Danmarks Nationalbank

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1 Danmarks Nationalbank Monetary Review 4th Quarter 2007 D A N M A R K S 4 N A T I O N A L B A N K

2 MONETARY REVIEW 4th QUARTER 2007 The small picture on the front cover shows the "Bankers" clock, which was designed by Arne Jacobsen for the Danmarks Nationalbank building. 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 7 December, 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. kommunikation@nationalbanken.dk Datagraf Auning A/S ISSN (Online) ISSN

3 Contents Recent Economic and Monetary Trends... 1 Two New Euro Area Member States: Cyprus and Malta Longevity Bonds a Financial Market Instrument to Manage Longevity Risk Governor Jens Thomsen and Jens Verner Andersen, Financial Markets The article discusses the perspectives for issuance of financial instruments that are indexed to the development in life expectancy (longevity bonds). Longevity bonds can transfer the risk in connection with higher life expectancy to investors in the financial markets. However, neither issuers nor investors have so far fully embraced the instrument. Against that background, the article outlines the challenges in relation to developing a market for longevity bonds, including why there is no basis for government longevity bonds. Flexicurity the Danish Labour-Market Model Erik Haller Pedersen and Johanne Dinesen Riishøj, Economics Over the last 15 years, unemployment in Denmark has gradually decreased to one of the lowest levels in the OECD. The decrease should be viewed against the background of the string of extensive labour-market reforms that were initiated in the mid-1990s. They have contributed to the special Danish labour-market model, flexicurity. The article provides a review and assessment of flexicurity. Development in Productivity in Denmark Per Flink Iversen and Johanne Dinesen Riishøj, Economics Productivity growth in Denmark has been modest in recent years compared to previously and to other countries. This article describes recent productivity trends in Denmark and makes comparison with other countries by means of harmonised data. Economic Development in the Baltic States: Success and New Challenges Karsten Stæhr, Tallinn University of Technology and Eesti Pank The Baltic States have seen very strong economic growth and rapidly increasing standards of living. This has been accompanied by very large current-account deficits and rising inflation. It is not clear whether the result will be a hard or a soft landing.

4 Hedge Funds and the Financial System Jesper Ulriksen Thuesen, Financial Markets Hedge funds can contribute to strengthening financial stability e.g. by enhancing price formation and supporting the development of new securities markets. At the same time, they can increase the risk of systemic crises. The most important means of protection against financial instability is competent risk management in the financial enterprises that are hedge-fund counterparties. Foreign-Exchange and Derivatives Markets in Rune Egstrup and Birgitte Damm Fischer, Statistics Average daily turnover in the Danish foreign-exchange market has more than doubled since Growth in the global foreign-exchange markets has also been significant. The higher turnover in the foreign-exchange markets reflects factors such as a sustained overall upswing and increasing internationalisation. In Denmark the increase is also to a large extent related to liquidity management by banks. Speech by Governor Nils Bernstein at the Annual Meeting of the Danish Bankers Association on 5 December Press Releases Tables and Graphs Section Vol. XLVI, No. 4

5 1 Recent Economic and Monetary Trends This review covers the period from mid-september to the beginning of December The global economy is subject to more uncertainty than it has been for a long time due to the continued turmoil in the financial markets and rising inflation in most countries. Global economic growth remains high, but is increasingly driven by the emerging market economies. Strong demand has led to continued high commodity prices, and above all to a surge in oil prices. The dampening of growth is primarily attributable to developments in the industrialised countries, notably a negative trend in the housing markets. GDP growth is expected to subside in the USA, but to remain stable and high in non-japan Asia and weaken in Japan. The expansion in Europe continues. The risk scenario is asymmetrical, so that global economic growth is more likely to be lower, and inflation higher, than in the central forecast. The Danish economy has heated up after several years' sustained boom. The considerable increase in activity in recent years has led to a pronounced rise in employment and the lowest rate of unemployment since Many business enterprises have problems recruiting the labour they need to match domestic and external demand. The shortage of labour is reflected in a clear upward trend in the rate of wage increase during Furthermore, it curbs supply-side growth. With a positive outlook for Denmark's trading partners, as well as sound household finances in Denmark, growth in demand is expected to increase in the near future. The pressure on the labour market is thus also likely to be sustained, and the rising rate of wage increase will have an adverse impact on Denmark's competitiveness. The risk of a subsequent period with unfavourable developments in activity and unemployment has thus increased. THE GLOBAL ECONOMY Global economic growth is high. According to the forecasts of the International Monetary Fund (IMF), global GDP growth is expected to be 5.2 per cent in 2007, compared to 5.4 per cent in In 2008, a decline to 4.8 per cent is expected. Growth may be lower due to the uncertainty concerning the US housing market and the resulting financial turmoil, as well as the risk of higher energy prices.

6 2 CONTRIBUTION TO GROWTH IN GLOBAL PPP-GDP Chart 1 Per cent USA Euro area Rest of OECD China and India Rest of world Note: Calculated on the basis of purchasing power parities (PPP) are estimates. Source: IMF World Economic Outlook, October The declining growth is attributable to developments in the industrialised world, particularly the USA. Emerging market economies and other developing countries now contribute the largest share of global growth, with China and India together accounting for approximately half of the growth, cf. Chart 1. CONSENSUS FORECASTS OF GDP GROWTH Chart 2 Per cent Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov USA 2007 USA 2008 EUR 2007 EUR 2008 JPN 2007 JPN 2008 Note: The horizontal axis indicates the time of the forecasts. Source: Consensus Economics.

7 3 GDP GROWTH, FORECASTS Table IMF EC OECD IMF EC OECD USA n.a Euro area n.a Japan n.a Note: The IMF's forecast is from October, the European Commission's and the OECD's are from November. Source: IMF World Economic Outlook, European Commission Autumn Economic Forecast, and OECD Economic Outlook. As a result of the turmoil in the international financial markets over the summer, expectations of global growth in industrialised countries have been adjusted downwards in the most recent consensus forecasts. The largest downward adjustment relates to growth in 2008 in the US economy, which is now expected to fall below its long-term level in both 2007 and 2008, cf. Chart 2. The international institutions expect even lower growth in the USA in 2008 than the respondents in the consensus forecasts do, but expect the economy to pick up in 2009, cf. Table 1. The high growth in the global economy, and mainly the rising demand in the emerging market economies, is reflected in commodity prices. During 2007, the price of a barrel of Brent crude oil rose from 57 dollars at the beginning of the year to 89 dollars at the end of November. In nominal dollar terms, oil has never been more expensive, but in real terms the price is still below the peak in the early 1980s, cf. Chart 3. OIL PRICE Chart 3 Dollars per barrel Nominal oil price Real oil price Note: 3-month moving averages. The price of a barrel of Brent oil is deflated by the US consumer price index excl. energy. Source: EcoWin.

8 4 COMMODITY PRICES Chart 4 Index, March 2003 = Metals Wheat Oilseeds Soy beans Note: Metal prices in dollars according to The Economist Index. Wheat, oilseeds and soy bean prices in dollars in the futures markets. Source: EcoWin. The price of non-energy commodities has also risen. As Chart 4 shows, this particularly applies to metals, oilseeds, soy and grain the latter partly on account of bad harvests. Since the summer of 2007, the financial markets in the USA and Europe have been characterised by considerable turmoil stemming from losses on subprime US mortgages. 1 Specialised funds that had invested in securities against subprime mortgages as collateral had difficulties in obtaining normal financing in the money market. These funds began to draw on liquidity facilities in dollars provided by e.g. US and European banks. In order to secure liquidity for their own payment obligations, banks showed restraint in lending. Uncertainty about the extent of the banks' exposures to the subprime crisis, and about the banks involved, also contributed to the general caution. Against that background, longterm uncollateralised money-market interest rates rose and credit spreads i.e. the spread between uncollateralised and collateralised interest rates widened substantially, cf. Chart 5. Danish interest rates and credit spreads showed the same trend, albeit less pronounced than in the euro area and the USA. 1 Cf. Jakob Windfeld Lund, Turmoil in the Financial Markets, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2007.

9 5 US CREDIT SPREAD Chart 5 Basis points Note: Spread between 3-month dollar Libor and 3-month US Treasury bills. Source: EcoWin. The European Central Bank, ECB, and the Federal Reserve System, the Fed, have at times provided additional liquidity during the turmoil. Central-bank liquidity was increased in order to counter the reluctance to exchange liquidity in the money market. Accounts with central banks thus to a certain extent acted as substitutes for the short-term interbank market, so that some of the normal money-market activities were in effect transferred to central-bank balance sheets. This liquidity was allocated within the normal framework, i.e. by way of collateralised shortterm loans to the market in general. As a number of financial institutions have announced considerable losses, banks in both the USA and Europe have tightened their credit standards. This has had a knock-on effect on housing prices and residential investments in a number of countries and thus contributed to cooling the housing markets. This development had already been observed particularly in the USA. The trend of rising housing prices and increasing residential investments in a number of countries over the last 10 years has thus moderated or ceased. Since early September the financial turmoil has caused the price of gold to rise substantially, and demand for government bonds has also increased. The yield on a 10-year US government bond has thus fallen by approximately 60 basis points. The equivalent German yield has not fallen correspondingly and was above the US yield at end-november. The yield spread between the USA and Europe has been narrowing since mid-2006 due to the relatively more favourable cyclical position in

10 6 DOLLAR VIS-À-VIS EURO AND KRONE Chart 6 EUR per USD DKK per USD EUR per USD (left-hand axis) DKK per USD (right-hand axis) Note: Before 1999, the euro curve shows D-mark scaled by its parity rate against the euro. Source: EcoWin. Europe. This development reflects expectations that US monetary policy will still be eased, while a potential tightening of European monetary policy is expected to be postponed. YEN, NEW ZEALAND DOLLAR AND ICELANDIC KRONA VIS-À-VIS EURO IN 2007 Chart 7 Index, January 2007 = Jan Feb Mar Apr Maj Jun Jul Aug Sep Okt Nov Dec New Zealand dollar Japanese yen Icelandic krona Note: An increase indicates depreciation. Source: EcoWin.

11 7 The dollar has reached an all-time low against the euro. At the end of November, the exchange rate was 1.46 dollars per euro, and the exchange rate vis-à-vis the Danish krone has not been lower since a brief spell at the end of 1978, cf. Chart 6. At the end of November the dollar traded at kr In relation to the yen, the dollar has depreciated by approximately 10 per cent since the summer. Carry trades, whereby investors borrow in yen and invest in high-yield currencies, have been settled. The appreciation of the yen vis-à-vis the euro in August and again in November and the depreciation of high-yield currencies such as the New Zealand dollar and the Icelandic krona against the euro, cf. Chart 7, support the impression that carry-trade positions have been settled. USA In the 3rd quarter, output in GDP terms rose by 1.2 per cent over the 2nd quarter, which was a higher growth rate than in the preceding quarters. Private consumption recovered after a weak 2nd quarter, and corporate investments and exports showed sound growth rates. The downturn in the housing market continued with a declining trend in both residential investments and housing prices, while housing turnover fell, as has been the case since the beginning of 2006, cf. Chart 8. US HOUSING MARKET Chart 8 Index 120 Per cent, year-on-year Existing-home sales, January 2005 = 100 Building permits, January 2005 = 100 Confidence indicator for the construction sector House prices, per cent year-on-year (right-h. axis) Note: Existing-home sales according to the National Association of Realtors, own indexation. Building permits from US Department of Commerce, own indexation. The confidence indicator is the NAHB index, in which a value above over 50 indicates good and a value below 50 bad sales conditions. House prices are the change in the Case-Shiller Home Price index. Source: EcoWin.

12 8 Export growth, which has been underpinned by the weaker dollar, has helped to improve the US balance of goods and services. In 2007 to September, the average deficit was 59 billion dollars per month, compared with 65 billion in the same period of The improvement is also attributable to the weak development in domestic demand. Since imports are around twice the size of exports, higher export growth will only slowly be reflected in a smaller external deficit. US employment picked up in November after a period of modest growth over the summer. Unemployment has been rising slightly since March and was 4.7 per cent in November. In October, consumer prices were 3.5 per cent higher than one year earlier due to the further energy-price hikes in the autumn. Consumer prices excluding food and energy rose by 2.1 per cent in October compared to one year earlier, which is in line with the trend in the preceding months. The Fed cut the fed funds target rate by 50 basis points on 18 September and by a further 25 basis points on 31 October, to 4.5 per cent, cf. Chart 9. According to the minutes of the September meeting, this was done in order to forestall some of the adverse effects on the economy that might otherwise arise due to the financial turmoil. After the rate reduction in October, monetary policy was assessed to balance the risk of higher inflation against the risk of lower growth, reflecting Fed expectations of subdued growth in the 4th quarter as a result of the continued decline in residential investments. The weak housing market, tighter credit standards and elevated oil prices are also expected US FED FUNDS TARGET RATE Chart 9 Per cent Source: EcoWin.

13 9 to curb growth in 2008, while higher growth is expected in In the financial markets, expectations in relation to short-term interest rates have been reduced considerably in recent months, and further rate cuts of 25 basis points each are expected from the Fed in the coming year. On 11 December, the fed funds target rate was lowered to 4.25 per cent, and the increased uncertainty was emphasised. ASIA In Japan, GDP was 0.4 per cent higher in the 3rd than in the 2nd quarter. Quarterly GDP growth in Japan remains very volatile, in that GDP fell in the 2nd quarter. Average economic growth has subsided in 2007 relative to previous years. In the 3rd quarter, GDP was mainly supported by rising exports. Consumer prices were 0.3 per cent higher in October than in the same month of 2006, while consumer prices excluding food and energy were 0.3 per cent lower year-on-year in October. Core inflation has not been positive since The sustained deflation has delayed normalisation of monetary policy, and the Bank of Japan has not changed its monetary-policy interest rate since it was raised by 25 basis points to 0.5 per cent in February. In China, GDP rose by 11.5 per cent in the 3rd quarter compared with the preceding year. A slightly slower growth rate is expected in future due to lower export growth as well as measures taken by the Chinese authorities in response to the first signs of overheating. Inflation has been rising and was 6.5 per cent annualised in October. The increase is primarily attributable to higher food prices. The People's Bank of China has not changed its interest rates since mid-september. In the same period, the downward trend of the dollar caused the renminbi to depreciate vis-à-vis the euro and other currencies, so that the effective exchange rate has fallen by just over 1 per cent. In India, where quarterly national accounts are not available, GDP rose by 9.4 per cent in the financial year ending in March 2007, and developments in e.g. industrial production over the summer point to sustained strong growth. Inflation remains relatively high. The most recent data relates to May, when consumer prices were 6.6. per cent above the level one year before, driven by factors such as higher food prices. EUROPE In the euro area, GDP growth was 0.7 per cent in the 3rd quarter over the preceding quarter. Growth was evenly distributed among the large euro area member states, with GDP rising by 0.7 per cent in Germany, France and Spain and by 0.4 per cent in Italy. In Germany, growth has picked up after the slowdown at the beginning of the year due to the

14 10 negative impact of the VAT increase on private consumption. Growth is now fuelled by both exports and domestic demand. In the other large euro area member states demand is mainly driven by private consumption. In effective exchange-rate terms, the euro has appreciated by just over 6 per cent since the beginning of The depreciation of the dollar and the currencies pegged to the dollar impedes competitiveness and thereby export growth. The euro area labour market continues to improve. Unemployment was down to 7.2 per cent in October, and wage increases are moderate. In the 2nd quarter, the ECB's wage index was 1.8 per cent higher than one year earlier. The average increase in 2006 was 2.2 per cent. In October and November, respectively, consumer prices were 2.6 and 3.0 per cent higher than one year earlier, reflecting the further energy price hikes and higher food prices in the autumn. Core inflation thus remains stable. Consumer-price inflation excluding food, energy, tobacco and alcohol was 1.9 per cent year-on-year in October. The ECB has not changed its minimum bid rate since it was raised to 4 per cent in June. In his statements after the meeting of the Governing Council in December, the President of the ECB said that there were upside risks to price stability over the medium term, but that reappraisal of risk in financial markets was still evolving and was accompanied by continued uncertainty about the potential impact on the real economy. Money-market interest rates indicate expectations of unchanged monetary-policy interest rates in the next six months. Before the summer, further increases were expected during 2007 and into In early December, the bank rate in the UK was lowered by 25 basis points to 5.50 per cent, while the central banks of three Nordic countries raised their interest rates all of them citing mounting inflationary pressure: Sweden's by 25 basis points on two occasions, in September and October, to 4.0 per cent; Norway's by 25 basis points on two occasions, in August and September, to 5.0 per cent; and Iceland's by 45 basis points on 1 November to per cent. Turning to Central and Eastern Europe, interest rates were raised by 25 basis points on two occasions, in August and November, in both Poland (to 5 per cent) and the Czech Republic (to 3.5 per cent). THE DANISH ECONOMY: MONETARY AND EXCHANGE-RATE CONDITIONS The Danish krone has been stable vis-à-vis the euro at a level slightly stronger than its central rate in ERM II. The yield spread between Danish and German 10-year government bonds has fluctuated around a level of 10 basis points since mid-september.

15 11 SPREADS BETWEEN MONEY-MARKET INTEREST RATES IN DENMARK AND THE EURO AREA 2007 Chart 10 Basis points Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1 month 3 months 6 months 12 months Note: Cibor and Euribor are the respective reference interest rates for uncollateralised interest rates in the Danish and euro area money markets. Source: Danmarks Nationalbank. The financial turmoil stemming from the subprime US mortgages has not entailed a need for extraordinary liquidity allocations in Denmark. In the Danish money market, the impact has more or less been limited to the uncollateralised long-term money-market interest rates. Turnover in the interbank market is relatively modest in this segment, but many loan contracts are linked to Cibor, which is the reference rate for uncollat eralised interbank loans. Thus the international financial turmoil does not seem to have had a restraining impact on Danish interbank lending in kroner at the short end of the money market. The day-to-day interest rate has followed a normal pattern, and turnover in uncollateralised day-to-day lending was higher in August and September than previously in Long-term uncollateralised money-market interest rates increased at the beginning of August, but less than the equivalent euro area interest rates, so that the spreads between Danish and euro area money-market interest rates narrowed, cf. Chart 10. This indicates that market participants at an early stage assessed the exposure of Danish banks in the subprime market to be limited. This was later to be confirmed. The spreads widened again during September and October, but have subsequently been affected by rising interest rates in the euro area since 1 Based on data from T/N (tomorrow/next) reporting banks.

16 12 3-MONTH CREDIT SPREAD Chart 11 Basis points Note: Spread between 3-month Cibor and repo rate. Source: Danmarks Nationalbank. many euro area banks adjust their balance sheets towards the end of the year. This means that the banks reduce their lending and build up liquidity reserves around the turn of the year. Such adjustments have also led to higher interest rates in the euro area in previous years, thereby reducing the yield spread. While borrowing by banks in kroner in the interbank market has been more or less normal, there are indications that access to liquidity in dollars has been constrained. This reflects the fact that the dollar market was the source of the financial turmoil. Even the otherwise very large and liquid market for FX swaps 1 between euro and dollars stagnated on 9 August and for a while it was almost impossible to borrow dollars against euro as collateral. A shortage was also seen in the Danish FX swap market, where the price of borrowing dollars and to a lesser extent euro against collateral in kroner rose sharply for a period, and by much more than differences between e.g. uncollateralised reference interest rates should warrant. In a situation with financial turmoil, the spread between uncollat eralised and collateralised interest rates will normally widen due to increased uncertainty. Chart 11 shows the 3-month credit spread in the Danish money market. The previous peaks relate to the currency unrest in connection with Russia's debt crisis and the problems experienced by 1 Loans in one currency against collateral denominated in another currency.

17 13 ADJUSTABLE-RATE LOANS IN RELATION TO TOTAL LENDING BY MORTGAGE-CREDIT INSTITUTES Chart 12 Per cent Adjustable-rate, total Of which adjustable within 1 year Note: Mortgage-credit loans for all non-mfi sectors. Source: Danmarks Nationalbank. the hedge fund LTCM in 1998, Y2K issues, and uncertainty about the outcome of the Danish referendum on adoption of the euro in The present credit spread is wide, but the impact on the money market in kroner is to a large extent limited to the long-term uncollateralised interest rates. Both the USA and the euro area have seen greater tensions in several segments of the money market, cf. also Chart 5 above. The Fed and the ECB therefore provided additional liquidity on several occasions. Net capital outflows from portfolio investments totalled around kr. 30 billion in September and October, primarily reflecting residents' net purchases of foreign bonds. The Danish krone weakened a little in September and at the end of the month Danmarks Nationalbank intervened in the market and sold foreign exchange for kr. 8.4 billion. The foreign-exchange reserve was kr billion at end-november. Growth in lending to households has been high, but receding, since the spring of 2006 and was 11 per cent in October compared with the same month of the preceding year. Growth in corporate lending was 15 per cent year-on-year in October. The sustained high growth rate in lending to the corporate sector reflects further growth in corporate investments, cf. the section on the real economy below. The ratio of adjustable-rate loans to total mortgage-credit loans has been rapidly declining, cf. Chart 12, one of the reasons being that many

18 14 GROWTH IN MORTGAGE-CREDIT LOANS WITH AND WITHOUT AMORTISATION, AND ORDINARY REDEMPTIONS Chart 13 Kr. billion 50 Kr. billion Growth in loans with amortisation Growth in deferred-amortisation loans Ordinary redemptions (right-h.axis) 1 Note: Mortgage-credit loans for owner-occupied dwellings. Quarterly growth and ordinary redemptions. Source: Danmarks Nationalbank. capped adjustable-rate loans were automatically converted into fixedrate loans when interest rates hit the agreed ceiling. In contrast, the share of deferred-amortisation mortgage-credit loans continues to increase. These loans have seen considerable net growth since their introduction on 1 October 2003, and the outstanding volume of mortgage-credit loans with amortisation has declined, cf. Chart 13. The shift towards deferred-amortisation loans means that aggregate redemptions on mortgage-credit loans have been more or less constant in recent years in spite of the increase in the total volume of outstanding mortgage-credit loans. In October 2007, a new type of mortgage loan was introduced, on which the interest rate cannot rise, but falls with interest rates in general. The price is a higher initial interest rate than on a fixed-rate mortgage loan. Technically, the mortgage loan is financed via covered mortgage-credit bonds (SDROs), cf. the Act on Covered Bonds (SDOs), which came into force on 1 July The loan could, in principle, also be structured as a mortgage-credit loan. The new loans are thus not a direct consequence of the Act. SDO legislation has paved the way for a new type of deferredamortisation loan financed via SDROs, with the possibility of deferred 1 See Recent Economic and Monetary Trends, Danmarks Nationalbank, Monetary Review, 2nd Quarter 2007, for a further description of SDOs.

19 15 GDP AND MAIN COMPONENTS SINCE 2001 Chart 14 Beginning of 2004 = GDP Private consumption Gross fixed capital formation Exports Imports Source: Quarterly national accounts, Statistics Denmark. amortisation for up to 30 years. Such loans were introduced in October. The precondition for deferring amortisation beyond 10 years is that the mortgage loan does not exceed 70 per cent of the value of the home at the time of mortgaging 1, while the threshold is 80 per cent in connection with deferred amortisation for up to 10 years. THE DANISH ECONOMY: REAL ECONOMY Economic activity, private consumption and the housing market Economic activity in Denmark, measured by GDP, rose strongly in the 3rd quarter with a growth rate of 1.3 per cent quarter-on-quarter. This should, among other factors, be viewed in the context of a fall in the 2nd quarter. Denmark has experienced a sustained upswing during the last four years. In , GDP grew by an average of 2.9 per cent p.a., while in the first three quarters of 2007 aggregate growth was 1.7 per cent over the same period of The lower growth rate in 2007 reflects pressure on production capacity. Confidence indicators point to a pronounced shortage of labour in both the construction sector and manufacturing, while capacity utilisation in manufacturing remains extremely high. According to these same indicators, the pressure does, however, seem to have eased in recent months. Fixed capital formation made a significant contribution to economic growth in 2005 and even more so in 2006, cf. Chart 14. Throughout the 1 From 2009 the threshold will be 75 per cent.

20 16 upswing, the strong growth in housing prices has led to extensive residential construction. This is reflected in a strong rise in residential investments until the end of 2006, by which time investments had grown by 67 per cent over the 2002 level. Over the last four quarters, residential investments have been fairly stable, and in the 3rd quarter they were 1.2 per cent below the level one year earlier. As the development in housing prices moderates, cf. below, residential investments can be expected to decline. Corporate investments increased more slowly in the first phase of the upswing, but have gained considerable momentum since Investments thus reached a very high level in the spring of 2007, and growth has declined since then. Following the slowdown in the 2nd quarter, corporate investments rose again in the 3rd quarter, reaching 7.9 per cent on aggregate for the first three quarters compared with the same period of It is the usual pattern for corporate investments in machinery, buildings, tools and equipment not to accelerate until an economic upswing is well under way, i.e. when labour has become scarce and production capacity is under pressure. Private consumption moderated in the 2nd quarter but picked up considerably again in the 3rd quarter, bringing aggregate growth in the first three quarters of 2007 to 2.2 per cent compared with the same period of This robust development reflects a sustained rise in income among Danish households, combined with a favourable labour market with considerable job security in the near future. The sound household finances are also reflected in consumer confidence, which remains very high after a fall in the summer, cf. Chart 15. Car sales to households, which are usually a strong indicator of private consumption, have risen sharply. However, the increase since the spring should also be viewed in the light of the uncertainty concerning the restructuring of car taxes, which may have led households to postpone car purchases that they would otherwise have made in the spring. As previously stated, housing prices have soared in recent years. According to Statistics Denmark's nationwide statistics, by the end of 2006 the mean price for single-family houses had risen by an average of 16 per cent p.a. over a period of three years. In 2007 the rate of price increase has been considerably more subdued. According to the Association of Danish Mortgage Banks' real-property price statistics, the average price of single-family and terraced houses was 3.6 per cent higher in the 3rd quarter of 2007 than in the same quarter of The booming prices since 2004 are attributable to factors such as the strong growth in incomes, which has strengthened household finances, as well as low interest rates and the introduction of deferred-amor-

21 17 CONSUMER CONFIDENCE AND CAR PURCHASES BY HOUSEHOLDS Chart 15 Thousands Percentage balances Consumer confidence (right-hand axis) Car purchases by households -4 Source: Statistics Denmark. tisation loans, which have made housing loans cheaper to service. The tax freeze on property value tax has also contributed. Conversely, the current slowdown in housing prices is linked to the rise in interest rates in 2006 and The price development in recent years has been characterised by large geographical differences, with considerable increases in the Greater Copenhagen area in particular, while prices have developed at a more measured pace in other, often less densely populated parts of Denmark. Consequently, the price per square metre varies markedly from one area to another. However, the above real-property price statistics show that the spread has narrowed in In areas where the price per square metre exceeded around kr. 23,000 by end-2006, a clear downward trend has been observed. On the other hand, robust increases were still seen in the first three quarters in most of the areas where houses are traded at prices closer to the national average of approximately kr. 14,000 per square metre, cf. Chart 16. The number of homes for sale has risen sharply throughout the country, underpinned by numerous residential construction projects. This development really took off in the spring of 2006 for both houses and flats, cf. Chart 17. According to the Association of Danish Mortgage Banks, the supply of houses continued to rise into the autumn, while the trend for owner-occupied flats has been receding slightly since May. The higher number of homes for sale dampens prices.

22 18 PRICES OF SINGLE-FAMILY HOUSES AND TERRACED HOUSES Chart 16 Per cent year-on-year ,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 Kr./square metre Capital Region, excluding Bornholm Other municipalities Note: For each municipality, the average price per square metre in the 3rd quarter of 2006 for single-family houses and terraced houses is shown on the horizontal axis, while the increase over the subsequent four quarters is shown on the vertical axis. The broken line shows the correlation using linear regression. Source: Association of Danish Mortgage Banks. The higher supply of homes has coincided with lower sales. The latter trend was, however, broken temporarily at any rate in the 3rd quarter, when the number of houses sold rose marginally to 8,600, while sales of owner-occupied flats fell slightly to 2,400 (seasonally adjusted). The slower sales and large supply suggest a fall in residential construction in future, and some subcontractors are reporting a decline in activity. Against the background of a sustained strong economy with higher disposable incomes and low unemployment, the current level of interest rates points to more or less unchanged average cash prices at the na- SUPPLY AND SALE OF HOMES Chart 17 Thousands Single-family houses Supply Sales Owner-occupied flats Thousands Supply Sales Note: Aggregate supply at the end of the month according to the supply statistics of the Association of Danish Mortgage Banks and quarterly sales according to the Association of Danish Mortgage Banks' price statistics for owner-occupied homes. Own seasonal adjustment of number of sales. Source: Association of Danish Mortgage Banks.

23 19 tional level over the next couple of years. The sound finances of the Danish households support this development, cf. Box 1. The considerable wealth reflects that the rising home equity has been mortgaged only to a limited extent. The increase in private consumption in recent years has generally been income-based, and consequently a slowdown in housing prices is not expected to have any major impact on private consumption. Foreign trade and balance of payments The current upswing has led to an overall rise in domestic demand that exceeds the production capacity of Danish business enterprises. This has resulted in substantial growth in imports since As the global economy has picked up, exports have, however, also increased substantially in recent years, and the growth in imports is to a large extent attributable to a considerable import content in Danish exports. The development in foreign trade in recent years is illustrated in Chart 19, showing trade in goods, excluding ships and aircraft. Pressure from domestic demand is reflected in the receding trade surplus. The surplus in the first nine months of 2007 was kr. 16 billion, compared with kr. 33 billion in the same period of The downward trend in the surplus has, however, abated in recent months thanks to the sound growth in exports. As stated in the above section on the global economy, the European economies have picked up recently. The economic upswing among Denmark's neighbours, notably Germany, has boosted the demand for Danish products. Growth within Danish export markets has remained high in 2007, albeit lower than in In the first nine months of 2007, the current-account surplus was kr billion, which is just over kr. 21 billion lower than in the same period of The declining surplus on the balance of goods and services is the primary reason why the balance of the current account has fallen substantially over the last 18 months. Of the total of kr billion, investment income contributed kr billion net. In other words, Denmark's interest and dividend income from abroad exceeds foreign interest and dividend income from Denmark, even though Denmark's external debt has not been completely eliminated. 1 1 This issue is described in further detail in Jannick Damgaard, From Debtor to Creditor Country An Analysis of Investment Income, Danmarks Nationalbank, Monetary Review, 1st Quarter 2007.

24 20 DEVELOPMENT IN HOUSEHOLD WEALTH Box 1 In the 2nd quarter of 2007, the households' aggregate wealth increased by kr. 50 billion over the preceding quarter. Aggregate household wealth has increased by 75 per cent since the onset of the upswing in 2003, to kr. 3,552 billion at end of the 2nd quarter of 2007, equivalent to kr. 1.4 million per household. However, the rate of increase has declined over the last year, primarily due to the slowdown in housing prices. The compilation of wealth comprises the households' financial assets, including pension wealth at an estimated value after taxation, as well as housing, and is stated net of loans and other liabilities. Wealth is compiled at market value. The households' housing wealth can be compiled one quarter ahead of aggregate wealth. Housing wealth1 fell slightly in the 3rd quarter due to lower prices for owneroccupied flats, cf. Chart 18. According to the Association of Danish Mortgage Banks, the price of owner-occupied flats fell by 2.3 per cent at national level in the 3rd quarter. In some areas of Greater Copenhagen, much sharper drops were, however, seen, reflecting correction of a regional price level that had become excessive. Since owner-occupied flats account for less than 20 per cent of aggregate housing wealth, the impact on the households' aggregate wealth is limited. As stated elsewhere, a similar adjustment has been observed in parts of the market for houses in and around Copenhagen, although house prices overall rose marginally in the 3rd quarter. HOUSEHOLD WEALTH Chart 18 Kr. billion 3,500 3,000 2,500 2,000 1,500 1, Housing wealth Liabilities, total Free financial assets Pension wealth Note: Pension wealth stated at estimated value after taxation. Source: Danmarks Nationalbank. The general slowdown in housing prices reflects factors such as an increase in longterm interest rates by just over 1 percentage point since 2005, while short-term interest rates in the same period rose by 2.5 percentage points until the autumn of The rising interest rates have exerted downward pressure on the market value of long-term fixed-rate loans, which, viewed in isolation, has contributed to increasing household wealth. The turmoil in the financial markets in the wake of the subprime

25 21 CONTINUED Box 1 crisis has dampened market expectations of further increases in short-term interest rates in the near future. Home equity, i.e. the difference between housing wealth and mortgages, has declined by approximately kr. 85 billion, to kr. 17,750 billion since the 3rd quarter of 2006, when the slowdown in cash prices set in. 2 In a longer perspective, home equity is very high, averaging almost kr. 1 million per home in the 3rd quarter of Overall, the households thus have robust financial buffers. Not only the average, but also the distribution of home equity across households must be taken into account when assessing the development. At present, those who might have negative home equity are mainly flat owners in the Copenhagen area who have purchased their homes within the last 18 months. This may affect the private finances of these households, but is scarcely likely to jeopardise the economy since the problem is regional. 1 2 Calculations of housing wealth after 1 January 2006 do not include the contribution from residential investments and thus the increase in the housing stock (the quantity variable). The impact on the compiled value of housing wealth is limited. In the calculations of home equity, mortgages are stated at nominal value. Labour market, wages and prices The economic upswing in recent years has increased employment considerably, to approximately 2.85 million in the 3rd quarter, and unemployment has fallen to the lowest level since the beginning of the 1970s. In October, unemployment fell by 3,900 to a total of 81,700, equivalent to 3.0 per cent of the labour force. MAIN ITEMS OF FOREIGN TRADE Chart 19 Kr. billion 60 Kr. billion Exports Imports Trade balance (right-hand axis) -3 Note: All items are shown exclusive of ships and aircraft. Source: Statistics Denmark.

26 22 UNEMPLOYMENT AND SHORTAGE OF LABOUR Chart 20 1,000 persons 500 Per cent Unemployment Labour shortage, construction (right-hand axis) Labour shortage, manufacturing (right-h. axis) Source: Statistics Denmark and own seasonal adjustment of indicators of labour shortage. There is an extensive shortage of labour. Confidence indicators show that this trend has been pronounced in the construction sector since 2005 and in manufacturing since 2006, cf. Chart 20. Following massive bottleneck problems in 2006 the situation in the construction sector seems to have improved slightly, but there is still a considerable need for more people. In manufacturing the labour gap has narrowed since the summer. However, a sharp increase was seen in the spring, and in the most recent survey the labour shortage was still greater than during the upswing in the mid-1980s. The need to recruit is also reflected in the number of job advertisements on the Internet, which has shown a pronounced upward trend since the end of Due to the difficulty in recruiting qualified labour, those in employment have increasingly had to work overtime. According to the most recent national accounts the number of hours worked per employee had risen by 2 per cent, to just over 1,600 hours p.a., from the onset of the upswing at the end of 2003 to the 1st half of The labour survey for the 2nd quarter of 2007 also shows that the proportion of employees who work more than the standard 37 hours per week has risen by 4 percentage points, to 33 per cent, since the end of More foreigners are working in Denmark. The number of active work permits to citizens of the new EU member states continues to rise, reaching 12,800 in October. To this should be added an estimated 20,000 commuters from Sweden and Germany. This number has been increasing

27 23 in recent years and does not include the growing number of Danes who move to southern Sweden, but continue to work in Denmark. Despite the extensive shortage of labour, the rate of wage increase remained relatively moderate until However, wages often tend to react to cyclical developments with a considerable lag, which has also been the case this time. In connection with the extensive collective bargaining in the spring and the subsequent local wage agreements, the rate of wage increase has risen significantly. For the 3rd quarter, privatesector wages overall rose by 4.0 per cent over the 3rd quarter of 2006, cf. Chart 21. The trend was most pronounced in the construction sector with annual growth of 4.9 per cent. In recent years, wages in Denmark have risen at a faster pace than wages in the countries that Denmark competes with in the global markets. Wage competitiveness has thus deteriorated substantially, cf. Chart 22. In addition, the starting point in 2006 was a situation where wage costs per working hour in manufacturing exceeded those of the euro area by 25 per cent. Since the end of 2005, the annual rate of wage increase in Denmark has been 2.3 percentage points higher than among Denmark's trading partners, weighted by their significance to Denmark's foreign trade, and stated in Danish kroner. Just over half of this increase is attributable to the weakening of the dollar, while the other half relates to particularly high wage increases in Denmark. This has led to a decline in market shares, which should, however, also be viewed in the light of the prob- WAGE INCREASES IN THE PRIVATE SECTOR Chart 21 Per cent, year-on-year Private sector, total Manufacturing Construction Services Source: Statistics Denmark.

28 24 DENMARK'S WAGE COMPETITIVENESS Chart 22 Beginning of 1995 = Note: Foreign hourly wages in Danish kroner in relation to Danish hourly wages. Foreign wages are weighted using weights from the effective exchange rate of the krone. An increase indicates an improvement in Denmark's wage competitiveness. Source: Danmarks Nationalbank. lems faced by Danish business enterprises in relation to raising pro duction levels in a situation with labour shortages. The current development in wages will reduce competitiveness further and increase the risk that the present upswing will be replaced by a prolonged downturn while wages adjust to a more competitive level visà-vis abroad. In recent quarters, competitiveness has also been affected by weak productivity development, cf. the article on pp. 67 ff. In the near future the collective bargaining for the public sector in the coming spring will increase the risk of further deterioration in competetiveness through a rub-off effect on the private labour market. The bargaining may be tough due to widespread expectations of substantial pay rises among many public-sector employees. Despite the pressure on the labour market and the substantial growth in demand, consumer prices have risen at a relatively measured pace throughout the upswing. Following increases in the range of 1 per cent over the summer, the EU's Harmonised Index of Consumer Prices, HICP, rose by 1.8 per cent year-on-year in October. This development is to a large extent linked to the global increase in food prices, cf. the section on the global economy. On the other hand, the high oil prices recently had only a limited impact on consumer prices in October. As oil prices are expected to remain high, energy prices overall are expected to

29 25 contribute to higher consumer-price inflation in the coming months. In October, HICP inflation rose to 2.5 per cent. Domestic market-determined inflation, IMI, which describes the increase in wages and profits in the Danish economy, has risen since last summer. Interpretation of data for 2007 is complicated by the fact that the price of clothing shows different development patterns in the consumer price index and the price index for the domestic supply of goods (previously the wholesale price index), cf. Box 2. Generally, IMI seems to have mirrored hourly wages, so in view of the most recent wage developments and the current capacity pressure, IMI can be expected to rise further in the coming months. The rising trend in inflation is supported by data for wholesale prices of goods, excluding energy and food, produced in Denmark, which were 9.1 per cent higher than one year earlier. Economic policy In the first three quarters of 2007, government consumption at constant prices increased by 1.6 per cent over This is a slightly higher growth rate than in the preceding years from 2004 to 2006 the increase in government consumption at constant prices averaged 1.4 per cent p.a. The 2008 finance bill that was presented in August 2007 envisaged growth in government consumption matching the indicated level for As with previous finance bills presented during the upswing from 2004, the 2008 bill entailed a positive fiscal effect. Moreover, local and regional government spending has increased since the bill was tabled, and further expenditure is usually approved during the year. Overall, an expansionary fiscal policy in 2008 was expected prior to the general election in Denmark in November In view of the cyclical position, Danmarks Nationalbank finds this inadvisable since it may add to the pressure on wages, thereby further undermining Denmark's competitiveness. With the election, the finance bill became obsolete and a provisional finance act is to adopted by the end of the year. A new final finance bill for 2008 is expected to be presented and adopted in early In this connection the government should review its fiscal policy.

30 26 IMI EXCLUDING CLOTHING PRICES Box 2 According to the index of net retail prices (the consumer price index net of indirect taxes), the price of clothing for a typical household fell by 4.5 per cent from October 2006 to October 2007, and since October 2003 clothing prices have been reduced by just over 10 per cent. A possible explanation could be cheaper imports from e.g. Eastern Europe and China. At any rate, the domestic element of the clothing price is scarcely likely to have declined. To calculate the domestic element of clothing prices, it is necessary to strip the falling index of net retail prices of a presumably more sharply falling price index for imported clothing. However, it turns out that the wholesale price index 1 for clothing, which includes imported clothing, and the unit value index for imported clothing have not declined in the same manner as the clothing component of the index of net retail prices, cf. Chart 23. It is normal for differences in calculation methods and goods included in consumer and wholesale price indices to make such price analyses difficult, and indeed clothing prices, for which each new collection brings new articles, are difficult to put into a price index. In the wholesale price index it can thus be confusing that outsourcing of production to a lower-wage country, e.g. from Portugal to China, is seen as a change in goods, not as a price reduction. Likewise, in the index of net retail prices a new collection is often linked to seasonal sale of the old collection, cf. the clear seasonal pattern of winter and summer sales in the index of net retail prices. CLOTHING PRICES, IMI AND WAGE INCREASES Chart = 100 Price indices for clothing Net retail price Domestic supply of goods Unit value index Source: Statistics Denmark and own calculations. Per cent, year-on-year Per cent, year-on-year IMI IMI, excl. clothing Hourly wages in manufact. (right-h. axis) Danmarks Nationalbank does not usually calculate a separate domestic marketdetermined price for clothing, but regularly does so for a wider selection of goods and services that include clothing. This selection constitutes 34 per cent of the index of net retail prices, cf. Table 20 of the Tables and Graphs Section regarding the calculation of domestic market-determined inflation, IMI. Clothing accounts for just over 4 per cent of the index of net retail prices, and if the import content is disregarded, for which no certain price index exists to match the clothing component of the index of net retail prices, clothing accounts for 12 per cent of the IMI calculation. Consequently, a fall in clothing prices is clearly reflected in IMI. Calculated in the normal way, IMI was 1.4 per cent in October, but stripped of clothing prices the increase was 2.4 per cent. In general, IMI excluding clothing mirrors IMI in recent years, but in the last few quarters it reflects the wage development more clearly, cf. Chart Also known as the price index for the domestic supply of goods.

31 Monetary Review - 4th Quarter Two New Euro Area Member States: Cyprus and Malta As of 1 January 2008, Cyprus and Malta have adopted the euro as their currency. They follow in the footsteps of Slovenia, which in 2007 was the first of the member states from the 2004 enlargement to adopt the single currency. In connection with the changeover, Cyprus pounds and Maltese lira will be exchanged for euro at the conversion rates adopted by the Ecofin Council in July Euro banknotes and coins will be in circulation from 1 January 2008, and the national currencies will gradually be withdrawn. The euro banknotes will be identical to those used elsewhere in the euro area, while the euro coins will have one national side. The national sides of the two member states' euro coins are shown in Box 1. THE NATIONAL SIDES OF THE CYPRUS AND MALTESE EURO COINS Box 1 1 cent 2 cent 5 cent 1 euro 10 cent 20 cent 50 cent 2 euro 1 cent 2 cent 5 cent 1 euro 10 cent 20 cent 50 cent 2 euro Note: The upper half of the Box shows the national sides of the Cyprus euro coins, while the lower half shows the national sides of the Maltese euro coins. Source: European Central Bank.