Recent Monetary Trends

In view of the first signs of higher growth in Germany and France the overall cyclical position of the EU member states now appears to be more favourable, and economic and financial convergence has continued. Convergence of interest and exchange rates accelerated particularly after it was decided during the weekend of May 1-3, 1998 that 11 countries will enter the third stage of EMU on January 1, 1999.

The Danish krone has tended to weaken and was subject to increasing pressure up to the beginning of May when the Nationalbank reacted by raising the official interest rates by ½ per cent. After this unexpected raising of interest rates foreign-exchange conditions stabilized.

The Danish economy continues to grow more strongly than those of Denmark's trading partners. Domestic consumption indicators rose further at the beginning of 1998, capacity utilization reached the level of the upswing in the 1980s and the balance of payments deteriorated strongly. It is thus necessary to maintain a tight fiscal policy in order to keep down domestic demand.

International background

Overall the dollar weakened by approximately 3 per cent against the D-mark and strengthened by almost 6 per cent vis-ā-vis the Japanese yen. Having appreciated strongly against the D-mark in 1996 and 1997, the dollar is nonetheless still relatively strong, viewed over a five-year period. Up to the end of March the pound sterling strengthened by almost 4 per cent against the D-mark, but weakened again in April and May by more than 7 per cent.

To a degree the effects of the crisis in Asia and the dollar's appreciation in 1997 have dampened the otherwise very strong expansion in the US economy. The level of activity continues to be strong, with annual GDP growth of almost 4 per cent, driven primarily by investments and private consumption. Unemployment is at its lowest level for more than 20 years and there are signs of pressure on wages. Inflation is still low, kept down partly by declining prices for raw materials, particularly oil, but also some metals in the wake of the crisis in Asia.

In Japan prospects are bleak and many observers fear a new recession. Japan has faced major economic problems since 1992. In 1996 the Japanese economy rallied strongly for the first time in several years, with a growth rate of approximately 4 per cent. However, in 1997 growth was held back first by a tightening of fiscal policy and then by the crisis in Southeast Asia. These factors have by and large brought the economy to a halt. Both private consumption and the business sector's earnings and investments have receded. Consumer confidence is very low and imports are declining. The IMF and the OECD have reduced their forecasts of growth in Japan for 1998 to around zero. Low consumption and the very high propensity to save are among the major problems faced by the Japanese economy. The strong depreciation of real and financial assets has considerably reduced net worth. High savings are a means of re-establishing private wealth in Japan where the problems related to a shift in the age composition of the population, with elderly people in the labour force, are particularly strong. In the government's most recent package of assistance measures a supplementary scheme for around kr. 800 billion (approximately 3 per cent of GDP) provides for an increase in primarily public consumption, although the package also includes tax reductions. However, the low level of consumer confidence makes it likely that tax reductions will lead to higher savings rather than consumption. As a result the intended expansionary effect will not be achieved. With a discount rate of 0.5 per cent there is hardly any scope for further relaxation of monetary policy, and the long-term interest rate is likewise at a record low of less than 2 per cent. However, during the last six months the short-term market interest rates have been 20-100 basis points above the official rates as a consequence of a "Japan premium" (equivalent to the differential between the prices paid by Japanese and international banks for loans in Japan). The risk premium should be viewed in the light of the problems faced by the Japanese financial sector, whose credit ranking continues to decline. The traditional economic-policy instruments now provide little scope in Japan's situation. Structural-policy reforms and a restructuring of the financial sector are important and necessary means to bring Japan out of the crisis.

In the last few years a number of European countries have experienced sound economic growth and declining unemployment. In particular these are Norway, Denmark, the Netherlands, the UK, Ireland and recently also Finland and Spain.

On the other hand, the large continental European countries, Germany and to a certain degree France, have seen low growth and, until recently, rising unemployment. Growth in these two countries is sustained by exports and to some extent also stockbuilding. This contributes to segregation of the business community into enterprises which manufacture for export and enterprises which sell their products on the domestic market. Exporting enterprises enjoy a large new-order intake and a high level of investment, while prospects for domestic-market oriented enterprises are less favourable. However, indicators of consumer confidence and business enterprises' expectations do show that the tide is turning. In France private consumption and investments have risen strongly in the most recent quarters. Unemployment is a major problem faced by both countries. In Germany the unemployment level is as high as 11.4 per cent of the workforce. Unemployment in western Germany is approximately 9.5 per cent and falling, but in eastern Germany it exceeds 19 per cent and is still rising. There have recently been weak signs of improvement since during the last 4 months the number of unemployed in Germany overall has fallen. In France, a 35-hour working week will be introduced during the next few years, but there is considerable uncertainty regarding the consequences for cost levels. This may lead business enterprises to adopt a wait-and-see attitude. For example, it has not yet been clarified what the level of wage compensation will be, nor has the future structure of overtime pay been determined.

Currently both German and French inflation are at the lowest levels for 10 years. In March the annual rate of increase in consumer prices in Germany was as low as 1.1 per cent, which should be viewed mainly against the background of high German unemployment and the drop in oil prices. In April German inflation rose again to 1.4 per cent. This can be attributed to a raising of the standard VAT rate from 15 to 16 per cent with effect from April 1, 1998. A greater increase in inflation was expected because this VAT rate applies to approximately 60 per cent of consumer expenditure. This indicates that in the first instance the VAT increase was only partly reflected in prices. It is expected to take some time for it to be fully passed on.

The convergence situaton in the EU member states

Within the ERM two exchange-rate realignments took place during the last quarter. Firstly, the Greek drachma joined the ERM on March 16, 1998 at a central rate of GDR 4,733 per kr. 100. As for the other participants the fluctuation band is +/- 15 per cent. On the same occasion the market price for the drachma depreciated by approximately 10 per cent against the krone. Greece's ERM entry should be viewed against the background of its wish to participate in the third stage of EMU in 2001. Like Denmark, Greece will participate in ERM2.

Secondly, on the same day the central rate for the Irish pound was revalued by 3 per cent against the other ERM currencies, to IEP 10.56 per kr. 100. This did not change the market rate for the Irish pound, which has since been relatively close to the ERM central rate. Ireland's revaluation emphasizes the convergence of all ERM currencies towards their central rates. The more volatile ERM currencies are now also very close to the central rate, cf. Chart 1.

Short-term interest rates have also continued to converge in 1998 when the southern-European countries gradually lowered their official interest rates. The level of short-term interest rates in southern Europe is now approximately 1-2 per cent higher than in the core countries. The convergence of long-term interest rates is even more pronounced and in mid-May the differential between 10-year government-bond yields in Italy and Germany was less than 25 basis points.

On May 2, 1998 the Council (Heads of State and of Government) resolved that 11 countries will participate in the third stage of monetary union, i.e. all EU member states except Denmark, the UK, Sweden and

Greece. The decision was based on two convergence reports on each member state's fulfilment of the convergence criteria and other conditions for the introduction of the single currency. The reports were prepared and published by respectively the European Monetary Institute (EMI) and the European Commission. Both reports were published at the end of March. On the publication of these two reports a broadbased EMU with 11 participating countries already began to emerge. The Commission's report draws the clear conclusion that 11 countries fulfil all of the convergence criteria and have therefore achieved a high level of sustained convergence. With regard to Sweden it is stated that the country does not meet the criteria as a consequence of its non-participation in ERM and that Sweden has made inadequate progress in fulfilling its legal obligations. Greece does not meet any of the four convergence criteria, while Denmark and the UK are not included in the Commission's evaluation due to their Treaty-bound right to remain outside. In contrast to the Commission's report the EMI report solely presents an evaluation of the individual countries' convergence situation and does not conclude with any direct recommendations. The report focuses more on the high debt ratios in Belgium and Italy and the difficulties in reducing the debt ratio within an appropriate period in view of the current budget deficits.

Exchange-rate and interest-rate development in Denmark

With effect from May 6, 1998 the Nationalbank raised the discount rate and the current-account interest rate by ½ per cent to 4 per cent. Interest rates for certificates of deposit and repurchase agreements were likewise raised by ½ per cent to 4.25 per cent.

The background to this unilateral Danish raising of interest rates was the development in the krone rate against the D-mark and the Nationalbank's sale of foreign currency to support the krone. Since the beginning of 1998 the krone had weakened gradually against the D-mark and was approaching its central rate, cf. Chart 2. During the same period the Nationalbank supported the krone by selling foreign currency against kroner in order to ensure a stable course. Net sales of foreign currency totalled approximately kr. 25 billion in the period from February to mid-May 1998. Most sales took place in April and the beginning of May, cf. Chart 2. The krone's tendency to weaken was thus amplified considerably during April and the beginning of May. Several factors may have contributed to this, including uncertainty regarding the outcome of the referendum on the Amsterdam Treaty, the collective wage negotiations and ultimately the strike. A further

contributing factor may have been some uncertainty concerning when and how the necessary fiscal-policy tightening will take place.

In connection with the raising of interest rates the short-term moneymarket rates rose immediately by an equivalent approximately ½ per cent, which indicates that the raising of interest rates came as a surprise to the market, cf. Chart 3¹⁾. Already at the beginning of April the long-term money-market rates began to rise moderately, a trend which could also be observed in the other core countries. The immediate reaction of the longterm money-market interest rates was also somewhat less pronounced than for the very short-term rates. The raising of interest rates did not have any noteworthy impact on the long-term bond yields. On the days after interest rates were raised there was some transitory uncertainty in the market and the money-market interest rates rose further, cf. Chart 3. The conditions normalized in the course of a few days, however. The Nationalbank bought currency in the market and the krone strengthened against the D-mark to approximately kr. 380.90 per D-mark in mid-May.

From February up to the beginning of May the short-term interest-rate differential to Germany stabilized at around 30 basis points. When interest rates were raised the short-term interest-rate differential widened to 80-100 basis points, while the long-term yield differential is close to 30 basis points.

As from the beginning of February to the end of April the yield on the benchmark 10-year government bond fell by almost ½ per cent to just over 5 per cent. The interest rate thereby receded to a historically low level. With the drop in interest rates the interest-rate differential to Germany and the other core countries also narrowed to 20 basis points, which is the lowest differential ever. The yield on government bonds rose again slightly at the beginning of May and in mid-month was close to 5.30 per cent, while the yield differential to Germany was 30 basis points. So far, the yield differential to Germany has tended to narrow during periods of falling interest rates, and when interest-rate levels have been low the differential has also been low²⁾. Therefore the long-term yield differential between the krone and the euro must also be expected to vary in the future.

In 1998 the yield on the benchmark mortgage-credit bond with a coupon rate of 6 per cent, maturing in 2026, has fallen by less the 10-year government-bond yield, cf. Chart 4. The widening of the differential between mortgage-credit and government bonds applies in particular to mortgagecredit bonds with a high coupon rate. For example, the yield on a 9-per-cent mortgage-credit bond maturing in 2026 has risen by approximately ½ per cent during the past year, while the government-bond yield fell by 1½ per cent over the same period. The widening of the differential between mortgage-credit and government bonds reflects primarily a higher conversion risk. The decline in interest rates during 1997 and 1998, together with borrowers' more active debt management, have contributed to increasing the volume of conversions significantly. This conversion activity is approaching the level during the wave of conversions in 1993-1994 when extraordinary loan redemptions totalled almost kr. 300 billion, although this time the development has been smoother. Moreover, the increase in turnover on the property market in 1997 and 1998 may be part of the reason for the large number of loans redeemed extraordinarily. The conversions in the first part of 1998 primarily concerned bonds with a coupon rate of 8 per cent or higher. However, conversions of bonds with a coupon rate of 7 per cent, for which the price rose to above par at the end of March, are also increasing.

"to be continued"

Footnotes