Nils Bernstein: Overview of developments in Denmark
Speech by Mr Nils Bernstein, Governor of the National Bank of Denmark, at the Annual
Meeting of the Danish Bankers Association, Copenhagen, 30 November 2009.
* * *
The recession in the world economy seems to be over. Most OECD countries are returning
to positive growth rates. World trade is slowly beginning to pick up again after its sharp
downturn.
Turning to Denmark, we currently only have an overview of developments in the first half of
the year. We still don't have a full picture of how things have evolved since the early summer,
but in the assessment of Danmarks Nationalbank, Denmark is also gradually beginning to
move out of the recession that set in around the turn of the year 2008.
It looks as if our aggregate output bottomed out in mid-2009 at a level of 7 per cent below the
most recent peak in 2007.
Most forecasts show that the recovery will be slow, and in our assessment we will not be
back at the 2007 output level until some time in 2013 at the earliest. The business sector has
considerable spare capacity, and unemployment is therefore set to rise for another year or
so.
Crucial factors will be consumer spending and the contribution from exports to growth. Right
now the extensive stimulus packages launched in Denmark and abroad, as well as inventory
adjustments, are the main factors that have halted the slowdown and are once again driving
the economy forward. It remains to be seen whether this momentum will be self-sustaining
once the stimulus packages and expansionary fiscal and monetary policies are phased out.
The outlook for the coming years is particularly uncertain - much can go wrong - but we
believe that the economy will gradually recover.
One of the current challenges is how to finance the large government deficits resulting from
the expansionary fiscal policies in Denmark and abroad. If these policies are rolled back too
late, fear of a debt spiral and inflation may push up interest rates. On the other hand, if they
are rolled back too early, the financial markets may, once again, come under strong
pressure. Further stimulus packages may be required.
This balancing act is very much about ensuring investor confidence in the sustainability of
the future economic policy. Lack of confidence will cause interest rates to rise, which in turn
could trigger a downward spiral of increasing budget deficits and interest costs. This risk
could dampen growth, so we need to have a sustainable fiscal consolidation plan. And a
sustainable and credible plan requires agreement - not only on the objectives, but also on
how to achieve them.
Now that the financial crisis is receding, it makes sense to put the course of events into
perspective - and to draw some lessons from these events. This has been the most serious
financial crisis since the 1930s, and its causes will be the subject of many thick, academic
volumes of economic literature.
At this point I can only say that a strong economic upswing in the USA, initially boosted by
tax cuts and highly accommodative monetary policy, spread to the rest of the world. At the
same time, the Chinese economy gained a more prominent role.
The US economy rode on a wave of optimism and a strong propensity for consumers to buy,
while the Chinese economy gained strength thanks to impressive export growth and massive
business investment. A very substantial US current-account deficit was to a large extent
financed by surpluses in China and in the oil-producing countries, which profited from the
strong growth in the world economy. The global financial system had access to ample and
inexpensive liquidity. The hunt for profit took on many shapes, and risk appetite was strong.
This also affected us here in Denmark. Being a small, open economy, we benefited from the
international upswing. The ample supplies of liquidity in the international capital markets
enabled banks to supplement traditional deposits with foreign loans for financing strong
growth in lending. In addition to traditional corporate financing, this period was characterised
by a boom in construction activity and refurbishment - not least in the housing sector. The
favourable economic conditions also meant that transactions in the financial sector
increasingly took on an international dimension, with acquisitions of banks to an extent not
previously seen.
The mounting foreign debt burdens of many banks made the sector dependent on continued
access to international liquidity.
The ample and inexpensive borrowing opportunities helped to fuel the upswing. The Danish
upswing was driven by exports, private consumption and investment, while government
spending also had a procyclical effect. The Danish economy reached its capacity limit
towards the end of 2007, independently of the emerging financial crisis, and was already
reversing when Lehmann Brothers collapsed in September 2008, sending shockwaves
through the financial markets and triggering the economic crisis. The decisive financial blow
came from abroad, but we had put ourselves in a vulnerable situation when the crisis struck.
We cannot prevent new crises, but we can, and must, learn from experience.
Looking back over the last decade or so, it is evident that developments in the Danish
property market amplified the economic fluctuations in both directions, thereby contributing to
the difficulties we are now facing.
Danish house prices showed an almost constant upward trend from 1993 to 2007,
particularly in 2005 and 2006. Until 2005, growth in property prices during the most recent
upswing was to a large extent attributable to low interest rates - especially at the short end of
the curve - deferred-amortisation loans, higher disposable incomes, falling unemployment
and the tax freeze.
But the trend became self-fuelling. In the expectation that prices would continue to rise, new
homes were purchased before the old ones were sold. Property became an object of
speculative investment. Driven by expectations, combined with the economic upswing, prices
of single-family and terraced houses soared by almost 25 per cent within one year from early
2005. The increase was even stronger in the Copenhagen area. A hike of that magnitude
cannot merely be explained by the underlying economic conditions. Expectations also played
a role.
The rising property prices added fuel to the upswing. Home equity increased, and consumers
gained extra purchasing power. We witnessed a strong expansion in construction activities,
with clear signs of overheating.
And last, but not least, lending growth was particularly strong for banks with large-scale
commitments to the property sector.
It is characteristic that in the shadow of property-market developments activities took place
that are now being investigated by the Danish fraud squad.
The rollback of these imbalances has amplified the impact of the international recession.
Declining property prices have not only affected the building and construction sector, but
have also exacerbated the fall in consumption when compared with other countries. As
regards the financial sector, it is worth noting that the ailing banks are primarily found among
those that previously displayed the most aggressive lending policies in the property market.
What does this tell us?
In a market economy, crises can never be avoided. We must accept economic downturns
from time to time. As a small, open economy we cannot guard ourselves against a sudden
drop in external demand, reducing exports by almost 20 per cent in six months, as we have
witnessed.
But we can seek to conduct economic policy that does not in itself amplify economic
fluctuations.
We have not been good at that. During the upswing, our economic policy was procyclical,
contributing to the upward trend.
Too little was done to curb it. You might say that we put the economy into a higher gear in a
situation when it was already running at a high speed, thanks to factors such as a low level of
international interest rates. And, overall, we gave the housing market in Denmark too much
leeway.
It is the imbalances created in Denmark and abroad during the boom that have brought on
the current situation.
As you know, the government guarantee on all deposits with and loans to banks in Denmark
will expire in just under one year. This scheme is the most extensive and necessary step
taken in Denmark when the financial crisis really hit us in autumn 2008. Guarantees of this
size must inherently be short-lived, and we must now prepare for the time after its expiry.
Don't count on an extension of the scheme. It will be replaced by an increased deposit
guarantee of kr. 750,000, and until the end of next year its will be possible to subscribe to
guarantees for individual loans applying until the end of 2013. This deposit guarantee of kr.
750,000 will cover the vast majority of all private individuals making bank deposits.
The temporary guarantee scheme for individual issuances is essentially mainly available to
large banks. Danmarks Nationalbank is aware that the sector is working on umbrella
schemes that will enable several smaller banks to make joint issues based on government
guarantees. Danmarks Nationalbank takes a positive approach to these initiatives and the
possibility of accepting them as part of our collateral basis.
As far as we can see, larger deposits and other financing have to some extent made their
way to some banks under cover of the general government guarantee. Some degree of
adaptation must be expected when this guarantee expires. For the credit extension system
overall, it is, however, important that the relevant financial institutions take timely action to
procure financing elsewhere or reduce their lending surplus. The larger banks must take their
share of responsibility for restoring the smooth operation of the money market. The financial
crisis has clearly demonstrated that banking is not just another sector of the economy. In
return for the extensive bank rescue packages I expect the banks to face up to their social
responsibility and role and to contribute actively to the functioning of the markets without
government guarantees.
The future financial architecture in Denmark also involves the expiry of the legislation
allowing "the Financial Stability Company" to acquire banks when the general government
guarantee expires. As far as I can see, the government's acquisition of ailing banks has had
the desired effect, i.e. banking transactions with traditional customers have, as far as
possible, continued although share capital and other liable capital has been lost.
The Financial Stability Company should still be empowered to make acquisitions - but
without any other guarantee than the statutory deposit guarantee. If the financial system is to
function without excessive assumption of risk, not only owners of liable capital should
potentially be exposed to losses - but also large investors and other unsecured creditors.
What matters is not whether a bank will survive, but whether its activities will be continued. In
future the Financial Stability Company should, in a specific situation, be able to carry out
appropriate restructuring, taking the above aspects into consideration. In future the sector
should make regular contributions to the deposit guarantee scheme by way of insurance, and
in such a manner that the bill for aggressive financial behaviour is footed by those
responsible. Action should be taken in this area, with a view to introducing new legislation
before the summer holiday so that the scheme can take effect when the current legislation
expires next autumn.
Finally, I would like to thank the retiring chairman and the Danish Bankers Association for
good cooperation based on mutual trust in a difficult situation. I would also like to say
welcome back to the newly appointed chairman. I look forward to continuing our fruitful
cooperation.