On behalf of the Danish authorities, we would like to thank staff for candid and constructive policy discussions in Copenhagen during the Article IV mission. The authorities appreciate staff’s high quality report and analytical work, addressing topical issues for the Danish economy. They broadly concur with staff’s assessment and will carefully consider the recommendations.

The output gap continues to narrow and employment is strengthening

The Danish economy is now in its third year of recovery. Measured by GDP growth, the pace is not high, but employment is growing quite strongly, along with nominal gross value added in manufacturing, business services, and the construction sector. For the first time in several years, growth last year was mainly driven by domestic demand. Looking ahead, the conditions for continued growth in domestic demand are in place, in particular owing to rising real wages, employment, and housing prices. Export growth is also expected to accelerate in 2016 and 2017, supported by a gradually improving external environment.

The relatively moderate pace of GDP growth partly reflects a drag from declining North Sea oil and gas production. However, as in many other countries, productivity growth seems very low for this stage of the cycle, whereas employment growth has been robust. While unemployment is already low, there is still some room for a further increase in employment in the coming years, due to a substantial increase in structural employment owing to recent years’ reform efforts. Nevertheless, the continuation of robust employment growth will result in a gradual closing of the output gap and the employment gap, and labor market conditions are expected to tighten over the next couple of years.

As noted by staff, the risks to the growth outlook are tilted to the downside. Denmark is a small open economy and an unexpected slowing of the global economy would lower growth in Denmark, not only directly through weaker exports, but also through the impact on the spending of consumers and businesses. However, the risks related to global financial conditions and a possible spike in the interest-rate burden facing Danish households are perhaps less clear than suggested by staff. In our assessment, large increases in interest rates are unlikely in the near term in view of the outlook for still-accommodative monetary policy, in particular in the euro area, as well as the significant current account surplus and increasing net international wealth of the Danish economy. Furthermore, overall household debt levels have not been rising lately and balance sheets are generally assessed to be robust, with households also holding substantial assets.

Gradual tightening of the fiscal policy will lead to structural balance in 2020

The narrowing of the output gap implies that accommodative fiscal policy should be gradually rolled back. Since the monetary policy stance is expected to remain very supportive throughout the forecast period, this in itself increases the need for tightening fiscal policy to support a sustained recovery.

Fiscal policy is planned mainly on the basis of the structural budget balance, with a planned adjustment from a structural deficit of 0.6 per cent of GDP in 2015 to a deficit of 0.4 per cent of GDP in 2016 and 2017. With the planned fiscal policy for 2016, there is a small margin to the deficit limit of 0.5 percent of GDP in the Budget Law. The medium-term target is still to achieve at least structural balance by 2020, which is aligned with the overall objective of fiscal sustainability.

Fiscal space will therefore be tight in the coming years, both in a historical context and relative to population trends. In part, this is due to the marked decline in Denmark’s oil and gas-related revenues. Furthermore, support, training programs, welfare services, etc. for newly-arrived refugees increase spending pressures. Meanwhile, public investments remain close to the historically high levels during the economic crisis. On both the public consumption and investment side, the current expenditure levels remain higher than before the financial crisis, despite some downward adjustment in recent years.

After the summer, the Danish Government will present a new medium-term economic plan (“2025 plan”), which will provide the framework for fiscal policy towards 2025.

Continued structural reforms supporting growth potential are key

Significant structural reforms have been implemented since 2008, raising productive potential by more than 5 percent by 2020. We are now seeing clear effects of reform efforts. As an example, a reform from 2011, which increases the age of eligibility for early retirement from 60 years to 62, is now clearly increasing the labor market participation rate of each cohort.

With respect to productivity growth, several initiatives have been implemented and the Government has put forward a growth package with over one hundred initiatives that focuses on both productivity and on strengthening growth in all parts of Denmark. The package includes initiatives to liberalise the Planning Act, and the Government has recently reached political agreement in Parliament to ease restrictions, in particular to increase the upper boundaries on shop sizes. Furthermore, there is ongoing work in relation to increasing productivity in the utility sector where the staff report has identified potential.

Increasing the growth potential of the Danish economy remains a clear priority for economic policy. The Government’s forthcoming 2025 plan to deal with the challenges facing the Danish economy will lay out further reform proposals to increase both labor market participation and productivity.

Increasing house prices reflect fundamentals, but are closely monitored by the authorities

The authorities assess that the recent developments in the housing market, including the rapid price increases in the largest cities, should be seen in light of developments in fundamentals, e.g. low mortgage rates, rising disposable incomes, and urbanization. However, price developments in the Copenhagen area need to be monitored closely. The freeze of housing taxes, in place since 2002, and the recent freeze of land taxes in 2016 are acknowledged by the authorities to increase the procyclicality of house price fluctuations.

The Danish Financial Supervisory Authority (FSA) has recently introduced a 5 percent down payment requirement, as well as 7 best practices for mortgaging of homes in geographical areas with high price levels and high price increases compared with the rest of the country. At present, the 7 best practices apply to the two largest cities and are expected to mitigate further price increases in these geographical areas.

The authorities would like to stress that the aim of recent measures is not to restrain mortgage lending, as stated in the staff report, but to ensure robustness of borrowers and credit institutions. The supervisory diamond addresses what the Danish FSA considers to be mortgage-credit activities with a higher risk profile. The benchmarks in the diamond have been set so they, on the one hand, counteract excessive risk assumption and, on the other hand, make it possible for resilient institutions to carry out profitable activities within the benchmarks and offer the credit required to undertakings and households.

The Danish authorities are not currently planning to introduce new macroprudential measures. However, developments in the housing markets will be monitored closely, especially in Copenhagen. The suggestion from the IMF regarding an early preparation of an adequate macroprudential “toolbox”, in order to ensure that measures can be implemented without delay when needed, is relevant to consider. Macroprudential measures such as limits on loan-to-value and debt-to-income may contribute to dampening a build-up of systemic financial risks.