The current account and the Jan Størup Nielsen Danish krone Nordea Research, 03 February 2017

Denmark has historically large current account surplus. The surplus has become permanent, creating underlying appreciation pressure on the krone. The consequence is that structurally the Danish policy rate must be lower than that of the ECB

The Danish current account performance over the past 30 years has been remarkable. In 1986 a record-high deficit of 5.5% of GDP was recorded. The following years have seen significant improvement; at the beginning of 2016 the surplus had climbed to 9.2% of GDP.

In today’s prices this corresponds to an improvement of DKK 260bn and Denmark is now among the countries worldwide with the largest surplus relative to GDP. The large surplus has since 2012 put Denmark on a collision course with the EU Commission, which according to the rules on macroeconomic imbalances only accepts a maximum current account surplus of 6% of GDP over a 3-year period.

nexus.nordea.com/research The marked surplus on the Danish current account is due to several coinciding factors. The goods balance surplus has risen sharply, now amounting to more than DKK 100bn annually. One of the reasons is continuously growing income from merchanting (Danish companies buying products abroad and reselling them abroad). Moreover, since the turn of the millennium we have seen a structural improvement of the balance of services, with notably higher income from sea transport making a positive contribution. Sea transport also explains the decreasing service balance surplus since 2015 – a decrease which, however, has been partly offset by declining bunkering costs, which have helped lift the goods balance.

nexus.nordea.com/research Given the continuous surplus on the current account since 1999, the Danish economy has accumulated huge net wealth relative to other countries – almost DKK 1,000bn or 50% of GDP. The ongoing return on this net wealth is recorded as current account income under the item for compensation of employees and investment income. This results in a self-reinforcing effect where a current account surplus is channelled into increased net wealth. This wealth gain generates a larger current return which ultimately ends up boosting the current account surplus.

Large savings surplus

The Danish current account performance can also be seen as the balance between savings and investments. The currently large surplus is a result of a sizeable surplus of savings in the private nexus.nordea.com/research sector. This is partly due to the structure of private pension savings and partly to unusually low investment activity since the financial crisis.

Has the surplus become permanent?

According to conventional economic theory, a country's current account surplus will over time become neutralised. Typically through exchange rate appreciation and rising domestic wage pressures. However, given Denmark's fixed exchange rate regime the adjustment will in this case happen only through price and wage formation. This implies that Danish wages would have to rise more briskly than wages in other countries for an extended period – and thus weaken exports through deteriorated competitiveness and at the same time lift imports through higher domestic consumption. In addition, stronger demand would contribute to boosting domestic investment activity and in turn reduce the surplus of savings.

However, there are several reasons why such an adjustment could take a very long time:

• Firstly, globalisation has greatly increased the elasticity of supply in the Danish labour market. Adjustment via the wage mechanism will therefore be less effective as wage formation is increasingly driven by conditions in the international labour market. • Secondly, a narrowing of the output gap may not necessarily reduce the surplus of savings markedly. The reason is that households and businesses alike are focusing more on consolidation in the wake of the financial crisis. If these conditions are permanent, the savings and investment rates nexus.nordea.com/research may remain below the historical average – even during a period when the economy is expanding more rapidly than its long-term potential. • Thirdly, the structure of pension wealth coupled with the current return on the substantial Danish net wealth gives rise to underlying upward pressure on the current account surplus. The Danish central bank has previously estimated that even if the private sector's propensity to invest and consume returns to the historical average, the current account surplus will still be 5% of GDP. • Fourthly, a string of fiscal policy measures (mainly the 2012 budget legislation) have been implemented to ensure a tight rein on the surplus of savings in the public sector.

Based on these four factors we believe that the current account surplus will remain exceptionally high for a long period. In the coming years the surplus should be relatively stable at around DKK 175bn – mainly driven by larger net income from sea transport as a consequence of increasing world trade. On the other hand, the goods balance is expected to show a moderately declining surplus. The surplus in both years corresponds to around 8% of GDP, which will be realised during a period when the output gap is expected to be closed. This shows that the current account surplus has become a permanent feature of the Danish economy

Effect on the Danish krone

As noted earlier the large and structural current account surplus creates underlying appreciation pressure on the Danish krone. Corresponding current capital exports are required to maintain a stable exchange rate versus the euro – either in the form of outflows from the private sector or through intervention from the Danish central bank where currency reserves are accumulated by current sales of kroner.

At the same time, the large current account surplus is a main reason for Denmark's safe-haven status in financial markets. This means that during periods of turbulence in financial markets, demand for Danish kroner may rise sharply from both international investors and Danish pension funds. This became obvious during the sovereign debt crisis in 2012 when the Danish central bank was one of the first central banks in the world to cut its deposit rate to below zero.

Lastly, the massive wealth relative to other countries means that Danish companies and pension funds are increasingly exposed to currency market fluctuations. In this context a very credible fixed nexus.nordea.com/research exchange rate regime is crucial, as it means that the hedge ratio in euro is much lower than in the case of other currencies. According to the central bank's quarterly Monetary Review, Q4 2016, less than 20% of the Danish pension sector's euro exposure is currently hedged.

The relatively low hedge ratio of pension funds' euro holdings, which currently amount to about DKK 800bn, implies an inherent risk of the Danish krone being caught up in a self-reinforcing process. For example if speculation about the future of the Euro area arises in the financial markets. If so, pension funds may have a stronger incentive to increase their euro hedge ratio, which will strengthen the Danish krone versus the euro. In this process pension funds will have a clear incentive to be first movers, as the price of hedging will go up in step with the growing demand. This mechanism became very apparent in connection with the massive krone demand after the Swiss central bank unpegged the franc from the euro in early 2015. According to the Danish central bank, domestic investors accounted for two-thirds of the net demand for Danish kroner.

Central bank must keep negative interest rate gap vs ECB

In our view, the consequence of the above factors is that structurally the Danish policy rate must be lower than that of the ECB to ensure a sufficient flow of capital exports to counter the appreciation pressure on the Danish krone versus the euro. Moreover, during periods of financial unrest situations may arise where the Danish policy rate needs to be significantly lower to counter the pressure from the safe-haven status and/or increased euro exposure hedging in the private sector. The largest gap so far between the deposit rates of the Danish central bank and the ECB was 55bp in early 2015 while it currently stands at 25bp.

nexus.nordea.com/research If we are right in assuming that the Danish central bank must keep its policy rate structurally below the EBC rate, it will have a spill- over effect on longer-term market rates in Denmark. The reasons why this is only partially the case now are the repercussions of the suspension of issuance of Danish government bonds in 2015 and the ECB’s current implementation of a comprehensive bond- buying programme in the Euro area that is not mirrored in the Danish market.

We believe that the market rate gap between Denmark and the Euro area will remain at the current level throughout the remainder of 2017. But from early 2018 we expect the ECB to gradually scale down its buying programme before fully winding it up at the beginning of the autumn. In our view, the exit from the QE programme will boost market rates in the Euro area, with only a partial spill-over to the Danish market, as fundamentals will at that time be in favour of a narrower interest rate gap.

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