Lars Rohde: Developments in the world economy, the Danish economy
and in its mortgage credit system
Speech by Mr Lars Rohde, Governor of the National Bank of Denmark, at the annual
meeting of the Danish Mortgage Banks' Federation, Copenhagen, 3 April 2014.
* * *
The international economy is recovering. The upswing is gaining momentum in the USA, and
euro area GDP has increased in the last three quarters. With the exception of Greece,
southern Europe was also picking up at the end of 2013. On the other hand, growth has
declined in the emerging economies, mainly as a result of weaker development in domestic
demand.
The US economy is now so strong that the Federal Reserve in January began the previously
announced tapering of its asset purchases. At the same time, some emerging economies
- including Argentina, Brazil and Turkey - saw capital outflows and pronounced weakening
of their currencies. This should also be viewed in the context of a deteriorated growth outlook
and internal imbalances in these economies. But the countries affected represent only some
5 per cent of global trade, so the derived effects of this turmoil on the advanced economies
are presumably limited. The same applies to the turmoil in Ukraine. So far, it has not led to
large fluctuations in the international financial markets, except in Russia.
In the euro area, price inflation has decreased in the last couple of years, to 0.5 per cent in
March. Core inflation has also declined. Besides subdued wage developments, the low rate
of inflation is attributable to downward pressure on import prices, to some extent reflecting
the appreciation of the euro. In addition, factors such as the freer movement of labour and
stronger international competition exert sustained downward pressure on import prices and
hence on the overall rate of wage and price increase.
In Denmark, economic activity is picking up, although the growth pattern has been somewhat
uneven. There are positive signs in the labour market, with falling unemployment and a rise
in the number of people in employment, especially in the private sector. But the number of
part-time employees has grown. Private consumption has not recovered yet, although the
foundation for increased consumption is in place. The level of private savings has been high
for some years. Interest rates remain historically low, while real wages are set to rise, partly
due to low - but nevertheless positive - price inflation. Add to this positive consumer
expectations and rising net wealth. Although the households' average gross debt ratio
remains high, and some households may have a wish for further consolidation, it is difficult to
see how Danmarks Nationalbank could be criticised for forecasting higher private
consumption in the coming years.
In its most recent projection, Danmarks Nationalbank forecasts growth in GDP at 1.4 per
cent this year, rising to 1.7 per cent next year. This may not sound of much, but it is above
the forecast potential, so the capacity situation will normalise towards 2016. If economic
growth is to reach a higher level while remaining sustainable, productivity growth must
increase. Reforms to boost productivity are on the government's agenda for the near future,
and I welcome these initiatives. Denmark must stay on the path of economic policy reform.
That is a precondition for future growth and prosperity.
***
Now let me turn to the housing market. In general, prices have been showing a slight upward
trend for the last 18 months. In January 2014, house prices were 6 per cent higher than in
mid-2012, while prices for owner-occupied flats had risen by 14 per cent in the same period.
Nevertheless, trading activity remains low, and the supply of homes for sale is still high - in a
long-term perspective. But it has not risen any more over the last year.
In recent years, economic activity - and hence the housing market - has developed
unevenly across Denmark. Economic growth is increasingly a city phenomenon. This has
been the case for many years and the same pattern is seen in other countries, but the trend
seems to have accelerated in Denmark in recent years. Since 2008, there has been a strong
influx of mainly young people and people with jobs to the Capital Region, while pensioners
and unemployed people have moved out. Especially young people aged 20-29 move to the
cities in connection with education or training, and they increasingly stay there afterwards.
This demographic development can be seen in the housing market. House prices are
considerably more cyclical in the cities than in the rest of Denmark. This is particularly true of
the Capital Region and surrounding areas, which are typically also the "first movers". In
addition, house prices in urban areas have risen in real terms over time, reflecting factors
such as underlying demographics, with still more people living in an area of a virtually given
size. Since the price of building a house is almost the same throughout the country, it is
mainly land prices that have risen.
The situation is exactly the opposite in the areas of Denmark where people are moving away.
Here, demand for housing is declining, while the supply is more or less unchanged. This
results in decoupling of house prices and construction prices, which are normally indicative of
the level of prices in the long term. The housing surplus means that some properties are
falling into disrepair and are, in effect, worthless.
The question is whether this development is cyclical, or whether it is a more structural
tendency. Causality between population growth and regional economic growth can go both
ways, and a cyclical recovery may stem the tide. At some point, the regional differences
between house prices may become so large that the gain from moving out halts the
migration towards the cities, but presumably this will affect only the immediate surrounding
areas. Beyond commuting distance, the development seems to be more structural. This is a
problem that neither can nor should be solved by the financial system. The Danish
mortgagecredit system is based on value behind the loans. If the value of a property is eroded
completely, there is no longer a foundation for providing a mortgage loan.
During the most recent boom, borrowing by households surged, rising more sharply than
ever before. The surge went hand in hand with an even stronger rise in housing wealth,
which enhanced homeowners' opportunities to raise loans against the home as collateral.
Previous analyses have shown that Danish households would still be able to service their
debts, even during an economic downturn, and the high gross debts do not pose a serious
threat to financial stability. One of the reasons is that the households also have considerable
financial assets. But high loan-to-value ratios amplify cyclical fluctuations in the Danish
economy. This highlights the importance of restoring the link between property values and
taxation.
***
While increased stabilisation of house prices via housing taxes is not immediately on the
cards, the Folketing - the Danish parliament - on 11 March passed a legislative amendment
to introduce contingent maturity extension of mortgage bonds if the underlying loans are not
pre-financed. This is a very important amendment, and a good way of dealing with various
tail risks in the Danish mortgage-credit model. I appreciate the positive contribution of the
sector to this process - from the presentation of the first proposal to the adoption of the final
legislation. Input from the sector and other market participants was taken into account, but
the purpose of the amendment has remained unchanged from day one. Firstly, a robust
solution for addressing the mortgage banks' refinancing risk has now been found. Secondly,
a credible resolution model for mortgage banks is re-established.
I am also pleased to note that the credit rating agencies' reception of this amendment is
predominantly positive. Although this solution is not a silver bullet, Moody's concludes that
the new legislation removes the refinancing risk on Danish mortgage bonds. This eliminates
a major source of credit risk, thereby supporting a high credit rating.
It is essential for the mortgage banks to maintain sound credit policies, also after the
legislative amendment. Investor confidence in the long-term credit quality is all-important
- irrespective of how the housing market develops. Against that background, Danmarks
Nationalbank recommends reducing the upper limit for deferred-amortisation loans - as a
percentage of the value of the home at the time of mortgaging. This should apply to
deferredamortisation loans underlying covered bonds, covered mortgage bonds or mortgage bonds
issued by banks and mortgage banks. In this way, borrowers will gradually move away from
the maximum loan-to-value ratio over time. This will further underpin the high degree of
security in the mortgage-credit system, even if house prices plummet, and contribute to
macroeconomic stability.
Experience shows that general changes in the amortisation profile, particularly the first-year
payments, also have an initial effect on the price of housing, and hence on the
macroeconomy. So the timing and dosage of restrictions on deferred amortisation should be
considered carefully.
In contrast, banks should not be restricted further from providing deferred-amortisation loans
if such loans are financed in other ways than by issuance of covered bonds. Mortgage
lending is a particularly secure business model that differs fundamentally from banking and
that is subject to special regulation. While mortgage banks finance their lending purely
through issuance of mortgage bonds that match the loans, banks finance their lending via
various sources of funding, such as deposits, issuance of covered bonds and issuance of
senior debt. As a main rule, mortgage banks can take on credit risk only - and even this risk
is contained through regulation of loan limits and redemption profiles. If a mortgage bank
wants to have the same opportunities as a bank, it must obtain a banking licence.
***
Now I will turn my attention to Europe. Here, the banking union is moving away from the
design phase and becoming a cornerstone of the financial architecture. Some people
primarily see the banking union as part of the strengthening of the euro. But from Danmarks
Nationalbank's point of view, the key element is that the banking union will contribute to a
well-functioning single market for financial services.
The Single Supervisory Mechanism, SSM, has already been adopted and is being
implemented. On 4 November 2014, the ECB will take over supervision of the largest euro
area banks. To ensure that the ECB takes over supervision of healthy, viable banks only, an
asset quality review of the 130 largest banks is well underway. Besides its own resources,
the ECB has employed an independent consultancy firm for this task, and in the summer a
follow-up stress test will be performed. Banks that fail the stress test will be met with a
demand for recapitalisation or resolution. All in all, the work to ensure that the corners of the
house which the ECB will be responsible for are neither rotting nor crumbling looks very
promising and ambitious.
Another core element of the banking union is the Single Resolution Mechanism, including a
Single Bank Resolution Fund. The European Parliament, the Commission and the Council
have just negotiated an agreement on this. The rules are expected to be adopted this month.
When your neighbours build a new house, you invariably look at your own house in a new
perspective. The banking union is a fact and will have a substantial impact on Denmark -
whether or not we choose to participate in this new financial architecture. In Danmarks
Nationalbank's opinion, Denmark's interests are best served by participating in the banking
union. The standard of supervision set by the SSM under the ECB can be expected to be the
benchmark for the member states participating, but also for those opting out. If Denmark
participates, it will be easier to adapt the standards to Danish conditions and experience.
Presumably, the SSM will be perceived as a quality stamp, as more eyes, including external
eyes, will be focused on the supervision of banks and the key supervisory decisions. Other
things being equal, this will give the banks in question a competitive edge over the banks of
"outsider" member states - even if they have credible national supervisory authorities as in
Denmark's case. If Denmark does opt out, this may require tighter supervisory practices. In
addition, investors can be expected to require more ambitious levels of excess capital and
liquidity than for banks within the union.
It is also in the clear interests of Denmark that a shared practice is established for crisis
management of banks. The Single Resolution Mechanism will make it easier to perform crisis
management of cross-border banks. When fully phased-in, the Single Supervisory and
Resolution Mechanisms will act as an insurance scheme for financial enterprises and provide
a better guarantee of equal treatment of the creditors of distressed banks across the EU.
***
New international liquidity standards are another area that due to our special Danish financial
architecture has attracted considerable attention. Since the Basel Committee's first
consultation paper on new international liquidity standards was published in 2009, both the
authorities and the sector have had a very special interest in the liquidity of Danish mortgage
bonds. On the basis of a detailed data set compiled by the Danish Financial Supervisory
Authority for all transactions in Danish government and mortgage bonds, Danmarks
Nationalbank has analysed liquidity in these two markets before, during and after the
financial crisis. In this connection, we have worked closely with experts from the
Copenhagen Business School and from the BIS. Our results, which we published in 2010
and 2012, show unequivocally that highly liquid Danish mortgage bonds were by and large
as liquid as government bonds during the crisis.
At the EU level, the European Banking Authority in 2013 performed a similar empirical
analysis with virtually the same outcome. Now we are awaiting the European Commission's
decision.
Seen from Danmarks Nationalbank's point of view, a liquidity buffer should be
welldiversified, and it should be empirically well-documented what such a buffer may include. In
that context, the treatment of government bonds in the financial regulation is a bit of a
paradox. Government bonds from all EU member states may freely be included, without
being risk-weighted and without any diversification requirement. This is puzzling, given that
the EU Treaty prohibits the public sector from gaining privileged access to financial
institutions.
In Danmarks Nationalbank's opinion, thorough empirical analyses with high credibility
provide a basis for determining that liquid Danish mortgage bonds should be classified as
extremely high quality liquid assets. Mortgage bonds can contribute to giving financial
enterprises a well-diversified portfolio of liquid assets. We will maintain this point of view,
irrespective of the EU outcome.
On the other hand, no true horror scenario can be conjured up for Denmark if the EU
- despite solid empirical evidence to the contrary - chooses not to classify mortgage bonds
as extremely high quality liquid assets. Yes, there will be a price to pay. But no, it will not
bring about the downfall of mortgage banks, banks or homeowners. The Danish
mortgagecredit system is far too stable for that.
***
Thank you for your attention.