Speech by Governor Bodil Nyboe Andersen at
the Annual Meeting of the Association of Danish
Mortgage Banks on April 23, 1998

In around one week's time the historical series of meetings will commence at which the formal decisions will be taken concerning the start of the third stage of Economic and Monetary Union. The outcome of these meetings is not likely to be a surprise. It has already been clear for some time that 11 of the 15 member states of the European Union will introduce the single currency on January 1, 1999.

Just a few years ago there were many sceptics who did not believe that EMU could become a reality. Even among EMU optimists the prevailing view was that maximum 6-8 countries would be able to participate from 1999.

However, in recent years the EU member states have achieved remarkable convergence of their economic performance. The statistics have been analyzed and evaluated in the various convergence reports appearing over the past month.

The focus of public debate has been on fiscal-policy convergence in particular. 14 EU member states have reduced their government-budget deficits to below the magical limit of 3 per cent of GDP. Reducing government debt is by nature a rather more protracted process and for a couple of the expected participants is anticipated to take quite a number of years.

However, the convergence criteria do not concern government finances alone. It is important that the participating member states have by and large equivalent inflation and interest rates and that their mutual exchange rates have been stable. This is a logical requirement of countries which are to share a single currency. At the beginning of the 1990s, when the Treaty was written, a further wish was to maintain the results achieved by the core European countries during the 1980s in terms of lower inflation and exchange-rate stability. After the considerable exchange-rate unrest at the beginning of the 1990s the core countries quickly re-established exchange-rate stability based on the central rates which have prevailed since 1987. The other countries which are expected to participate in the currency union have only in recent years achieved exchange-rate stability in relation to each other and to the core countries.

However, low inflation rates in the 1990s is not a unique EU phenomenon, but can be seen in most other OECD countries.

Even strong economic growth and low unemployment have not led to the strong price increases seen in previous times, and this has surprised most economic forecasters. It has given rise to many deliberations in articles and speeches by academics, politicians and central banks. The concept of "new economics" has been launched as one explanation.

New economics are not, or at any rate not yet, a comprehensive theory which might be an alternative to traditional economic theory. New economics are rather a generic term for a number of ad hoc explanations for the apparent shift in the nature of the well-known relations between growth, unemployment and inflation. Particularly the technological development is used to explain a change in reaction patterns among both commercial enterprises and wage-earners.

However, so far it would appear that overall the economic development can be explained on the basis of the traditional economic models.

Low inflation has influenced the debate in other ways too. Suddenly concern has arisen that inflation is falling too much and that prices may fall. For most people "deflation" is a code word for the economic problems of the inter-war years. Particularly during the world crisis in the 1930s the threat of deflation was perceived as a vicious circle of price drops, wage drops and strongly rising unemployment.

The development in Japan in particular gives grounds for concern. Even though packages of economic measures are adopted at frequent intervals it has so far proved impossible to stimulate demand.

The situation in our part of the world is very different. Real wages show good increases and the very low inflation figures in many countries are due to such factors as price drops on individual commodities. Many raw materials, such as energy, are subject to very strong price fluctuations. Therefore in some periods these commodities will contribute to reducing the price index.

Prices for other products drop over extended periods due to the very rapid technical development. The most common example is computers. However, price drops for these high-tech commodities do not indicate a crisis situation, perhaps the contrary in fact. Even though experience tells us that it is possible to buy a better product at half the price if one is patient enough to wait a year or two, this does not appear to have a negative impact on demand for these products.

So even if inflation were to drop even further, and even if price indices may be falling in some periods, it is hard to see how this could lead to the same problems for our society as those seen in the 1930s.

Denmark has chosen to remain outside the third stage of EMU, but nonetheless the Danish economy was also evaluated in the convergence reports. We can be satisfied that these evaluations are extremely positive. They boost the financial markets' confidence and it is pleasing to note that the yield differential between 10-year Danish and German government bonds is now below ¼ per cent. It is obvious to regard this ¼ per cent as the current best estimate of the future yield differential to euro-denominated bonds. However, there is a tendency for the yield differential to narrow in periods of falling interest rates and for it to be small if interest-rate levels are low. Therefore the yield differential between krone-denominated and euro-denominated bonds must also be expected to vary over time, as has been the case with the yield differential between Danish and German government bonds.

The narrow yield differential is related to the favourable economic fundamentals as well as market confidence that the Danish krone's exchange rate will be very stable against the euro.

In contrast to many other countries in Europe Denmark's problem is that the economic growth is currently too strong. Consumption is rising strongly, against the background of very optimistic expectations of the future. This might be termed a de luxe problem, but unfortunately it does have consequences for the balance of payments, which is the Achilles heel of the Danish economy. There is a considerable risk of a current-account deficit in 1998. Even if a small surplus should be the result, the reality is that the foreign debt is no longer being reduced.

Two years ago, at this same occasion, I stated that it appeared to be a basic characteristic of the Danish economy that the balance of payments deteriorates if our growth is stronger than abroad's. The last two years have confirmed this relation.

It is therefore very important that the fiscal policy adopted for 1999 includes a decisive tightening - and that it does take place. In recent years public expenditure during the course of the year has unfortunately risen more strongly than planned.

Planning the overall fiscal policy for 1999 will begin very soon with agreements between government and local governments. These agreements are of very great significance to the economy, since most of the public sector's activity takes place under local governments and it must be ensured that the agreed expenditure levels are complied with in both 1998 and 1999.

The record-low bond yields do not make it easier to maintain balance in the economy, since the financial conditions have an expansionary effect. This is a consequence of the fixed-exchange-rate policy, combined with a low level of interest rates throughout Europe.

One year ago many people expected that market interest rates would rise over the year. However, the development has taken quite the opposite path, among other reasons because uncertainty concerning the development in the Far East has dampened expectations of coming years' growth.

The drop in interest rates in 1993 led to a wave of loan conversions after decades in which conversions were only part of economic history. The wave of conversions in 1993 and 1994 in most cases significantly reduced home-owners' debt service payments. There is no doubt that the consumption-stimulating effects are a significant part of the explanation for the economic upswing in Denmark as from 1993.

The conversions made ordinary home-owners aware of opportunities to restructure their debt. In addition, the development of new software programs has made it easy to calculate the consequences, turning loan conversion into a national sport. However, in most cases the gains released by today's loan conversions are significantly lower than 4-5 years ago, since some of the loans which are now being refinanced were raised during the last few years. The impact on consumption will therefore be considerably less than during the last wave of conversions. On the other hand, the situation today is that we most certainly do not need any stimulation of demand.

A number of home-owners accept loan-conversion offers even though the actual saving is no more than a few hundred kroner per month, once charges have been paid. This creates employment and earnings for banks and mortgage-credit institutes, but the final bill is paid by the bond owners when the bonds are redeemed at par. This may have consequences for the future strategies of the more professional Danish and foreign investors.

A key aspect of my speech today is that it will be necessary for Denmark to keep total domestic demand down by carrying out a significant tightening of fiscal policy. This should be an element of the planning of the credit institutes' lending policy, even though the possibility of losses on mortgage-credit loans may appear to be theoretical in the present situation.

It has often been said, but it cannot be repeated often enough: the credit policy pursued in the good times will be the seed of future crises.

March 16, 1998 on realignment of exchange rates within the EMS

As a consequence of the realignment of exchange rates within the European Monetary System (EMS) the central rate of the Irish pound has been revalued by 3 per cent.

The Greek drachma has joined the Exchange-Rate Mechanism of the EMS with a fluctuation band of +/-15 per cent.

As from Monday, March 16, 1998 the following intervention rates between Danmarks Nationalbank and foreign-exchange dealers apply to the Irish pound and the Greek drachma.

The intervention rates between the other ERM currencies will remain unchanged.

This implies adjustment of the central rates of all ERM currencies
vis-ā-vis the ECU. The new central rates are as follows:

The theoretical central rate for the pound sterling, which does not participate in the Exchange-Rate Mechanism, is as follows:

May 5, 1998 on the interest rate increase

With effect from May 6, 1998 the discount rate will be raised by ½ per cent to 4 per cent. The rate of interest on the banks´ current accounts with the Nationalbank is also raised by ½ per cent to 4 per cent. On May 6 the rate of interest on the Nationalbank´s certificates of deposit and the repo rate will be 4.25 per cent, an increase of 0.50 per cent.

During recent months the Danish krone has tended to weaken. Since February the Nationalbank has sold foreign exchange to support the krone. Since the beginning of April the tendency has been more pronounced and the sale amounted to DKK 16 billion in April. The sale of foreign exchange has continued in May. The foreign-exchange reserve is, however, still substantial, more than DKK 100 billion.

The objective of the foreign-exchange-rate policy is to maintain a stable krone rate against the D-mark and the other core currencies. This is achieved through the use of the short-term interest rates and interventions in the foreign exchange market.

The continuing and increasing requirement to support the krone through sale of foreign exchange during recent months has made it necessary to increase the Nationalbank´s interest rates.

For further information please contact Ms Kirsten Mordhorst on telephone +45 33 63 60 21.