Danmarks Nationalbank

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1 Danmarks Nationalbank Monetary Review 3rd Quarter 2004 D A N M A R K S 3 N A T I O N A L B A N K

2 MONETARY REVIEW 3rd QUARTER 2004 The small picture on the front cover is a section of the national coat of arms as redesigned in 2003 as the motif on the reverse of the 20-krone. Text may be copied from this publication provided that Danmarks Nationalbank is specifically stated as the source. Changes to or misrepresentation of the content are not permitted. The Monetary Review is available on Danmarks Nationalbank's website: under publications. Managing Editor: Jens Thomsen Editor: Anders Møller Christensen This edition closed for contributions on August 31, The Monetary Review can be ordered from: Danmarks Nationalbank, Information Desk, Havnegade 5, DK-1093 Copenhagen K. Telephone (direct) or Inquiries: Monday-Friday 9.00 a.m.-4 p.m. info@nationalbanken.dk SCHULTZ GRAFISK A/S ISSN (Online) ISSN

3 Contents Recent Economic and Monetary Trends... 1 New Terms and Conditions for Accounts The Basel Committee's Endorsement of New Capital-Adequacy Rules Counterfeit Banknotes Maria Carlsen and Johanne Dinesen Riishøj, Secretariat Since the spring of 2004 quite a few genuine-looking counterfeit 100-krone banknotes have been found. This article explains how the counterfeit banknotes are distinguishable from the genuine ones and describes the incidence of and measures to combat counterfeiting. Danmarks Nationalbank's Costs of Supporting Ship Finance Peter Jayaswal, Financial Markets Over the years, Danmarks Nationalbank has provided support for ship finance, e.g. by acquiring Ship Finance bonds at a price that was typically above the market price. The costs of this support are estimated to be in the range of kr. 33 billion in 2003 prices. Money Demand in Denmark Allan Bødskov Andersen, Economics An analysis of money demand in Denmark shows that it develops according to generally accepted hypotheses, but may be described in somewhat simpler terms today than previously. Among other factors, this is attributable to the stable development in the krone's exchange rate vis-à-vis the euro, as well as the high degree of convergence between Danish and German interest rates in recent years. The Role of Capital in Banks Kristian Kjeldsen, Financial Markets Banks play a distinct role in the economy and they are therefore subject to extensive regulation, including capital requirements as an important element. This article explains why special capital requirements for the banks are necessary and why the banks usually prefer to hold excess reserves. The expected implications of the new capital-adequacy rules to the banks are also considered.

4 The Economic Situation in the Faroe Islands Winnie Jakobsen and Pernille Thinggård, Secretariat Since 2003 the Faroese economy has seen a downturn, attributable to, inter alia, a decline in fish farming and fish processing. Fisheries have also seen a decrease although most of the fleet still makes a good profit. Speech by Bodil Nyboe Andersen at the Conference on the Economy in the Danish Commonwealth hosted by the North Atlantic Group of the Folketing (Parliament), 25 May Press Releases Tables and Graphs Section Vol. XLIII, No. 3

5 1 Recent Economic and Monetary Trends This review covers the period from the middle of May to the end of August 2004 INTERNATIONAL FINANCIAL CONDITIONS The global upswing continued over the summer, albeit with a few signs of weakness. In general US data releases were weaker than earlier in the year, and a slight slowdown is observed in Asia. In the euro area growth picked up in the 1st half of the year, but remains moderate, and there are no clear indications that the upswing is gaining momentum. Rising oil prices have generated uncertainty in the financial markets, which has resulted in declining stock prices and long-term interest rates. The international upswing has increased the demand for oil, which pushed oil prices upwards during the summer. The price of a barrel of US crude oil exceeded 49 dollars in mid-august, corresponding to more than 45 dollars per barrel of Brent, as such the highest level ever. However, the oil price declined a little at the end of August. Adjusted for general inflation trends, oil prices are, however, considerably below previous peaks, e.g. in connection with the oil crisis in the early 1980s, cf. Chart 1. In addition to increasing demand for oil, fears of attacks on oil installations in Saudi Arabia, unrest in Iraq, problems in relation to the Russian company Yukos and political unrest in Venezuela have contributed to higher prices. At the same time, US oil stocks have been depleted. OPEC has attempted to dampen the rise in prices by increasing production, but it is uncertain how much production can be stepped up in the short term. The concerns in the oil market towards mid-august were also reflected in the price of oil for future delivery. For instance, the price of oil for delivery in December 2009 rose from 29 dollars per barrel in June to 36 dollars per barrel in mid-august, cf. Chart 1. The price of oil futures declined slightly at the end of August as uncertainty receded. The latest decrease in the oil price, which is attributable to increasing production from Iraq, among other factors, has dampened fears that higher oil prices may have a decisive impact on the global upswing. If the current oil prices are maintained, the international upswing may be curbed, but scarcely halted completely.

6 2 NOMINAL AND REAL OIL PRICE (WEST TEXAS) AND US OIL FUTURES Chart 1 Dollars per barrel Dollars per barrel Jan Apr Jul Oct Jan Apr Jul West Texas in constant 1995 prices West Texas Oil future, closest Oil future, December 2009 Oil future, 24 months Note: The Charts show the US oil prices, not the European reference oil, Brent crude oil, which is not immediately comparable with the futures. The real oil price has been deflated by US consumer prices, excluding energy. Source: EcoWin and Bloomberg. The price of the cyclically sensitive industrial metals rose a little during the period under review, and the gold price also showed a slight increasing trend from May to August. The yields on both German and US 10-year government bonds increased until mid-june, followed by a reversal to a marked fall, particularly in the USA, where the 10-year yield decreased from 4.9 per cent to 4.1 per cent at end-august in spite of the raising of monetary-policy interest rates, cf. page 7. The main factors contributing to the decline in long-term interest rates were disappointing labour-market reports and subsiding fear of inflation, cf. Chart 2. Overall, the higher oil prices and generally weaker RELEASE OF US LABOUR-MARKET REPORTS AND INFLATION DATA, AND THE 10-YEAR BOND YIELD Chart 2 Per cent January February March April May June July August Monetary-policy interest rates raised Note: Source: Unbroken vertical lines indicate the dates when labour-market reports were released. Broken lines indicate the dates when inflation data were released. Dots indicate that official interest rates have been raised. EcoWin.

7 3 10-YEAR GOVERNMENT-BOND YIELD IN THE USA AND GERMANY Chart 3 Per cent USA Germany Note: Daily observations. The latest observation is from 31 August Source: EcoWin. US data releases than in the first months of the year have led to doubts as to the strength of the upswing. This has dampened expectations of future increases in monetary-policy interest rates in spite of the immediate stimulating effect of the higher oil prices on inflation. In the period under review, the USA saw considerably greater interestrate fluctuations than Europe, although the overall pattern was more or less the same. At one point the German yield was more than 45 basis points lower than its US equivalent, but the spread later narrowed to between 10 and 15 basis points, cf. Chart 3. In Japan the 10-year yield rose by 40 basis points to 1.9 per cent from end-may to end-june, following data releases indicating robustness in the Japanese upswing and signs of subsiding deflation. The yield curve levelled off in July, and in August it followed the downward trend of US and European yields, to just over 1.5 per cent at end-august. Seen over the entire year, the international stock markets have moved sideways with a slight declining trend from July to mid-august, more or less in line with the increase in the oil price, as well as a few signs of weakness in the global upswing. In the latter half of August the stock markets generally began to pick up again. An indicator of the uncertainty is the volatility in stock prices expressed as the VIX index for US stocks, which exploits the fact that expected stock-price volatility is reflected in option prices. Volatility has generally been falling since mid-

8 4 THE DOLLAR AND THE US CURRENT-ACCOUNT DEFICIT Box 1 For a number of years, the USA has had a considerable current-account deficit. At present the deficit is around 5 per cent of GDP. A deficit of this magnitude, particularly one which is not attributable to a high level of investment, but rather to lack of savings, will normally lead to a weakening of the currency of the country in question, but this has not been the case in 2004, cf. the Chart. The preceding two years did see some weakening, primarily vis-à-vis the euro, while a number of Asian countries intervened to maintain a stable, or almost stable, exchange rate against the dollar. A case in point is China, but also e.g. India, Korea, Taiwan and Japan have maintained a more or less stable exchange rate vis-à-vis the dollar. These countries generally have large current-account surpluses, cf. the Chart. While these countries maintain a stable exchange rate, the balance of payments for this extended group of countries, comprising the USA and a number of Asian countries, will be one of the factors contributing to the course of the dollar. Since the surplus of the Asian countries is more or less equivalent to the US deficit, global deviation taken into account, these countries and the USA taken as one can be seen as an extended "dollar group" with balance-of-payments equilibrium. This helps to stabilise the dollar. DOLLAR RATES (LEFT-HAND CHART) AND CURRENT-ACCOUNT SURPLUSES (RIGHT-HAND CHART) FOR SELECTED COUNTRIES Index, January 2003 = Jan Apr Jul Oct Jan Apr Jul Effective exchange rate of the dollar China Korea Taiwan Japan Euro area Billion dollars USA Euro area Japan Emerging Asia Global deviation In the 1st half of 2004 the greatest deviations were seen around the release of US labour-market reports. The market was positively surprised in the spring, while the latest report (for July) was disappointing. In the summer months, as earlier in the year, the euro/dollar exchange rate was more or less stable at around dollars per euro, following a strengthening of the euro. In this period the foreign-exchange market was focused on the sustainability of the global upswing, particularly in the USA, while there was less focus on the US imbalances. The Japanese yen appreciated vis-à-vis the dollar from mid-may to the end of June, but has subsequently depreciated and traded at 110 yen per dollar at end-august. Since the beginning of 2002 the dollar has depreciated by per cent against the euro, while its weakening vis-à-vis a number of Asian

9 5 currencies has been less pronounced. This is attributable to large-scale interventions by the Asian central banks to limit the strengthening of their own currencies vis-à-vis the dollar. These purchases have more or less financed the US current-account deficit. The Asian countries have large current-account surpluses, which contributes to stabilising the dollar rate, cf. Box 1. THE INTERNATIONAL ECONOMY USA The quarterly growth rate of 0.7 per cent in the 2nd quarter was slightly lower than expected for the US economy and lower than in the preceding four quarters, cf. Chart 4. On the other hand, 1st-quarter growth was adjusted slightly upwards. Growth in the 2nd quarter was mainly driven by strong growth in private investments, which are, however, still at an unusually low level relative to GDP, while private consumption showed disappointing growth of only 0.4 per cent over the 1st quarter. The contribution from net exports was negative as in the preceding two quarters, since imports rose more than exports. The declining growth in private consumption and weak employment trends have raised doubts as to the strength of the upswing. Following significant growth in employment in the spring (March-May), when almost 900,000 new jobs were created, only a minor increase in non-farm US GDP GROWTH AND GROWTH CONTRIBUTIONS FROM SUBCOMPONENTS Chart 4 Per cent, quarter-on-quarter Private consumption Net exports Other BNP growth Source: EcoWin.

10 6 employment was seen in June and July, totalling just over 100,000. Labour-market conditions may determine the course of private consumption, which accounts for more than two thirds of US GDP. Consumption has been hampered by the high oil price. The seasonally adjusted volume index for retail sales, excluding cars, was lower in the 2nd quarter than at the end of the 1st quarter. Consumer confidence is moderate and decreased from July to August; consumer expectations of the future accounted for the strongest decline. A positive factor is a sustained strong housing market, to some extent characterised by increasing use of variable-rate mortgage-credit loans, which account for more than 40 per cent of total lending. If the expected increases in short-term interest rates materialise, there is thus a risk that the housing market may weaken. The ISM index, a measure of confidence in the US manufacturing industry, still points to economic recovery, but at a slower pace than earlier in the year. In spite of the considerable growth in US output in the last 4-5 quarters, the federal budget deficit will increase further in the current fiscal year, which closes at end-september. The Congress Budget Office estimates that the budget deficit for the fiscal year will be 422 billion dollars, equivalent to approximately 3.75 per cent of GDP, against 374 billion dollars in the fiscal year The large budget deficit since 2001 is primarily a result of very expansionary fiscal policy, but a small proportion may be attributed to the weak economy from 2001 to The US trade balance showed a record deficit in June. The total current-account deficit in the 2nd quarter is estimated at more than 5 per cent of GDP. A current-account deficit need not in itself constitute a problem. It could be an indication that the country in question is borrowing abroad in order to finance productive investments to enhance future output, as was to a large extent the case in the USA in the latter half of the 1990s. The current deficit is chiefly a result of the low level of savings, which makes the current situation less sustainable, cf. Chart 5. Inflation measured as the Consumer Price Index, CPI, was 3.0 per cent in July. This was slightly lower than in the preceding two months, but considerably higher than at the beginning of the year, when inflation was below 2 per cent. The increase should mainly be seen against the background of the high oil prices. Inflation excluding food and energy, i.e. core inflation, was 1.8 per cent in July against 1.1 per cent at the beginning of the year. The rising core inflation may reflect increased activity and sales opportunities.

11 7 SAVINGS BALANCES AND CONSUMPTION AND INVESTMENT RATIOS IN THE USA Chart 5 Percentage of GDP Percentage of GDP Percentage of disposable income Balance of payments Public savings balance Private savings balance Investment ratio, business Consumption ratio (right-hand axis) Note: The public savings balance comprises both the federal savings balance and local authorities' savings balances. The investment ratio corresponds to business investments in current prices as a percentage of GDP. Source: OECD, Economic Outlook 75 and EcoWin. In June the Federal Open Market Committee, FOMC, raised the Fed funds target rate by 0.25 per cent. This was the first increase since May 2000, when the rate of interest reached 6.5 per cent. In August it was raised by a further 0.25 per cent to 1.5 per cent at present. In both instances the FOMC indicated that short-term interest rates will be raised at a measured pace. The main scenario is thus a gradual return to a more neutral level of short-term interest rates. This is also reflected in market expectations, cf. Chart 6. The present level of interest rates is lower than the rate of inflation. This supports growth in the US economy, where economic growth has been strong and core inflation rising. MONETARY-POLICY INTEREST RATES IN THE USA AND IMPLIED FORWARD RATES Chart 6 Per cent Source: EcoWin. Fed funds target Implied forward rates (31 August 2004)

12 8 Japan and the rest of Asia The upswing in the Japanese economy has now been underway for just over a year. The rate of growth has been similar to the US growth rate for the past year. The main driving forces have been a significant increase in exports, inter alia as a result of increasing trade with China, as well as increasing business investments. In the 2nd quarter, however, GDP only rose by 0.4 per cent over the 1st quarter, the lowest increase since the 1st quarter of The lower growth primarily reflected a fall in fixed investments. Exports declined slightly, while growth in private consumption was lower than in the preceding two quarters. Both consumer and business confidence continued to rise in the 2nd quarter, however. A sustained high level of oil prices will affect Japan relatively hard and may dampen the upswing. Consumer prices remained unchanged in July after an increase in June by 0.4 per cent over May, primarily as a result of higher energy prices. In the summer months of June and July the price level was almost unchanged compared to the same months of the preceding year. The general economic development points to the Bank of Japan maintaining its zero-interest-rate policy. Inflation above zero may contribute to boosting domestic demand and thus to making the Japanese economy self-sustaining. Another major factor is the development in the labour market. Employment declined during the summer, following a positive trend from November 2003 to April 2004, so the rise in activity has not yet fully passed through to the labour market. Unemployment fell in the spring until June, but rose again in July to 4.9 per cent. This is equivalent to the level at the beginning of the year. In the rest of Asia growth remains high, but several countries saw a few signs of weakness in domestic demand during the summer. In China the pace of growth has slowed down, cf. Chart 7. Owing to the risk of overheating the Chinese authorities have implemented measures to dampen growth. These include restrictions on bank loans in order to cap a very high investment level. Investments as a ratio of GDP are in the range of 40 to 50 per cent. The euro area According to preliminary data for the euro area, GDP rose by 0.5 per cent in the 2nd quarter, slightly below the growth in the 1st quarter. Exports are still expected to be the driving force in the euro area, while growth in domestic demand, which is a prerequisite of a self-sustaining upswing, is expected to remain low. National GDP data for the 2nd quarter showed a clear dispersion among the largest euro area member states. For the fourth consecutive quarter France showed the highest growth rate, 0.8

13 9 GDP GROWTH AND INDUSTRIAL PRODUCTION IN CHINA Chart 7 Per cent, year-on-year 15 Per cent, year-on-year GDP Industrial production (right-hand axis) Note: GDP is a quarterly series, while industrial production is on a monthly basis. The large fluctuations in industrial production at the beginning of the year are attributable to the Chinese New Year, which follows the Lunar calendar and falls somewhere at the end of January or the beginning of February. Source: EcoWin. per cent in the 2nd quarter, while growth rates were more moderate in Germany and Italy, at 0.5 and 0.3 per cent, respectively. Domestic demand in Germany declined for the second quarter running, reflecting flat development in private consumption and falling investments. Growth in the 2nd quarter was thus driven by exports. This was not the case in France, where private consumption saw high growth, and the contribution from net exports was negative. Since the turn of the year consumer confidence in the euro area has been consistent at a low level. Retail sales developed positively in June after a fall in May, but viewed over a prolonged period retail sales have moved sideways. In the largest euro area economy, Germany, retail sales continue to show a declining trend, while consumer confidence remains at an unchanged low level, cf. Chart 8. The labour market remains the Achilles heel of the euro area economies. Employment and unemployment remained more or less stable over the summer. A relatively flat labour market, compared with e.g. the USA, has characterised the euro area during the past three sluggish years. The lacking cyclical effect is to a large extent a result of the rigid labour-market structures in many euro area member states. A case in point is Germany, where labour-market reforms are, however, under-

14 10 RETAIL SALES AND CONSUMER CONFIDENCE IN THE EURO AREA AND GERMANY Chart 8 Per cent, year-on-year 8 Euro area Percentage balances 10 Per cent, year-on-year 8 Germany Percentage balances Retail sales Consumer confidence (right-hand axis) Retail sales Consumer confidence (right-hand axis) Source: EcoWin. way. Over the summer several large German enterprises concluded supplementary collective agreements with their employees in order to reduce payroll costs, which are among the highest in the world. One element of the new agreements was longer working hours without pay compensation. Business confidence in the euro area increased until May and then levelled out. In Germany the IFO index has been yielding since the turn of the year. The development in euro area industrial production resembles the development in business confidence, rising in the spring and showing a weaker trend in the latest data. Euro area inflation in terms of annual HICP growth was 2.3 per cent in July, representing a marginal increase during the summer 1. The latest trough was 1.6 per cent in February. The subsequent rise was to a large extent driven by energy prices. Core inflation stated as HICP excluding energy, food, alcohol and tobacco, which more accurately captures internal price pressures, was 1.8 per cent in July, i.e. still on the low side of 2 per cent. The ECB did not change its monetary-policy interest rates in the period under review. The Governing Council finds that in the coming months HICP will remain above 2 per cent, but in the slightly longer run it will be in accordance with the ECB's objective of price stability, i.e. below but close to 2 per cent. The summer saw renewed focus on the Stability and Growth Pact. Several member states still have large government budget deficits, thus jeopardising the credibility of the Pact. In July the Court of Justice delivered its judgment in respect of the dispute from the autumn of 2003 between the European Commission and the Council, cf. Box 2. 1 The preliminary flash estimate for August shows unchanged annual growth compared to July.

15 11 JUDGMENT OF THE COURT OF JUSTICE OF 13 JULY 2004 CONCERNING THE EXCESSIVE DEFICIT PROCEDURE Box 2 In recent years, a number of EU member states have failed to comply with the limit set by the EU Treaty for government budget deficits, i.e. 3 per cent of GDP. The indications that Germany and France would once again exceed the 3-per-cent limit in 2004 meant that in the autumn of 2003 the European Commission recommended that the Ecofin Council ordered the two member states to tighten fiscal policy to correct their deficits. The recommendations of the Commission failed to achieve the required majority in the Ecofin Council of 25 November Instead the Ecofin Council adopted conclusions calling for a reduction of the budget deficits to less than 3 per cent of GDP by Furthermore, the Council conclusions held the excessive deficit procedure in abeyance so that sanctions would not initially be imposed on the two member states. 1 On 27 January 2004 the Commission brought an action before the Court of Justice challenging the Ecofin Council's failure to adopt the decisions recommended by the Commission, and the conclusions adopted by the Council, which the Commission believed to be contrary to the Treaty guidelines. The Court delivered its judgment on 13 July In the judgment, the Commission's first claim is declared to be inadmissible, while the Court finds for the Commission in respect of the second claim. In other words, the Court refuses to annul the Ecofin Council's failure to adopt the Commission's recommendations. According to the judgment, the lack of the required majority in the Ecofin Council for a recommendation from the Commission merely means that no decision, not even an implied one, exists, which can be challenged. On the other hand, the judgment states that the Council's conclusions of 25 November 2003 to explicitly hold the excessive deficit procedures in abeyance are not valid. Furthermore, it is pointed out that the Ecofin Council cannot modify recommendations already adopted without being prompted again by the Commission since the Commission has the right of initiative in the excessive deficit procedure. In summary the judgment must be interpreted to the effect that the Ecofin Council can de facto hold the excessive budget procedure in abeyance if the required majority for adopting a decision is not achieved. Nevertheless, the judgment also states that the Ecofin Council is not empowered to put forth new conditions and recommendations for member states under the excessive deficit procedure, except on the basis of the rules laid down by the Treaty and at the recommendation of the European Commission. 1 See Thomas Haugaard Jensen and Jens Anton Kjærgaard Larsen, The Stability and Growth Pact Status 2004, Danmarks Nationalbank, Monetary Review, 2nd Quarter 2004 for a detailed review. UK The UK economy seems to be robust. GDP growth was 0.9 per cent in the 2nd quarter, and since the 2nd quarter of 2003 quarterly growth has been in the range of 1 per cent. This is considerably above the EU average. In the 2nd quarter growth was still driven by domestic demand, with rising private consumption and investments. Exports and imports rose again in the 2nd quarter after having fallen in the 1st quarter.

16 12 A price boom in the housing market has been an important stimulus to private consumption in the UK. The rising trend in housing prices became less pronounced in 2003, but in 2004 the annual rate of increase has once again exceeded 20 per cent (Halifax index). General inflation, measured by the Harmonised Index of Consumer Prices, HICP, has been stable at around 1.5 per cent year-on-year. Core inflation increased slightly in the 1st half of the year. The strong economic growth has entailed a tight labour market, bringing the economy close to its capacity limit. Unemployment has declined steadily since May 2003 and is now below 5 per cent. As a result of the increasing pressure on the economy, the Bank of England raised it benchmark interest rate in August, for the fifth time since November It was raised by 0.25 per cent, from 4.5 to 4.75 per cent, the highest level for almost three years. The government budget balance has deteriorated significantly in recent years and is close to 3 per cent in spite of the surge in activity. The budget deficit is primarily attributable to fiscal-policy relaxations in 2002 and THREE NEW MEMBER STATES JOIN ERM II Box 3 With effect from 28 June 2004 Estonia, Lithuania and Slovenia joined the EU's exchange-rate mechanism, ERM II, as part of their preparations for euro area membership. The table below shows the fixed central rates and the fluctuation margins of +/- 15 per cent for the new currencies. Estonia and Lithuania will unilaterally continue their currency boards within the framework of ERM II. The euro is at the core of ERM II, and the other participating currencies have central rates vis-à-vis the euro, but not vis-à-vis each other. The obligation to intervene if a participating currency reaches one of its fluctuations margins rests on the central bank of the relevant member state and the ECB only. Other participating member states are under no obligation to intervene. The entry of the new member states will not entail any changes in the central rate, fluctuation band and other terms and conditions for the Danish krone in ERM II. CENTRAL RATES AND FLUCTUATION BANDS IN ERM II National currency per euro Estonian kroon (EEK) Lithuanian litas (LTL) Slovenian tolar (SIT) Danish krone (DKK) Upper rate Central rate Lower rate Fluctuation band, per cent.. +/- 15 +/- 15 +/- 15 +/- 2.25

17 13 Sweden The past year or so has seen a clear increase in activity in the Swedish economy. In the 2nd quarter of 2004 GDP rose by 0.9 per cent compared to the preceding quarter. Of particular significance is the marked rise in fixed investments. This reflects a relatively high degree of capacity utilisation and increased profitability for business enterprises. In spite of the prolonged period of robust growth, unemployment did not begin to fall slightly until the summer. An unemployment rate of 5.7 per cent is not alarming, but the marked rise in unemployment seen so far may indicate structural problems. At 1.1 per cent, underlying inflation according to the index preferred by Sveriges Riksbank, UND1X, continued to be very low in July, and it is still the estimate of Sveriges Riksbank that inflation is not likely to exceed the inflation target of 2 per cent in a 2-year perspective, for which reason an unchanged interest rate of 2 per cent has been maintained since April Norway After a few years of declining growth in mainland Norway, the trend has reversed. GDP rose by 0.5 per cent in the 1st quarter and was thus 3.5 per cent higher than in the 1st quarter of The recovery in the 1st quarter reflected an increase in private consumption by almost 2 per cent, among other factors. Inflation in terms of KPI rose slightly in July to 1.5 per cent, and underlying inflation, which is stated exclusive of increases in energy prices and changes in real indirect taxes, was low at an annual growth rate of 0.2 per cent in July. Norges Bank maintained its sight-deposit rate at 1.75 per cent during the summer, referring to a low level of inflation but increasing growth. The wording of the time horizon for the inflation target has been changed to better reflect the monetary-policy strategy. The previous 2- year clause has been replaced by "Norges Bank sets the interest rate with a view to stabilising inflation at the target within a reasonable time horizon, normally 1-3 years". DEVELOPMENT IN THE DANISH FINANCIAL MARKETS In the period under review the krone has been stable vis-à-vis the euro at a slightly stronger level than the central rate. In May and June the krone strengthened marginally from kr per euro to kr per euro, and Danmarks Nationalbank made net foreign-exchange pur-

18 14 chases for small amounts. At the end of August the exchange rate was kr per euro. The modest strengthening of the krone in May and June coincided with non-residents' net purchases of Danish krone-denominated bonds and a pause in residents' net purchases of foreign securities. In July and early August the strengthening of the krone ceased, and at the same time residents again began to buy foreign securities and non-residents resold Danish bonds. At the end of August, Danmarks Nationalbank's lending rate was 2.15 per cent, while the discount and current-account rates were 2.0 per cent. As in the euro area, monetary-policy interest rates in Denmark have remained unchanged since June The spread between Danmarks Nationalbank's lending rate and the ECB's minimum bid rate is therefore still 0.15 per cent. Money-market interest rates in Denmark have mirrored those in the euro area, and the spreads have generally been on the low side of the spread between the monetary-policy interest rates. The yield on Danish 10-year government bonds has mirrored that of the equivalent German securities. The replacement of the Danish benchmark security on 1 July 2004 with a security with 2 years' longer maturity entailed a technical widening of the calculated yield spread by approximately 20 basis points. At the end of August the long-term yieldspread vis-à-vis Germany was around 35 basis points, measured on the basis of the new benchmark security 1. In July lending by banks and mortgage-credit institutes was approximately 8 per cent higher than in the same month of the preceding year, cf. Chart 9. Growth in business lending, which generally fluctuates considerably, decreased a little during the summer after having risen significantly in the spring. Lending to households increased by almost 9 per cent year-on-year in July This growth rate is in line with the development in recent years and still somewhat higher than growth in consumption. Growth in the money stock (M2) was 10 per cent year-on-year in July In July, year-on-year growth in lending by banks to households and business was 16 and 6 per cent, respectively. While growth in lending by mortgage-credit institutes has been relatively stable in recent years, growth in lending by banks has been rising from low levels since the summer of 2003 and the spring of 2004 for households and business, respectively. This is primarily attributable to the circumstance that banks have begun to offer loans resembling mortgage-credit loans. 1 Adjusted for the difference in maturity between the bonds, the spread was just under 25 basis points.

19 15 LENDING BY BANKS AND MORTGAGE-CREDIT INSTITUTES Chart 9 Per cent, year-on-year Households Business Totalt Note: Including lending by the banks' foreign branches. Source: Danmarks Nationalbank. The proportion of new loan types in the mortgage-credit market has continued to increase in recent months. Deferred-amortisation mortgage-credit loans, mainly with adjustable interest rates, accounted for 12 per cent of outstanding mortgage-credit loans at the end of the 2nd quarter of Adjustable-rate loans accounted for 42 per cent of total mortgage-credit loans at end-july The households' interest payments on loans from banks and mortgagecredit institutes have been falling as interest rates have gone down in recent years. Box 4 elaborates on this development and the conclusion is that the fall in the households' interest expenditure has had a positive, albeit limited, impact on private consumption. THE DANISH ECONOMY The preliminary quarterly national accounts for the 2nd quarter pointed to strong recovery in the Danish economy in the first two quarters of the year, driven by private consumption and exports. Quarterly growth in GDP in constant prices was 0.2 per cent in the 2nd quarter and 1 per cent in the 1st quarter, and this indicates growth of over 2 per cent for the full year The relatively modest growth in the 2nd quarter is attributable to, inter alia, a considerable decrease in stockbuilding,

20 16 THE HOUSEHOLDS' INTEREST PAYMENTS Box 4 The decline in interest rates in recent years has entailed lower interest expenditure for households, cf. the Chart. Average interest rates on outstanding loans from banks and mortgage-credit institutes have been falling steadily, and in June 2004 they were just over 1 per cent lower than at the beginning of In the same period, the households' quarterly interest payments to banks and mortgage-credit institutes decreased from kr billion to kr billion, reflecting a considerable fall in interest payments on mortgage-credit loans and practically unchanged interest payments to banks. Household borrowing from both banks and mortgage-credit institutes has risen since the beginning of 2003, and thus the lower interest payments do not reflect reduced borrowing. The declining trend in interest payments is attributable to the generally lower level of interest rates, as well as the households' shift to cheaper products (e.g. from fixed-rate to adjustable-rate mortgage-credit loans). Viewed in isolation, the lower interest payments seen recently have left households with more money for consumption. If the fall in interest payments, kr. 1.3 billion per quarter, had fully passed through, the effect after tax would have been an increase in private consumption by around 0.5 per cent. However, the total impact on private consumption is affected by a number of factors. For instance, the households' interest income from bank deposits has also decreased (quarterly interest income fell by kr. 0.4 billion from the beginning of 2003 to the first quarter of 2004), and as a result of the declining interest payments to mortgage-credit institutes the return on investments in mortgage-credit bonds has fallen. The households' direct ownership of outstanding mortgage-credit bonds is limited, while the indirect ownership share (e.g. via pension savings) is somewhat larger. Overall the fall in the households' interest expenditure is deemed to have had a positive, but limited, impact on private consumption. On the other hand, the households' interest expenditure will increase if interest rates go up again. Initially, interest payments on variable-rate loans from banks and adjustable-rate loans from mortgage-credit institutes would increase. Viewed in isolation, a rise in interest rates by 1 per cent would cause quarterly interest payments by households to rise by just over kr. 1 billion in the first year, assuming that the debt and its composition are unchanged. This corresponds to almost 0.5 per cent of private consumption if the tax deductibility of interest payments is taken into account. INTEREST RATES AND PAYMENTS FOR HOUSEHOLD LOANS Per cent Yield to maturity on household loans Jan Apr Jul Oct Jan Apr Mortgage-credit institutes Banks Kr. billion Interest payments by households Kr. billion Q1 03 Q2 03 Q3 03 Q4 03 Q1 04 Q2 04 Banks Mortgage-credit institutes (right-hand axis) Note: Lending in Danish kroner. Source: Danmarks Nationalbank.

21 17 which made a strong negative contribution to GDP growth by -0.7 per cent. In the 1st quarter stockbuilding contributed 1.2 per cent to GDP growth. Private consumption continued to rise in the 2nd quarter, partly as a result of higher car sales. Public consumption and investments, excluding stock fluctuations, rose again after a slight decline in the 1st quarter. Both exports and imports increased strongly, and net exports were an important factor behind GDP growth in the 2nd quarter. In conclusion, the national accounts available indicate a reversal in the Danish economy in the summer of 2003 and a continued upward trend, cf. Chart 10. The reversal is becoming more evident. Growth in 2003 has been adjusted upwards from 0.4 per cent to 0.5 per cent as a result of higher growth rates in the 2nd half of the year, and GDP growth in the 1st quarter of 2004 has also been adjusted upwards. The strong level of consumption is reflected in e.g. retail sales, which picked up further during the summer. Car sales have also improved. In particular, sales of vans have increased considerably during the past year, one reason being higher sales of low-tax, restricted-use vehicles (yellow licence plates) to private households. The increase in car sales should also be viewed against the background of the ageing Danish vehicle fleet. A sustained robust housing market, low interest rates, tax cuts and higher employment all boost private consumption. This is reflected in GDP GROWTH AND GROWTH CONTRIBUTIONS FROM PRIVATE CONSUMPTION AND NET EXPORTS Chart 10 Per cent, quarter-on-quarter Growth contribution, net exports Growth contribution, domestic demand Quartely GDP growth Source: Statistics Denmark

22 18 CONSUMER AND BUSINESS CONFIDENCE Chart 11 Percentage balances Percentage balances Manufacturing Service Building/construction Consumer confidence (right-hand axis) -6 Note: All series are seasonally adjusted, consumer confidence by Danmarks Nationalbank. Source: Statistics Denmark. the consumer confidence indicators, which rose in the 1st half of the year and are at the highest level since the spring of 1998, cf. Chart 11. Business confidence in the non-farm sector is also picking up. The industrial confidence indicator in particular has risen, and in the summer it was above its usual average. Expectations are positive in all key manufacturing sectors with an overweight in the durable consumer goods sectors. However, these expectations have not yet fully passed through to industrial production, which only rose slightly in the 1st half of the year. The most recent data for Danish foreign trade apply until June and show that both imports and exports have been rising since mid On the exports side, the trend has been particularly noticeable for manufactured exports, which constitute more than half of total exports. In addition, exports of energy and services have risen due to the development in oil prices and freight rates. On the imports side, both consumer imports, excluding cars, and business imports have risen. The seasonallyadjusted trade surplus was kr. 5.5 billion in June and has now been fluctuating at this level on a monthly basis for more than three years. The current-account surplus was just over kr. 44 billion for the 12- month period July 2003 to June This was just over kr. 13 billion more than in the preceding 12-month period, i.e. July 2002 to June Above all, the balance of services has improved with continued growth

23 19 in net revenue from marine transport and also higher net revenue from intermediation of goods as well as consultancy services. In addition, there have been improvements in respect of interest and dividends. Unemployment has been falling since the turn of the year and was slightly lower in July than in the autumn of 2003, cf. Chart 12. The decline in unemployment in 2004 reflects e.g. a higher rate of activation by the Danish Employment Service (AF). Employment as stated in the national accounts increased by a total of 12,000 in the first two quarters of the year. Since this figure is not matched by a fall in unemployment, the indications of a labour-market recovery must have attracted more people to the labour force. The annual wage-increase rate in the sectors covered by agreements with the Confederation of Danish Employers has declined from 4.3 per cent at end-2002 to 3.4 per cent in the 2nd quarter of 2004, inter alia reflecting rising unemployment until the end of During the last four quarters the declining trend in the wage-increase rate has, however, levelled off and the latest decrease from the 1st to the 2nd quarter is to some extent attributable to the effect of extra days of holiday entitlement from 1 May 2003 having dropped out of the annual increase rate. Overtime payments rose in the 2nd quarter of 2004, which could indicate that some enterprises have initially applied overtime to meet increasing demand. NUMBER OF PERSONS IN AF ACTIVATION SCHEMES OR UNEMPLOYED, SEASONALLY ADJUSTED Chart 12 1,000 persons 1,000 persons Unemployment Unemployment + AF activation schemes AF activation schemes (right-hand axis) Note: Own seasonal adjustment of AF activation data. Source: Statistics Denmark and the National Labour Market Authority.

24 20 With the improved prospects for the euro area, high growth in the rest of the world economy and indications that the labour market is picking up, the economic prospects for Denmark are better than they have been for long. This affects the requirements as to the forthcoming Budget Proposal. In its Budget Proposal for 2005 the government contemplates a neutral fiscal policy in terms of the fiscal effect. The latter is an estimate of the immediate effect of fiscal policy on GDP. The fiscal policy for 2005 aims at improving the budget by 0.3 per cent of GDP. In addition, a positive cyclical effect is expected. Following the relaxation of fiscal policy in 2004 it is important to prioritise the medium-term fiscal orientation again. In June the government and the Danish People's Party concluded an agreement to reform the framework for handling public tasks and providing public services, known as the structural reform. Among other things, the reform will entail considerable amendments of the localgovernment structure, including a reduction of the number of municipalities. In this connection it is essential to avoid a surge in localgovernment expenditure, particularly in the field of construction, prior to the implementation of the reform. The government has revised its medium-term economic orientation, the 2010 Plan. The objective of the revised plan is still to ensure sustainable fiscal policy so that no need for adaptation will arise after This calls for a permanent improvement in employment and tight management of government expenditure. More specifically, growth in government consumption must be reduced to 0.5 per cent annually from 2005 onwards, which is significantly lower than the growth rate for many years, while employment must improve by 100,000 persons. Initiatives already launched are deemed to contribute 40,000 extra jobs, while forthcoming initiatives are to provide permanent employment for a further 50-60,000 persons. Price development Inflation, measured as the annual rate of increase in the Harmonised Index of Consumer Prices, HICP, rose from 0.5 per cent in April to 1.1 per cent in July. This was mainly attributable to a hike in energy prices. The annual rate of change in energy prices, excluding taxes, went from a slight decrease in April to an increase by more than 10 per cent in July. This not only reflects a rise in energy prices from April to July 2004, but also a decrease in the same three months of The overall increase in HICP is still somewhat below the level in the euro area, where inflation was compiled at 2.3 per cent in July. For all

25 21 HICP INFLATION AND CORE INFLATION IN DENMARK AND THE EURO AREA Chart 13 Per cent, year-on-year 3.5 HICP-inflation Per cent, year-on-year 3.5 Core inflation Denmark Euro area Denmark Euro area Note: Core inflation measured as HICP inflation excluding energy, food, alcohol and tobacco. Source: Statistics Denmark and Eurostat. EU member states, HICP inflation is stated exclusive of energy, food, alcohol and tobacco. This may be seen as a simple measure of the price development adjusted for volatile and special prices. Unlike overall inflation, this core inflation was higher in Denmark than in the euro area for some time, but since April Danish core inflation has been below that of the euro area, cf. Chart 13. This may be attributable to special factors, but presumably also reflects greater flexibility in terms of adapting payroll costs in Danish business enterprises. The subdued Danish price pressure is also reflected in domestic market-determined inflation, IMI, which was down from 2.2 per cent in the 1st quarter to 1 per cent in the 2nd quarter. In July IMI was 0.9 per cent.

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27 23 New Terms and Conditions for Accounts On 14 June 2004 Danmarks Nationalbank made a number of changes to its terms and conditions for accounts. The terms and conditions for accounts 1 constitute the formal basis for access to and use of accounts, extension of credit and collateral at Danmarks Nationalbank. The most important changes were as follows: Access to use euro-denominated government and mortgage-credit bonds as collateral for monetary-policy loans and intra-day credit in kroner and euro. Previously, access solely encompassed kronedenominated securities. Like krone-denominated securities, eurodenominated securities must be listed on the Copenhagen Stock Exchange and registered at VP Securities Services to be pledged as collateral to Danmarks Nationalbank. A deduction (exchange-rate haircut) of 3 per cent is used to calculate the collateral value of eurodenominated securities pledged as collateral for credit in kroner. The provisions relating to margin and securities-specific deductions (market-price haircuts) in the market value when calculating the collateral value of securities in connection with credit in kroner have been adjusted to correspond to the provisions in force since 8 March 2004 regarding credit in euro. The new provisions for credit in kroner use more differentiated haircuts depending on the securities' remaining maturity and liquidity characteristics. In return, the general excess collateral (margin) of 2 per cent has been discontinued. Use of synthetic prices for calculating the collateral value of securities that have not been traded during the last 5 banking days. The calculated collateral value thus reflects the current price conditions. This has enabled discontinuation of the previously used 10-percentage-point illiquidity addition to the market-price haircuts. The terms and conditions for accounts can be viewed at Danmarks Nationalbank's website under "Rules". 1 Documentation for monetary-policy instruments and settlement of payments.

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29 25 The Basel Committee's Endorsement of New Capital-Adequacy Rules On 26 June 2004 the members of the Basel Committee 1 endorsed the revised recommendations for the capital requirements 2 imposed on credit institutions by supervisory authorities, also known as Basel II. Against this background the European Commission on 14 July 2004 submitted a proposal for directives on new capital-adequacy rules applying to credit institutions and investment firms. 3 The proposal is to be adopted by the European Parliament and the Council according to the codecision procedure. The proposal is expected to be considered by the Council towards the end of the year. The directive is expected to come into force in The documents from the Basel Committee and the European Commission are in broad terms identical, but there are deviations owing to their different target groups and legal effects. With the adoption of the new capital-adequacy rules the present uniform set of rules is replaced by more institution-specific rules, whereby the capital requirements reflect more clearly the risks incurred by the individual credit institution. At the same time, the credit institutions are encouraged always to strive for the best possible risk management. Overall, the new capital-adequacy rules consist of three pillars. Pillar 1 is the minimum capital requirements to cover credit and market risk and, as a new element, operational risk. The individual institution may choose between different calculation methods, subject to approval by the supervisory authorities. Under pillar 2 the supervisory review process is strengthened. The supervisory authorities must supervise that the credit institutions' capital base is sufficient to support their risks and to encourage the credit institutions to optimise internal risk management and control. Pillar 3 lays down a number of requirements for credit institutions as regards disclosure of more detailed information on risks, cap The Basel Committee, whose secretariat is at the Bank for International Settlements, BIS, was set up in 1974 with the purpose of strengthening the stability of the international financial system. The following countries are represented on the Committee: Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain, Sweden, Switzerland, UK and USA. The Basel Committee, International Convergence of Capital Measurement and Capital standards: a Revised Framework. The document can be downloaded from Commission, Proposal for directives of the European Parliament and of the Council, Re-casting Directive 2000/12/EC of the European Parliament and of the Council of 20 March 2000 relating to the taking up and pursuit of the business of credit institutions and Council Directive 93/6/EEC of 15 March 1993 on the capital adequacy of investment firms and credit institutions, COM (2004) 486 final.

30 26 ital structure and capital adequacy, risk management, etc. with the purpose of increasing transparency and strengthening market discipline. The Basel Committee's first proposal for a revision of the existing capital-adequacy rules from 1988 was published in 1999 and has been followed by three consultations and quantitative impact studies. It has thus been a lengthy process in which inter alia the results of the three quantitative impact studies have caused major changes to the recommendations. Since the Third Consultative Paper was published in April 2003, the Basel Committee has postponed the commencement of the rules from 2007 to 2008 for the institutions that wish to use the advanced method when calculating the minimum capital requirement to cover credit and operational risks. During the additional year the existing rules will apply to the institutions, but the institutions must concurrently make calculations according to the advanced methods. It is still unknown whether the EU will apply the same approach. As something new, only non-expected losses are included in the calculation of minimum capital requirements according to the internal ratings-based approaches, whereas expected losses are covered by the provisions made by the institutions. Provisions in excess of expected losses can to some extent be included in the capital base. 1 Conversely, the capital base is reduced if provisions are lower than expected losses. Basel II aims at the same global capital level as under the existing rules at the time of commencement, but the new rules will lead to greater dispersion in the credit institutions' capital requirements as a result of diverse risk profiles. The latest quantitative impact studies indicate inter alia that the objective of an unchanged global capital level cannot be met, due to the altered basis of calculation. Against this background the minimum capital requirements to cover credit risks calculated according to the internal ratings-based approaches are expected to be revised upwards. 1 As from 1 January 2004 the term for liable capital has been changed to capital base in Danish law.

31 27 Counterfeit Banknotes Maria Carlsen and Johanne Dinesen Riishøj, Secretariat INTRODUCTION Since spring 2004 quite a few genuine-looking counterfeit 100-krone banknotes have been found. Even the latest security features have been copied on these banknotes. Whereas most counterfeit banknotes are made using printers, these counterfeit 100-krone banknotes have been made using a printing press. For the first time in approximately 15 years, press-printed counterfeit Danish banknotes have been detected. Most of the counterfeit 100-krone banknotes have been found in the Copenhagen area. The incidence of counterfeiting is still limited in Denmark, however. In ,239 counterfeit banknotes were found in circulation. The direct financial loss totalled kr. 456,500, equivalent to kr per capita in Denmark. DETERMINANTS OF THE INCIDENCE OF COUNTERFEITING Counterfeit banknotes found in circulation entail a financial loss for the enterprises or individuals who inadvertently receive them, and a large number of counterfeit banknotes in circulation can undermine the confidence in money. A stable monetary system is essential to a wellfunctioning society. Central banks therefore seek to make the production of genuine-looking copies difficult by maintaining a high quality of banknotes in circulation and by enhancing the security level of the banknotes. Knowledge of the look and security features of the banknotes is another determinant of the incidence of counterfeiting. The more people who know how to distinguish between a genuine banknote and a counterfeit one, the harder it is to use counterfeit banknotes. A key element of Danmarks Nationalbank's fight against counterfeiting is thus to make the public familiar with the look and security features of the banknotes. 1 1 Information is provided e.g. at Danmarks Nationalbank's website, Notes and coins, in leaflets distributed to all households and free postcards available at cafés, in cinemas, etc.

32 28 Counterfeiters' reproduction technology has become cheaper and more readily available in recent years years ago, the production of counterfeit banknotes required specialised equipment that was expensive and difficult to obtain. Today, ordinary scanners and colour printers make it possible to produce, at low cost, counterfeit banknotes that are quite genuine-looking at first sight. A colour printer is often included in the purchase of a computer. In per cent of all Danish households owned a computer. 1 The incidence of counterfeiting is not only determined by the quality of banknotes. Police efforts to investigate and solve cases involving counterfeit banknotes also influence the volume of production and distribution of counterfeit banknotes. In addition, the incidence of counterfeiting depends on the criminal environment in the relevant country. If the criminal network is extensive, it is easier to distribute counterfeit banknotes. Counterfeiting, attempted counterfeiting or aiding and abetting counterfeiters are offences liable for a maximum penalty of 12 years, which is one of the most stringent penalties under the Danish Penal Code. Even counterfeiting a few banknotes will normally entail an unsuspended prison sentence. COUNTERFEIT DANISH BANKNOTES As mentioned above, quite a few relatively genuine-looking counterfeit 100-krone banknotes have been found since spring Whereas counterfeit Danish banknotes are typically produced using a printer, these counterfeit 100-krone banknotes have been press-printed, and the new security features, the hologram and fluorescent colours, have also been copied. The counterfeit 100-krone banknotes look genuine at first sight, but if tilted it is obvious that the window thread does not change colour. If a counterfeit 100-krone banknote is held to the light, it appears that the hidden security thread is missing, the window thread does not join up in the banknote's full height, and the watermark is only faintly visible on the reverse side. In addition, there is no "movement" in the hologram of the counterfeit banknotes, and some of the motifs in the hologram, e.g. the notes, are missing. The counterfeit banknotes have been printed in weaker colours than the genuine banknotes. The weaker print also makes the portrait of Carl Nielsen appear differently. A banknote with weaker colours should be examined closely. Some security features have been reproduced well on the counterfeit 100-krone 1 A detailed description of counterfeiting technology and the efforts to prevent counterfeiting can be found in Ulrik Bie and Sebastian Gabel, Counterfeit Banknotes, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002.

33 29 CHECKING A BANKNOTE Genuine... Box 1 Windows thread Hidden security thread...and counterfeit When a Danish banknote is held to the light, a security thread, which is otherwise hidden, must become visible, and the window thread must join up, see the upper illustration. These are two of several methods to check whether a banknote is genuine, and they have been used to identify e.g. the counterfeit 100-krone banknotes found since spring banknotes while others have been poorly reproduced. The case illustrates the importance of having several security features to focus on. Counterfeit Danish banknotes in circulation The number of counterfeit Danish banknotes found in circulation has risen significantly in the last ten years. While the number of counterfeit banknotes in circulation was approximately 100 per year in the mid-1990s,