Nils Bernstein: Danish economy developments and the 2020 plan
Speech by Mr Nils Bernstein, Governor of the National Bank of Denmark, at the annual
meeting of the Association of Danish Mortgage Banks, Copenhagen, 27 April 2011.
* * *
Growth in the global economy remains robust and is increasingly self-sustained. As regards
2011, the International Monetary Fund has lowered its growth expectations for the USA,
Japan and the UK a little, while expectations for Germany have been adjusted upwards.
Factors such as the high energy and commodity prices are expected to curb growth.
The rising energy and commodity prices have contributed to higher inflation worldwide, not
least in many developing countries. In the euro area, inflation stood at 2.7 per cent in March,
which is considerably above the medium-term target of just below 2 per cent.
In the assessment of the European Central Bank, inflationary risks in the euro area are on
the upside. Against this background, the ECB raised its lending rate by 0.25 percentage point
at the beginning of this month, after having kept it constant at a very low level for almost two
years. Danmarks Nationalbank followed suit.
The debt crisis in the EU is still evolving. Portugal has now - some people might say finally -
applied to the EU and the IMF for financial assistance. Matters are further complicated by the
uncertain political situation in Portugal, where a caretaker government is in charge until the
election in June. It has been indicated that the assistance package will impose more
stringent conditions than the reform package which brought down the Portuguese
government - and that broad political agreement must be reached before the election.
Viewed on the basis of developments in yield spreads, there seems to be a decoupling of
market assessments of the situation in the three troubled member states - Portugal, Ireland
and Greece - on the one hand, and the rest of the euro area - including Spain and Italy - on
the other hand. This is positive and gives us reason to hope that the debt crisis in the EU can
be contained.
* * *
Turning to the Danish economy, the upswing is also becoming more evident here. The
negative growth in the 4th quarter of 2010 seems to have been a one-off. Danmarks
Nationalbank expects growth in 2011 to be just below 2 per cent, which is actually above the
EU average. Household disposable income is set to develop at a substantially weaker pace
than last year, but on account of the currently very low consumption and investment ratios -
combined with strong growth in some of Denmark's largest export markets - we still expect
some growth in private consumption and business investment. Momentum in the Danish
economy is presumably so strong that a gradual increase in short-term interest rates to a
more normal level is unlikely to trigger an economic reversal, although it will, viewed in
isolation, have a dampening effect.
The positive outlook is supported by developments in the labour market. Gross
unemployment had been flat for a while, but fell by 3,000 in February. It is probably too
optimistic to expect similar declines in the coming months, but the figures do indicate that
unemployment has peaked at a considerably lower level than previously expected. Right now
it is only slightly above its structural level.
So there is no need to ease fiscal policy relative to the plans laid down for the next couple of
years. In the current situation, expansionary fiscal policy could easily strengthen cyclical
trends rather than smoothing them, as it did in the boom years before the financial crisis.
That would not be expedient.
* * *
A few weeks ago, the Danish government presented its 2020 plan. The plan quantifies the
challenges that we must meet if we are to ensure balanced public finances in 2020. It also
includes proposals for tackling these challenges. I welcome that.
Some of the assumptions behind the 2020 plan are highly ambitious, not least the target of
very low growth in public spending in the next decade. However, it is essential to keep
growth in public spending under control if we are to achieve balanced public finances.
Otherwise we will be heading for unsustainable debt developments that will amplify the
problems. Unlike many other countries, Denmark has little room for manoeuvre on the
revenue side as taxes are already high. Consequently, balance must be achieved by reining
in expenditure.
If we look at the development in public consumption as a ratio of GDP over the last 50 years
- from the introduction of the welfare state until today - two facts stand out. Firstly, public
consumption has increased relative to total output throughout the period - except in the first
4 years of the Schlüter government in the 1980s. Secondly, it is worth noting that the rising
trend has continued, irrespective of the colour of the government.
It is not surprising that growth in public consumption was strongest in the first 25 years of the
welfare state, when the educational level and participation rate of women increased rapidly.
That has not been the case in the last 25 years. Yet public consumption as a ratio of total
output has still risen, albeit at a slower rate. My conclusion is that in Denmark there is an
ingrained pressure to solve problems by increasing public spending, both among politicians
and in the population in general. Altering that will require a radical change of attitude;
statutory control mechanisms to cap public spending as a ratio of GDP could be the first
step. It will be difficult - extremely difficult! But it is unavoidable.
Even if all the proposals in the 2020 plan were to be adopted, we will be facing a lengthy
period of sustained government deficits after 2020. So although the deficit remains well
below the 3-per-cent limit in the baseline scenario presented by the government, we still risk
being hit by large government deficits in connection with the cyclical downturns that tend to
occur from time to time. For this reason it is important to have automatic stabilisers in place
that can curb cyclical fluctuations.
This is the main background to Danmarks Nationalbank's proposal to phase out
deferredamortisation loans and to let property value tax develop in step with house prices. Both
proposals would contribute to dampening fluctuations in the housing market and hence in the
economy overall.
* * *
In addition to strengthening public finances, we need to boost growth in the Danish economy.
I am chiefly thinking of measures to increase potential output. This is not achieved through
expansionary fiscal policy, but through structural reforms to improve the economic framework
conditions and increase the supply of labour.
Phasing out the early retirement scheme is an example of such a reform. Discussions tend to
centre on how much this step might improve public finances. That is indeed an important
aspect, but we often forget that phasing out the scheme is also likely to contribute to
increasing potential growth in the economy in the phasing-out period by preventing a decline
in the labour force. In other words, phasing out the early retirement scheme can contribute
both to improving public finances and to strengthening the growth potential of the economy,
thereby providing a permanent wealth gain. Few alternative measures can match that.
Potential growth is the determining factor for how difficult it will be to achieve the 2020 plan's
target of reducing public consumption as a ratio of cyclically adjusted GDP from 29 to 27 per
cent. The lower the potential growth, the more painful the process will be. In the coming
decades demographics are against us. Productivity developments will be of paramount
importance to growth in the Danish economy.
* * *
The extraordinary measures introduced by the European Central Bank to supply liquidity to
the market during the crisis led to a period of very low market interest rates in the euro area.
Spreads to the corresponding Danish interest rates widened, leading to capital inflows and a
tendency for the krone to strengthen. To keep the krone stable against the euro, Danmarks
Nationalbank purchased foreign exchange in the market in the 1st half of 2010 and on
several occasions lowered its interest rates unilaterally. From the spring of 2010, only the
rate of interest on certificates of deposit and the current-account rate were lowered, while the
lending rate was kept unchanged, so that the spread to the ECB's benchmark interest rate
remained 0.05 percentage point.
Liquidity conditions in the euro area are now normalising, and euro area money market
interest rates are, once again, approaching the ECB's benchmark interest rate. To the extent
that higher market interest rates in the euro area lead to pressure on the krone, Danmarks
Nationalbank will follow its usual practice, including raising interest rates if necessary. This
will apply to both lending and deposit rates. We have no plans to deviate from the principle of
operating with a margin between the rate of interest on certificates of deposit and the lending
rate.
* * *
Public debate sometimes focuses on the high gross debt of Danish households relative to
GDP or to household disposable income. But the households' pension and housing wealth is
also high. The fact that the assets are less liquid than the liabilities entails a certain degree of
vulnerability.
The high gross debt is primarily reflected in household mortgages. This, in turn, should be
viewed against the background of the efficient Danish mortgage credit system, which differs
materially from those seen in most other countries.
Despite their high gross debt, Danish households have weathered the financial crisis. Losses
in the banking sector have been limited seen in relation to the crisis in the early 1990s, and
have only to a small extent been attributable to the household sector. Mortgage arrears ratios
are also low and declining.
All the same, I believe that the resilience of the households should be strengthened on
account of their high debt ratios. After all, tax cuts, special pension savings disbursements
and very low interest rates might not be on the agenda the next time a crisis comes knocking
on our door. High debt goes hand in hand with a risk of technical insolvency and lack of
mobility.
* * *
Since it became possible to issue covered bonds - in Denmark known as SDOs - instead of
traditional mortgage bonds in 2007, these bonds have accounted for an increasing share of
the outstanding volume of mortgage bonds - currently 60 per cent. As you know, SDOs are
subject to the condition that the value of the individual loan must never exceed 80 per cent of
the underlying collateral. If house prices go down, the mortgage banks must pledge top-up
collateral. One way of financing this is by issuing less collateralised junior covered bonds.
The proceeds are used to buy e.g. government securities that are pledged as top-up
collateral. In our estimate, a 10-per-cent fall in house prices entailed a need for top-up
collateral amounting to around kr. 25 billion in 2008. By 2010, this figure had risen to an
estimated kr. 100 billion plus, mainly due to the more widespread use of SDOs.
Consequently, Danmarks Nationalbank is pleased to note that the minister for economic and
business affairs has met the wish to look into this issue. The risk is increasing and should be
addressed in time. Danmarks Nationalbank has on previous occasions pointed to the option
of reducing the borrowing limit in connection with mortgage credit.
Another familiar issue is refinancing risk in connection with adjustable-rate loans - in both
kroner and euro. Spreading the refinancing auctions over the year reduces the volume of
adjustable-rate loans affected if an auction date coincides with a complete or partial market
crash. Danmarks Nationalbank welcomes the invitation from the Association of Danish
Mortgage Banks and the Danish Mortgage Banks' Federation to work with them to identify
the possibilities of reducing the refinancing risk on adjustable-rate loans.
With these words I would like to thank the Association of Danish Mortgage Banks and its
members for our successful cooperation during the past year.
Thank you for your attention.