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Monday, July 14, 2008

The Danish Economy - Sailing into Dire Straits?

by Claus Vistesen: Copenhagen

Stagflation, credit crunch, bank bails-outs, and housing market busts are all concepts that are unfortunately now becoming all too familiar to the current Danish economic discourse and indeed even to the Danish public at large as they read their morning paper over breakfast, or listen to the radio on their way to work. And not of course in their United States version, but rather in their homegrown variant. But just how serious is the construction and banking problem in Denmark?

A quick initial glance at the short term data definitely suggests that a serious batch of storm clouds may well be gathering above the economy. Not only did Denmark claim the dubious honor of being the first economy in Europe to exhibit a technical recession but it was also recently handed its very own banking crisis à la Bear Stearns and Freddie/Fannie, since only last Friday the 10th largest bank, Roskilde Bank, had to go hat in hand to the central bank for a provisional liquidity guarantee as the writedowns it was about to announce to the market were judged to be too tough to swallow without risking a bank run.

However, things in Denmark need not be as serious as that initial glance might suggest, and, at this point at any rate, I would most definitely not group Denmark together with other European economies - Spain, the UK, Ireland - who who certainly seem to be facing a very tough time indeed moving forward. On the other hand, I think it is reasonably safe to say that things in Denmark will almost surely get a lot worse before they get better, and really the key question is not how deep will the recession be, but what will be the structural characteristics of the economy which subsequently emerges?

So in the analysis which follows I will attempt to answer this question question through an in-depth look at the Danish economy, where it is, where it has been, and where it is about to go.

If we start at the beginning, with headline GDP growth, it is easy to see the extent of the recent slump of the Danish economy.

In fact, for all the talk about a Danish recession which evidently is measured on a q-o-q basis the y-o-y is more enlightening in terms of what is actually going on, since if we look at y-o-y we can see how the slowdown can be traced back to the first quarter of 2007 , from which point Danish growth has been consistently oscillating between negative and positive, while it is only now that the shoe has finally dropped into recessionary territory. Some economists do question this view it should be noted and are busy cooking up a their own ragoût, offering a what boils down to a technical explanation for the consecutive negative q-o-q GDP reading. This time around, they argue, Easter may be a distoring factor since it fell in Q1. Ironing out the "Easter impact" may positively affect the GDP reading for the second quarter. If Denmark does rebound with a bang in the second quarter, then this would probably be the reason. But will it? The Easter argument is convincing as far as it goes, but it should not distract us from the main message in the sense that activity across the board was down in Q1 and that Denmark may now be entering a longer term correction.

In order to put us on more solid ground here is a break-down of the GDP components. If we start by looking at private consumption, it is clear the Danish consumer seems now to have pretty definitely thrown in the towel, but what a ride it has been on the way to this point.

As I will explain below one of the key drivers of the recent Danish consumption boom has been the upward march of house prices. Now that higher interest rates and rising energy costs are rolling in at the same time as the housing boom gets well past its peak it is only natural that consumers are scaling back. Danske Bank analysts however (the only link is in Danish I am afraid) are fairly sanguine when it comes to their assessment of the Danish consumer. They limit themselves to pointing out that when compared with other "property driven" countries such as the UK, the US, Norway and Sweden the increase in Danish consumption has not been that outstanding. I think such comparisons are - by their very nature - rather spurious. The main point we need to think about is not really the relative strength of the Danish consumer but simply how much in absolute terms we expect consumption to be a drag on growth. In this respect I tend to agree with Danske Bank that it is unlikely that consumption will plummet completely. This is true, at least, in terms of the immediate outlook where an extremely tight labour market will support consumption in the sense that people still have a steady income to spend from. Yet, the credit crunch following the subprime turmoil has not passed the Danish doorstep without paying a visit. The recent quarterly report by the Danish central bank elaborates on this in great detail. Especially chart 11 (p. 20) offers a nice perspective as it shows the year on year trend in lending growth which is inexorably moving down even if the growth rate is still positive. As a final point, Danske Banks points out that real income is still climbing if we deflate the wage bill using core prices only.

Ultimately, my feeling is that it is still too early to call it on the consumption side. The outlook is clearly deteriorating though, and consumer confidence is slumping. Much will depend on the extent to which the labour market softens in the coming quarters (and indeed years). Apart from this, the degree of the unravelling on the housing market boom and the extent to which lending institutions tighten credit standards and lending conditions will obviously also be important. Danske Bank is looking for an increase in consumption at about 1% y-o-y in 2009. Given the outlook on lending and housing I would say that Danske Bank is perhaps rather optimistic.

While it is still a bit too early to say whether consumption will drop down through the floor and descend into the basement, it does seem clear that investment is now heading into a decisive slowdown.

The very impressive recent investment performance by Danish companies - which formed the backdrop to the recent expansion - is by now pretty well known. A tight labour market and low interest rates have consequently provided Danish companies with ample reason to invest. This coupled with residential investment that has been literally booming has meant that investment was a strong driving force in the Danish economy. From 2001 to 2006/07 residential investment increased from 3% of GDP to 7%. All good things must come to and end however and it seems clear from the above graph that the trend is now much more modest and even possibly back stepping in the form of contraction. If Danske Bank are correct in their assessment of fall in residential investment to the tune of about 2% in 2008 this will be a significant drag on aggregate fixed capital formation.

Moving on to the public sector we find one major advantage for Denmark going into the coming downturn, since Denmark has been running a very healthy surplus on the public books to the tune of 4.4% in 2007. Moreover and as can be observed below Denmark is trying to be the proverbial top of the class EU student by bringing down public debt quite dramatically over the past decade.

So far, however, it is far from certain that the coffers will be opened to accommodate the slowdown. Economic advisors to the Treasury and central bank economists seem to have carried the day in the initial skirmish over whether fiscal policy should be used to cushion the economy. In fact, there is an emerging discourse pointing to the fact that the failure to implement fiscal spending contraction measures back in 2006 are what has brought Denmark into its current mess with an overheating and now also stagflating economy. This sentiment will linger until we see a marked deterioration in labour market conditions after which politics may well take over. At this point however the continuing extreme tightness of the labour market will mean that overheating concerns could even lead to a preemptive move to reign in public spending further for the fiscal year 2009.

Finally, if we come to look at the external sector we find another of the defining factors that separates Denmark from many other credit crunch struck economies.

The main point would be that even though Denmark has been ramping up consumption to a significant degree this has not lead to a deficit on the external books; even if recent quarters have seen the balance edging slightly into negative. This relatively healthy position, when taken with the situation in the public accounts, is obviously quite important. What we seem to have here is a picture of an economy that has not, on the face of it, been living beyond its means.

One important point to take away from all this I think is the idea that Denmark may be benefiting from being a small open economy situated near the apex of the global value chain. This should then translate into the fact that at any given point in time what goes out adds more value than what goes in, making it "easier" to sustain a positive external balance even if the economy is operating near full capacity. In a cyclical perspective however, there is reason to believe that with the recent surge in the Euro - and by implication the Danish Krona which is effectively locked into it - the positive balance will be more difficult to sustain in the immediate future. This would be certain to bring all kinds of ghosts forth from the past as it was exactly a ballooning external deficit which prompted the Conservative government in the 1980s to instigate the, among Danes now famous, Potatoe Treatment which was a quite harsh bout of fiscal contraction aimed at halting domestic consumption and putting a lid on housing and residential investments.

If the above charts and narrative sketch out the immediate state of play with respect to the Danish economy it could still be argued that I am missing one important aspect of the situation, since Denmark, like the rest of the world, has also caught the stagflation flu which seems to be going the rounds of the global economies right now. And just to prove that it isn't always different, Denmark's inflation is now running close to the 4% mark at one and the same time as the economy is slowing significantly.

As with the general global picture, the increase in prices is coming almost exclusively from headline pressures but many domestic economists would also point towards the fact that the failure to prevent the Danish economy from bumping up against its capacity limit will exacerbate the incoming downturn. However, if we really want to get down to business with respect to the recent performance of the Danish economy, and its immediate outlook, there are two sectors which are absolutely crucial. One is the labour market (and the associated demographic profile of Denmark) and the other is the housing sector.

We Don't have Subprime Loans in Denmark, Or ... ?

Among the wide array of economies who have seen a housing boom in the recent years Denmark has been right up there at the top of the list.

For several consecutive installments Denmark thus presided firmly over the pole position in the Economist's house price index and also OECD's 2006 survey of Denmark voiced concerns about the state of the Danish housing market and its potential impact on the real economy should the edifice collapse. In this light, it could seem as if what was back then treated as mere worries now is very much reality. Consequently, the Danish real estate and housing market began its slowdown in some time in 2006 and at the present time there does not seem to be a pick up in sight.

Due to a big reform of the Danish municipal governance system in 2007, statistical work on this topic is quite difficult. Basically, there is a structural break in the statistical series right at its apex in 2006, which makes it rather difficult to obtain a clear picture of what has happened since, and thus put the present situation in some sort of context. Yet, there can be no doubt that the slump is lingering and even intensifying. The price chart above shows us that much.

Moreover, it is very important, in a Danish context, to latch on to the crucial importance of the Copenhagen region in the whole housing discussion. Basically, and while both total turnover and prices are declining on a country-wide basis, the correction in Copenhagen has been particularly severe. This is important because the Copenhagen region naturally commands a crucial position in terms of wealth and income concentration in the Danish economy. Particularly noteworthy has been the extent to which apartments have seen a correction in prices. The situation is now one of a quite serious mismatch between the supply of housing and demand side capacity to absorb it. Obviously, everything has its price and while I have faith in the dynamics of supply and demand the key is the extent to which this price will allow existing owners to actually repay their mortgages. So far, this talk about "technical defaults" is only a fringe discourse but the longer prices fall the more this problem will grow I think.

We also need at this point to consider the relation between house prices and consumption. In overall terms, there are two ways in which we could do this. One is through a traditional academic type discussion about the so-called wealth effect in the context of home price appreciation and whether this link has been strengthened by creative credit products and, as a consequence, the ability to tap mortgage wealth for consumption. The second would be a more subtle point about the link from housing/construction to the banking sector and thus over to tightening credit standards for companies and consumers. This after all is what the lingering credit-crunch mess is all about. Roskilde Bank for example is an important warning shot across the bow in the sense that it was exactly an overly lax lending strategy towards construction/real estate investors that brought the bank to its knees last week.

Regarding the wealth effect from housing a considerable amount of ink has been spilt by academics in recent times over the strength of this link. Normally, the discussion cuts a sharp line between Europe and the US where the wealth effect in general is considered to be stronger; this, by the way, goes for most asset classes. In e.g. a US and UK context, Jirka Slacalek has estimated that that wealth effect from housing is considerably stronger than it is for equities while at the same time confirming that this effect is particularly strong in Anglo-Saxon economies. Turning to Denmark, the rule of thumb, as it has emerged amongst forecasters in the central bank and the Treasury is that 100 dkk increase in housing wealth will translate into a 10 dkk increase in consumption. In general however, this link is not carved in stone and it may then be a question of just what metrics you look at. However, it is reasonable to assume I think that given the appreciation in house prices, and then the subsequent increase in wealth, in Denmark consumers will have had a tendency to increase their propensity to consume. The principal point would really be that the wealth accumulated via the appreciation of household's main asset act has served as a de-facto substitution for saving which would otherwise have been done out of income.

At the end of the day the vulnerability of the Danish economy to a housing downturn basically boils down to the extent to which Denmark has been drinking the subprime cool aid in some way or another. Danish bureaucrats would almost certainly frown at such a suggestion, and point to the key institutions in Denmark; the so-called real estate agency institutes who hold the sole right to issue the convertible bonds used to finance homes. However, with amortization free loans, maturities running up 100 years and adjustable rates it merely seems as if Denmark has had its own distinct subprime lingo rather than holding the high ground as many claim. So far though none of these major credit institutions have shown signs of distress while at the same time many analysts expect banks in the mid-size segment (e.g. Roskilde Bank, Amagerbanken, Fionia Bank, and Forstædernes Bank) to be in the frontline of the barrage which may come next. Yet, as house prices continue to drop and as delinquencies steadily rise, it is not certain that old dictums and assertions may not be in a need of some speedy revision.

Needless to say, I believe that the housing sector and the link to the financial sector and then over to the real economy is crucial to watch in a Danish context. At this point, Denmark may very well be able to navigate the skerries which lie ahead but I definitely think that the ingredients for something much more dramatic are there.

Labour Market and Demographics; an Economy at Full Capacity

Having described the housing sector above we turn now to the labour market. Even though many would perhaps, tongue in cheek, call yours truly a bit of a demographics fundamentalist I do not think that it is entirely out of place to say that if you want to understand the Danish economy at the present moment, it is all about demographics.

As can be seen from the unemployment chart above, recent years have steadily ground down Danish spare human capital. But in reality an unemployment rate running at 3.8% in 2007 does not really tell the whole story here, since if we look at the monthly development we can see that unemployment dropped to an almost unbelievable level of 1.7% in May or a mere 47.500 people. These levels adds a whole new perspective to the adage of full employment. Even as the economy contracted in the two last quarters it still created employment, albeit at a slower pace than in recent quarters.

Obviously, the number of new jobs created will steadily decrease as the slowdown grabs hold but there is a silver lining to all this. Given the demographic analysis I field below we may in fact be witnessing an economy at its historical peak in terms of capacity to produce economic growth or more aptly economic trend growth; (migration as always may adjust the path of the process). This conclusion is mainly pinned on the supposition that economic growth at all points in time is driven by people, or more specifically; the right mix between the quality and quantity of human capital.

The formal picture of Danish demographics is shown in the chart below as it plots the Danish population and its growth rate.

The series for natural increase also includes migration which is why there is a spike around 2005-2007 as Denmark received a large batch of workers from Eastern Europe; especially Poland. However, one thing is total population growth and quite another is the proportional change of the population. Thus, if one wants to understand what it means that the economy is at its "peak" one need to accept the tenets of demographic economic analysis which isn't that difficult once you get down to the basics.

Firstly, we need to take a look at two process which combines to form a steady process of ageing of the Danish society; fertility and life expectancy. Starting with the former we actually get a quite interesting picture.

The graph above is very thus very illuminating. Not only does it show that Denmark like most other societies has gone through the demographic transition with a subsequent drop in fertility, it also shows how the decline in fertility during the final (and at this point still ongoing) stages of the demographic transition is driven by two processes. One the one hand you have the tempo effect (also called birth postponement) which covers the process by which women postpone the birth of their first child. This has a knock-on effect on the second process (the so-called quantum effect) which is really synonymous with the fact that women choose to have fewer children in total. The main quibble with measuring the quantum effect is that it can only be done post-hoc through measurement of total-cohort-fertilty, although some "on the fly" proxies such as ideal family size can be used to get an impression of what is happening.

As can be seen Danish women have definitely taken birth postponement to heart, but luckily the quantum effect in Denmark seems to be much less pronounced than in some of the very low fertility European societies. Thus, Denmark is one of the few countries (France would be another example) who have been able to rebound from close-call brush with lowest-low fertility (a TFR of 1.5). On the other hand, on the life expectancy front Denmark is not particularly different in that she is, like most other OECD countries, experiencing a steady, and nearly linear, increase in life expectancy for both sexes.

The decline in fertility and increase in life expectancy taken together serve to produce a steady population ageing process which can be fairly easily tracked through either the rise in the median age of the population, or, more intuitively, via the decline, relative to total population, of the most productive cohort. In this case, I have chosen to label the cohort the proportion of the population aged 25-49.

As can be seen this age group peaked in Denmark around 1997 and is now set to steadily decline. Clearly, and given the fact that Danish fertility seems healthy in comparative terms at about 1.8 child per women, this decline will fairly be slow.

The main point to take away from all this is thus not that Denmark should now be grouped together with the strong demographic decliners like Italy, Germany and Japan, but rather that Denmark may well, in these very quarters we are passing through now, be operating at a level in terms of disposable human capital to which it will never, all things being equal, return. This does not mean that Denmark's economy won't grow but simply that momentum of growth steadily will decline from this point on. None of this is certain of course but the real silver lining is indeed to be found in the graphs above.

Consider the following. The women born at the end of 1960s as well as the beginning of 1970s are about to finish their reproductive period and an educated guess will suggest that a total cohort fertility will clock in at about 1.8 children per women. This achievement is quite extraordinary since it comes on the back of a generation of women whose fertility slumped to 1.5-1.4 in the middle of the 1980s. However, Denmark is then only now entering the interesting period since it is absolute crucial that the women who are now set to begin birth postponement (i.e. those born in the 1980s) manage to stay at a fertility level around 1.8. In fact, the postponement effect itself may well mean that Denmark will experience a marked drop in TFR in the years to come. Moreover, it is not difficult to see that if the population momentum is to be sustained, fertility needs to be considerably higher since these women come from a comparatively small generation. This same intuition can be applied to the labour market where the generation now set to enter the labour market is comparatively small. Actually, another adverse effect of the fact that a relatively small generation is about to enter the labour market is that the housing market correction may be much longer since the first-time buyers who are coming out of school in these very years are quite simply not enough to support the glut of housing at the current high prices. Talk about bad timing!

Smooth Sailing or Dire Straits?

This note has been a mixture of an immediate outlook of the Danish economy together with a little bit of longer term structural assessment. Even if the two are intimately related, it would still be fruitful initially separate them in my concluding remarks.

The immediate outlook for the Danish economy seems set to become steadily worse although there are some bright spots. The key to gauge whether the Danish slowdown will turn from bad to worse is the nexus formed by the housing/residential market and banking sector. An important indication to this potential vicious circle was given last Friday when Roskilde Bank had to throw in the towel. Real economic activity is definitely slowing but it is too early at this point to decisively call the extent of the slowdown. The bright spots, and thus what seperates Denmark from some of the other casualities of the credit crunch, is that she will be going into the slowdown with a surplus both on the public and external books. In my opinion, the housing market and the extent of the incoming correction is absolutely crucial in the context of assessing what comes next in the Danish economy. If the correction is very severe the slowdown could become disorderly. So far, I will hold off my call but the smooth sailing is definitely over and a firm grip is now needed on the helm if the upcoming skerries are to be navigatied without a capsize.

Apart from the immediate outlook in Denmark I have also fielded a demographic profile and explained how one might deduce some important information about the future path of the Danish economy from this. The key is the extent to which the current slowdown will coincide with more structural factors to make things rather more worse for the Danish economy than one might otherwise expect.

Ultimately, I do not see Spain-like conditions in Denmark but all the necessary factors are definitely in place for something rather worse than what we are currently observing.

List of Main References

Danish Central Bank (2008) - Monetary Review 2nd Quarter

Bocian Steen (2008) - Danmark i teknisk recession… men påsken driller, Danske Bank Flash Comment

Bocian Steen, & Stramer Damgaard, Tore (2008) - Danmark: Ustadigt bygevejr, Danske Bank Investment Analysis

Erland, Esenspen, Lundsgaard, Jens and Huefner, Felix (2006) - The Danish Housing Market: Less Subsidy and More Flexibility, OECD Working Paper

Lunde, Jens 2005 - Fluctuations and Stability in the Danish Housing Market: Background, Causes and Policy

European Central Bank, The (2003) - Structural Factors in EU Housing Markets.

Slacalek, Jirka (2006) - What Drives Personal Consumption? The Role of Housing and Financial Wealth, German Institute for Economic Research, DIW Berlin

Setser, Brad (2006) - Is it Europe's Turn to Rise a Housing Bubble?, RGE Blog Entry