based on available economic statistics, including Statistics Denmark's quarterly national accounts for the 2nd quarter of 2007^[2].

The Danish economy continues to be in a strong cyclical position, with GDP constraints coming from the supply side. GDP growth is expected to be 1.9 per cent in 2007, 2.1 per cent in 2008 and 1.3 per cent in 2009, cf. Table 1. As shown in Chart 1, these growth rates are clearly lower than in recent years. The Danish economy came out relatively strongly from the recession in 2001-03 and has since then been on a cyclical course ahead of the euro area, but slightly behind the US economy. As a result of the sustained upswing in the euro area, its growth is expected to exceed that of Denmark in 2007 and 2008.

Since 2005, private-sector employment has increased strongly and unemployment has fallen to the lowest level for more than 30 years. The strong production capacity pressures across the economy, and the highest labour shortage for decades, have brought the Danish economy to its capacity limit. This is reflected in the fact that demand growth is primarily accommodated by increased imports, but also in the high level of investment to expand the capital stock. The effects are now seen, with a more pronounced lag, in wage and price developments too. The latest collective agreements will entail higher rates of wage increase than in the previous collective agreement period, and there are widespread expectations of considerable wage increases among public-sector employees. The development in wages contributes to domestic inflationary pressures, but inflation has remained at a modest level of below 2 per cent due to falling energy prices and moderate increases in administered prices, among other factors.

The strong growth in demand in recent years is expected to continue in the coming quarters. Growth in domestic demand is receding, but not coming to a halt. The dampening can be attributed to e.g. private consumption, against the background of the interest-rate increases observed in the last two years. The higher interest rates have weakened the housing market, where turnover has declined and recent years' strong price increases have ceased. The outlook is favourable for many of Denmark's major export markets, and sound export growth is expected despite weaker competitiveness.

As a consequence of the labour shortage, growth in GDP will not match growth in demand. Capacity pressures will remain high in the near future, and there is still a risk of marked adverse effects on the Danish economy in the form of high wage increases and loss of competitiveness, in spite of the interest-rate increases, cf. Box 1.

The assumptions behind the forecast are described below, followed by a more detailed review of the forecast.

ASSUMPTIONS IN THE PROJECTION

This projection is based on a number of assumptions concerning the international economy, the financial conditions and fiscal policy, cf. Table 2.

The international economy
Global economic growth is strong. In the USA, the pace has slowed down, while the upswing is continuing in Europe, Asia and other regions. In the calculations, the turmoil in the financial markets, cf. the article on pp. 37ff, is assumed to have only a limited impact on demand. The global upswing, which really took off during 2004, thus appears to be the strongest upswing since the early 1970s. The high export-market growth in the projection can be attributed to the favourable outlook for Denmark's export markets.

Price increases in the export market will gain momentum from 2007 to 2009, but will remain moderate. Foreign prices are expected to follow the same pattern, rising by 1.9 per cent in 2009. In the light of the positive cyclical position of the euro area, among others, the projection operates with gradually rising foreign wage increases, albeit from a low level.

Interest rates, exchange rates and oil prices
In the forecast, the development in short-term and long-term interest rates is based on the expectations that can be derived from the yield curves in the financial markets.

In the projection the short-term interest rate is assumed to be 4.1 per cent in 2008 and 2009. The long-term interest rate is assumed to remain virtually unchanged at 4.75 per cent. Estimating market expectations is, however, subject to heightened uncertainty in view of the turmoil in the financial markets.

Since the beginning of 2006, the krone has strengthened in nominal effective terms, primarily reflecting the dollar's weakening vis-à-vis the euro. In the projection, the effective krone rate and dollar rate are unchanged from the level on 10 September.

Global growth has entailed growing demand for commodities, and oil prices peaked in mid-July at almost 80 dollars per barrel (Brent). In the projection, oil prices follow futures prices, which weaken somewhat from around 75 dollars per barrel at the beginning of the forecast period.

Fiscal assumptions
The fiscal assumptions of the projection are based on the Finance Bill 2008 and the most recent tax agreement concluded between the Danish government and the Danish People's Party. Real growth in public consumption is projected to be 2.0 per cent in 2008, which is slightly higher than according to the Finance Bill. This reflects the normal tendency to exceed the target set in the Finance Bill, cf. p. 21, and should be viewed in the light of the strong pressure on public service expenditure in Denmark. Public investments are expected to grow by 8.6 per cent in 2008, which means that fiscal policy will act as a considerable economic stimulus next year. Only a slight increase in public-sector employment is envisaged in the projection.

FORECAST FOR THE DANISH ECONOMY 2007-09

Output and employment
According to the available national accounts data, GDP growth has slowed down over the last year, and average annual GDP growth in the forecast period is expected to be lower than in 2005 and 2006. The principal explanation for the dampening is that output cannot keep up with demand due to labour shortages and to the already high utilisation of the capital stock. Continuous pressures on the capital stock and the labour market are expected throughout the forecast period, as reflected in the sustained wide output gap, cf. p. 17.

The demographic development contributes to the strong pressure on the labour market in the projection. The number of persons in the age group with the highest participation rate, i.e. 20-59 years, is declining by approximately 18,000 annually, and thus reducing the supply of labour. Despite the demographic development, the labour force is assumed to be almost unchanged in the forecast period, cf. Table 3. This reflects the expectation that the favourable employment opportunities will attract more Danes to the labour market, and that Danish business enterprises will continue to employ more foreigners, including commuters from neighbouring countries. In recent years, Danish business enterprises and organisations have gained more experience with recruiting from abroad and have expanded their recruiting channels. This can make it easier to attract labour from abroad in the future. However, unemployment has also declined in many of Denmark's neighbouring countries, which entails intensified competition for labour. Danish business enterprises need to be competitive in this regard if the high level of employment and the labour force are to be sustained.

Unemployment in Denmark has decreased considerably since 2003, to a very low level. The forecast operates with continued strong demand for labour and a declining unemployment rate until mid-2008. The pressure on the labour market will then begin to ease, and unemployment will increase somewhat as economic growth slows down.

In view of the low unemployment rate and stagnating labour force, productivity will be the determining factor for economic growth in the near future. Over the last year, the development in productivity has been weak in the light of the strong growth in employment. In the forecast employment grows only moderately from 2007 to 2008 since it is difficult to attract new employees due to the low unemployment rate and stagnating labour force. Business enterprises are expected to respond to the tight labour market by continuing to invest in new production equipment and by restructuring production to enhance the efficiency of labour input. This will stimulate productivity growth, which will increase to a level close to the average of the last 15 years, cf. Table 4.

Wages and prices
Wage increases have gained momentum since 2005 as unemployment has decreased. The rate of wage increase is expected to accelerate further in the coming quarters against the backdrop of the notably higher wage adjustments agreed in this year's annual local wage negotiations in industry. In the forecast unemployment continues to be low and annual growth in hourly wages in industry is expected to be 4.5-5 per cent, cf. Table 4.

In the projection, wage increases remain higher than abroad. As mentioned above, the favourable cyclical conditions in e.g. the euro area are expected to lead to higher foreign wage increases, resulting in a slight narrowing of the spread to Danish wage increases in 2009. However, the development implies further deterioration of wage competitiveness in the coming years.

Several of the new collective agreements include a " free choice wage account" that allows the wage-earner to use saved funds for extra days off, pension, wages or continuing training. The option of more days off is expected to lead to a minor decrease in working hours per employee in 2008. Looking ahead, hourly wage costs in the non-agricultural sector are expected to follow the same pattern as hourly wages.

Unit labour costs increase in the forecast as the expected growth in hourly productivity of just under 2 per cent in 2008 and 2009 is lower than the growth in hourly wage costs. Should productivity growth fail to recover as expected, there is a risk of significant growth in unit labour costs, which will result in upward price pressures and loss of competitiveness.

A higher wage share (measured as payroll in relation to gross value added in the non-agricultural sector) is expected since higher payroll costs are not fully offset by price increases for manufactured goods in 2007. The wage share is almost constant for the rest of the forecast period.

Annual consumer price inflation was just under 2 per cent at the beginning of 2007, but has decreased to around 1 per cent in recent months. Domestic market-determined inflation, IMI, has been on an upward course since the end of 2004, because capacity pressures have, among other things, led to higher production costs, including payroll costs. Rising sales prices in manufacturing industry, together with the recent strong growth in wholesale prices for Danish goods, also point to an upward price pressure. In the projection, the higher wage increases are reflected in higher price increases over time, cf. Table 5.

In the next few months, annual energy price inflation is expected to increase, especially since the calculation no longer includes the high energy prices in August 2006. A minor increase in energy prices is expected in 2008 due to higher oil prices, cf. Table 2. Food price inflation is expected to increase in the near future against the backdrop of higher world market prices for e.g. grain and milk. The intensified domestic price pressure and rising energy and food prices are expected to bring HICP inflation to just over 1.5 per cent towards the end of 2007.

In 2008, IMI is expected to rise further to 2.7 per cent. The index of net retail prices is expected to increase by 2.5 per cent, while annual consumer price inflation is expected to be slightly lower. This is because specific taxes are assumed to be unchanged, with the exception of the agreed indexation of energy taxes. Inflation is expected to rise to 2.4 per cent in 2008 and 2009.

Domestic demand
Private consumption increased by 0.2 per cent in the 2nd quarter of 2007 after an increase by almost 1 per cent in the 1st quarter. Consumption growth for the 1st half of 2007 is 1.3 per cent compared to the 2nd half of 2006. Since 2005, consumption growth has been slower than growth in private-sector disposable income, resulting in a lower consumption ratio, cf. Table 6. The background is the increase in interest rates over the last two years, primarily at the short end of the spectrum. The higher interest rates have also contributed to a slowdown in the housing market. However, consumption growth is not likely to come to a halt, in view of the sound financial position of the households characterised by robust growth in income and strong wealth. This picture is supported by the high level of consumer confidence, despite the drop in August. Consumption growth is expected to exceed 2 per cent in 2007 and 2008, corresponding to a small decrease in the consumption ratio.

The housing market has slowed down since the autumn of 2006. Quick turnover and surging prices have been replaced by more difficult sales conditions and almost stagnating prices. Generally, prices have dropped in the segments where the price per square metre had reached the highest levels. The segments of the housing market which had previously seen more moderate development experienced modest price increases. In the forecast, housing prices are expected to stay close to the current level in nominal terms.

Recent years have seen strong growth in residential investments. The high housing prices and sound household finances have increased demand for new homes and improvement of existing homes – to such an extent that construction companies have been unable to meet the demand. Residential investments are expected to stay at the high level in the next few quarters. In 2008 and 2009, residential investments are expected to recede a little as many building projects are completed and house prices decline in real terms.

Business investments fell by 4.8 per cent in the 2nd quarter of 2007, following an increase of the same magnitude in the 1st quarter. In the 1st half of 2007, business investments were 3.8 per cent higher than in the 2nd half of 2006, i.e. the strong development seen in the last three years continued. Investments in plant and equipment in the non-agricultural private sector have reached a very high level, resulting in a considerable expansion of the capital stock in relation to output. The background for this is robust output growth, and at the same time many business enterprises are finding it difficult to recruit sufficient labour. As this pressure is not about to cease, business investments are expected to remain high in the coming quarters. During 2008 and 2009, the investment ratio is expected to be reduced from its current high level. Non-residential construction rose during 2006 from a low level and is forecast to increase a little further. This more or less offsets the expected dampening of residential investments and thus contributes to maintaining the strong pressure on the construction sector.

Domestic demand, excluding inventory investments, fell by 0.6 per cent in the 2nd quarter of 2007 after strong growth in the two preceding quarters. The positive contributions from private consumption and residential investments were more than offset by the decrease in business investments. For the 1st half of 2007 as a whole, growth in demand was 1.3 per cent up on the 2nd half of 2006. Growth in demand is expected to remain high in the next few quarters, i.e. 2.5-3 per cent year-on-year, but will decline to just over 2 per cent in 2008 and below 1 per cent in 2009, due to the gradual slowdown in consumption growth and a declining level of investment.

Foreign trade and the balance of payments
The strong growth in demand and the capacity pressures in the Danish economy have resulted in a pronounced increase in imports. Especially imports of services rose steeply in 2005 and 2006, in step with exports of services, which have a considerable element of foreign services. Growth in imports of goods was also high, primarily for goods for direct consumption and goods for use in the non-agricultural private sector. The growth in business imports should be viewed in the light of the strong increase in investments and domestic industrial production.

In the 1st half of 2007, total imports were 1.4 per cent higher than the level observed in the 2nd half of 2006. This development masks a robust increase in imports of goods and a small decline in imports of services. For 2007 as a whole, import growth is estimated at 5 per cent, compared to more than 14 per cent in 2006, cf. Table 7. In the following years, import growth will decrease further as growth in demand slows down. Nevertheless, import growth is expected to remain high in 2008, reflecting the capacity pressure, which contributes to the sustained high growth in imports of goods, and the standardised import ratio increases throughout the forecast period.

Exports of goods and services have risen strongly during the recovery, albeit less than imports. Growth in sea-freight exports has been particularly high, against the background of the expansion of the merchant fleet in 2005. Exports of services declined in the 1st half of 2007, compared to the 2nd half of 2006, and are expected to follow a more moderate pattern in the near future. In the 1st half of 2007, total exports rose by 0.7 per cent, i.e. a somewhat lower growth rate than in the two preceding years. In the forecast annual growth in exports will be in the range of 4-5 per cent.

Industrial exports have risen considerably since the beginning of 2005, driven by strong growth in the export markets. Growth in exports of manufactured goods is expected to be approximately 9 per cent in 2007, and subsequently to diminish. The dampening of growth in industrial exports reflects weakened wage competitiveness, high capacity utilisation and labour shortages, while the strong growth in export markets declines only marginally. Import growth in Denmark's export markets is stronger than Denmark's export growth, entailing loss of market shares for the manufacturing sector.

The forecast operates with declining energy exports, driven by reduced oil and gas production, although energy exports are still expected to be somewhat higher than energy imports. Annual growth in agricultural exports is expected to be a few per cent, supported by strong global demand for food.

Since 2006, price increases on the export side have been lower than those on the import side, resulting in deterioration of the terms of trade. The forecast operates with a modest improvement in the terms of trade.

The balance of payments has deteriorated rapidly since the beginning of 2006, from a high level supported by considerable income from energy and sea freight. The balance of payments thus still shows a surplus. The forecast operates with sound surpluses, particularly on trade in services and investment income, while a small deficit on trade in goods is estimated for 2007 and 2008. Bunker expenses, i.e. payment for ships' purchases of fuel abroad, have increased in step with the expansion of the merchant fleet, and the forecast maintains annual bunker expenses at around kr. 30 billion. For 2007 and 2008 the forecast assumes a current-account surplus of approximately kr. 25 billion, cf. Table 8. It is expected to increase to kr. 40 billion in 2009, when growth in domestic demand is lower than for Denmark's trading partners taken as one.