IMF Wraps Up 2023 Consultation with Denmark

Washington, DC: On June 16, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1]with Denmark and endorsed the staff appraisal without a meeting.

The Danish economy recovered strongly from the pandemic. Following a relatively mild contraction in 2020, the economy grew by around 5 percent in 2021 and 3¾ percent in 2022. With the level of output now well above its pre-pandemic trajectory, tight labor markets, and much-elevated import prices, headline harmonized consumer price index inflation reached a 40-year high in October 2022 before decelerating. More recently, there are signs that economic activity is cooling, as inflation is lowering real incomes, financial conditions are tightening, and external demand is weakening, but labor markets remain relatively tight.

Economic activity is set to soften in the first half of 2023, followed by a gradual recovery. GDP growth for 2023 is projected at 1¼ percent due to weaker external demand, high inflation, and tightening financial conditions. Inflation will continue to decelerate but stay above 2 percent in the near term. Moderating energy prices will continue to reduce headline inflation, but core inflation will decelerate slowly as the positive output gap persists in the near term. Risks to growth are broadly balanced, but risks to inflation are tilted to the upside, reflecting renewed supply shocks and stronger-than-expected and persistent wage pressures.

Executive Board Assessment[2]

In concluding the 2023 Article IV consultation with Denmark, Executive Directors endorsed staff's appraisal, as follows:

Denmark's recovery from the pandemic was impressive, but strong output and employment growth has contributed to inflationary pressures. GDP growth is expected to slow in 2023, while inflation will remain elevated in the near term. Risks to growth are broadly balanced, while upside risks dominate inflation. In the medium term, Denmark faces lower economic growth due to lower global growth and demographic challenges.

Near-term fiscal policy should support disinflation, given persistently elevated inflation. There is uncertainty regarding the contractionary effects assumed in the fiscal plan, while positive output gaps and high inflation are expected in the near term. Accordingly, the authorities should, as insurance, consider keeping tight spending control and saving any revenue above budget forecasts aiming to improve the structural balance by ½ percentage points of GDP. If downside risks to growth materialize and inflation eases, automatic stabilizers should be allowed to operate fully.

Medium-term fiscal policy should be recalibrated as needed to adhere to the fiscal rules. The structural balance will weaken to a deficit over the medium term mainly due to defense and demographic-related spending. The authorities' forward-looking efforts to contain the level of the structural deficit within 0.5 percent of GDP set for 2030 by deploying supply-side measures are commendable. However, if fiscal trends suggest the risk of breaching the structural deficit limit (one percent of GDP), the authorities should stand ready to recalibrate medium-term fiscal policy. In this context, any changes to the indexation of statutory retirement age to life expectancy should safeguard long-term fiscal sustainability.

The financial system remains sound, but rising risks warrant continued vigilance and close monitoring. The authorities should closely monitor banks' liquidity risk management and ensure that their impairment charges are continuously updated as economic prospects change. In addition, commercial real estate (CRE) risks should continue to be closely watched, and further efforts are needed to close data gaps. The authorities should also consider an increase in risk weights on CRE exposures or the introduction of a sectoral systemic risk buffer. Furthermore, the supervisor's initiative to develop a pilot stress test for pension and insurance companies is welcome. Finally, given the increased risk of cyberattacks on critical infrastructure and institutions, efforts to monitor cyber security risks and strengthen resilience against cyberattacks should continue.

The authorities should consider tightening macroprudential policies to target pockets of vulnerability. The increase of countercyclical capital buffer was appropriate. However, tightening of borrower-based macroprudential measures should be considered to contain riskier mortgages, especially variable-rate mortgages with deferred amortization. Once house prices and inflation stabilize, the authorities are encouraged to review the high tax deductibility of mortgage interest expense and complex rental market regulations from the financial stability perspective. In this light, the government's plan to link property taxes to market valuations starting in January 2024 is welcome. The authorities are also encouraged to consider reforming the institutional setting of financial sector policy making in line with the 2020 Financial Sector Assessment Program.

Denmark is exposed to money laundering and terrorist financing threats. Progress has been made in strengthening the anti-money laundering/combatting the financing of terrorism (AML/CFT) framework. The authorities should continue efforts to increase the use of cross-border data and technological solutions in assessment of AML/CFT risks.

The authorities' strong focus on labor market reforms is welcome amidst the expected decline in the working-age population in the coming years. Canceling a public holiday will help increase annual hours worked, while the proposed personal income tax reform will help improve work incentives. The government is also planning to reform the early retirement schemes to increase employment. But additional measures should be explored consistent with Denmark's well-functioning flexicurity model. These include: (i) reviewing the structure of marginal effective tax rates, including benefits, to minimize disincentives to work and earn more, especially for lower-income households; (ii) continuing efforts to increase employment rates of immigrants; and (iii) enhancing education outcomes of students with immigrant backgrounds.

Further measures are needed to achieve Denmark's ambitious climate goals. In addition to strengthening of carbon pricing (Green Tax Reform), policy should consider complementary fiscal incentives at the sectoral level, including feebates in agriculture.

It is recommended that the next Article IV consultation be held in the standard 12-month cycle.