Danmarks Nationalbank Monetary Review 4Th Quarter

3 4 : 9 1 : 4 1

8 0 0 2 - 1 0 - 8 1 18-01-2008 14:19:43 2007 4 D A N M A R D K S A T A L I N O N 2 0 7 K N A B Danmarks Nationalbank Monetary Review Quarter 4th

Danmarks Nationalbank Monetary Review 4 07 Havnegade 5 DK-1093 Copenhagen K Telephone +45 33 63 Telephone Fax +45 33 63 71 25 [email protected] E-mail: www.nationalbanken.dk Danmarks Nationalbank 1

d d n i . 7 0 _ 4 N O M MON4_07.indd 1 Monetary Review - 4th Quarter 2007

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 permit- ted.

The Monetary Review is available on Danmarks Nationalbank's website: www.nationalbanken.dk under publications.

Managing Editor: Jens Thomsen Editor: Anders Møller Christensen

This edition closed for contributions on 7 December, 2007.

The Monetary Review can be ordered from: Danmarks Nationalbank, Information Desk, Havnegade 5, DK-1093 Copenhagen K. Telephone +45 33 63 70 00 (direct) or +45 33 63 63 63. Inquiries: Monday-Friday 9.00 a.m.-4 p.m. E-mail: [email protected]

Datagraf Auning A/S ISSN 0011-6149 (Online) ISSN 1398-3865

18-01-2008 07:22:00 Antal sider: 1 Rev. nr. kolofon Oprettet af Alice Colombo Monetary Review - 4th Quarter 2007

Contents

Recent Economic and Monetary Trends ...... 1

Two New Euro Area Member States: Cyprus and Malta ...... 27

Longevity Bonds – a Financial Market Instrument to Manage Longevity Risk ...... 29 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 ...... 45 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 ...... 67 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 ...... 79 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.

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Hedge Funds and the Financial System ...... 97 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 2007 ...... 115 Rune Egstrup and Birgitte Damm Fischer, Statistics Average daily turnover in the Danish foreign-exchange market has more than doubled since 2004. 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 2007 ...... 129

Press Releases ...... 135

Tables and Graphs Section

Vol. XLVI, No. 4

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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 1974. 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 2007. 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 Inter- national Monetary Fund (IMF), global GDP growth is expected to be 5.2 per cent in 2007, compared to 5.4 per cent in 2006. 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.

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CONTRIBUTION TO GROWTH IN GLOBAL PPP-GDP Chart 1

Per cent 6

-1 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

USA Euro area Rest of OECD China and India Rest of world Note: Calculated on the basis of purchasing power parities (PPP). 2007-08 are estimates. Source: IMF World Economic Outlook, October 2007.

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 3.00

2.75

2.50

2.25

2.00

1.75

1.50 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.

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GDP GROWTH, FORECASTS Table 1

2008 2009

IMF EC OECD IMF EC OECD

USA ...... 1.9 1.7 2.0 n.a. 2.6 2.2 Euro area ...... 2.1 2.2 1.9 n.a. 2.1 2.0 Japan ...... 1.7 1.9 1.6 n.a. 2.3 1.8

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 Novem- ber. 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 100

0 1974 1978 1982 1986 1990 1994 1998 2002 2006 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.

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COMMODITY PRICES Chart 4

Index, March 2003 = 100 400

350

300

250

200

150

100

0 2003 2004 2005 2006 2007 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, long- term 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.

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US CREDIT SPREAD Chart 5

Basis points 300

250

200

150

100

-50 1987 1992 1997 2002 2007 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 allo- cated within the normal framework, i.e. by way of collateralised short- term 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

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DOLLAR VIS-À-VIS EURO AND KRONE Chart 6

EUR per USD DKK per USD 2.0 20

1.8 18

1.6 16

1.4 14

1.2 12

1.0 10

0.8 8

0.6 6

0.4 4

0.2 2

0.0 0 1974 1978 1982 1986 1990 1994 1998 2002 2006 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 = 100 110

105

100

80 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.

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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. 5.09. 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 im- pression 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 Per cent, year-on-year 120 20

100 15

80 10

60 5

40 0

20 -5

0 -10 2005 2006 2007

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.

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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 2006. 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 Sep- tember 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 7

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: EcoWin.

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9 to curb growth in 2008, while higher growth is expected in 2009. 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 1998. 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

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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 2007. 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, to- bacco 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 2008. 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 13.75 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.

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SPREADS BETWEEN MONEY-MARKET INTEREST RATES IN DENMARK AND THE EURO AREA 2007 Chart 10

Basis points

0 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 2007.1 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.

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3-MONTH CREDIT SPREAD Chart 11

Basis points 180

160

140

120

100

0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 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 swaps1 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.

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ADJUSTABLE-RATE LOANS IN RELATION TO TOTAL LENDING BY MORTGAGE-CREDIT INSTITUTES Chart 12

Per cent

0 2001 2002 2003 2004 2005 2006 2007 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 2000. 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 ten- sions 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 inter- vened in the market and sold foreign exchange for kr. 8.4 billion. The foreign-exchange reserve was kr. 179.2 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

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GROWTH IN MORTGAGE-CREDIT LOANS WITH AND WITHOUT AMORTISATION, AND ORDINARY REDEMPTIONS Chart 13

Kr. billion Kr. billion 50 6

30 5

10 4

-10 3

-20

-30 2

-40

-50 1 2003 2004 2005 2006 2007 Growth in loans with amortisation Growth in deferred-amortisation loans Ordinary redemptions (right-h.axis) Note: Mortgage-credit loans for owner-occupied dwellings. Quarterly growth and ordinary redemptions. Source: Danmarks Nationalbank. capped adjustable-rate loans were automatically converted into fixed- rate 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 2007.1 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 deferred- amortisation 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.

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GDP AND MAIN COMPONENTS SINCE 2001 Chart 14

Beginning of 2004 = 100 145

140

135

130

125

120

115

110

105

100

90 2001 2002 2003 2004 2005 2006 2007 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 mortgaging1, 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 2004-06, 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 2006. 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.

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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 2005. Invest- ments 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 2006. 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 2006. 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 Asso- ciation 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 2006. 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-

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CONSUMER CONFIDENCE AND CAR PURCHASES BY HOUSEHOLDS Chart 15

Thousands Percentage balances 10 16

9 14

8 12

7 10

6 8

5 6

4 4

3 2

2 0

1 -2

0 -4 2000 2001 2002 2003 2004 2005 2006 2007 Consumer confidence (right-hand axis) Car purchases by households 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 2007. 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 2007. 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.

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PRICES OF SINGLE-FAMILY HOUSES AND TERRACED HOUSES Chart 16

Per cent year-on-year 25

-5

-10

-15 0 5,000 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

Single-family houses Owner-occupied flats Thousands Thousands 35 18

30 15

25 12

20 9

15 6

10 3

5 0 2004 2005 2006 2007 2004 2005 2006 2007 Supply Sales 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.

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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 2004. 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 2006. 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 2006. In the first nine months of 2007, the current-account surplus was kr. 16.3 billion, which is just over kr. 21 billion lower than in the same period of 2006. 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. 16.3 billion, investment income contributed kr. 10.2 billion net. In other words, Denmark's interest and dividend income from abroad exceeds foreign interest and dividend income from Denmark, even though Den- mark'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.

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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 owner- occupied 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

1,000

500

0 2000 2001 2002 2003 2004 2005 2006 2007 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 long- term 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 2007. 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

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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 2007. 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 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. 2 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 Kr. billion 60 12

50 9

40 6

3 20

0 10

0 -3 1990 1992 1994 1996 1998 2000 2002 2004 2006 Exports Imports Trade balance (right-hand axis) Note: All items are shown exclusive of ships and aircraft. Source: Statistics Denmark.

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UNEMPLOYMENT AND SHORTAGE OF LABOUR Chart 20

1,000 persons Per cent 500 50

400 40

300 30

200 20

100 10

0 0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 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 2004. 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 2007. 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 2003. 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

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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 2006. 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, private- sector 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 6

0 2000 2001 2002 2003 2004 2005 2006 2007 Private sector, total Manufacturing Construction Services Source: Statistics Denmark.

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DENMARK'S WAGE COMPETITIVENESS Chart 22

Beginning of 1995 = 100 105

100

85 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

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 vis- à-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 compete- tiveness 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

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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 2006. 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 2007. As with previous finance bills presented during the upswing from 2004, the 2008 bill entailed a positive fiscal effect. More- over, 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 2007. 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 2008. In this connection the government should review its fiscal policy.

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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 index1 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. Like- wise, 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 23

2000 = 100 Per cent, year-on-year Per cent, year-on-year Price indices for clothing 5.0 5.5 115 110 4.0 5.0 105 3.0 4.5

100 2.0 4.0 95 1.0 3.5 90 0.0 3.0 85 80 -1.0 2.5 75 -2.0 2.0 96 97 98 99 00 01 02 03 04 05 06 07 96 97 98 99 00 01 02 03 04 05 06 07 Net retail price Domestic supply of goods Unit value index IMI IMI, excl. clothing Hourly wages in manufact. (right-h. axis) Source: Statistics Denmark and own calculations.

Danmarks Nationalbank does not usually calculate a separate domestic market- determined 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 23.

1 Also known as the price index for the domestic supply of goods.

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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 2007. 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.

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Monetary Review - 4th Quarter 2007

Longevity Bonds – a Financial Market Instrument to Manage Longevity Risk

Governor Jens Thomsen and Jens Verner Andersen, Financial Markets

INTRODUCTION

Life expectancy has been increasing over the last centuries. Naturally, it is positive that people live longer, but this also means that they must reconsider their savings in order to maintain a satisfactory standard of living when they retire. If people outlive their reserves, they will at some point have to reduce their standard of living. Since the exact time of death is not known, there will always be some uncertainty regarding the savings required. Many pension schemes include life annuities, so that the pension companies make fixed monthly payments during the remaining part of the policyholder's life1. This transfers the longevity risk2 from the individual policyholder to the pension company. If life expectancy increases more than expected, pension companies will have to pay out more than projected, resulting in a loss to those companies. With a view to managing the uncertainty related to future life expectancy, various players have sought to develop financial instruments that are indexed to the longevity of the population. These new instrument types, known as longevity bonds, transfer the risk in connection with higher life expectancy to investors in the financial markets. The market for the issuance of longevity bonds has received considerable attention in the financial press. However, neither issuers nor investors have so far fully embraced the instrument. Against that background, this article discusses the prospects for future use of such instruments. The underlying considerations behind the products are outlined in the first section, followed by a status of the current usage in the second section. The third section analyses supply and demand factors governing the limited use, and finally, the fourth section examines the potential for establishing a market for longevity bonds and discusses why there is no basis for government involvement.

1 In Denmark, life annuity schemes constitute a relatively large share of the pension schemes, but the ratio is declining. See ATP Faktum No. 27 (in Danish only), December 2005. 2 In the following, risk is reviewed in relation to management of longevity risk in the pension sector.

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IMPROVEMENT PER DECADE IN LIFE EXPECTANCY IN OECD COUNTRIES 1960-2000 Table 1

Country At birth At 65

Canada ...... 1.9 1.0 Denmark...... 1.2 0.6 France ...... 2.2 1.3 Netherlands ...... 1.3 0.7 Italy ...... 2.6 1.2 Spain ...... 2.5 1.1 Sweden ...... 1.7 0.9 UK ...... 1.7 1.0 USA ...... 1.8 0.9

Note: Life expectancy is measured as a weighted average of life expectancy at birth and at 65, respectively, calculated on the basis of estimated mortality rates. The improvement in life expectancy is the growth rate between 1960 and 2000. Source: Human Mortality Database, OECD and Antolin (2007).

BACKGROUND

In many OECD countries, life expectancy has increased by up to 2.6 years per decade over the last half century, cf. Table 1. The higher life expectancy has been achieved following substantial declines in the mortality rates of both the young and the old.1 Despite of the positive message contained in this information, it is a challenge for the population, pension companies and policymakers to implement mechanisms that can alleviate the implications of higher longevity. At the centre of the discussion is the possibility that the life expectancy of e.g. younger generations may far exceed the present projections, which may have social implications2. If people outlive the capital that has been saved they will have to reduce their standard of living sooner or later. Life expectancy has been increasing during the last centuries and projections show that this will continue for future generations in the western world, supported by new, improved healthcare treatments, among other things. Many governments have this issue on the agenda and con- tingent planning has been initiated in order to prepare for the change in demographics. Some of the measures implemented in OECD countries include later retirement and incentives for higher savings. In many countries the possibility of postponing the retirement age of future generations has been considered3. Thus, at the centre of the discussion is the speed and magnitude of these changes, and not the direction. In other words, the main issue is

1 Gillian Tett and Joanna Chung, Death and the salesmen, FT Magazine 24/25 February 2007. 2 See, for example, Mervyn King (2004). 3 Danish Welfare Commission, Future welfare – what are other countries doing? (in Danish only), 2005.

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HIGHER LIFE EXPECTANCY – UNEXPECTED VERSUS EXPECTED Box 1

Model projections show that life expectancy in Denmark will follow an upward trend in the period until 2100.1 From the risk management perspective of the pension companies, the risks associated with higher life expectancy stem from the uncertainty related to the prediction of the precise number of years the individual policyholder will live. If policyholders outlive the projections, pension companies will realise losses. Chart 1 illustrates life expectancy for women, as well as the related uncertainty, illustrated by the 5th and 95th percentiles. In other words, in 2100 life expectancy will be around 87 years, while the uncertainty, expressed as a 90 per cent confidence interval, will be ±2 years. The pension sector manages the two effects differently; higher life expectancy is addressed by reducing payments to policyholders, while deviations are handled through specific risk premiums which are part of the general provisions of pension funds.

EXPECTED AND UNEXPECTED DEVELOPMENT IN LIFE EXPECTANCY FOR WOMEN IN DENMARK Chart 1 Age

50 1850 1900 1950 2000 2050 2100 2150

Life expectancy including projections 95th percentile

5th percentile

1 Haldrup (2004). For men, an upward trend is also seen in the period until 2100. that the life expectancy of present generations may deviate substantially from the course projected today, cf. Box 1. Life expectancy in Denmark has not increased at a constant rate, cf. Chart 2. There have been substantial fluctuations during the period. For example, the pandemic influenza in the 1920s has been viewed as one of the factors that improved the life expectancy of subsequent generations. Conversely, obesity is seen as a factor which may reduce the life expectancy of present generations1.

1 Jacob S. Siegel, The Great Debate on the Outlook for Human Longevity: Exposition and Evaluation of Two Diverging Views, Society of Actuaries, 2005

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DEVELOPMENT IN LIFE EXPECTANCY IN DENMARK 1835-2006 Chart 2

Years Years

80 8

6 70 4

2 60

50 -2

-4 40 -6

30 -8 1835 1855 1875 1895 1915 1935 1955 1975 1995 Deviation from trend (right-hand axis) Development in life expectancy (left-hand axis) Note: Life expectancy is measured as a weighted average of life expectancy at birth, calculated on the basis of estimated mortality rates. Over the above period, life expectancy has increased by an average of 3 months per year, and the deviation from the trend is measured on the basis of this average growth rate. Source: Human Mortality Database.

Implications for the pension sector In general, past projections have underestimated the fact that people live longer. In practice this implies that pension companies need to make additional provisions in order to address the shortfall. Given that pension companies have made long-term commitments, they need to manage the longevity risk1. Before 2000, there was awareness of this issue, but high returns had helped to alleviate the problem. Due to poor equity market performance and low interest rates in the following years, it became evident that decades of improvements in life expectancy had become a challenge for the pension industry2. Moreover, many countries have introduced new pension regulation, requiring pension fund managers to update their pension plan assump- tions and apply a mark-to-market approach in the valuation of the risks embedded in the pension plans3. Finally, many pension companies have implemented new risk management techniques, known as asset liability

1 Ted Clarke, Living with the Risks – Is your pension deficit what it seems?, Prudential, 2007. 2 Hermes: BT Pension Scheme: A decade of outperformance, 2007. 3 Since 1 January 2005, listed insurance companies have been subject to the International Financial Reporting Standards (IFRS).

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33 management (ALM), which imply a closer linkage between pension fund assets and liabilities. Against this background there is an increasing interest in analysing new instruments that can be used to hedge against longevity risk. The pension industry has for some time struggled with other risk factors such as the management of interest rate risk, and in many defined benefit pension schemes inflation is also an embedded risk element. In both cases there exist a range of financial instruments, such as cash products (bonds with maturities of up to 50 years, and inflation-linked bonds) and derivatives (interest-rate swaps and inflation-linked swaps) that offer the pension industry options for managing such risk factors. In relation to longevity risk, the application of capital market instruments has been limited. So far the pension industry has used other types of hedging tools which can basically be divided into three categories:

1) Self-insurance and implicit coverage Typically pension funds have managed liabilities related to longevity risk without specific hedging instruments. Thus, the exposure to longevity risk has been part of their overall risk management. However, life insurance companies that enter into contracts with both pension and insurance elements have been able to obtain some degree of hedging. After an insurance event such as pandemic influenza there will normally be a negative correlation between insurance and pension claims. The claim from insurance policies increases, but at the same time future payments on pension policies are reduced because the lives of the policyholders were shorter than initially forecasted1.

2) Reinsurance Traditionally, reinsurance companies have provided capital to life insurance companies and pension funds seeking hedging opportunities. How- ever, longevity risk is so specific that reinsurance companies have so far been reluctant to undertake business unless it was part of an existing client relationship. Nevertheless, factors such as increasing demand from insurers and pension funds plus better modelling of longevity risk may increase reinsurers' appetite for this business2.

3) Sale to external buyout funds In recent years, companies with defined benefit schemes (primarily in the UK) have been looking for alternative risk transfer solutions, and

1 Richards (2004). 2 Richards (2004).

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34 more are expected to follow suit in the coming years. According to a survey by PwC, 11 per cent of UK companies with defined benefit schemes are considering the option of selling off their pension obligations within the next 5 years1. The set-up may take various forms; however, the key underlying model is that companies transfer the portfolio of pension contracts to an external investor that will assume the con- tractual obligations. In the last couple of years, the UK has seen the establishment of around 20 new investment companies specialising in this area.2

STATUS FOR ISSUANCE OF LONGEVITY BONDS

The evolution of financial market instruments has brought a number of new risk-diversification options to the attention of investors. Most notable has been the development in credit markets, where a multitude of products have been introduced during the last decades. This reflects, among other things, an interest in developing products that can help financial institutions to hedge against various types of risk. Experience from other markets has generated an interest in developing capital market products that can also help diversify longevity risk. Nevertheless, issuance of longevity bonds has so far been limited. A few reinsurance companies have used capital market instruments to transfer risk from pension and life insurance companies to investors in financial markets. The most developed market is based on mortality- linked derivatives, which in some respects resemble longevity bonds, but are nevertheless significantly different in that they are based on mortality rates, while longevity bonds are based on survivor rates, cf. the Ap- pendix. Since 2003 some companies have issued mortality-linked securities, cf. Box 2. In addition, anecdotal evidence suggests that a number of investment banks have been active in setting up similar structures, but these transactions have been established on the basis of private placements3. Issuance of longevity bonds has not taken place so far, even though there has been an indication of strong interest from the pension sector. In 2004, the EIB aimed to launch a longevity bond with a value of GBP 540 million which was intended for UK life insurance companies and pension funds. The structure was initiated in partnership with BNP Paribas and Partner Re, which ultimately were the final assumers of the

1 PricewaterhouseCoopers, PwC pensions survey: Tracking the views of key decision makers, Autumn 2007. 2 Phillip Inman, More firms seek to sell off their pension schemes as costs rise, The Guardian, 19 October 2007. 3 IFR, UK longevity risk hot spot, 10 June 2006.

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ISSUANCE OF MORTALITY-LINKED SECURITIES Box 2

In 2003, Swiss Re established a special purpose vehicle (Vita Capital) that issued USD 400 million in 3-year notes. In 2005, Vita Capital issued a second note with an outstanding amount of USD 362 million and 5-year maturity. In December 2006, Vita III was launched with an outstanding volume of USD 700 million in tranches with 4- and 5-year maturities. The key objective was to replace Vita I, which expired at the end of 2006.1 In 2006, Scottish Re raised USD 155 million via Tartan Capital in 3-year notes.2 Osiris Capital was arranged by Swiss Re, but on behalf of the AXA Group, which was the ultimate buyer of protection in 2006. The outstanding volume was EUR 345 million and the maturity was 4 years.3

1 Swiss Re. 2 Scottish Re. 3 IFR, Taking a view on mortality, 21 October 2006.

risk. The launch received much attention in the financial press because the deal was considered to be the first of its kind and had an innovative set-up. However, it never reached the market. Besides technical issues such as design problems, anecdotal evidence indicates that pension funds and life insurance companies did not subscribe to the deal, primarily because coverage was considered to be too expensive, see Box 3. The above-mentioned capital market transactions have all been focused on hedging the pension sector's longevity risk. In addition, a number of bonds have been issued, predominantly in the USA, with the purpose of funding life insurance business or funding regulatory capital

EIB LONGEVITY BOND PROJECT Box 3

In November 2004, the European Investment Bank announced plans to issue the first longevity bond that would offer coverage for UK pension schemes and life insurers with exposure to longevity risk for the male population of England and Wales. The initial size of the note was GBP 540 million and the maturity of the bond would be 25 years. Although the bond was launched by the EIB, issuance was arranged and managed by BNP Paribas. Under this structure BNP would effectively bear the investment risk and the longevity risk would be covered by Partner Re that had concluded an agreement with BNP. The bond would still be rated AAA, equivalent to the EIB rating, and thus purchasers of coverage would have an AAA counterparty risk. The issue was withdrawn in late 2005 without being issued, primarily because the pension industry found the price of coverage on longevity risk too high. In addition, other factors were mentioned such as missing mandates in the pension industry and concerns about basis risk between the index embedded in the bond and the longevity risk faced by insurance and pension funds.

Source: T. Cox (BNP Paribas) and F. Blumberg (Partner Re), Longevity bonds, 2005 Life Convention, Barnett Waddingham LLP, Longevity bond to be issued by the EIB, 2005 and Financial Times, Changing attitudes mean there is more life left in longevity bonds, 22 November 2006.

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36 requirements. These transactions have used a securitisation set-up in which asset-backed securities have been structured on the basis of a pool of life insurance policies. In general, these transactions are aimed at financing traditional life insurance business without having a specific focus on hedging longevity risk. The bulk of the outstanding volume has been linked to such structures, cf. Chart 3.

INTEREST IN LONGEVITY BONDS AMONG INVESTORS AND ISSUERS

Notwithstanding the appealing characteristics of longevity bonds, the market has not evolved. A number of factors have contributed to the slow growth in longevity bonds; factors related that are applicable to both buyers and sellers. In general, the market is short of investors in longevity risk, and capital needs to be attracted by offering alluring risk- adjusted returns. In addition, some externalities may hinder the development of markets. A factor such as the outstanding volume is often essential for a market to develop, but once the volume has passed a critical level, growth may potentially be very high. In the following the various factors behind the lacklustre evolution will be illustrated.

General capital market considerations Viewed in retrospect, the most successful launches of new capital market instruments during the past decade have been undertaken in an envir-

INSURANCE-LINKED SECURITIES AND MORTALITY NOTES Chart 3

USD billion 16

0 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006*

Insurance-linked securities Mortality notes Note: The data for insurance-linked securities is based on information until the end of August 2006. The data includes accumulated issuances since 1996. Source: Swiss Re and IFR.

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37 onment where initially there was a fair balance between participants with buying and selling interests. If markets are relatively biased towards one side, it may be difficult to launch a product due to lack of interest in and understanding of business characteristics. Consequently, the price will typically be established at a level that is not deemed attractive. In the case of longevity bonds, the most obvious challenge is the lack of natural investors who would benefit from an unexpected rise in life expectancy. Pharmaceutical companies and care providers are often mentioned as examples of investors with a natural interest in assuming this risk1. These sectors would be exposed to losses if life expectancy decreases, and thus the companies would be able to hedge their own exposures by issuing longevity bonds. In spite of the theoretical arguments, it is more than doubtful whether the natural investors would actually enter into these transactions, due to corporate governance considerations, among other things. For example, it is debatable whether a company would be able to explain to its share- holders how it can benefit from entering into transactions that may influence profits in a distant future. If this obstacle can be overcome, it is also uncertain whether the potential volume would be more than a drop in the ocean when compared with the overall demand in the pension industry. Another challenge in relation to establishing a market for longevity bonds is that the underlying characteristics differ significantly from those of other types of financial instrument, such as mortgage-credit bonds, where the risk premium is determined on the basis of the development in the credit quality in the mortgage-credit market. The process related to development in life expectancy is characterised by a high duration and low volatility, particularly in recent years, cf. Chart 4. If a comparison is made with the development in credit quality in the mortgage-credit market (illustrated by growth in GDP at factor cost), the duration is lower and the volatility substantially greater. The reason is that the economy has historically gone through complete business cycles in less than 10 years. Consequently, an investor in mortgage-credit bonds does not have to wait many years to realise whether the investment was profitable. In addition, economic indicators are frequently published, giving an idea of future developments.

1 European Pensions and Investment News: Looking for a buyer in face of longer lives, 4 December, 2006.

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GROWTH IN DANISH LIFE EXPECTANCY AND ECONOMIC GROWTH IN DENMARK ILLUSTRATED BY THE CHANGE IN GDP AT FACTOR COST Chart 4

Per cent 10

-2

-4

-6

-8 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 Annual growth in life expectancy Annual growth in GDP at factor cost Note: Life expectancy is measured as a weighted average of life expectancy at birth, calculated on the basis of estimated mortality rates. Source: K. Abildgren, Monetary Trends and Business Cycles in Denmark Since 1875, Working Paper 43, Danmarks Nationalbank, 2006, and Human mortality database.

Perspectives for investors in longevity bonds (hedging sellers) Besides companies with a natural exposure to longevity risk, a number of other investors have also been mentioned in the debate about the issuance of longevity bonds. These are primarily investors that are already active in the asset management sector, including hedge funds, investment funds, etc. The low correlation between an unexpected increase in life expectancy and the yield on other financial instruments is typically cited as the major reason why longevity bonds would be attractive. The instrument would contribute to reducing the risk on the investors' aggregate investment portfolio, which means that the investors would require only limited risk premiums when investing in this instrument. In contrast, the financial instruments presented so far have had a number of disadvantages. Primarily, they have been highly complex instruments with maturities in the range of 25 years or more. So far, it has been difficult to sell products that combine high complexity and long maturities. It has, at the same time, been difficult to reach agreement on some measure of standardisation, including how to estimate the future development in life expectancy and the related uncertainty1.

1 JP Morgan (2007).

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Against that background it has been difficult to build up a market since investors have had to accept that they were buying an instrument that could prove to be practically impossible to resell. In view of the long maturity of the product, investors would have limited opportunities to exit the transaction for many years. The lack of liquidity has led investors to demand a liquidity premium, so that the resulting price of hedging has been unattractive for the pension sector, despite the low correlation.

Perspectives for issuers of longevity bonds (hedging buyers) So far, the pension sector has predominantly seen longevity risk as a factor that has been managed via internal risk-management systems. Capital provisions have been made as a general buffer against fluctuations in the value of pension commitments. However, as the pension sector has increased its focus on risk management, it has also turned its attention to instruments for explicit management of the primary risk factors that a pension company is exposed to, including longevity risk. In spite of this, the pension sector has not welcomed the launch of longevity bond. The reason may be that the instruments presented so far, such as the EIB's longevity bond, allow only partial hedging of the pension sector's exposure to unexpected increases in life expectancy. For example, the development in life expectancy may differ considerably from one socio-economic group to another, and between geographical areas, etc. Against this background, a Danish pension fund investing in the EIB's longevity bonds would not be able to fully hedge its exposure owing to the different developments in life expectancy in Eng- land/Wales and Denmark, cf. Box 3. These issues reflect a dilemma, in that on the one hand pension funds want the closest possible correlation between hedging and exposure in order to avoid a basis risk, and on the other hand investors want instruments that are as standardised as possible. Furthermore, pension funds are typically not yet empowered to enter into transactions that may involve less exposure to longevity risk. This is attributable to factors such as the uncertainty concerning the regulatory treatment of longevity bonds.

PERSPECTIVES FOR FUTURE DEVELOPMENT OF LONGEVITY BONDS

The lacklustre market for longevity bonds has led to considerations as to whether government issuers should intervene in this market. Tradition- ally, government issuers have an objective of covering the central gov-

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40 ernment's financing requirement at the lowest possible long-term costs, subject to a prudent degree of risk. Furthermore, their aim is to facilitate the central government's access to the financial markets in the longer term and to support a well-functioning domestic financial market. Consequently, it might be considered whether government issuers should get actively involved in the development of a market for longevity bonds. In some countries government issuers have in this way contributed to the development of bond segments with long maturities as well as inflation-linked instruments, cf. the 50-year issuances in France and the UK. This has provided a benchmark for private issuers of financial instruments in the same segments1. Likewise, it could be argued that the central government should issue longevity bonds in order to provide a benchmark that could support the development of a market for longevity bonds. However, it is difficult to imagine that sovereigns would be able to issue such longevity bonds on attractive terms2. Furthermore, the central government is already highly exposed to increasing life expectancy as extra government spending will be required to tackle the implications of demographic changes3. By issuing longevity bonds to pension funds, the government would therefore further increase their balance-sheet exposure. Several pension funds have also indicated that they see the management of unexpected increases in life expectancy as an inherent challenge for the pension funds4. It could also be argued that the pension sector knows its clients better than the external investors and is therefore better equipped to manage the risk, rather than selling it off to investors in the financial markets. One issue that has been pointed out in relation to the new products launched in the credit market has indeed been that it would, perhaps, be best that financial institutions manage the risks in relation to their commitments, instead of repackaging them and selling them off to financial investors. The same argument could be put forward in respect of longevity. On the other hand, by selling off, the pension sector disperses the risk to an investor group which may be better equipped to manage risk that is characterised by a low probability but a potentially high cost. For investors in the financial markets there are, however, a number of obstacles to be overcome before longevity bonds become a marketable instrument, and it is very likely that the final product design has not yet been developed. In any case, it is important to achieve a higher degree

1 Danish Government Borrowing and Debt 2005, chapter 9: Issuance of Long-Term Government Bonds. 2 Swedish National Debt Office, Comment on Longevity bonds: summary by Bo Lundgren, 2005. 3 The Danish Welfare Commission's main report 2006 (in Danish only). 4 European Pensions and Investment News: Looking for a buyer in face of longer lives, 4 December 2006.

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41 of standardisation within the area. Several investment banks, including JPMorgan and Credit Suisse, have issued reports on this topic, thereby generating debate and awareness about the issue.1 One of the critical themes raised is the development of better models for predicting life expectancy.

CONCLUDING REMARKS

Higher life expectancy will pose substantial challenges for pension funds in the coming years. In general, increasing life expectancy needs to be addressed via higher savings for the retirement age. Moreover, the uncertainty about projections of the future development in life expectancy implies that pension funds that have issued life annuities will have to manage the risk on their liabilities. In itself this is nothing new; pension funds have hedged their risks for many years. In recent years pension funds have, however, to a large extent implemented asset-liability management techniques, and thereby focused on almost complete hedging of risks not deemed to be part of their core business. Viewed in that perspective, some pension funds, e.g. in the UK, have actively sought opportunities to hedge the balance-sheet risk, including the possibility of using longevity bonds. Nevertheless, the market for longevity bonds has not really taken off yet, although there have been a few experiments with products whereby investors assume the risk of an unexpected increase in life expectancy against receipt of a risk premium. The extensive focus on the pension sector by several investment banks reflects investments in the development of various models. In view of the innovation seen in other financial areas, it is not impossible that a private market for longevity bonds will emerge, although not necessarily based on the product structures known today.

1 JPMorgan (2007) and Credit Suisse Longevity index.

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REFERENCES

Antolin, Pablo (2007), Longevity Risk and Private Pensions, Financial Market Trends, OECD, Volume 2007/1 No. 92, June.

Antolin, Pablo and Hans Blommestein (2007), Governments and the Market for Longevity-indexed Bonds, Financial Market Trends, OECD, Volume 2007/1 No. 92, June.

Blake, David and William Burrows (2001), Survivor Bonds: Helping to Hedge Mortality Risk, The Journal of Risk and Insurance, Vol. 68, No. 2, pp. 339-348, June.

Blake, David, Andrew Cairns and Kevin Dowd (2006), Living with Mortality: Longevity Bonds and other Mortality-Linked Securities, Presented to the Faculty of Actuaries, 16 January.

Blake, David, Andrew Cairns, Kevin Dowd and Richard MacMinn (2006), Longevity Bonds: Financial Engineering, Valuation, and Hedging, The Journal of Risk and Insurance, Vol. 73, No. 4, pp. 647-672.

Brown, Jeffrey R. and Peter R. Orszag (2006), The Political Economy of Government Issued Longevity Bonds, Prepared for The Second Inter- national Longevity Risk and Capital Market Solutions Conference, April.

G10 (2005), Ageing and pension system reform: implications for financial markets and economic policies, September.

Gründl, Helmut, Thomas Post and Roman N. Schulze (2006), To Hedge or Not to Hedge: Managing Demographic Risk in Life Insurance Companies, The Journal of Risk and Insurance, Vol. 73, No. 1, pp. 19-41.

Haldrup, Niels (2004), Estimation of average longevity for men and women in Denmark 2002-2100 based on the Lee-Carter method (in Danish only), Working report 2004:3, Danish Welfare Commission, 15 May.

JPMorgan (2007), LifeMetrics. A toolkit for measuring and managing longevity and mortality risks, Version 1.0, 13 March.

King, Mervyn (2004), What Fates Impose: Facing Up To Uncertainty, The Eighth British Academy Annual Lecture.

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Loeys, Jan, Nikolaos Panigirtzoglou and Ruy M. Ribeiro (2007), Longev- ity: a market in the making, J.P. Morgan Securities Ltd., July.

Richards, Stephen and Gavin Jones (2004), Financial aspects of longevity risk, The Staple Inn Actuarial Society, 26 October.

Securitization – new opportunities for insurers and investors, Sigma, Swiss Re, No. 7/2006.

Health Committee and Political and Economic Committee of the Danish Parliament (2006), Significant increase in life expectancy – what is the situation and what are the potential implications for the future retirement age? (in Danish only), www.folketinget.dk/samling/20061/almdel/PØU/Bilag/12/313205.PDF, 18 October.

Visco, Ignazio (2006), Longevity Risk and Financial Markets, Banca d'Italia, October.

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APPENDIX

The following provides a description of the overall structure of the mortality-linked instruments issued to date, as well as a comparison with the EIB's proposal for issuance of longevity bonds1.

Swiss Re Vita I The overall concept is that the issuer (Swiss Re) seeks to hedge any risk arising from a substantial increase in the mortality rate. Viewed in isolation, the issuer achieves a gain on the instrument if the mortality rate, Mt, substantially exceeds a predefined index, M0. On the other hand, the investor gains if the mortality rate, defined by Mt, is not extremely high.

The maturity of the instrument is 3 years. The Mt index is defined as a basket of mortality rates in five countries with different weights – the USA (70 per cent), the UK (15 per cent), France (7.5 per cent), Switzerland (5 per cent) and Italy (2.5 per cent). The gender distribution is 35 per cent women and 65 per cent men, and the instrument has a broad age distribution. The instrument pays a variable coupon, equivalent to LIBOR plus 135 basis points, on an ongoing basis. The part of the principal that is lost is determined using the following loss function:

0 % Mt < 1.3 M0

Lt = (Mt – 1.3 M0)/(0.2 M0)*100 % if 1.3M0 ≤ Mt ≤ 1.5M0

100 % 1.5* M0 < Mt

Issuance takes place via Vita Capital, a special purpose vehicle. This structure entails a number of advantages, partly due to the transaction's status as an off-balance-sheet item, partly because it offers more favourable counterparty risks for the investor.

EIB longevity bond The EIB's proposal for a longevity bond (that never reached the market) is constructed with a maturity of 25 years. The instrument hedges the pension fund against an unexpected increase in the survivor index for people in the age group 65-90 years. The bond has an annuity structure, with the annual coupon payments starting from the base of GBP 50 million. Subsequently each coupon payment reflects the percentage of the population of England and Wales aged 65 that is still alive each year until the 25 years have passed. If the survivor rate increases substantially, the pension fund will receive higher coupons. The resulting overall coupon structure is as follows:

rt (St) = GBP 50 million * St for t = 1,2,….,25, where St is the survivor index in the year t.

1 The description is based on Standard & Poors, Vita Capital Ltd.'s Principal-at-risk variable rate mortality catastrophe-indexed note, 2003, and Blake, Cairns, Dowd and MacMinn (2006).

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Flexicurity – the Danish Labour-Market Model

Erik Haller Pedersen and Johanne Dinesen Riishøj, Economics

INTRODUCTION AND CONCLUSION

Over the last 15 years, unemployment in Denmark has gradually fallen to one of the lowest levels in the OECD concurrently with an increase in employment. So far, this has not given rise to any large imbalances in the economy – an achievement that has attracted both national and international attention. The positive development should be viewed against the background of e.g. the comprehensive reforms of the labour market that were launched in the mid-1990s. Fine tuning of labour-market policies has continued up to the present time. The result is the special Danish labour- market model referred to as flexicurity1. The model combines a flexible labour market with social security and active labour-market policies. This article describes and evaluates the Danish labour-market model. Flexicurity has already been the subject of intensive research, and it is not possible to discuss all contributions in this article. The general consensus seems to be that the flexicurity model has contributed to the decline in unemployment during the period, but also that it is expensive for the public purse. In particular, a stronger focus on labour-market policy incentives, such as increased use of proven incentive schemes, seems to have had an effect. However, the decline in unemployment should be considered a precondition for the political approval of the many labour-market reforms. Although the term flexicurity had not been invented at the time, all the elements of the model were present for a period up to the early 1970s. Only after the rise in unemployment following the two oil price shocks in 1973 and 1979, did Denmark begin to take a more socio- political approach to labour-market policy. This process was reversed with the labour-market reforms of the 1990s, but it is an open question whether the flexicurity model in its present form will prove to be robust if the country reverts to a situation where unemployment rises signifi-

1 For a historical explanation of the origin of the term flexicurity, see Jørgensen and Madsen (2007).

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46 cantly. The historical development illustrates that flexicurity is not a panacea for labour-market policy. One of the advantages of the Danish labour-market model is that it has probably contributed to a more positive general view of globalisation in Denmark than is the case in many other countries. The Danish labour-market model has been the subject of considerable international interest. However, the model is an integral part of the Danish welfare model, and as such it is difficult to implement in other countries with different labour-market traditions and a different institutional framework.

A DYNAMIC LABOUR MARKET

The Danish labour market has seen extraordinary development over the last 15 years. Since the kick-start of the Danish economy in 1993, unemployment has dropped from more than 9 per cent to approximately 3 per cent in 2007, cf. Chart 1. It is the lowest unemployment figure in Denmark for more than 30 years and the lowest in the EU. Especially the rate of long-term unemployment has gone down. Youth unemployment has declined in step with general unemployment, but remains relatively high in other countries, cf. Chart 2. During the period, overall employment increased to the highest level ever.

UNEMPLOYMENT DEVELOPMENT IN DENMARK Chart 1

Per cent 14

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Harmonised unemployment Youth unemployment Structural unemployment (NAIRU) Note: Harmonised unemployment assumes that to be included in the unemployment statistics, the unemployed must be actively seeking jobs. Youth unemployment includes the 15-24 age group. Structural unemployment indicates the lowest unemployment possible without causing major imbalances in the economy. 2007 is an average of the first ten months. Source: Eurostat and OECD (NAIRU).

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YOUTH UNEMPLOYMENT Chart 2

Per cent 25

0 UK USA EU15 France Finland Norway Sweden Germany Denmark Netherlands Harmonised unemployment Youth unemployment Note: Average of the first three quarters of 2007. Youth unemployment includes the 15-24 age group. Source: Eurostat.

Remarkably, the substantial drop in unemployment has not so far resulted in a significantly higher wage-increase rate. This reflects the decrease in structural unemployment that is now presumably among the lowest in the OECD. This is the result of active labour-market policies as well as other factors. An increased understanding of the conditions of the fixed-exchange-rate policies has anchored inflation expectations at a level close to 2 per cent p.a. Together with more decentralised wage formation and increased opportunities to relocate production, this has to a greater extent brought Danish wage increases on a par with those of other countries. Decreases in unemployment typically have a delayed impact on wages, and recent developments with incipient wage acceler- ation show that all good things come to an end. The general public's perception of unemployment has changed in line with the decline in unemployment. Previously, when unemployment was high, it was a widely held view that a high rate of unemployment was an inherent defect in our economic system that we had to live with while seeking to remedy its worst negative social consequences. Today, the opinion tends to be that the right financial conditions and an appropriate economic policy provide for a more permanent reduction of structural unemployment. Obviously, this is no guarantee against unemployment temporarily going up some time in the future, e.g. as a result of unsustainably high wage increases and the ensuing loss of competitiveness.

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The Danish labour market is characterised by a relatively low average number of working hours: just under 1,600 hours per year. On the other hand, the participation rate is high by international standards, especially for women. It is a typical pattern across countries that a low number of individual working hours implies a high general participation rate. In addition to the number of working hours and participation rates, the total input of work in the economy is determined by the population aged 20-64 years. The labour force is mainly recruited from that age group. The combination of the three factors can be measured by the total number of working hours per capita per year. In such a comparison, Denmark is above the EU15 average, but below the total OECD average. Overall, the total number of Danish working hours in relation to the size of the economy, is thus not particularly high by international standards. Naturally, besides the total number of hours worked, actual performance during those hours, is crucial. The allocation of labour is important to ensure that the human capital available is utilised in the best possible way. In a changing world this calls for regular adjustments, and in this area the Danish labour market stands out. 250,000 jobs disappear every year in Denmark, but even more jobs have been created in recent years, cf. the Confederation of Danish Industries (2006). In addition, the rate of job turnover is high. More than 600,000 people change jobs every year. The average seniority on the Danish labour market is only 4.8 years, the lowest in the OECD, cf. Chart 3. Part of

AVERAGE JOB DURATION Chart 3

Years 12

0 UK Italy EU15 Spain France Poland Ireland Austria Finland Sweden Belgium Portugal Germany Denmark Netherlands Luxembourg

Czech Republic

Note: The figures concern 2005. Source: Mobility in Europe from "European Foundation for the Improvement of Living and Working Conditions", 2006.

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49 the explanation is the extensive lay-off opportunities, e.g. in connection with seasonal production fluctuations. In this situation employees receive unemployment benefits for a short period and then return to their original jobs. This, however, does not significantly alter the overall picture. One drawback of high job turnover may be a reduction of the enterprises' incentive to invest in employee education. In Denmark, this is solved by increased government involvement in the co-financing of supplementary training, etc. Denmark has one of the highest rates of supplementary training, so in practice the potential problem has turned out not to be significant.

FLEXICURITY

The upswing in the Danish economy since 1993 has been accompanied by a number of reforms of the Danish labour market. Combined with continued adjustments up to the present time, this has resulted in the special Danish labour-market model referred to as flexicurity. The model combines a high rate of labour-market flexibility with a social safety net and active labour-market policies and has attracted international attention in recent years, cf. e.g. OECD (2004) and (2005) and the European Commission (2007). The flexicurity model comprises three main components: liberal rules for the hiring and dismissal of employees (the "flexi"' part), a relatively fine-meshed economic safety net in case of unemployment (the security part) and active labour-market policies, cf. Chart 4. The latter area in particular has seen significant changes in the last 15 years. The most important measures since 1993 are listed in the Appendix1. A characteristic of the Danish labour market is a considerable degree of regulation arrived at through agreements between the social partners, rather than legislation. Presumably, such a system assumes a fairly high rate of unionisation. Danish trade-union membership comprises about 75 per cent of the labour force. This level has been more or less constant for several decades, but with significant shifts between different unions due to the change in education patterns.

Flexibility The basic system of agreements between employers and employees dates all the way back to the September Agreement of 1899. This agreement adopted the principle of the employer's right to manage and distribute work, while employees obtained the right to be members of a

1 For an overview and evaluation of the flexicurity model, see the Ministry of Employment (2005). For an international comparison of labour-market models, see Gaard and Kieler (2005).

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THE FLEXICURITY MODEL Chart 4

Flexible labour market

Active Social labour-market security policies

Source: The Ministry of Labour (1999). trade union. Ever since that time, the employer's right to hire and fire employees has been relatively liberal compared to most other OECD countries, cf. Chart 5. Employers also have a wide scope to redeploy employees within individual enterprises, which facilitates adjusting the number of employees to match demand. Recent legislation, e.g. EU rules concerning collective dismissals, is typically incorporated into current col-

JOB SECURITY Chart 5

Scale from 0 to 6 3.5

3.0

2.5

2.0

1.5

1.0

0.5

0.0 UK USA Italy Spain France Finland Sweden Belgium Germany Denmark

Netherlands Note: Job security is assessed on a scale from 0 (low security) to 6 (high security). The assessment is based on three criteria: regulation of temporary employment, job security in ordinary employment and rules on collective dismissals. The calculation concerns the situation in 2003. Source: OECD Employment Outlook (2006).

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51 lective agreements, but EU regulation of the labour market does generally represent a challenge to the Danish collective agreement system. A high level of job security makes it more costly for an enterprise to reduce its labour force. This is an immediate advantage to those who already have a job. On the other hand, the inability of enterprises to quickly reduce the labour force makes them more reluctant to hire new staff. This hits young job seekers particularly hard. Thus, a distinct insider/ outsider conflict is created in countries with a high level of job security. It is unclear whether a high level of job security in itself influences unemployment, but it unequivocally reduces the labour-market dynam- ics. This entails a risk of actually protecting jobs in sectors in decline while impeding socially desirable redeployment of the labour force to sectors with higher added value. At the same time it becomes more difficult for individual enterprises to withstand fluctuations in supply and demand. Box 1 seeks to quantify the flexibility of the Danish labour market.

MEASURING LABOUR-MARKET FLEXIBILITY Box 1

High labour-market flexibility is evident e.g. in quick adaptation of employment to changes in the production of an enterprise. The quicker the adaptation, the smaller the cyclical fluctuations in simple productivity measured as GDP per employee. The employees of an enterprise normally represent knowledge and education that are neither immediately replaceable nor replaceable free of charge. The enterprise, therefore, typically does not adapt the number of employees to brief production fluctuations. Consequently, it is a normal cyclical phenomenon that productivity fluctuates with the economic cycle, cf. Chart 6.

ANNUAL GDP GROWTH AND GDP PER EMPLOYEE Chart 6

Per cent 7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

-1.0

-2.0 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

GDP GDP per employee Source: Statistics Denmark and own calculations.

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CONTINUED Box 1

Average volatility in annual GDP growth over the last 35 years is estimated at 1.9 per cent, while volatility in GDP growth per employee is 1.1 per cent. The 0.8 per cent difference reflects the flexibility with which employment adapts to production fluctuations. An international comparison shows that the adaptation estimated using the above method takes place more quickly in Denmark than in most other countries, cf. Chart 7. This is a specific indication of the relatively high level of flexibility in the Danish labour market1. The fast employment response to production changes is not the only criterion indicating whether the labour-market policies are working well. In a flexible labour market, employment should adapt to the labour force, resulting in a low unemployment rate.

EMPLOYMENT ADAPTATION TO PRODUCTION Chart 7

Per cent 1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4 UK USA Italy Spain France Ireland Austria Finland Canada Norway Sweden Belgium Portugal Germany Denmark

Netherlands Note: The bars measure the dispersion of annual GDP growth less the dispersion of productivity growth in the period 1970-2006. For Germany the period is 1992-2006. Source: Own calculations.

1 See Kiander and Virén (1998) for further discussion.

Flexibility is not just a question of low job security. During the 1990s, more flexible rules on the organisation of working hours throughout the year were incorporated in the collective agreements, and wage formation became more decentralised. As a result, wages are to a higher extent fixed on the basis of the circumstances of individual enterprises and the performance of individual employees. This principle is applied to a lesser degree in the public sector. Questionnaire surveys show that the Danish labour market with higher job turnover implies less fear of unemployment than in countries with high job security, cf. the European Commission (2006). Under these cir-

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53 cumstances, part of the explanation is that Denmark has been ahead in the economic cycle, and a strong economic position reduces the fear of unemployment.

Security Increased flexibility with respect to the organisation of working hours is a typical demand on the part of employers. On the other hand, employees are ensured relatively favourable compensation in the event of unemployment. The unemployment benefit and employment service system dates back to the beginning of the 20th century, but found its present form in the late 1960s. The union insurance system is contribution-financed, but with substantial government co-financing. The government finances the costs of marginal unemployment. Unlike the situation in a number of other countries, membership of an unemployment fund is voluntary in Denmark, and the admission requirements are relatively lenient. The degree of compensation for persons entitled to unemployment benefits is 90 per cent of the previous income for the lowest income brackets, but with a fixed cap. The average degree of compensation is just over 50 per cent and has been declining over time. In the early 1990s, the average degree of compensation was almost 60 per cent. Thus, for high-income groups the unemployment benefit system is not particularly attractive, but it may be supplemented with private supplementary insurance. Overall, the finely-meshed safety net that is often attributed to the Danish unemployment benefit system is only evident for low-income groups, while high-income groups typically suffer substantial income losses in the event of unemployment. This illustrates that the Danish unemployment benefit system includes a significant market- determined element. Proposals have been made to increase the degree of compensation in general, but also to reduce the unemployment benefit entitlement period of four years, which is relatively long in Denmark, and, as is the case in a number of other countries, to scale down unemployment benefits over the period of unemployment. The reforms of the 1990s were aimed at the unemployment benefit system, among other things, based on the principle of retaining the unemployment benefit level1 while increasing the incentives for the unemployed to seek and take jobs. Among the most significant changes, the effective period of unemployment benefit entitlement was reduced

1 Reduced benefit levels in the form of start help benefits and lower introductory benefits were introduced in 2003 for certain groups without unemployment insurance. A minimum requirement of 300 hours' employment over the past two years was introduced in 2006 for married couples who both receive cash benefits. This rule does not apply to the most vulnerable. The purpose is to motiv- ate even people with very few qualifications to take jobs.

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54 to four years. Previously, unemployed persons were able to regain the right to unemployment benefits by participating in activation projects, and therefore the period of entitlement was actually unlimited. The active period used to be preceded by a passive period during which the unemployed were under no obligation to participate in supplementary training, upgrading of qualifications, etc. The passive period was gradually reduced and was discontinued completely as of 1 July 2003. Now the unemployed are met with requirements from the first day of unemployment. If they do not succeed in getting a regular job during the four-year unemployment benefit entitlement period, they are transferred to cash benefits at a lower benefit level that is dependent on the family's financial circumstances. Cash-benefit recipients, except the most vulnerable, also have a right and obligation to activation. The youth unemployment programme from 1996 deviated from the principle of not touching the benefit level. The reform was aimed at young people under the age of 25 without a qualifying education, who were entitled to unemployment benefits and who had been unemployed for more than six months. These young people used to be entitled to either unemployment benefits or cash benefits at levels significantly above student grants, but this changed with the new scheme aimed at young people that required them to get an education at 50 per cent of the unemployment benefit level, find a job or get reduced cash benefits. From 1999, these requirements applied to all young people under the age of 25. These reforms may be the most obvious success of the flexicurity model and contributed strongly to the fact that the youth unemployment rate in Denmark is among the lowest in the world. It also illustrates the importance of creating the right incentive mechanisms.

Active labour-market policies The entitlement to compensation in the event of unemployment is countered by the obligation to actively seek a job and to participate in job-related activities. The reforms have resulted in activation of unemployed persons earlier in the period of unemployment, more frequent assessments of their availability and sanctions in case of non-compliance with the rules. The aim of the active labour-market policies is to ensure that unemployed persons are actually available for work and to promote upgrading of qualifications through job training and education. Their availability is checked through guidance, job plans, meetings with case- workers and other administrative procedures as well as sanctions in case of non-compliance, e.g. if the unemployed person fails to appear for compulsory meetings. For unemployment benefit recipients, sanctions

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55 against non-compliance with the availability rules are usually imposed by the unemployment fund concerned. The level of sanctions against unemployed persons varies from one unemployment fund to the next. The unemployment funds with the highest rates of unemployment are typically the most reluctant to impose sanctions, cf. the Danish Direct- orate of Labour (2006) If the unemployed person does not succeed in getting a job, an activation process is initiated. This includes private or public job training with wage subsidies, educational activation or other activation. The majority of the persons in activation receive educational activation, but their share has gone down in recent years. Only approximately 10 per cent are in private job training. Recipients of cash benefits are activated more often than recipients of unemployment benefits in whose case administrative procedures are more commonly used. The Danish Economic Council (2007) has presented an empirical analysis of the labour-market policies, including the activation part. The conclusions of this, and a number of other analyses, are fairly discouraging. It is typically found that only private job training has any significantly positive effect on employment. It is a statutory requirement that employment of persons in activation should result in a net increase of the number of employees to ensure that ordinary jobs are not just replaced. A survey by the Danish Labour Market Authority (2005) shows that in practice the replacement effect is fairly limited. Analyses of educational activation, which is a priority area, indicate that it is both expensive and inefficient in terms of improving the job opportunities of unemployed persons. This is the conclusion of the Danish Economic Council (2007) and the Ministry of Labour (1999), among others. To the extent that courses and other forms of supplementary education result in the unemployed subsequently seeking a narrower range of jobs, educational activation may actually be harmful to their chances of finding a job. Ideally, activation is about upgrading qualifications, but it has some side effects. The activated person's job search will typically decline during the activation period, and as a result he or she may remain unemployed longer than necessary. Obviously, this sustaining effect is an unintentional effect of activation. The prospect of activation affects the behaviour of all unemployed persons, not just those in activation. Activation is time-consuming, and payment in the form of cash or unemployment benefits is lower than wages earned in a job, so the unequivocal incentive is to get a job at a regular wage if at all possible. The literature refers to this as a motiv- ation or threat effect. For theoretical modelling of these effects, see Andersen and Svarer (2007), and Zhou (2007).

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It seems well-documented that active labour-market policies contain an element of threat vis-à-vis the unemployed, and that in practice this effect is a significant channel through which the policies work. For an overview of studies, reference is made to Bjørn et al. (2004). According to an estimate by the Danish Economic Council (2007) the threat effect reduces the unemployment period by just under a week. This translates into a social gain of kr. 2 billion per year. Others have found similar effects, cf. Rosholm and Svarer (2004), and Svarer (2007).

Costs of labour-market policies Compared to other countries, Denmark spends a fairly large amount of resources activating the unemployed, and the number of persons in activation has almost doubled since 1994 despite the fall in unemployment. A requirement to participate in activation after a certain period of unemployment exists only in few countries. Even at the current low rate of unemployment, in 2006 the resources spent amounted to 4.26 per cent of GDP, including expenses related to both active measures and passive benefits, i.e. unemployment benefits and early-retirement benefits, cf. Chart 8. This is the highest level in the OECD. Expenditure on passive benefits has declined concurrently with the fall in unemployment, while expenses related to active measures have remained more or less unchanged in relation to GDP since the mid- 1990s.

GOVERNMENT LABOUR-MARKET POLICY EXPENDITURE IN 2006 Chart 8

Per cent of GDP 3.0

2.5

2.0

1.5

1.0

0.5

0.0 UK USA Italy Spain France Finland Sweden Belgium Germany Denmark Netherlands Active Passive Note: In Denmark’s case passive support covers unemployment benefits and early-retirement benefits. Source: OECD Employment Outlook (2007).

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Comparisons across countries are affected by the fact that while in Den- mark expenses related to early-retirement benefits are included in the costs of labour-market policies, expenses related to pensions are generally excluded. In some countries, the retirement age is considerably lower than in Denmark, so that in certain cases the retirement age in those countries is lower than the Danish early-retirement age. In other countries, the system is very much based on private schemes that are not included either. Adjustment for these factors is not possible.

THE DANISH LABOUR-MARKET MODEL – AN EVALUATION

Up to the mid-1970s, unemployment was as low as it is today, but it increased steeply in the wake of the oil price hikes in 1973 and 1979. The term flexicurity was not invented in the 1970s, but all the elements of the model were present when growth in unemployment began to accelerate. The rules of employment and dismissal were as liberal as they are today, the unemployment benefit coverage level was approximately 75 per cent, while the unemployment benefit entitlement period of 2½ years was shorter than today. Finally, active labour-market policies had been introduced in the 1960s in order to increase geographical and professional labour mobility. Then as now the key issue was to find the right approach to a tight labour market. Even so, the downturn of the 1970s hit the Danish labour market hard, and the active labour-market policies were watered down in favour of the aim of simply compen- sating the unemployed. The labour-market policies pursued prior to the launch of the reforms should be seen in the light of the fact that unemployment was considered to be a system error, and therefore activation was very much regarded as a social measure. The introduction of early-retirement benefits in 1979 and the extension of the transitional allowance in 1994 were based on the same line of thought. Both schemes contributed to draining the labour market of labour in a deliberate attempt to reduce registered unemployment. The rise in the unemployment rate had to be stopped. The leave schemes (child-minding leave, educational leave and sabbatical leave) tended to have the same effect. They were first extended in the mid-1990s, only to be phased out over the following years. On the other hand, the maternity leave was extended. This illustrates that the reform process was not fully planned in advance. Instead it was to some extent a matter of trial and error in step with the decrease in unemployment. The labour-market reforms shifted the focus of the unemployment system towards a labour-market policy aim. As described above, the

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58 effective unemployment benefit entitlement period was reduced, the opportunities to regain the right to benefits were discontinued, the availability and mobility rules were tightened, the sanctions were made more stringent and the activation obligation was tightened. So overall, it is very much a case of increased use of the 'stick' rather than the 'carrot' approach. However, the use of schemes with a mixed labour-market and social policy aim has also increased. By way of example, the number of persons in flexijobs and light jobs has grown substantially. Here, the aim is to get persons who are not completely fit for work into jobs. Empirical surveys of the Danish labour-market policies clearly indicate that while results have been positive, the economic costs have been high, and it is not evident that the most cost-intensive policies have the greatest effect. Increased use of labour-market policy sanctions interacts with general social policies. The stricter the labour-market policy methods used, the more attractive social benefits without an obligation to be available for work become, even at a slightly lower benefit level. Thus, flexicurity has a direct impact on the number of persons with a loose or no attachment to the labour market. As a result of the development since 1993, margin- alised persons are increasingly receiving other forms of public benefits than unemployment benefits. Thus, the decline in registered unemployment compared to harmonised unemployment, cf. Chart 9, not only reflects the rise in employment. The number of persons of working age receiving public benefits remains high and is at the same level as in the early 1990s. At relatively favourable benefit levels for low-income brackets, the flexicurity model together with general social policies contributes to a high minimum wage level in Denmark. This may also have to do with the fact that in Denmark the minimum wage is not fixed by law the way it is in many other countries, but is agreed directly between the social partners. The high minimum wage level acts as a barrier to the labour market for people with poor qualifications. In fact, in an international perspective the entire Danish wage structure is compressed both before and, even more so, after tax. This is in line with the popular Danish attitude in favour of income distribution to avoid excessive inequalities of income in society. Denmark has the lowest inequality of disposable incomes in the OECD. The labour-market reforms have contributed to a reduction of structural unemployment. However, actual unemployment has fallen even more and must be considered to be below structural unemployment at the present time. Looking ahead, the pressure on the labour market will be aggravated by a demographically-determined decline in the labour

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UNEMPLOYMENT ACCORDING TO TWO DEFINITIONS AND RECIPIENTS OF TRANSFER PAYMENTS Chart 9

1,000 persons 1.000 full-year persons

400 1,000

350 900

300 800

250 700

200 600

150 500

100 400

50 300 88 90 92 94 96 98 00 02 04 06 Harmonised unemployment Registered unemployment Persons aged 18-66 receiving transfer payments (right-hand axis) Note: The harmonised unemployment curve assumes that to be included in the unemployment statistics, the unemployed must be actively seeking jobs, while this is not the case for registered unemployment. The labour- market reforms have tightened the demands made on the unemployed, and today registered unemployment is closer to registering only those who are actually available for work and who want jobs. This is reflected by the fact that the difference between the two curves has been practically eliminated. The curve for recipients of transfer payments excludes persons receiving student grants, state retirement pension and public service retirement pension. The collection of data on harmonised unemployment was restructured in early 2007. Source: Eurostat and Statistics Denmark. force of 80,000 up to the year 2020. This means that the labour market is under pressure from both the demand and the supply side. It is uncertain whether the flexicurity system will be able to survive a renewed general rise in unemployment. Experience from the 1970s and 1980s shows that rising unemployment typically leads to political pressure to ease requirements in relation to the unemployed. At the same time there is a risk that expenses for the cost-intensive activation policies will increase further.

THE DANISH WELFARE MODEL AND FLEXICURITY

The Danish welfare model is based on a market economy where the central government defines the general framework but does not manage private production in detail. Enterprises that are unable to match the competition are allowed to go out of business, and direct government subsidies to enterprises are limited. At the same time there is an extensive social safety net with massive redistribution of income between different social groups and for individuals over their lifetimes. The welfare model may be viewed as a number of implicit insurance

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60 contracts between different social groups which protect people, not jobs. There are tax-financed social safety nets not only covering unemployment, but also insuring against sickness, disability, loss of economic capacity, old age, etc. The welfare model assumes a high willingness to pay and thus popular acceptance of a high tax burden. To achieve such acceptance it is probably essential that the distribution of government expenditure on production of public services and the redistribution of income are considered to be fair. This assumes that everyone who is able to do so contributes to the national household, and that no benefits for major groups are seen as improper. The demographic changes whereby the group of elderly people is growing and the age groups from which the labour force is predominantly recruited are becoming smaller, pose a major challenge to the Danish welfare model. Labour-market policies play a key role in this context. If we are to preserve and preferably increase our prosperity, we still need a high labour supply in the years to come. The flexicurity model helps to ensure this, but it is hardly enough in itself. The tightening of the early-retirement scheme, including the gradual raising of the retirement age by two years from 2019 and the subsequent indexation of the retirement age to life expectancy will boost the labour supply, but only in the long term. In addition, importing foreign labour may also play a part in securing sufficient labour supply in the short term, but it is no miracle cure. Im- porting labour leads not only to an increase in output, but also in the number of people on whom it is to be distributed. At the average participation rate of the Danish population, real income per capita will only rise if the imported labour is productive, i.e. contributing above-average income. In terms of the effect on government finances, importing foreign labour typically contributes only half as much as the effect of getting an unemployed person a job. This is because unemployment benefits are saved only in the latter case, and because a separation allowance is granted for temporary jobs. This reduces tax payments for foreign labour. Furthermore, it is essential whether importing foreign labour also involves the relocation of the family of the persons concerned. Calcula- tions based on the DREAM model show that fiscal-policy sustainability deteriorates through increased immigration from less developed countries and is slightly improved as a result of immigration from more developed countries, including Eastern Europe. The fundamental assumption of the calculation is that the immigrants are similar to those already in Denmark in terms of participation rate and drain on public

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61 services. Generally, there is a significant correlation between the immigrants' home country and the extent to which they get jobs rather than transfer payments, cf. Table 1. To some degree, this pattern also applies to descendents. Thus, if immigration is to support the labour market and the Danish welfare model in general, it should be targeted at groups with a high participation rate. The evaluation of the flexicurity model is far from clear-cut. For an example of a predominantly positive evaluation, reference is made to Jørgensen and Madsen (2007), where the introduction states that "Flexicurity as a political strategy promises to make an end to the old conflict between efficiency and equity". Another example at the other end of the spectrum is CESifo (2007) in which practically all positive flexicurity model contributions are rejected as being "largely a myth". In the EU context, flexicurity has been made an element of the Lisbon strategy, the aim of which is to develop the EU into one of the most dynamic regions in the world, cf. the Ecofin recommendations (2007). The associations of European employer and employee organisations, respectively, also recommended the model recently. However, flexicurity is an integral part of the Danish welfare model, and as such it cannot be implemented unchanged in other countries with different traditions and a different institutional framework, which is also emphasised by Ecofin. Basically, the development of the flexicurity model may hinge on the character of the Danes, cf. Alger and Cahuc (2006): "This paper argues that the efficiency of the Danish Flexicurity Model relies on strong public-spiritedness which is absent in many other countries …. this may hinder the implementation of the Danish recipe. More generally, this analysis suggests that public-spiritedness is a key ingredient in the possibility for a society to implement efficient public unemployment insurance. To that regard, a country may be unlikely to succeed in its labour market reforms without a comprehensive policy affecting civic behaviour of its citizens."

PARTICIPATION RATE FOR THE 16-64 AGE GROUP, 2006 Table 1

Per cent Men Women Total No. of persons

Total population ...... 78.3 72.0 75.2 3,520,612 Danish origin ...... 80.1 74.4 77.3 3,195,026 Immigrants from Western countries ...... 66.2 58.9 62.5 98,932 Immigrants from non-Western countries .... 56.1 42.1 49.1 196,160 From Sri Lanka ...... 70.6 52.0 61.4 6,177 From Somalia ...... 33.3 15.8 25.0 7,660 Descendents, Western countries ...... 73.2 71.3 72.3 8,969 Descendents, non-Western countries ...... 61.9 59.8 60.9 21,525

Source: Statistics Denmark.

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LITERATURE

Alger, Yann and Pierre Cahuc (2006), "Civil Attitudes and the Design of Labor Market Institutions: Which Countries can Implement the Danish Flexicurity Model", Université Marne la Vallée, CEPREMAP, OEP, IZA Bonn and CREST-INSEE, CEPR Discussion Paper no. 1928.

Andersen, Torben M. and Michael Svarer (2005), Flexicurity, Department of Economics, University of Aarhus, CEPR, CESifo, IZA and CAM (Unpublished paper).

Andersen, Torben M. and Michael Svarer (2007), The role of workfare in striking a balance between incentives and insurance in the labour market, Working Paper no. 9, University of Aarhus.

Danish Directorate of Labour (2006), Report on benchmarking of unemployment funds (in Danish only).

Danish Labour Market Authority (2005), Survey of potential replacement of ordinary jobs when using activation with wage subsidies. Report, the Labour Market Committee

Danish Ministry of Labour (1999), Status of the labour-market reforms (in Danish only).

Danish Ministry of Labour (2000), Effects of the activation measures (in Danish only).

Danish Ministry of Employment (2005), Flexicurity – Challenges to the Danish model (in Danish only).

Bjørn, N. H., L. Geerdsen and P. Jensen (2004), The Threat of Compulsory Participation in Active Labour Market Programmes for Unemployed, Preliminary version of research overview, www.sfi.dk.

Blanchard, Oliver (2007), A Review of Richard Layard, Stephen Nickell, and Richard Jackmans' Unemployment: Macroeconomic Performance and the Labour Market, Journal of Economic Literature, Vol. XLV, June.

CESifo (2007), The EEAG Report on the European Economy. By L. Calmfors, G. Corsetti, M. P. Devereux, S. Honkapohja, G. Saint-Paul, H-W. Sinn, J-E. Sturm and X. Vives.

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Confederation of Danish Industries (2006), In Search of Best Nordic Practice, A Case Study on How to Adjust to Globalisation.

Economic Council (2007), The Danish Economy, Spring.

Ecofin (2007), ECFIN/EPC(2007)REP/54182, September.

European Commission (2006), European Employment and Social Policy, Special Eurobarometer, October.

European Commission (2007), Commission Communication on Flexicurity, MEMO/07/256.

Gaard, S. and Mads Kieler (2005), Two decades of structural reform in Denmark: A review, Danish Ministry of Finance, Working Paper no. 16.

Jørgensen, Henning and Per Kongshøj Madsen (2007), Flexicurity and Beyond, Finding a new agenda for the European Social Model, DJØF Publishing, Copenhagen.

Kiander, Jaakko and Matti Virén (1998), Employment Growth and Labour Market Flexibility in OECD Countries, Government Institute for Economic Research, Helsinki.

OECD (2004), Employment Outlook OECD (2005), Employment Outlook OECD (2007), Employment Outlook

Rosholm, M. and M. Svarer (2004), Estimating the Threat Effect of Active Labour Market Programmes, IZA DP 1300.

Svarer, M. (2007), The Effect of Sanctions on the Job Finding Rate: Evidence from Denmark, University of Aarhus, Manuscript, April.

Zhou, Jianping (2007), Danish for All? Balancing Flexibility with Security: The Flexibility Model, IMF Working Paper no. 36.

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APPENDIX: IMPORTANT LABOUR-POLICY MEASURES SINCE 1993

1993 Cash-benefit recipients obtain the same right and obligation to activation that unemployment benefit recipients have had since 1978.

1994 Labour-market reform I Discontinuation of the right to regain the right to unemployment benefits by activation Period of entitlement to unemployment benefits fixed at 7 years Possibility of transitional allowance for the 50-59 age group Improved access to take leave

1995 Tightening of the availability rules and possible sanctions Right and obligation to activation after 4 years of unemployment Admission to transitional allowance scheme stopped

1996 Labour-market reform II Reduction of the unemployment benefit entitlement period to 5 years with full effect from 1998 Earlier offer of activation and tightening of sanctions Programme aimed specifically at combating youth unemployment: After six months of unemployment, young people under the age of 25 without a qualifying education, who were entitled to unemployment benefits, obtained a right and obligation to activation at an allowance corresponding to 50 per cent of the unemployment benefits. If a young person rejected the activation offer, he or she would lose the entitlement to unemployment benefits and be transferred to reduced cash benefits. Unemployment benefit recipients aged 25 or more obtained a right and obligation to activation after 2 years of unemployment

1998 Obligation for unemployed persons to take jobs outside their own field after 6 months of unemployment More in-depth availability assessment of cash-benefit recipients Cash-benefit recipients registered by the employment service

1999 Labour-market reform III Reduction of the unemployment benefit entitlement period to 4 years with full effect from 2001 Earlier offer of activation Limitation of access to take leave All young people under the age of 25 obtained the right and obligation to activation after 6 months of unemployment

Early-retirement reform with a view to reducing admission to the scheme

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2000 Educational leave discontinued

2001 Tightening of availability rules

2002 Introduction of start help benefits and reduction of introductory benefits. Granted to unemployed persons who have not been in Denmark for 7 out of 8 years Phasing-out of child-minding leave

2003 Labour-market reform "More people in jobs" Unemployed persons must be available for work from the first day of unemployment Earlier offer of activation Standardisation and tightening of the availability rules for recipients of cash and unemployment benefits Tightening of sanctions against unemployed persons who are not actively seeking jobs or who fail to appear for interviews, etc. Reduction of the cash benefit level for certain groups

2006 Requirement for 300 hours of work during a 2-year period for spouses who both receive cash benefits

2007 Welfare agreement Increased activation and tightened availability assessment Raising the early-retirement age by two years from 2019 to 2022, raising the retirement age by two years from 2024 to 2027 and indexation of age limits after 2025 based on the remaining life expectancy of 60-year-olds Discontinuation of the extended entitlement to unemployment benefits for persons aged 55-59 and granting of a right and obligation to activation for persons aged 58-59 in line with other unemployed persons

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Monetary Review - 4th Quarter 2007

Development in Productivity in Denmark

Per Flink Iversen and Johanne Dinesen Riishøj, Economics

INTRODUCTION AND SUMMARY

Danish productivity, measured as gross value added per working hour, has decreased during the past year according to the available quarterly national accounts data. This masks a decline in output growth and a continued rapid increase in labour. Over the last decade Danish productivity has grown modestly both in relation to previously and compared to other countries. Productivity growth has decreased despite Danish business enterprises' considerable investment in information technology and other capital stock, and a higher level of education of the labour force. The development is probably due to the fact that Denmark's ability to capture efficiency gains from other areas, such as improved procedures or more effective production processes, has been less pronounced compared to previously, and to other countries. This may be the result of more people, including marginal groups, gaining a foothold in the labour market, due to such factors as the labour-market reforms since the mid-1990s and the economic upswing of recent years. The composition of the business sector in Denmark, with a relatively small IT production sector, may also be part of the explanation. Moreover, the degree of research and development and the level of education of the labour force have been slightly lower in Denmark than in some of our key trading-partner countries. Higher productivity makes it possible to produce more with the same input, and in the long term productivity growth is important for the underlying economic growth, real incomes and the standard of living. Productivity increases are also an important parameter in international competition. Productivity gains will become ever more important to Denmark in the years to come, when the labour supply will fall as a result of the demographic development. This article outlines the development in Danish productivity in recent years and compares it with the development in other countries by way of harmonised data.

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MEASUREMENT OF PRODUCTIVITY

The size of a country's output depends on the input of labour, capital and other production resources, including how efficiently they are applied. The efficiency is also called productivity. There are several ways of measuring productivity. This article focuses on labour productivity, i.e. output in relation to labour input. Usually, labour productivity is calculated as output per employee or output per working hour (hourly productivity). If the average number of working hours per employee varies over time or from country to country, the two measures of labour productivity will be different. Hourly productivity is the productivity measure used below. A key factor to be considered is whether the productivity measure includes the whole economy, or only the market-related part of the economy. The reason is that the productivity increase in the public sector per construction is zero, irrespective of any actual efficiency gains, cf. Box 1. Productivity growth in the public sector is important to e.g. fiscal sustainability, but as it is difficult to measure, this article only takes into consideration the development in the market economy. The overall productivity pattern is best assessed over a number of years because productivity growth varies with the cyclical development. During a recession, a lower than normal productivity increase will typically be observed. This may be attributed to the tendency for business enterprises to retain valuable employees who can be of use when cyclical changes occur. Thus employment rarely decreases to the same extent as production, and productivity may even fall. At the beginning of an upswing, there will typically be a higher than normal productivity increase due to low capacity utilisation as a result of the employees having been retained during the recession. Besides, business enterprises will be reluctant to take on new employees at the beginning of the upswing, as they are uncertain about its duration and force. As the upswing becomes more stable, business enterprises will employ more people, and productivity growth will drop to just below its normal level. The flexibility in the labour market is a determining factor for cyclical fluctuations in productivity. High flexibility enables business enterprises to faster adjust the number of employees to the development in output. This tends to reduce the effect of cyclical fluctuations on productivity, cf. the article on flexicurity, p. 45 ff.

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PROBLEMS IN RELATION TO MEASURING PRODUCTIVITY Box 1

In order to measure productivity growth, output at constant prices and labour input must be estimated. Different estimation methods and measurement errors may lead to variations in productivity level and growth. In principle, the calculation methods used by the various European national statistical offices are now more or less identical since all countries use the same manual, whereas US national accounting principles differ in a number of ways. Output is difficult to measure, e.g. because some elements are not registered, such as moonlighting. Output is measured as added value, i.e. production of goods and services for final use. Goods and services used as intermediate goods for production in other parts of the economy are not included. The distinction between goods for final use and intermediate goods may vary from one country to another. For example, the USA classifies more financial sector services as final use than many European countries do. These include Denmark. All other things being equal, this increases the US output figures relative to the European figures. In the short term, different calculations of the output level may affect growth rates. In the longer term, however, growth rates are not affected, provided that the methodology is consistent.1 Measurements of output growth are subject to uncertainty, partly because it is difficult to take quality enhancements such as faster computers into account. Quality enhancements can be included if a hedonic price index is applied, in which the price of goods is set to fall over time. In other words, the volume rises for a given market value. It is particularly difficult to estimate the development in the quality of IT equipment and non-traded goods and services. The size of the public sector has a major impact on productivity growth in the economy overall. Since output in the public sector is not usually valued at a market price, the output value is estimated as the value of the resource input, primarily payroll expenditures. Thus productivity growth is by definition zero. For technical reasons, a large public sector therefore reduces productivity growth in the economy overall. The size of the public sector can be approximated by taking government consumption as a ratio of aggregate GDP. If productivity growth is e.g. 2 per cent p.a. in the private sector, the larger public sector in Denmark compared with the rest of Europe entails that productivity growth is approximately 0.1 percentage point lower in Denmark. Measured in relation to the USA, productivity growth in Denmark is approximately 0.2 percentage points lower. The production value of other sectors, notably the service sectors, can also be difficult to calculate. The labour input measurement is also subject to uncertainty, mainly because it is typically questionnaire-based. The data quality thus depends on the honesty of the respondents and their ability to remember factors such as absence due to illness, overtime, etc. In order to improve the data quality, the results of the questionnaire surveys are subsequently adjusted by applying data from employers and the public sector concerning absence due to illness, etc.

1 See Ahmad et al. (2003).

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DEVELOPMENT IN PRODUCTIVITY IN DENMARK AND ABROAD

In the past decade, productivity growth in Denmark has been modest compared to previously, cf. Chart 1. From 1996 to 2006, annual growth in hourly productivity in the market economy was 1.0 per cent on average against 3.9 per cent in the previous 30 years. There are indications that the downward trend in productivity will be aggravated in 2007. From the 2nd quarter of 2006 to the 2nd quarter of 2007, hourly productivity in the private sector dropped approximately 2 per cent according to the available national accounts data. This masks a decrease in economic growth and a simultaneous rapid increase in the number of working hours. The latest figures are, however, preliminary and can be re- vised. Growth in hourly productivity has also been weaker in Denmark than in our key trading-partner countries. While Denmark saw the second- largest average annual improvement in hourly productivity among the old EU member states in the period 1971-95, we came last but three in the following years, cf. Chart 2. Since the mid-1990s hourly productivity growth has also been slower in Denmark than in e.g. the USA, where output per working hour has increased by approximately 3 per cent p.a. for the period.

GROWTH IN HOURLY PRODUCTIVITY IN DENMARK 1970-2006 Chart 1

Per cent, year-on-year 8

-1

-2 70 73 76 79 82 85 88 91 94 97 00 03 06 Hourly productivity in the private sector Trend Note: Hourly productivity calculated as gross value added per working hour in the market-related part of the economy. The trend is calculated with a HP filter where lambda equals 100. Source: Statistics Denmark and own calculations.

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AVERAGE ANNUAL GROWTH IN HOURLY PRODUCTIVITY Chart 2

Per cent 1971-1995 Per cent 1996-2005 5.0 4.5 4.5 4.0 4.0 3.5 3.5 3.0 3.0 2.5 2.5 2.0 2.0 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 UK UK Italy Italy Spain Spain France Greece France Ireland Austria Greece Finland Ireland Austria Finland Sweden Belgium Sweden Portugal Belgium Portugal Germany Denmark Germany Denmark Netherlands Netherlands Luxembourg Luxembourg Note: Hourly productivity calculated as gross value added per working hour in the market-related part of the economy. For Germany, the period 1971-90 covers only West Germany. For Portugal, the last period includes only 1996- 2004. Source: EU KLEMS' database and own calculations.

The weaker development in Danish hourly productivity has been broad- based. All main sectors, with the exception of the transport, postal and telecommunications sectors, have experienced lower hourly-productivity growth during the last decade compared with previous years, cf. Chart 3. Productivity growth was more than halved in most main sectors. In the business-service sector, output per working hour has even decreased since the mid-1990s, whereas it has been largely unaltered in the construction sector and in trade, hotels and restaurants, according to the available data.

AVERAGE ANNUAL GROWTH IN HOURLY PRODUCTIVITY IN DENMARK Chart 3

Per cent 10

-2 Industry supply etc. construction Building and restaurants Agriculture, etc. Trade, hotels and Energy and water Transport, post and telecommunications, 1970-1995 1996-2006 Business etc. services, Note: Hourly productivity calculated as gross value added per working hour in the market-related part of the economy. Source: Statistics Denmark.

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FACTORS BEHIND THE WEAKER PRODUCTIVITY GROWTH IN DENMARK

Improvement in employment and the cyclical development Employment has increased strongly in Denmark since the mid-1990s, a result of a number of labour-market reforms, among other factors. The increase in employment has also included people with limited labour- market experience. If average productivity of those who have entered the labour market has been lower than that of those who were already employed, the increase in employment may help explain the low growth in productivity. The last year has seen an outright decrease in productivity in Denmark, while capacity pressures have been high. The current situation deviates from the typical trend for productivity growth during a business cycle. Normally, growth will be relatively high during an upswing and the reverse during a recession, cf. the curves in Chart 4 are usually closely correlated. The current situation may reflect that output has not been able to keep up with demand, because business enterprises have been short of qualified labour and excess production capacity. While output has been limited due to capacity shortages, business enterprises have continued to take on more employees to catch up with the backlog. This may temporarily have curbed productivity growth. The same phenomenon was apparently also observed in the mid-1980s, when capacity pressures also were high.

PRODUCTIVITY AND PRODUCTION IN DENMARK Chart 4

Per cent 6

-2

-4

-6 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 Productivity, cyclical component GVA, cyclical component Note: Cyclical component calculated as fluctuations of 18 months' to 8 years' duration in quarterly gross value added (GVA) and productivity in the non-agricultural sector. The fluctuations have been isolated by means of a Baxter- King filter. Source: Mona databank.

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The normal positive relation between the cyclical position and productivity implies that the cyclical position at the beginning and end of the period under review also influences productivity growth. Part of the explanation why for example Sweden and Finland have seen greater productivity gains than Denmark since 1995 is that those two countries experienced a recession at the beginning and middle of the 1990s. This probably meant that capacity utilisation was low from the outset, and that especially business enterprises with low productivity were forced to close down. The opportunities to boost productivity have thus been better in Sweden and Finland than in Denmark.

Research and development Research and development is key to productivity growth in Denmark and the other industrialised countries, cf. the Danish Economic Council (2003), among others. The explanation is that investments in research and development enhance innovation and the implementation of new technologies, and makes more efficient production processes possible. In the period 1995-2005 Denmark invested 2.2 per cent of GDP in research and development according to Eurostat data. That is more than the euro area, which invested 1.8 per cent of GDP in the same period, but less than in e.g. Sweden and Germany.

Capital intensity, labour quality and total factor productivity Productivity increases may be distributed on contributions to growth from capital intensity, labour quality and total factor productivity, TFP, cf. Box 2. Capital intensity designates the amount of capital a worker has at his disposal. The capital intensity may grow by increasing both the amount of capital (more computers) and the quality of the capital stock (faster computers) per worker. Quality improvements are difficult to measure and make it difficult to assess how rapidly the capital stock should be written down. Moreover, there is a risk that some quality improvements may not be registered, which leads to incorrect assessment of the development in capital intensity. Labour quality is closely connected to the level of education of the labour force. New technology can be introduced faster with a more highly educated labour force. A higher level of education may therefore con tribute to an increase in productivity. Growth in TFP illustrates the remainder of the increase in productivity. The factors behind this part of the productivity increase cannot be iden- tified with any certainty, but they could be e.g. smarter production processes, more efficient work procedures and better organisation.

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STANDARD METHOD FOR DECOMPOSING GROWTH IN LABOUR PRODUCTIVITY Box 2

Economic analyses of growth in labour productivity are normally based on a production function. The production function may be written as:

= () , LBKfAY ttttt (1)

where Yt is the gross value added (GVA) in the period t, f is an increasing function in

the capital stock (Kt) and in labour input (BtLt). Bt is the quality of labour, while Lt is

working hours. The function aggregates the factor input into one variable, and At describes the efficiency of the factor input. Assuming a constant scale yield, (1) may, after total differentiation and log transformation, be written as:

=α −+ α −+ α + ,1 KdYd ttt ,1 Ld tt ,1 tt AdBd t )ln()ln()1()ln()1()ln()ln( (2)

Relation (2) shows that output may grow if the capital stock, labour input, quality of labour and/or efficiency are increased. Assuming perfect competition and profit maximisation, the factors of production will be remunerated at the value of their α marginal products, so that ,1 t is the remuneration to the capital stock of the total −α income, and ,1t )1( is the remuneration to labour of the total income. When rewriting (2), growth in hourly productivity may be expressed as:

=− α dLdYd Kt −+ α + AdBd )ln()ln()1()ln()ln()ln( (3) t ,1 tt Lt ,1 tt t

where d Kt )ln( is growth in capital intensity, Bd )ln( is labour-quality growth in and Lt t Ad t )ln( is total growth in factor productivity. Relation (3) lies behind the breakdown in the first column of Table 1, where the contribution from capital intensity has been divided into two components corresponding to a formulation of the input function with two variables for capital instead of one.

With data from EU KLEMS1, productivity growth may be decomposed in the above way, cf. Table 1. EU KLEMS is a statistical and analytical research project encompassing contributions to economic growth financed by the European Commission. Data covers the EU, the USA and Japan, and some of the variations in calculation methods mentioned in Box 1 have been taken into consideration. This has facilitated cross-border comparison.

Weak development in TFP The low growth in hourly productivity in Denmark in recent years is mainly due to the fact that growth in TFP has ceased, cf. Table 1. Growth in Denmark's TFP has in recent years also been considerably lower than

1 K stands for capital, L for labour, E for energy, M for materials and S for service. The data used here was published in November 2007 at www.euklems.net. This data has not yet been finally confirmed by the national statistics offices.

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CONTRIBUTIONS TO GROWTH IN PRODUCTIVITY IN THE YEARS 1981-1995 AND 1996-2005 Table 1

Average annual growth, per cent Denmark Germany UK Sweden USA

1981-1995 Hourly productivity ...... 3.52 2.39 2.90 - 1.54 Contributions from capital intensity ...... 1.51 1.34 1.33 - 0.69 Of which IT and communication technology 1.03 0.33 0.56 - 0.47 Of which other capital equipment ...... 0.48 1.01 0.77 - 0.22 Contributions from labour quality ...... 0.29 0.10 0.30 - 0.23 TFP ...... 1.55 0.94 1.46 - 0.66

1996-2005 Hourly productivity ...... 1.39 1.64 2.51 3.05 3.00 Contributions from capital intensity ...... 1.18 1.16 1.32 1.16 1.11 Of which IT and communication technology 0.97 0.53 0.91 0.66 0.73 Of which other capital equipment ...... 0.20 0.63 0.42 0.50 0.38 Contributions from labour quality ...... 0.27 0.13 0.46 0.35 0.31 TFP ...... -0.11 0.40 0.81 1.46 1.67

Note: Data comprises the market-related part of the economy. Data for Sweden is only available for the period 1996- 2004. Contributions do not completely add up to the total hourly productivity growth due to rounding and small differences in weights in our and EU KLEMS' calculations, cf. Box 2. Source: EU KLEMS' and own calculations. in our key trading partner countries. Shifts of labour and capital stock between sectors, e.g. from sectors with high productivity growth to sectors with low productivity growth, have an impact on TFP. Nevertheless, Denmark's lower TFP cannot be explained merely by sector shifts, as the growth rate has slowed in all main sectors, cf. Table 2. A Harberger chart1 can provide a more detailed picture of how large a part of the economy and which sectors have made a positive contribution to TFP growth. This is shown in Chart 5 for Denmark. Here the business sectors' accumulated contributions to TFP growth from 1996 to 2005 are plotted against the business sectors' accumulated share of output. The sectors are organised in descending order according to TFP growth, so that the fastest growing sectors are closest to (0;0) and those with lower or downright negative growth are further to the right in the grouping. If all sectors had shown TFP growth, the slope of the entire curve would have been positive. In Denmark, chemical production showed the largest percentage growth in TFP from 1996 to 2005. The sector made up about 2 per cent of output in 1995 and contributed to elevating total TFP by approximately 10 percentage points for the period. Consequently, chemical production has been placed in (0.02;0.1) in the Harberger chart. The chart shows that TFP increased in about half of the private sector in the period 1996-2005, cf. the slope of the curve is positive for the first ap-

1 Cf. Harberger (1998).

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CHANGE IN TFP GROWTH AND CONTRIBUTIONS FROM SECTORS Table 2

Average annual growth, per cent Denmark Germany UK Finland USA

TFP growth 1981-1995 ...... 1.55 0.94 1.46 1.47 0.66 TFP growth 1996-2005 ...... -0.11 0.40 0.81 2.56 1.67 Change in TFP growth ...... -1.67 -0.54 -0.66 1.09 1.01

Of which contribution from sectors: Electronics, post and telecommunication . -0.04 0.18 -0.04 0.92 0.32 Manufacturing except electronics ...... -0.19 0.01 -0.56 -0.07 0.24 Other production1 ...... -0.62 0.03 -0.29 -0.09 0.08 Trade and transport ...... -0.24 -0.02 -0.22 0.35 0.14 Financing and business services...... -0.36 -0.68 0.51 0.07 0.19 Personal services ...... -0.17 -0.08 -0.02 -0.01 0.02

Note: Data comprises the market-related part of the economy. Data for Sweden is not available for the period 1980-95, for which reason data for Finland is shown instead. Source: EU KLEMS' database. 1 Includes construction, agriculture, forestry, fishery, raw materials extraction, electricity, gas and water supplies. proximately 50 per cent of output. In the remaining part of the private sector, TFP decreased. The decrease in TFP was strongest in the hotel and restaurant sector and in the business-service sector. These sectors are characterised by relatively high employment growth. On the other hand, more export-oriented sectors, such as the pharmaceutical industry and agriculture, have achieved higher efficiency gains. The same applies to IT-intensive sectors, such as the post and telecommunications and the fi-

SECTOR CONTRIBUTIONS TO TOTAL DANISH TFP GROWTH 1996-2005 Chart 5

Contributions to TFP growth, accumulated 1.0 Transport Construction 0.9 Electronics Textiles Metals 0.8 Transport equipment Paper, etc. Food sector Stone, clay and glass Retail trade 0.7 Wholesale trade Agriculture, etc. Repair and sale of Raw materials extraction Furniture and other goods 0.6 motor vehicles Machinery 0.5 Post and telecommunications Electricity, gas og water 0.4 Financing 0.3 Personal services 0.2 0.1 Chemical production 0.1 0.0 Business services -0.1 0.02 -0.2 Hotel and restaurants -0.3 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 Contributions to production, accumulated Note: Data comprises the market-related part of the economy. The sectors' accumulated contributions to TFP growth are shown on the vertical axis, while the sectors' accumulated share of the gross value added in 1995 is shown on the horizontal axis. Sectors are sorted in descending order according to TFP growth from 1996 to 2004, so that the fastest growing sectors are shown far left. Source: EU KLEMS' and own calculations.

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77 nancial sector. This phenomenon is also observed in our key trading- partner countries. The electronics sector, i.e. production of IT and telecommunications equipment, etc., forms a relatively small part of total output in Den- mark, and the sector has made only a limited contribution to TFP growth. This contrasts with the development in our key trading-partner countries where the electronics sector has been among the largest contributors to TFP growth. The electronics industry has grown especially rapidly in Sweden and Finland, where it today accounts for a considerably larger share of total output than in Denmark. The sectoral composition thus partly explains why TFP growth has been lower in Denmark than in some of our neighbouring countries.

Large contribution from increased capital intensity Growth in hourly productivity since 1995 is to a large extent due to the fact that Danish business enterprises have invested heavily in capital stock, entailing more capital per worker, cf. Table 1. Especially investments in IT and telecommunications technology have boosted productivity, and the contribution from increased IT capital intensity has been slightly larger in Denmark than in our key trading-partner countries. The electronics sector, the post and telecommunications sector and the util- ities sector account for the highest capital intensity. In our key trading- partner countries, the contribution from IT-capital deepening has also been most significant in the electronics industry and the post and telecommunications sector, and contrary to Denmark, also pronounced in trade and transport.

Labour quality and education The level of education of the Danish labour force has increased contin- ually, and the quality of the labour force has thus improved. On average, the higher labour quality has contributed approximately 0.3 percentage points annually to productivity growth since 1980, cf. Table 1. This is on a par with the contribution in the countries with which Den- mark normally compares itself. The level of education of the labour force also affects TFP growth. A high level of education often means a more flexible labour force. Be- sides, there are positive side effects, as people who work together with highly-educated people also boost productivity. Finally, studies suggest that highly-educated people are more mobile, which enhances knowledge sharing in society. Data from EU KLEMS shows that the input of highly educated labour makes up a smaller part of the total labour input in Denmark than in our key trading-partner countries. However, the

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78 quality of education and training at the same levels may vary across countries. Moreover, in Denmark there is a deep-rooted tradition for further training of labour, which is not included in the EU KLEMS calculation.

Sound Danish economy despite weak productivity development Although productivity growth has been low during the recent decade, the Danish economy has performed well. The unemployment rate has dropped markedly, the current-account surplus has been sound for a number of years, and corporate earnings have increased, among other things as a result of improved terms of trade, cf. Beier and Pedersen (2005). Higher productivity growth in the future would benefit the Danish economy. It will contribute to Danish business enterprises remaining competitive. Moreover, it may alleviate some of the problems related to the future demographic development, with fewer people actively employed and more elderly people.

LITERATURE

Ahmad, N., F. Lequiller, P. Marianna, D. Pilat, P. Schreyer and A. Wölfl (2003), Comparing growth in GDP and labour productivity: Measure- ment issues, OECD Statistics Brief, No. 7, December.

Beier, Niels C. and Erik Haller Pedersen (2005), Wages, Competitiveness and the Balance of Payments, Danmarks Nationalbank, Monetary Review, 1st Quarter.

The Danish Economic Council (2003), The Danish Economy, Spring.

Harberger, A.C. (1998), A Vision of the Growth Process, American Economic Review, March, Vol. 88, no.1.

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Economic Developments in the Baltic States: Success and New Challenges

Karsten Stæhr1, Tallinn University of Technology, and Eesti Pank

INTRODUCTION AND SUMMARY

This article provides an overview of the economic developments in the Baltic States since 1991 when they regained their independence from the Soviet Union. The emphasis is on recent years and the economic- policy dilemmas. Thanks to comprehensive economic reforms, the Baltic States are now open, dynamic market economies. After difficult years in the early 1990s, the countries have gradually regained their economic strength. They have shown the highest growth rates in Europe since the mid-1990s despite a slowdown in 1999 in the wake of the Russian crisis. Unemploy- ment has declined to 4-6 per cent of the labour force, and in 2006 income per capita reached 50-60 per cent of the level in Western Europe. The Baltic States are now facing new challenges as labour shortages, higher inflation and considerable current-account deficits seem to indicate overheating of the economies. The countries' entry into the Euro- pean Monetary Union, EMU, has been postponed since inflation is too high to meet the inflation criterion of the Maastricht Treaty. This article outlines two possible scenarios. One scenario foresees a gradual cooling of the economies, entailing lower inflation rates and smaller external deficits. The other scenario is a crisis scenario with capital flight, exchange-rate pressures and tight credit markets. The result could be a strong drop in demand from the private sector, with the risk of an economic downturn. The probability of each scenario is difficult to assess. The countries have stable exchange-rate regimes which have proved to be resilient in the past. In addition, they have implemented a number of measures to cool down the economies, although policies are considerably restrained by a lack of economic instruments and the wish to rapidly bridge the income gap to Western Europe.

1 Karsten Stæhr is a professor at the Tallinn University of Technology and research supervisor to Eesti Pank. All views expressed in this article are the views of the author and cannot be attributed to his employers or Danmarks Nationalbank.

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BACKGROUND AND REFORM

In August 1991 the Baltic States broke loose from the Soviet Union and regained independence after almost 50 years of Soviet rule. As a result, the Nordic countries acquired three new neighbours on the eastern shore of the Baltic Sea. The Baltic States are relatively small in terms of both area and population. Estonia, the northernmost of the three, has a population of 1.4 million, of which almost half live in the capital, Tallinn. Latvia, whose capital is Riga, has a population of 2.3 million, while Lithuania, whose capital is Vilnius, has a population of 3.4 million, cf. Eurostat (2007a). The countries have considerable national minorities, primarily Russians in Estonia and Latvia, and Poles and Russians in Lithuania. Until 1991, the Baltic States were an integral part of the Soviet Union, with centrally planned economies, fixed prices and state-owned means of production. However, at the end of the 1980s, the countries gained a certain degree of economic autonomy thanks to Mr. Gorbachev's pere- stroika reforms. Small private enterprises were allowed, the economies were decentralised to some extent, and the tax systems were restructured. After having regained independence in August 1991, the countries had to make a number of difficult choices in the establishment of the new market economies that were to replace the planned economies. The cornerstones of the reforms were well-known from Latin America and Central Europe, namely (i) liberalisation of production, trade and prices, (ii) stabilisation of inflation, (iii) privatisation, and (iv) institutional reform, cf. Andersen and Stæhr (2006). The implementation of the reforms was challenging since the countries had just regained independence, which meant that they had to build up most government institutions from scratch. In addition, the countries' output collapsed, inflation came close to hyperinflation, Russia imposed a trade restrictions, and trade relations with the other former Soviet repub- lics were partly cut off. Despite their unfavourable starting points, all three countries managed to implement extensive reforms over a period of very few years, resulting in a fundamental restructuring of their economies. By the mid-1990s, the countries had been transformed to market economies in which privately- owned business enterprises accounted for the major share of output. For the sake of brevity, only sample elements of the reforms are mentioned here.1

1 The economic reforms of the Baltic States are discussed in more detail in e.g. Berengaut et al. (1998), OECD (2000), Staehr (2004) and the EBRD's Transition Report for the years 1992-2007.

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It took the Baltic States only a few years to liberalise their economies. Being very small economies, they opted for a high degree of free trade. In 1992 Estonia completely abolished import duties and quotas and ab- stained from measures to protect agriculture and other business interests. Latvia and Lithuania maintained certain protective duties, but the tariffs were kept low. From the outset the Baltic States encountered monetary instability with surging annual inflation that reached around 1,000 per cent in all three countries in 1992. The reason was a strong expansion of the money stock in the rouble zone. Each former Soviet republic thus issued money, ex- pecting the inflation burden to be borne by all countries in the zone. It was therefore necessary to decouple the Baltic States from the rouble zone in order to stabilise inflation. In June 1992 Estonia was the first country to introduce its own currency, and the exchange rate was fixed against the D-mark via a currency board, i.e. the domestic money stock is fully covered by reserves in foreign currency. In 1994 Lithuania introduced a currency board too, but chose to peg its currency to the dollar. In 1994 Latvia introduced a more conventional fixed-exchange-rate regime vis-à- vis the SDR, i.e. the basket of currencies fixed by the International Mon- etary Fund, IMF, while maintaining a very high level of reserves to domestic money stock, cf. Berengaut (1998), Chapter III. The three countries chose different approaches to privatisation. Estonia opted for the most radical solution, which was to sell as many business enterprises as possible to foreign investors. Latvia and Lithuania initially opted for complex coupon privatisation schemes for distribution of businesses to their citizens, but these countries subsequently chose to sell many state-owned enterprises to foreign investors. Most of the banking sector is foreign-owned in all three countries. The Baltic States implemented a large number of structural and institutional reforms concerning banking and finance, property rights, business liquidation, regulation and public administration. The most notable reform may be the introduction of the "flat tax", whereby all private individuals pay the same percentage of their income above a certain basic allowance. Estonia was the first to introduce a flat tax rate in 1994, followed by Lithuania later in 1994 and Latvia in 1995. A number of other Eastern European countries have since adopted the same model, cf. Saavedra et al. (2007). As a result of the reforms, the Baltic States soon became integrated into the international economy and the major European institutions. In particular, close relations have been established between the Nordic countries and the Baltic States. Estonia was invited to open negoti ations on EU accession in 1997, while Latvia and Lithuania were invited

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82 in 1999. All three countries joined the EU in May 2004, which was a stamp of approval to show that they had attained functioning and adaptable market economies – one of the Copenhagen criteria that candidate countries have to fulfil prior to joining the EU. Overall, the Baltic States have shown great commitment to reforms despite their unfavourable points of departure. Quantification of the extent of reform and the degree of market orientation place the Baltic States far ahead of the other countries that emerged from the collapse of the Soviet Union. Such quantification also shows that the Baltic States have reached almost the same level as the former Communist countries in Central Europe, cf. Andersen and Stæhr (2006). In several areas the Baltic States have chosen unconventional or radical solutions, in most cases pioneered by Estonia, cf. Laar (2002).

GROWTH AND INCOME CONVERGENCE

Until the late 1990s economic policy aimed at establishing national autonomy, abolishing the planned economy and laying down the framework for a dynamic market economy. Subsequently, the principal aims of economic policy were compliance with the requirements for EU membership and further structural reform of e.g. pension systems, social legislation and education systems. From the outset the cornerstone of economic policy in Estonia, Latvia and Lithuania was to generate economic growth with a view to enhancing the living standard, cf. Vilpisauskas (2005). Already at the time of independence in 1991 it was clear that the countries' income levels were considerably lower than those of their Nordic neighbours and the other Western European countries. The opening of borders and the ensuring travel activity made it clear to a large part of the populations how wide the income gap was. According to IMF statistics, in 1992 PPP- adjusted GDP per capita was approximately 25-35 per cent of the Danish level at the time, cf. IMF (2007a).1 Chart 1 shows economic growth in each of the three countries since 1989. There are three notable features. Firstly, output plummeted before and after independence in 1991. It can be argued that the official output figures to some extent overestimate the actual drop, due to such factors as insufficient statistical coverage of production in the new emerging private sector, cf. Andersen and Stæhr (2006). Private consumption declined less than output as e.g. investments and military expenditure were reduced strongly in the period.

1 In the inter-war years the three countries' income levels were 40-60 per cent of the Swedish level (and hence also the Danish level), cf. Central Statistical Bureau of Latvia (2002). The following 50 years of Soviet rule further widened the income gap to Western Europe.

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ECONOMIC GROWTH IN THE BALTIC STATES Chart 1

Per cent year-on-year 20

-10

-20

-30

-40 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Estonia Latvia Lithuania Note: IMF forecast for 2007. Data for the period before1995 is subject to large uncertainty. Source: IMF (2007b) and EBRD (2007) before 1994.

Secondly, the Chart shows an economic downturn after the Russian crisis in 1998-99. Exports to the eastern neighbour of the Baltic States collapsed when Russia defaulted on its government debt and had to devalue the rouble. Estonia and Lithuania were the most severely affected, but for all three countries the downturn was short-lived because they quickly managed to restructure their foreign trade and redirect exports to Western Europe. Thirdly, Chart 1 illustrates the very strong growth in the region since 2000, with annual growth rates of 6-12 per cent and a tendency for increasing growth after EU membership in 2004, at least in Estonia and Latvia. These growth rates and their relative stability have caused some observers to use the term "Baltic tigers" about these countries, borrowing the term frequently applied to the high-growth economies in Asia, cf. IHT (2003). The natural or trend growth rates of the Baltic States are difficult to estimate, due to the very short time series for output, employment, capital stock, etc. Lithuania's growth rate of 7-8 per cent is probably at the level of the medium-term natural growth rate, while the growth rates of Estonia and Latvia have probably been somewhat higher in recent years than what is compatible with price stability in the longer term. The high growth brings about a gradual narrowing of the income gap to Western Europe.

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All three Baltic States have considerably lower income levels than the Nordic countries and the rest of Western Europe. Chart 2 shows PPP- adjusted GDP per capita for the Baltic States compared with Denmark and the EU15 average. The high growth rates since 1995 have entailed a considerable narrowing of the income gap to Western Europe. PPP-adjusted GDP per capita was around 30 per cent of the EU15 level in 1995, while it had reached 50-60 per cent in 2006. Estonia, which is the most affluent of the three countries, has seen somewhat higher growth than the other two, but the income gap to Western Europe is still significant. In all three countries a key objective for policy-makers is to continue the rapid convergence with the income level in Western Europe. Considering the Baltic States' well-educated labour force, strong cap ital built-up and largely well-functioning institutions, there should still be potential for continued growth above the Western European level. Income convergence is important to the welfare of the population, as higher incomes pave the way for improved living standards and more favourable social conditions. The latter is particularly important because the income distribution is relatively unequal in these countries where the upper income quintile earns on average 6-7 times as much as the lower income quintile. The corresponding inequality measure for Den- mark is 3.5, while it is 4.8 for EU15, cf. Eurostat (2007c).

PPP-ADJUSTED GDP PER CAPITA IN THE BALTIC STATES AND DENMARK Chart 2

Index EU15 = 100 120

100

0 95 96 97 98 99 00 01 02 03 04 05 06

Estonia Latvia Lithuania EU15 Denmark Source: Eurostat (2007b).

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One important effect of the high economic growth has been a considerable reduction of unemployment in all three countries. Chart 3 shows the EU harmonised unemployment rate since 1999. The decline in unemployment has been very strong since the turn of the century, especially in Lithuania. The Baltic States' policy objectives of rapid income convergence and low unemployment have an extra dimension, namely to restrain emigration. The latter is a priority area considering the countries' small populations and ongoing reconstruction processes after decades of occupation. As a result of the Baltic States' EU membership in 2004, the UK, Ireland and Sweden allowed Baltic citizens to freely take up resi- dence and employment in these member states. It is relatively easy for the highly-educated to get a work permit in the other EU member states. There are no reliable statistics for emigration since 1991, or for that matter since the Baltic States joined the EU in 2004. One reason is that it is difficult to determine when exactly a person has emigrated. It is also difficult to track an individual emigrant who may work in Sweden, but has retained his/her registration in the home country. An interview-based analysis in 2005 showed that among the EU member states the percentage of the population that wanted to emigrate was highest in the Baltic States and Poland. Approximately 7 per cent of the population in Estonia and Latvia thus expected to move to another EU member state within five years, while the corresponding figure for

UNEMPLOYMENT IN THE BALTIC STATES, SEASONALLY ADJUSTED Chart 3

Per cent 18

0 99 00 01 02 03 04 05 06 07

Estonia Latvia Lithuania Source: Eurostat (2007d).

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Lithuania was around 9 per cent, cf. Vandenbrande et al. (2006). Data from Finland, the UK and Ireland shows considerable immigration from the Baltic States, leading to a shortage of certain types of labour, e.g. doctors, engineers, technical staff and craftsmen, in the Baltic States.

INFLATION AND EMU MEMBERSHIP

As mentioned previously, after regaining independence Estonia and Lithuania opted for currency boards and Latvia for a traditional fixed- exchange-rate regime in their efforts to stabilise inflation from almost hyperinflation. During the 1990s the three countries succeeded in reducing annual inflation to below 10 per cent, and they have retained their chosen exchange-rate regimes with only very few adjustments despite considerable financial shocks, e.g. in connection with the Russian crisis. Estonia switched anchor currency from D-mark to euro on the introduction of the euro in January 1999, Lithuania switched anchor currency from dollar to euro in 2002, and Latvia chose to target the euro as from 2005. Chart 4 shows annual consumer price inflation on a monthly basis since 1999. Inflation was relatively low in all three countries until 2004, although it was generally higher in Estonia than in the other two countries. Lithuania's switch of anchor currency from dollar to euro entailed a considerable real appreciation of its currency, which led to negative inflation from mid-2002 to mid-2004.

CONSUMER PRICE INFLATION Chart 4

Per cent year-on-year 14

-2

-4 99 00 01 02 03 04 05 06 07 Estonia Latvia Lithuania Source: Eurostat (2007e).

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Inflation rose in all three countries when they joined the EU in May 2004, caused by e.g. higher food prices. The price hike was particularly strong in Estonia due to the prior absence of protection of the agricultural sector or duties on most other imported goods. The inflation increase in 2004 turned out to be more persistent than expected. In 2004-06, annual inflation in Latvia was around 6-7 per cent, while it was a few percentage points lower in Estonia and Lithuania. However, inflation rose further in 2007, reaching more than 10 per cent in Latvia in August. The higher inflation in recent years is driven by several factors. In general, trend inflation is high in countries with high economic growth and a fixed exchange rate, cf. the Balassa-Samuelson effect. High productivity growth in traded sectors leads to wage increases that influence wages in non-traded sectors, entailing strong price inflation in the non- traded sectors. Such structural inflation is an unwanted side effect of a basically favourable development, i.e. high economic growth, but is difficult to combat under a fixed-exchange-rate regime, cf. Dobrinsky (2006).1 However, the higher inflation since 2004 is also driven by a number of specific shocks such as higher energy prices, administrative prices and indirect taxes. Furthermore, it probably also reflects increased pressures on the product and labour markets, against the background of high growth and declining unemployment. In recent years inflation in Estonia, Latvia and Lithuania has reached a level where it interferes with economic decision-making and thus becomes a cause of concern. The high inflation rates also prevent the countries from joining EMU. The three countries' EU membership entails an obligation to apply for EMU membership as they – unlike Denmark – have no derogation. Entry into EMU as soon as possible is a priority goal for policy-makers in the Baltic States. EMU membership assumes compliance with the Maastricht criteria, i.e. a stable exchange rate, small budget deficits, a relatively small government debt and converging interest rates and inflation. The Baltic States have long complied with the first four criteria, but have been unable to meet the inflation criterion. According to the inflation criterion, the inflation rate measured by the Harmonised Index of Consumer Prices, must not exceed a reference value, which is calculated as the average of the inflation rates of the three EU member states with the lowest inflation plus 1.5 percentage points.

1 It is important to point out that domestic inflation as a result of the Balassa-Samuelson effect does not erode international competitiveness, which is solely determined by the price of traded goods.

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Lithuania is the only Baltic State to have applied for EMU membership, but according to the 2006 convergence reports of the European Central Bank and the European Commission, Lithuania did comply with the inflation criterion. Specifically, the inflation rate in Lithuania was 0.1 percentage point above the reference value and it was expected to increase in future, cf. ECB (2006). Lithuania's application was therefore rejected. All three countries are still in ERM II, i.e. the waiting room for member states before EMU membership. It is uncertain when inflation will fall sufficiently for the countries to meet the inflation criterion. In this connection it is worth noting that the enlargement of the EU to 27 member states has brought about a lower reference value than before, which means that it is even more difficult to meet the inflation criterion, cf. Lewis and Staehr (2007). The labour markets in the Baltic States are generally regarded as flexible and market-oriented. However, the question is how wage formation will be affected by the declining unemployment and the rising inflation – and whether a wage and price spiral will emerge. Chart 5 shows growth in nominal wage costs in the Baltic States since 1998. There are clear signs of considerable wage pressures in recent years, particularly in Latvia. The very large wage increases should, however, be viewed against the background of the high real GDP growth and high inflation in these economies. At the same time, there may be a catching-up effect in relation to the functional distribution , as the wage share was previously very low.

NOMINAL WAGE COSTS Chart 5

Per cent year-on-year 35

-5

-10 98 99 00 01 02 03 04 05 06 07 Estonia Latvia Lithuania Source: Eurostat (2007f).

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The Chart also illustrates the pronounced fluctuations in the rate of nominal wage increase observed over the years. The curve for Lithuania even shows a wage decrease from 1999 to 2000. Overall, this suggests considerable flexibility with wage growth adapting to the cyclical pos ition. If this interpretation is correct, the countries are still facing the problem that recent years' economic upswing can lead to considerable nominal wage increases, which may in turn contribute to higher inflation.

IMBALANCES

Inflow of capital from abroad has been a key driver of the high growth in the Baltic economies. These countries are attractive investment targets since high returns are expected, while legislation and regulation of the financial markets are compliant with international rules. As regards the balance of payments, the capital inflow has generated large capital- account surpluses and substantial current-account deficits. Chart 6 shows the current account of the balance of payments relative to GDP since 1995. There were considerable deficits in the period, although with some moderation in the years immediately after the Russian crisis, when the unrest in the global financial markets temporarily reduced the capital inflow. The current-account deficits have risen significantly in all three countries in recent years, with Latvia accounting for the strongest increase.

BALANCE OF PAYMENTS - CURRENT ACCOUNT Chart 6

Per cent of GDP 0

-5

-10

-15

-20

-25

-30 979695 98 99 00 01 02 03 04 05 06 07

Estonia Latvia Lithuania Note: IMF forecast for 2007. Source: IMF (2007c).

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The composition of the capital inflow has changed considerably in recent years. From the 1990s until the Baltic States joined the EU, a very large share of the current-account deficits was financed by direct investments, which do not increase the external indebtedness of the recipient country. The direct investments could be attributed to privatisation of state-owned enterprises as well as establishment of new enterprises in the Baltic States. Recent years' capital inflow has primarily consisted of bank and bond loans either raised directly by businesses in the Baltic States or channelled to enterprises and households via the banking sector. The substantial capital inflow in 2005-07 is mirrored in strong domestic credit expansion. In Estonia, the stock of loans to non-financial corporations and households thus increased from 48 per cent of GDP in 2004 to 95 per cent in 2006. In Latvia, the loan stock increased from 51 to 93 per cent of GDP, and in Lithuania from 29 to 54 per cent of GDP, cf. IMF (2007d, p. 38). In 2006 the loan stock in Estonia and Latvia, as a share of GDP, roughly corresponded to the average level in Western Europe. Another notable feature is that most of the loans to business enterprises and households are denominated in foreign currency, typically euro. In Estonia and Latvia more than 70 per cent of the loan stock is denominated in foreign currency, cf. IMF (2007d, p. 41). As a result, the borrow- ers are highly exposed to exchange-rate changes. One conesquence of the improved access to loans for business enterprises and households has been surging real-estate prices, which in turn have made it easier to provide collateral for loans. The high growth rates, rising inflation and considerable current- account deficits can be regarded as signs of overheating of the economies in the Baltic States, particularly in Estonia and Latvia. This raises the issue of whether a correction will take place in the near future and especially what form it may take. Two scenarios are indicated. The first is a "soft landing" with gradual, controlled adjustment. In this scenario, various factors will bring economic growth down towards the trend growth, inflation will subside and capital imports will be reduced. First, one possibility is that the capital inflow to the Baltic States will be gradually reduced, e.g. as a result of the international financial turmoil that started in the US loan markets in the summer of 2007, cf. IMF (2007d). Second, the demand for loans in the Baltic States may decline in a situation where much of the population has already taken out substantial loans.1 Third, the increasing real wages will re-

1 In all three countries growth in new lending seems to have subsided somewhat during 2007, even though it is still considerable. For example, the stock of loans from Estonian banks to households and non-financial corporations rose by 61 per cent in the 12 months up to October 2005 and by 65 per cent in the 12 months up to October 2006, but "only" by 40 per cent in the 12 months up to October 2007, cf. Eesti Pank (2007). The pattern is similar in the two other Baltic countries.

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91 duce competitiveness and help dampen economic growth. Fourth, various policy measures may contribute to a soft landing, as described below. The second scenario is a "hard landing", i.e. a financial crisis scenario. In this scenario, a shift in expectations may lead to capital flight from the Baltic States, entailing pressure on the exchange rates and tight credit markets. This will significantly reduce domestic demand, leading to an economic downturn. A number of observers have emphasised that the crisis scenario can become reality, especially if nothing is done to cool down the economy. The concerns related initially to Latvia, but Estonia and sometimes Lithuania have later been described as vulnerable, cf. IMF (2007d) and IHT (2007b). It is notoriously difficult to predict financial crises with any degree of precision.1 Statistical analyses of financial crises have failed to identify individual factors or certain variables as reliable indictors of a future crisis, cf. Kaminsky et al. (1998). The current-account deficits of the Baltic States have received attention, but many of the countries that were affected by the financial crisis in Asia in 1997 had negligible current- account deficits or even surpluses. Another argument against the crisis scenario is that it is not clear whether the currencies in question stand to be devalued or revalued. The high growth rates and the inflationary pressures may warrant re- valuation, whereas the large current-account deficits point to devaluation. In other words, there is no indication of any unambiguous imbalance in the present fixed-exchange-rate regimes. The high economic growth rates in the Baltic States will make it easier for them to service their external debt in the future, assuming, of course, that their industry structure is adaptable so that the traded sector can expand sufficiently in the future, cf. IMF (2007d). The resilience of the countries' exchange-rate regimes and financial systems in previous situations has also been emphasised. This applied both in the crisis years until 1995 and during the Russian crisis. Finally, the national authorities have implemented a number of measures to prevent overheating of the Baltic economies. Chart 7 shows the development in the overall government budget balance in the three countries since 1995. Fiscal policies have been relatively restrictive in recent years, especially in comparison with the situation in the 1990s. Estonia has shown considerable government surpluses, Latvia's deficit has been reduced, and a surplus is expected

1 The economist Yoram Bauman has said that "macroeconomists have predicted nine out of the last five downturns", with a slight twist of a Paul Samuelson dictum (http://www.standupeconomist.com/). The proportion of false alarms is probably even greater for analysts predicting financial crises.

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CONSOLIDATED GOVERNMENT BUDGET BALANCE Chart 7

Per cent of GDP 4

-1

-2

-3

-4

-5

-6

-7 94 95 96 97 98 99 00 01 02 03 04 05 06 07

Estonia Latvia Lithuania Note: IMF forecast for 2007. Source: EBRD (2007) and IMF (2007d) for 2006 and 2007.

in 2007, while Lithuania's deficit has been in the range of 1-2 per cent of GDP. Fiscal policy is difficult to assess in a situation with high economic growth. Many observers have argued that especially Latvia and Lithuania should tighten their fiscal policies under the present circumstances, cf. IMF (2007d). In 2007, the two countries indeed began to tighten fiscal policy. The Latvian authorities have thus made a commitment to balance the budget for 2007 as an element of a major stabilisation package. Lithuania suspended the supplementary budget for 2007, and in November 2007 a new act came into force, stipulating that as from 2009, the government budget must always be balanced. Other measures may also help to stabilise the economies. Estonia has on several occasions raised the reserve requirements imposed on the banks, in order to dampen lending growth and thus the inflow of foreign capital. Latvia, too, has raised the lending requirements for the banks and introduced requirements for better risk assessment of bor- rowers. In addition, Latvia is planning to impose tax on increases in the value of real property, while also preparing measures to increase the supply of labour. Lithuania has taken the unconventional step of seeking to dampen inflation through direct negotiation with the retail sector.

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CONCLUSION

Denmark's Baltic neighbours have experienced remarkable changes since regaining independence in 1991. They have been on a ride on the eco nomic roller coaster with a deep recession, a short upswing, a new downturn in connection with the Russian crisis, and then again full speed ahead since 2000. These countries' economic success has given rise to a number of imbalances in recent years, including rising inflation and considerable current- account deficits. This represents a dilemma for policy-makers. The objective of rapid income convergence with Western Europe is a high priority in view of the countries' low income levels and the risk of extensive emigration. Against this background, it is perhaps not surprising that policy measures to counter these imbalances have been initiated at a relatively late stage. It is important not to let the imbalances overshadow the fact that the countries have shown very high growth rates for many years. If growth rates of at least 6 per cent can be sustained, the three countries' income levels will catch up with the Western European average within 15-20 years. By then, the economic wounds left by 50 years of planned economy and the subsequent transition period will have healed. In this connection, subsidies from the EU social and regional funds can prove valuable if applied efficiently. Short-term uncertainties are primarily associated with the developments in the financial markets and the issue of when inflation will fall to a level that enables the countries to join EMU. In the slightly longer term one of the greatest risk factors is probably the development of the countries' economic and political institutions. In this respect there is still a need to combat corruption and abuse of power, ensure rule-based decision-making by the authorities and strengthen public administration. Another concern is the development in Russia, which potentially has great economic significance to the Baltic States. From time to time, Russia has imposed trade restrictions, reduced transit transport and interrupted oil supplies to the Baltic States, cf. IHT (2007a). Nowadays, such shocks have less economic significance than previously, but hinder the expansion of economic relations with the eastern neighbour of the Baltic States.

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LITERATURE

Andersen, Rune Holmgaard, and Karsten Stæhr (2006): The Political and Economic transition in the Former Eastern Bloc Countries (in Danish only), Politica, volume 38, no. 4, pp. 446-465.

Berengaut, Julian et al. (1998): The Baltic Countries. From Economic Stabilization to EU Accession, IMF, Occasional Paper, no. 171.

Central Statistical Bureau of Latvia (2002): The Baltic States before the Second World War, http://www.stat.ee/files.aw/id=38688/baltic_states_before_the_second_ world_war.pdf.

Dobrinsky, Rumen (2006): Catch-up inflation and nominal convergence: The balancing act for new EU entrants, Economic Systems, volume 30, no. 4, pp. 424-442.

EBRD (2007): Transition Report Update, electronic database, http://www.ebrd.org/country/sector/econo/stats/index.htm (Economic statistics and forecasts, Selected economic indicators).

ECB (2006): Convergence Report, May, European Central Bank.

Eesti Pank (2007): Electronic database, http://www.eestipank.info/frontpage/en/ (Statistical Indicators, Financial sector statistics, 2.1.1 Loans granted by groups of customers (loan stock)).

Eurostat (2007a): Elektronic database, http://ec.europa.eu/eurostat (Long-term indicators, Population and social conditions, Population, Total population, Total population).

Eurostat (2007b): Electronic database, http://ec.europa.eu/eurostat (Structural indicator, General economic background, GDP per capita in PPS).

Eurostat (2007c): Electronic database, http://ec.europa.eu/eurostat (Social Cohesion, Inequality of income distribution).

Eurostat (2007d): Electronic database, http://ec.europa.eu/eurostat (Euro- Indicators, Labour market, Harmonised unemployment rate, Total, Sea- sonally adjusted).

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Eurostat (2007e): Electronic database, http://ec.europa.eu/eurostat (Euro- Indicators, Consumer prices, HICP All items - Index (2005=100)).

Eurostat (2007f): Electronic database, http://ec.europa.eu/eurostat (Euro- Indicators, Labour market, Labour cost index - Percentage change t/t-4, Working day adjusted).

IHT (2003): The Baltics: Europe's newest tigers: On a sprint to make up for lost decades, International Herald Tribune, 1 November.

IHT (2007a): An assertive Russia sends chill through Baltics, International Herald Tribune, 11 November.

IHT (2007b): Latvia's hot growth fuels devaluation fears, International Herald Tribune, 12 November.

IMF (2007a): World Economic Outlook Database for October 2007, electronic database, http://www.imf.org/external/pubs/ft/weo/2007/02/weodata/index.aspx (By countries, All countries, Select countries, Gross domestic product based on purchasing-power-parity (PPP) per capita GDP).

IMF (2007b): World Economic Outlook Database for October 2007, electronic database, http://www.imf.org/external/pubs/ft/weo/2007/02/weodata/index.aspx (By countries, All countries, Select countries, Gross domestic product, Constant prices, Annual percent change).

IMF (2007c): World Economic Outlook Database for October 2007, electronic database, http://www.imf.org/external/pubs/ft/weo/2007/02/weodata/index.aspx (By countries, All countries, Select countries, Current account balance, Per cent of GDP).

IMF (2007d): Regional Economic Outlook: Europe, International Monetary Fund.

Kaminsky, Graciela, Saul Lizondo and Carmen Reinhart (1998): Leading indicators of currency crises, IMF Staff Papers, volume 45, no. 1, pp. 1-48.

Lewis, John, and Karsten Staehr (2007): The Maastricht inflation criterion: what is the effect of expansion of the European Union?, De Nederlandsche Bank, Working Paper, no. 151/2007.

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Laar, Mart (2002): Little Country that Could, Centre for Research into Post-Communist Economies (CRCE), New Series no. 19.

OECD (2000): Baltic States. A Regional Economic Assessment, OECD Economic Surveys.

Staehr, Karsten (2004): The economic transition in Estonia. Background, reforms and results, in Rindzeviciute, Egle (ed.): Contemporary Change in Estonia, Baltic and East European Studies, volume 4, Södertörns Högskola.

Saavedra, Pablo, Anto Marcincin and Juraj Valachy (2007): Flat income tax reforms, in Gray, Cheryl, Tracey Lane & Aristomene Varoudakis (ed.): Fiscal Policy and Economic Growth: Lessons for Eastern Europe and Central Asia, The World Bank.

Vandenbrande, Tom, Laura Coppin and Peter van der Hallen (2006): Mobility in Europe, European Foundation for the Improvement of Living and Working Conditions, http://www.eurofound.europa.eu/pubdocs/2006/59/en/1/ef0659en.pdf.

Vilpisauskas, Ramunas (2005): The political economy of Baltic States' accession into the EU: The impact on the role of the state, Jean Monnet/ Robert Schuman Paper Series, volume 5, no. 21.

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Hedge Funds and the Financial System

Jesper Ulriksen Thuesen, Financial Markets

INTRODUCTION AND SUMMARY

The increasing prevalence of hedge funds has been a key trend in the international financial markets in recent years. The strong growth in the number of hedge funds and the capital they manage has been accompanied by an internationalisation of hedge- fund activities, a larger dispersion of investment strategies, a change in the composition of the investor base and less clearcut interfaces to other types of investment and financial market players. Today, hedge funds account for a considerable share of total turnover in the international securities markets. The influence of hedge funds on financial stability is not unambiguous. On the one hand they contribute to strengthening financial stability by, among other factors, improving price formation and supporting the development of new securities markets. On the other hand, the growing importance of hedge funds is associated with potential risks of systemic crises, primarily because it can be difficult for both market participants and authorities to obtain detailed information relating to the strategies and portfolios of the hedge funds. Recent years' experience has shown that even problems and losses of large hedge funds have not generated systemic crises in the international financial markets. Neither can the turmoil in the financial markets that began in the summer of 2007 be attributed to hedge-fund activities. Furthermore, in 2007 hedge funds have to date generated decent overall yields, despite the financial turmoil. The development has spurred international discussions on both the need for and the feasibility of regulating hedge funds. These discussions have resulted in an indirect and market-based approach to regulation of hedge funds is still being applied. The best protection against financial instability caused by hedge funds is competent risk management in the financial enterprises that are hedge- fund counterparties.

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ASSETS UNDER MANAGEMENT (AUM) IN HEDGE FUNDS Chart 1

USD billion 2,000

1,800

1,600

1,400

1,200

1,000

800

600

400

200

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Note: Figures for 2007 relate to end-June. Source: OECD (2007:1)/Hedge Fund Research.

INTERNATIONAL HEDGE-FUND DEVELOPMENTS

The increasing role of hedge funds has been a key structural trend in the international financial markets in recent years. The current number of hedge funds is estimated to be around 10,000 globally, with AUM (assets under management) totalling 1,500-2,000 billion dollars. The uncertain estimate can be attributed to incomplete statistical coverage of hedge funds and their activities in national and international financial markets. This is partly due to the absence of a clear and generally accepted definition of a hedge fund1, partly to the fact that a considerable number of hedge funds do not report data systematically to authorities or international databases. The hedge funds' AUM have been on the increase since 1990, and the development has accelerated especially in the last five years, as illustrated in Chart 1. The growth in hedge funds has taken place even though yields reported since 2003 have not been systematically higher than those on e.g. shares- only portfolios, cf. Table 1 and Box 1. The relatively more modest yields can be viewed as a result of the maturing and broadening of the sector.

1 The ECB has presented the following definition: "A hedge fund can be defined as a fund whose managers receive performance-related fees and can freely use, and do use, various active investment strategies to achieve positive absolute returns involving any combination of financial leverage, long and short positions in securities, derivatives or any other assets in a wide range of markets. … Hedge funds represent a flexible business model rather than an alternative asset class". ECB (2004).

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ANNUAL PERCENTAGE YIELD IN HEDGE FUNDS COMPARED WITH SHARES AND BONDS Table 1

2000 2001 2002 2003 2004 2005 2006 20071

Hedge funds ...... 8.4 6.3 0.1 18.6 7.7 8.6 12.1 9.5 Shares ...... -9.1 -11.9 -22.1 28.7 10.9 4.9 15.8 9.1 Bonds ...... 11.6 8.4 10.3 4.1 4.3 2.4 4.3 3.8

Note: The yield is stated as the yield calculated on the basis of S&P 500 (for shares), Lehman Brothers Aggregate Bond Index (for bonds) and Greenwich Global Hedge Fund Index (for hedge funds). The latter index is constructed on the basis of information on approximately 7,000 hedge funds in and outside the USA. Fund of funds are not included in the index. Yield in hedge funds is excluding manager fees. Source: Greenwich Alternative Investments. 1 Calculated up to and including September 2007.

In addition to actual hedge-fund activities, similar investment strategies1 are being pursued from managed accounts with considerable funds at their disposal, i.e. portfolios managed by hedge-fund managers on behalf of private or institutional investors. For managed accounts, the investors typically have direct ownership of the managed assets, which ensures the investors almost full transparency as to the composition of the portfolio and the trading activity. Furthermore, the investors can realise their portfolios at very short notice. The extent of managed accounts is difficult to estimate. However, it is estimated that around one quarter of the existing hedge funds operate managed accounts, and that private managed accounts alone amounted to more than 300 billion dollars at the end of June 2005.2

CHALLENGES IN THE CALCULATION OF RISK MEASURES FOR HEDGE FUNDS Box 1

Direct application of traditional risk measures to investment in hedge funds often entails problems. As a result, comparisons with traditional investments in e.g. shares and bonds are difficult to interpret. One reason is that the yield profiles of hedge funds may be characterised by other distributions than those traditionally used for calculations of risk-adjusted yields. Another problem is the potential bias in the available data on hedge-fund yields. Funds with particularly high yields may have an incentive to keep a low profile if the investors call for discretion. Funds with particularly low yields may have an incentive to refrain from reporting, considering new potential investors. In addition, data from the hedge funds that have closed down because of unsuccessful investments are not included. Finally, some hedge funds differ from more traditional investments in that the hedge-fund manager can choose not to manage the capital in periods when attractive placement opportunities are found to be insufficient within the hedge fund's chosen strategy. In that case, the deposits are simply returned to the investors until the manager can see investment opportunities again.

1 The hedge funds' most frequently applied investment strategies are outlined in Thuesen (2005). 2 Source: ECB (2007:2).

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GEOGRAPHICAL SPREAD OF HEDGE-FUND ACTIVITIES Chart 2

AUM Number of funds

USA UK EU excl. UK Australia USA UK EU excl. UK Australia Non-Japan Asia Switzerland Canada Japan Non-Japan Asia Switzerland Canada Japan Note: Data is based on questionnaires from the OECD and IOSCO, mainly calculated as of mid-2006. Source: OECD (2007:2) and OECD (2007:3).

Furthermore, strategies similar to those pursued by hedge funds are increasingly being applied by the proprietary trading desks of major international banks.1 In addition, strategies that might be applied by hedge funds have been indirectly applied by some banks through the establishment of conduits and SIVs.2

Changing geographical spread of the activity Until 10 years ago, hedge funds were almost exclusively a US phenomenon. The USA still accounts for the largest share by far of hedge-fund activity, but in recent years hedge funds have also gained ground rapidly elsewhere, especially in the UK. Chart 2 illustrates the geographical spread measured in terms of AUM and the number of hedge funds.

Hedge funds in Denmark and the other Nordic countries It is estimated that around 120 hedge funds are managed from the Nordic countries, with AUM totalling approximately 18 billion euro3. For comparison’s sake, the Danish investment associations manage assets amounting to more than 130 billion euro. Most of the Nordic hedge funds are found in Sweden, primarily focusing on various share-portfolio strategies. There are just over 20 hedge funds in Denmark4. As opposed to Swedish funds, most of these are funds of hedge funds (FoHF), i.e. hedge funds investing in hedge funds, and fixed-income hedge funds. This may explain recent years' relatively lower yields in Danish hedge funds compared to Swedish hedge funds and Nordic hedge funds overall, cf. Table 2.

1 Source: ECB (2007:2). 2 Conduits, SIVs, etc. and the financial-market turmoil are described in more detail in Jakob Windfeld Lund, Turmoil in the Financial Markets, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2007. 3 Source: HedgeNordic. 4 Of which most are managed from Denmark without being residents.

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ANNUAL PERCENTAGE YIELD IN NORDIC HEDGE FUNDS Table 2

2001 2002 2003 2004 2005 2006 20071

Nordic hedge funds ...... 12.3 8.4 9.3 8.2 10.1 7.9 3.0 Danish hedge funds ...... n.a. n.a. n.a. 6.6 8.7 5.8 3.3 Swedish hedge funds ...... n.a. 11.8 9.5 8.0 10.1 7.3 2.6 Norwegian hedge funds ... n.a. n.a. 15.1 11.0 10.2 12.6 4.5 Finnish hedge funds ...... n.a. n.a. n.a. 6.6 10.3 5.93 1.5

Note: The Nordic Hedge Fund Index is estimated to include the predominant part of hedge funds managed from the Nordic countries. There are no registered funds managed in Iceland. The index includes both onshore and offshore hedge funds Source: HedgeNordic. The Nordic Hedge Fund Index. 1 Calculated up to and including September 2007.

Key role in trading and price formation in the securities markets Despite the growth in recent years, the portfolios managed by the hedge funds are still modest compared to the estimated amount of approximately 18,000 billion dollars managed globally by conventional investment funds, in Denmark by investment associations. In most countries, AUM for hedge funds account for less than 10 per cent of AUM for investment funds. In Sweden, Austria and the USA, the figure is approximately 10 per cent, while Switzerland and the UK are notable exceptions with approximately 20 per cent and almost 60 per cent, respectively.1 Many hedge funds tend to trade their portfolios more often than other portfolio managers. Consequently, hedge funds now account for a considerable share of total turnover in many major securities markets. This is illustrated by US data in Table 3. Hedge funds therefore play a key role in liquidity and price formation in the international securities markets.

Wider spread on more hedge-fund strategies Many hedge funds try to identify and exploit market imperfections. As the number of hedge funds increases, and in step with the growing complexity of the financial markets, hedge funds are increasingly specialising, and the pattern of investment strategies shows greater dispersion. This means that the traditional long/short strategies2 are less dominant than previously, although they are still estimated to make up almost one third in terms of AUM.

1 Source: OECD (2007:3). According to the OECD, Denmark's share is 0.25 per cent. However, for hedge funds this calculation includes only the assets of the registered Danish hedge associations. 2 A long/short strategy enables the hedge fund to utilise any assumed imbalances in relative prices within the same class of assets. For instance, a hedge fund might buy a corporate bond that it believes to be priced too low and short-sell a corporate bond that it believes to be priced too high. The overall position may be neutral in relation to the market, so that the yield does not depend on changes in the level of interest rates, but only on changes in the relative prices of the two bonds selected. The classic hedge fund is an equity long/short fund, with short and long positions in shares within the same category, e.g. the same industry. Such hedge funds are not always market neutral, and some may rapidly shift from being net long to being net short in the market. The investment strategies most frequently applied by hedge funds are outlined in Thuesen (2005).

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HEDGE FUNDS' SHARE OF TRADING IN SELECTED SECURITIES IN THE USA, 2006 Table 3

Security Percentage of trading

Shares ...... 30 Credit derivatives (plain vanilla) ...... 60 Credit derivatives (structured) ...... 33 Emerging market bonds ...... 45 Distressed debt ...... 47 Leveraged loan trading ...... 33 High yield bond trading ...... 25

Source: OECD (2007:2), Greenwich Associates, Financial Times.

Less clearcut interfaces to other investment types and financial players In step with the increasing prevalence of hedge funds, the traditional distinction between hedge funds and other investment types and financial players has in some cases become blurred. A case in point is the distinction between hedge funds and private equity funds. The latter are characterised by investing in individual business enterprises in order to obtain a controlling influence on the enterprises' strategies and operations, i.e. "governance activism". In contrast, conventional hedge funds operate with portfolio investments only, among other characteristics. However, recent years have seen several examples of large hedge funds playing an active role in e.g. negotiations on consolidation of banks or operators of securities markets.

Changed composition of investors Traditional investors in hedge funds are private individuals with very substantial wealth. Part of the growth in hedge funds can be attributed to the higher number of such people globally. In recent years, institutional investors, including a number of pension companies, have placed an increasing share of their assets in hedge funds. Furthermore, there has been a tendency for increased investment in hedge funds by private individuals who do not fall into the category of very affluent. These investments are primarily indirect investments via FoHF.1 The structural shift in the investor base, especially the tendency towards more retail investors, has given rise to an international debate concerning whether the authorities should introduce consumer protection rules in relation to hedge funds similar to the rules applying to traditional investment products offered to retail investors.

1 Cf. e.g. Crockett (2007).

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HEDGE FUNDS AND FINANCIAL STABILITY

Many international analyses of hedge funds are carried out by central banks as an element of their financial stability effort.1 Many analyses indicate that hedge funds have generally had a positive impact on financial stability e.g. by contributing to better price formation and spreading of risk in the global financial markets.2 This can be attributed to the following direct and indirect factors, among others: • Hedge funds' strategies and methods of analysis are often based on identifying and exploiting even very small market imperfections, thereby contributing to more efficient price formation. • Through considerable trading activity and position-taking, hedge funds contribute liquidity to the financial markets • Hedge funds often possess financial expertise and risk appetite that can benefit the development of new markets. An example is the development of the credit derivatives markets, which has gained momentum in recent years. • Hedge funds may contribute to limiting market volatility. Since they often aim at absolute yields, they might be less inclined to buy in a rising market and sell in a falling market.3 • Hedge-fund investors cannot usually withdraw their deposits at short notice. This contributes to dampening the hedge funds' need for rapid realisation of assets, which could result in an unintentional negative impact on already falling markets. In this respect, hedge funds are different from e.g. conduits and SIVs, whose financing structure has contributed strongly to the turmoil in the financial markets in recent months. • Yields on investments in hedge funds have proved to be significantly less correlated with yields in the share and bond markets than e.g. yields in the share and bond markets with each other. Inclusion of hedge funds in portfolios therefore increases investors' possibilities of diversifying their portfolios.

1 ECB (2005) is an example. The ECB analyses aspects of the development in hedge funds on an ongoing basis. The results of these analyses are presented in e.g. the biannual publication Financial Stability Review. The Bank of England publishes its analyses on hedge funds in e.g. the Financial Stability Report. There is also extensive academic literature on hedge funds and financial stability, e.g. Barth et al. (2007). 2 For example, the ECB finds as follows in ECB (2007:2): "So far, experience with the active participation of hedge funds in financial markets over the past decade has, on balance, been very positive …". 3 An example of a stabilising effect: When an index rises, investors that benchmark themselves against the index are increasingly exposed in the index, particularly in the securities that rise the most. Hedge funds aiming at absolute yields (not relative yields) will leave the index as it rises (basically, they do not want to change their exposure in the index). The opposite applies when the index falls.

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However, the increasing importance of hedge funds is also associated with a number of potential risks. The risks that are most often pointed out are as follows: • Probably the largest risks associated with hedge funds are "crowded trades", i.e. a situation with most of the hedge funds trading in the same direction in a falling market, thereby reinforcing downturns in the international securities markets. Since hedge funds account for a large share of trading in many securities markets, they play a key role in price formation, as mentioned above. This can be amplified by the fact that the proprietary trading desks of large investment banks may pursue trading strategies similar to those of hedge funds. • Due to the increasing hedge-fund activity, prime brokerage1 has become a substantial business area for some of the large international investment banks. For these banks, there are risks associated with the further development of the hedge-fund sector and potential shifts in the terms of competition between the existing and any new providers of prime brokerage. • Losses on hedge funds had no significant implications for financial stability as long as the investors were mainly very affluent individuals. As more and more banks and institutional investors have increased their direct or indirect positions in hedge funds, the potential risks associated with hedge funds have risen. It is essential that the financial institutions that are, in one way or another, counterparties of hedge funds have the necessary risk management tools and information at their disposal to be able to manage portfolios that include hedge funds. The risk management of financial institutions is generally found to have improved significantly in recent years.

These potential risks, among other factors, have given rise to the debate on hedge funds in recent years. A central policy issue in the debate has been whether it is expedient – and possible – to launch international initiatives to strengthen the regulation of hedge funds.

The recent history of major hedge-fund crises In connection with the most well-known collapse of a hedge fund, Long- Term Capital Management, LTCM, in the autumn of 1998, the Federal Reserve actively encouraged a solution in view of the potential negative impact on the financial markets of compulsory liquidation. LTCM was thus subsequently acquired by other private financial enterprises.2

1 Prime brokers are the investment banks that service hedge funds in connection with their activities in capital markets. Typical prime broker services are described in Thuesen (2005). 2 In connection with the LTCM crisis in the autumn of 1998, 17 LTCM counterparties stood to lose 3-5 billion dollars in total.

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SELECTED CRISES IN HEDGE FUNDS 1998-2006 Table 4

Estimated loss, million Hedge fund USD Year

Amaranth ...... 6,400 2006 Long-Term Capital Management ...... 3,600 1998 Tiger Management ...... 2,600 2000 Soros Fund ...... 2,000-5,000 2000 Princeton Economics International ...... 950 1999 Lipper ...... 700 2001 Lancer ...... 600 2003 Beacon ...... 500 2002 Manhattan Investment Fund ...... 400 1999 MotherRock ...... 230 2006

Source: Ferguson et al. (2007).

However, recent years' experience shows that problems and losses for even large hedge funds have not since given rise to systemic crises in the international financial markets. Table 4 provides an overview of the largest hedge-fund crises since LTCM. It is estimated that well in excess of 2,000 hedge funds closed down in the period 1999-20051. None of these events gave rise to systemic crises in the financial markets. ECB analyses indicate that around 5 per cent of the hedge funds go into liquidation during a year.2 The liquidation can be voluntary, i.e. initiated by the hedge-fund manager, or involuntary if it is no longer possible to obtain sufficient AUM volume. Many liquidations are attributable to the latter reason either because the hedge funds are unable to attract a sufficient number of new investors, or because the investors execute their right to withdraw their investments from the hedge funds.

Hedge funds and the turmoil in the international financial markets in 2007 As apparent from Table 5, hedge funds have year-to-date in 2007 generated reasonable yields despite the turmoil in the financial markets, which began in the summer of 2007. Several hedge-fund strategies generated positive yields in July, when the turmoil began, while most, but not all, strategies generated – relatively modest – negative returns in August, when the turmoil really took off. In September virtually all strategies again generated positive yields.

1 Cole et al. (2007). The assessment is based on the inflow and outflow of reporting hedge funds to the LipperTASS Database. It is not possible to state the precise number of closed-down hedge funds since there might be other reasons why a hedge fund chooses no longer to report to the database. According to an estimate for 2006, more than 700 hedge funds closed down, while just under 1,000 new funds were established. 2 ECB (2007:2).

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MONTHLY PERCENTAGE YIELD, SELECTED HEDGE-FUND STRATEGIES IN 2007 Table 5

Index Jan Feb Mar Apr May Jun Jul Aug Sep Jan-Sep

All strategies ...... 1.2 0.6 0.9 1.8 2.0 0.9 0.4 -1.6 2.6 6.4 Distressed securities ...1.6 1.6 1.1 1.6 1.7 0.5 -0.4 -1.3 0.4 6.8 Merger arbitrage ...... 2.1 0.6 0.8 1.7 2.1 -0.7 -0.9 0.2 1.5 7.6 Convertible arbitr...... 1.5 1.3 0.7 0.2 0.8 0.1 -0.3 -1.9 1.5 3.9 Fixed income arbitr. ...0.9 1.3 0.9 0.6 0.7 0.3 0.4 -0.8 1.0 5.3 Statistical arbitr...... 0.9 0.1 0.9 1.8 1.0 0.2 -0.1 -1.8 1.5 4.4 Short selling ...... -1.5 1.6 -0.2 -3.0 -2.5 2.5 3.6 1.4 -0.9 0.8 Global macro ...... 0.5 0.4 0.4 1.1 1.7 0.9 1.4 -1.6 3.6 8.7

Note: The various hedge-fund strategies are described in more detail in Thuesen (2005). Source: Greenwich Alternative Investment.

So far, the financial turmoil has not had a significant impact on the hedge-fund sector as a whole. Part of the explanation is the heteroge- neous nature of the sector in terms of chosen strategies and risk level. Consequently, the hedge funds are affected in different ways by sudden shifts in market conditions, and they also have different response patterns. In its latest Financial Stability Report1, the Bank of England concludes that although a few hedge funds have had to close down, the recent financial turmoil has seen few examples of hedge funds being forced to sell their assets or having to refuse investors who wanted to withdraw their investments, in order to avoid forced sale of the their assets. In other cases, hedge funds have apparently contributed to stability by buying assets in falling markets. The ECB is also noticing these trends:

"It does not seem that selling pressure coming from hedge funds was a major factor behind the recent turbulence, since problems in interbank, ABCP and other credit markets, as well as losses experienced by some banks, were far more important for the smooth functioning of the global financial system." 2

In addition, the Bank of England points out a trend in the hedge-fund sector towards reallocation of funds between various hedge-fund strategies, while the financial turmoil has not led to any decrease in total AUM.

1 Bank of England (2007). 2 ECB (2007:3).

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APPROACHES TO REGULATION OF HEDGE FUNDS

Traditionally, special regulation of financial institutions has been gov- erned by two primary considerations, i.e. consumer protection and limiting systemic risks. The latter is the risk that problems in one part of the financial sector will spread to the rest of the sector, resulting in a financial crisis. The consumer protection issue has so far not been relevant to hedge funds, as the funds' investors have traditionally been private individuals with very substantial wealth and subsequently also institutional investors and other professional investors. These investors are able to assess the risks on their investments and to bear any losses without any significant impact on the economy as a whole. As described above, the systemic risk issue has become relevant as the total activities of the hedge funds have reached a level that can have a considerable impact on the rest of the financial system. As regards regulation of hedge funds, an overall distinction can be made between direct, indirect and market-based regulation.1 Direct regulation of hedge funds can be associated with a number of problems. One objective of establishing a hedge fund has been to implement investment strategies that could not have been implemented under the regulatory framework for traditional financial institutions such as banks and investment associations. Any need to regulate hedge funds' portfolio management should therefore be considered in relation to the potential drawbacks of regulation. It would be just as difficult to regulate hedge funds on the basis of risk-based requirements for capital adequacy and risk management systems, along the lines of the regulatory framework applying to other financial institutions. One reason is that the rapid restructuring of the hedge funds' often very complex portfolios would require frequent, resource-intensive inspections by the supervisory authorities. On the liabilities side it may be somewhat easier for the authorities to limit investor access, in practice blocking retail investors' access to invest in hedge funds, which would minimise consumer protection concerns. However, this raises the fundamental issue of whether only already very affluent individuals should have access, as private investors, to the potentially higher yields that can be achieved by including hedge funds in the portfolio. The Danish Act on Hedge Associations, which entered into force on 1 July 2005, provides a solution that does not limit the associations' investment strategies, while accommodating consumer informa-

1 This distinction is often applied in the literature, cf. e.g. Crockett (2007).

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108 tion needs by imposing information requirements on the hedge associations as regards investment strategies and risk profile. In addition, there is the perhaps most important and practical problem in relation to direct regulation, i.e. that many hedge funds are registered in offshore financial centres1, or can easily move to offshore financial centres if new regulatory requirements are imposed. Indirect regulation of hedge funds may take prime brokers as the starting point. Prime brokers are typically already regulated and subject to financial supervision. By imposing the right requirements on prime brokers, the authorities can contribute to curbing the risk that problems in the hedge-fund sector spread to the core of the financial system. Such requirements could encompass the size and quality of collateral for loans and securities lending, the size of margins on derivatives contracts, capital requirements for exposure to hedge funds and the quality of risk management systems. In principle, the objective of, and approach to, indirect regulation of hedge funds is no different from the regulation applying to prime brokers and other traditional financial enterprises to ensure appropriate risk management and capital adequacy in these enterprises. However, having hedge funds with complex investment strategies as counterparties may present special challenges. An important advantage of indirect regulation is that it is feasible in practice, which makes it the most frequently recommended approach to hedge funds in recent years' international reports.2 There is no need for direct regulation of hedge funds in so far as prime brokers apply appropriate risk management. Basically, losses in hedge funds and for their investors do not represent a problem to the financial system or the economy as a whole. However, it should be noted that indirect regulation does not necessarily prevent problems in one or more hedge funds from causing problems in the financial markets as a result of crowded trades and sudden liquidity shortages, as described above. Proposals for market-based regulation of hedge funds are based on the assumption that if all market participants are sufficiently well informed, they can take the relevant risks into account.3 This also applies to the risks associated with e.g. crowded trades. A considerable degree of market transparency is therefore a precondition for well-functioning market-based regulation.

1 The Cayman Islands, the British Virgin Islands, Bermuda and the Bahamas are examples of offshore financial centres with a large number of registered hedge funds. 2 Examples are Financial Stability Forum (2007) and Alternative Investment Expert Group (2006). 3 Another prerequisite for well-functioning market-based regulation is that the market participants can use the available information for risk assessment purposes.

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Prime brokers and financial investors in hedge funds are qualified counterparties that should only do business on an informed basis. The hedge funds are therefore effectively under substantial pressure to provide information to the counterparties, although not necessarily to the general public. Nevertheless, there may still be a need to increase the transparency of hedge funds with a view to monitoring by both market participants and authorities of the potential risks that hedge funds may represent to the financial system overall. For example, how will the compulsory liquidation of a large hedge fund affect the financial system, and what are the potential risks associated with crowded trades? However, even if a documented need for increased transparency exists, it is not always clear how the right information can be provided in practice. For example, in many cases the balance sheet of a hedge fund does not provide a true and fair view of its risk profile since exposure management is also conducted on an off-balance-sheet basis, including widespread use of credit derivatives. Another example is the risk associated with crowded trades. Here, a snapshot of a hedge-fund portfolio may become obsolete very quickly due to frequent portfolio restructuring by the hedge funds.

THE LATEST INTERNATIONAL DISCUSSIONS AND INITIATIVES

Recent years have seen intensification of the international discussions relating to the need for regulation, and opportunities to regulate hedge funds amongst others under the auspices of the EU and G8. A number of initiatives have been taken. The overall result of the discussions has been that the approach to regulation of hedge funds at the international level is still indirect and market-based, and that the authorities as well as the financial sector will continue to focus on the development. In February 2007, the G71 Ministers of Finance and central-bank govern- ors concluded that hedge funds make a significant contribution to the efficiency of the financial system, but that the development should be closely monitored in view of their increasing importance and complexity. In this connection, Financial Stability Forum, FSF,2 was asked to update a previous report from 2000 on highly leveraged institutions. The FSF report was published in May 20073 after a series of meetings with e.g. high-level representatives of the hedge funds. The report contains recommendations

1 G7 comprises the USA, the UK, France, Germany, Japan, Italy and Canada. G8 consists of these countries and Russia. 2 FSF was established in 1999 by the G7 Ministers of Finance to strengthen international financial stability via increased exchange of information and international cooperation on supervision and monitoring. The FSF secretariat is located at the Bank for International Settlements (BIS). Further information on FSF is available on www.fsforum.org. 3 Financial Stability Forum (2007).

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110 aimed at supervisory authorities, prime brokers, investors and hedge-fund managers in order to limit the potential systemic risks associated with hedge funds and other highly leveraged financial institutions. In line with the previous FSF report, direct regulation of hedge funds is not recommended, and the report does not concern itself with consumer protection issues. The following recommendations are made: • Supervisory authorities and prime brokers should work to strengthen the latter's risk management and resilience to drops in market liquidity. • Prime brokers and investors should seek to strengthen market discipline, including requiring accurate and timely information from the hedge funds on their portfolios and risk management. • Supervisory authorities should initiate work to clarify the extent to which more systematic and consistent data collection on prime brokers' consolidated exposures to hedge funds might strengthen the existing supervisory regime. • Finally, the hedge-fund sector should review and strengthen the existing best practice benchmarks for hedge-fund managers in the light of expectations to this effect from the rest of the private sector and from the authorities.

Subsequently the G8 leaders discussed hedge funds in June 2007 and supported the recommendations in the FSF report and thus an approach based on indirect regulation/supervision and market discipline. In the EU, hedge funds were discussed at the informal Ecofin meeting in April 2007, and in May the Ecofin Council adopted Council conclusions on hedge funds. The conclusions acknowledge that the existing approach with indirect regulation/supervision has so far strengthened the resilience to systemic risks, and the Council encourages market participants and authorities to remain alert as to potential risks. How- ever, at the same time the Council points out the need for better understanding of the significance of hedge funds to financial stability. Finally, the Council conclusions refer to the concerns expressed by some member states regarding retail investors' investments in hedge funds. The European Commission has been asked to investigate the need for EU regulation of the investment funds that are currently subject to national legislation and are on offer to the general public. These might include some funds of hedge funds. In March 2007, IOSCO1 issued a consultation report2 on the principles for the valuation of hedge-fund portfolios and issues that arise in con-

1 International Organization of Securities Commissions (IOSCO) is the international organisation for authorities regulating securities markets. 2 IOSCO (2007:1).

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111 nection with the valuation of illiquid or complex financial products. The purpose is to lay down a set of overall principles to ensure consistent, independent and transparent valuation of hedge funds. Besides the immediate challenges of valuing illiquid and complex portfolios, a special characteristic of hedge funds is that the hedge-fund manager's remuneration is to a high degree directly linked to the calculation of the hedge fund's yields. IOSCO issued another consultation report in April 20071 to provide input for the discussion of which issues IOSCO should concentrate on in future in relation to FoHF for retail investors. The consultation periods for the two reports expired during the summer, and IOSCO is now continuing the work on specific initiatives. The strong political focus has put pressure on the hedge-fund sector to be more willing than previously to engage in a dialogue with the authorities on the potential risks associated with hedge funds. One result has been that in the summer of 2007, a working group of 14 of the largest European hedge funds invited other European hedge funds to cooperate on formulating a code of conduct for hedge funds. In October the group issued an extensive consultation report2 with a total of 15 draft standards, in the first instance primarily about more information on hedge funds and issues related to the significance of hedge funds to financial stability. The issues include valuation of complex financial products, efficient risk management, governance structures to handle potential conflicts of interest, and rules on exerting influence on companies. The report suggests application of the "comply or explain" principle, i.e. that each hedge fund should comply with the future standards, or alternatively explain to the public why it has chosen not to do so. The consultation period expires on 14 December. The final report with a code of conduct is expected in January 2008.

1 IOSCO (2007:2). 2 Hedge Fund Working Group (2007).

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LITERATURE

Alternative Investment Expert Group (2007), Report of the Alternative Investment Expert Group, European Commission, July.

Bank of England (2007), Financial Stability Report, Issue No. 22, October.

Barth, James R., M. Bertus, T. Li and T. Phumiwasana (2007), Hedge Funds: A Global perspective on Strategies and Risks, Prepared for the Joint Meeting of the Shadow Financial Regulatory Committees of Europe, Japan, Latin America and the United States, Copenhagen, Denmark, September.

Cole, Roger T., G. Feldberg and D. Lynch (2007), Hedge funds, credit risk transfer and financial stability, Financial Stability Review, Banque de France, April.

Crockett, Andrew (2007), The evolution and regulation of hedge funds, Financial Stability Review, Banque de France, April.

ECB (2004), Financial Stability Review, December.

ECB (2005), Hedge Funds and their Implications for financial Stability, Occasional Paper Series, August.

ECB (2007:1), The Transparency of Hedge Funds, Contribution to the Financial Stability Table, March.

ECB (2007:2), Financial Stability Review, June.

ECB (2007:3), Financial Stability Review, December.

Ferguson, R., og D. Laster (2007), Hedge funds and systemic risks, Financial Stability Review, Banque de France, April.

Financial Stability Forum (2007), Update on the FSF Report on Highly Leveraged Institutions, May.

Greenwich Alternative Investments, www.greenwichai.com

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G8 (2007), Chair's Summary. Heiligendam, 8 June. Hedge Fund Working Group (2007), Hedge Fund Standards, Consultation Paper, October.

HedgeNordic, www.hedgenordic.com

IOSCO (2007:1), Consultation Report. Principles for the valuations of hedge fund portfolios, March.

IOSCO (2007:2), Consultation Report. Call for views on issues that could be addressed by IOSCO on funds of hedge funds.

OECD (2007:1), Recent market developments, the boom in private equity and the rise of hedge funds, OECD Financial Roundtable Meeting, May.

OECD (2007:2), An overview of hedge funds and structured products. Issues in leverage and risk, OECD May.

OECD (2007:3), Selected questions regarding hedge funds. Result from the CMF questionnaire and previous CMF discussions, OECD May.

Thuesen, Jesper U. (2005), Hedge Funds in Denmark and Internationally, Danmarks Nationalbank, Monetary Review, 1st Quarter.

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Monetary Review - 4th Quarter 2007

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Foreign-Exchange and Derivatives Markets in 2007

Rune Egstrup and Birgitte Damm Fischer, Statistics

INTRODUCTION AND SUMMARY

Turnover has risen strongly in both the Danish and the global foreign- exchange markets. Average daily turnover in the Danish foreign- exchange market more than doubled from April 2004 to April 2007. Turnover has risen for all traditional foreign-exchange instruments. In the Danish foreign-exchange market, growth in absolute terms was most significant for FX swaps traded between reporting dealers, which indicates that the increase in turnover is to a large extent related to liquidity management by banks. In the global foreign-exchange market, FX swaps also account for the highest growth in absolute terms, but here the increase primarily stems from trading with other financial institutions. Part of the rise in turnover is attributable to technical factors, in particular a tendency towards shorter maturities for foreign-exchange transactions. The higher turnover in the foreign-exchange markets should furthermore be viewed in the light of the sustained overall upswing and the increasing internationalisation of e.g. trade and investments. Most foreign-exchange transactions still have one leg in dollars, but in Denmark's case the euro's share of foreign-exchange turnover is rising. Activity in the global OTC derivatives markets1 has also increased significantly, with some foreign-exchange and interest-rate instruments achieving 3-year growth rates of around 100 per cent. The Danish OTC market for foreign-exchange and interest-rate derivatives is very modest seen in an international context. These results are presented in an international survey of turnover in the foreign-exchange and OTC derivatives markets. Danmarks National- bank conducted the Danish part of the survey2, which is coordinated by the Bank for International Settlements (BIS)3. Details of the survey are provided in Box 1.

1 Derivatives are traded on stock exchanges and over the counter (OTC), i.e. directly between two parties. This article relates to OTC derivatives only. 2 For further information on the Danish part of the survey, including sources and methodologies, see Danmarks Nationalbank (2007). 3 The results of the global survey can be found at the BIS website, www.bis.org/triennial.htm, cf. BIS (2007).

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INTERNATIONAL SURVEY OF THE FOREIGN-EXCHANGE AND DERIVATIVES MARKETS Box 1

Danmarks Nationalbank's survey of the foreign-exchange and derivatives markets is part of a large international survey coordinated by the Bank for International Settlements, BIS. The survey has been conducted every third year since 1989 for the foreign-exchange market and since 1995 for the derivatives markets. The largest market participants from 54 countries took part in the 2007 survey. The respondents in the Danish part of the survey are 6 banks that are jointly estimated to account for at least 97 per cent of turnover in the Danish foreign-exchange and derivatives market. The survey comprises trades concluded by the banks' entities in Denmark, including intra-group trades concluded on market terms. Duplicated reporting of transactions between two reporting dealers has been eliminated. Turnover is stated as the gross value of all trades concluded in April 2007, i.e. the sum of the numerical purchase and sales values. Results are stated in dollars in order to ensure comparability between national surveys.

The survey comprises the following instruments: Foreign-exchange market: • Spot transaction: Foreign-exchange trade for settlement within two banking days of the trade date • Outright forward: Foreign-exchange trade for settlement later than two banking days after the trade date • FX swap: Transaction that combines a spot transaction with a forward transaction in the opposite direction, e.g. a loan with foreign exchange as collateral OTC foreign-exchange derivatives market: • Currency swap: A transaction involving ongoing swaps of interest payments and principals in different currencies • Currency option: A transaction that grants one party the right, but not the obligation, to buy or sell an amount in a given currency at an agreed price at an agreed future point in time. OTC interest-rate derivatives market: • Forward rate agreement (FRA): An agreement to fix a rate of interest for an agreed amount over a future period • Interest-rate swap: An agreement to swap interest payments for a period. Typically, fixed interest rates are swapped for variable interest rates • Interest-rate option: A transaction that grants one party the right, but not the obligation, to receive or pay a specified rate of interest on an agreed principal in a future period

Turnover is broken down by currency and counterparty for all instruments and also by original maturity for outright forwards and FX swaps. Turnover is broken down by the following counterparty categories: • Other reporting dealers, i.e. institutions participating in the BIS survey – mainly large banks • Other financial institutions, i.e. financial institutions that did not participate in the BIS survey – e.g. small banks, pension and insurance companies, investment banks and hedge funds • Non-financial customers

For each counterparty category, a distinction is also made between those domiciled in Denmark and those domiciled abroad.

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THE FOREIGN-EXCHANGE MARKET

The global survey and the Danish part of the survey both show that in 2007 growth in turnover in the foreign-exchange market was higher than at any time since the start of the survey. Average daily foreign- exchange turnover in Denmark rose by 111 per cent from 2004 to 2007, while the corresponding global growth was 71 per cent, cf. Chart 1.

Higher interbank trading in FX swaps in Denmark Turnover in the traditional foreign-exchange market in Denmark by way of spot and forward transactions and FX swaps averaged 86 billion dollars per banking day in April 2007. The equivalent global turnover was 3,210 billion dollars. All three instruments have contributed to the rising turnover in the Danish foreign-exchange market. In value terms, FX swaps make up by far the largest part of the market, and this is also the instrument that has seen the greatest absolute increase. A similar pattern is observed in the global foreign-exchange market, cf. Table 1. Most of the increase in turnover in the Danish market relates to trading between reporting dealers, clearly reflecting the counterparty distribution in the Danish foreign-exchange market. Interbank trading among domestic and foreign reporting dealers accounts for as much as

3-YEAR GROWTH RATES IN TOTAL TURNOVER IN THE FOREIGN-EXCHANGE MARKET IN DENMARK AND GLOBALLY Chart 1

Per cent 120

100

-20

-40 1992 1995 1998 2001 2004 2007 Denmark Globally Note: Turnover is stated in dollars, so that fluctuations in the exchange rate of the dollar influence growth rates. Adjusted for dollar fluctuations, the growth rate from 2004 to 2007 is 96 per cent for Denmark and 65 per cent globally.

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TURNOVER IN THE FOREIGN-EXCHANGE MARKET IN APRIL BROKEN DOWN BY INSTRUMENT TYPE Table 1

Billion dollars per banking day 1989 1992 1995 1998 2001 2004 2007

Denmark Spot transactions ...... 6.4 10.5 8.6 6.3 4.3 9.2 15.1 Outright forwards ...... 1.3 2.0 1.5 1.1 0.7 2.1 10.0 FX swaps ...... 5.5 14.4 19.7 19.9 18.3 29.6 61.0

Foreign exchange, total ... 13.2 26.9 29.8 27.3 23.3 40.9 86.1

Global Spot transactions ...... 317 394 494 568 386 621 1,005 Outright forwards ...... 27 58 97 128 130 208 362 FX swaps ...... 190 324 546 734 656 944 1,714

Foreign exchange, total ... 590 820 1,190 1,490 1,200 1,880 3,210

Note: "Foreign exchange, total" for global turnover does not match the sum of the individual transaction types as the total includes an estimate of unreported transactions.

78 per cent of the aggregate foreign-exchange turnover in the Danish survey, while the segments other financial institutions (e.g. pension and insurance companies, investment banks and hedge funds) and non- financial customers each account for 11 per cent of turnover, cf. Chart 2. The relatively high share of interbank trading between reporting dealers in the Danish foreign-exchange market is primarily related to FX swaps. These often have short maturities, sometimes only one day, which

TURNOVER IN THE DANISH FOREIGN-EXCHANGE MARKET BROKEN DOWN BY COUNTERPARTY Chart 2

Per cent 100

0 2001 2004 2007 2001 2004 2007 Denmark Globally Reporting dealers Other financial institutions Non-financial customers

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GROSS VALUE OF FOREIGN-EXCHANGE TRADES SETTLED, AND NUMBER OF INDIRECT CLS PARTICIPANTS Chart 3

Billion dollars Kr. billion Indirect participants 100,000 10,000 2,000 90,000 9,000 1,800 80,000 8,000 1,600 70,000 7,000 1,400 60,000 6,000 1,200 50,000 5,000 1,000 40,000 4,000 800

30,000 3,000 600

20,000 2,000 400

10,000 1,000 200

0 0 0 2004 2005 2006 2007 2003 2004 2005 2006 2007 Turnover in all currencies, billion dollars Turnover i Danish kroner, kr. billion (right-hand axis) Banks Funds Other

Note: In the calculation of the gross value of trades settled, all trades are counted twice since each leg of a trade entails a separate payment instruction. Data for November 2004 and February 2005 have been adjusted for two outliers. The gross value of trades settled in CLS is not directly comparable with the turnover data from the BIS survey of the foreign-exchange markets. For example, the geographical compilation and the instrument types may vary. Moreover, CLS turnover is stated as total monthly turnover in the individual calendar months, while BIS data is mainly presented as average daily turnover in April. To the number of indirect participants should be added the direct participants in CLS, currently 57 compared with 39 when CLS commenced operations in September 2002. Source: CLS Bank International. is a contributing factor to the high turnover of this instrument in the Danish market. In Denmark, FX swaps are the banks' preferred money- market instrument for managing krone-denominated liquidity, partly because FX swaps are easier to administer for banks than other types of collateralised money-market instruments such as repos. The sharp rise in turnover in FX swaps between reporting dealers should also be viewed in the light of the more widespread use of CLS (Continuous Linked Settlement)1, cf. Chart 3, for settlement of foreign- exchange transactions. Settlement via CLS limits the risk on foreign- exchange transactions because the two legs can be settled simultan- eously in the system, and this may have contributed to the rise in interbank trading in FX swaps in Denmark.

The change is partly technically driven A substantial part of the increase in total turnover in the foreign- exchange markets is a result of a higher share of foreign-exchange instruments with relatively short maturities. When contracts are renewed more often, this contributes to increasing turnover. Even a small reduction of the average maturity can generate considerable growth in turnover. The maturity of traditional foreign-exchange transactions was generally lower in the 2007 survey than in the two preceding surveys. Chart 4 shows the maturity distribution for FX swaps, which account for the largest share in value terms of turnover in the Danish foreign-

1 See e.g. Natorp and Sørensen (2006).

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DANISH BANKS' TURNOVER IN FX SWAPS BROKEN DOWN BY ORIGINAL MATURITY Chart 4

Per cent 100

0 2001 2004 2007 7 days or less Over 7 days and up to one year Over one year exchange market. As the Chart shows, there has been a shift towards FX swaps with shorter maturities1. This shift coincides with a steepening of the yield curve, cf. Chart 5. Larger yield spreads between maturities may have contributed to higher turnover in short-term transactions. Fluctuations in the volatility in the foreign-exchange market and credit-line issues may also have affected the choice of maturity. A small part of the increase in turnover in the foreign-exchange markets may also be attributable to the weakening of the dollar in the period 2004-07, as turnover is stated in dollars. However, even after adjustment for the development in the dollar rate, growth rates are still considerable, at 96 per cent in Denmark and 65 per cent globally.

A sustained overall upswing and increased internationalisation also play a role The strong growth in turnover in the foreign-exchange markets should also be viewed against the backdrop of a sustained overall upswing in the global economy in recent years with high GDP growth, increasing international trade and rising stock markets. Foreign-exchange trading may also have been boosted by technological advances and new players such as hedge funds, as well as relatively low interest rate levels, which have made leveraged buyouts attractive.

1 A similar development in FX swaps is seen in the global survey and for forward transactions in the Danish survey.

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YIELD CURVES FOR THE DANISH MONEY MARKET IN APRIL 2004 AND APRIL 2007 Chart 5

Per cent Per cent 2.50 4.50

2.45 4.45

2.40 4.40

2.35 4.35

2.30 4.30

2.25 4.25

2.20 4.20

2.15 4.15

2.10 4.10

2.05 4.05

2.00 4.00 1 week 2 weeks 1 month 2 months 3 months 4 months 5 months 6 months 9 months 12 months

April 2004 (left-hand axis) April 2007 (right-hand axis)

Note: Average Cibor rates have been applied. For April 2004, an ordinary uncollateralised money-market rate has, however, been applied to the two shortest maturities as Cibor was not quoted for these maturities in 2004. Source: Danmarks Nationalbank.

Increasing globalisation also affects turnover in the foreign-exchange markets. In Denmark's case, external assets and liabilities have increased substantially in recent years, both in absolute terms and as a ratio of GDP, cf. Chart 6.

DENMARK'S EXTERNAL ASSETS AND LIABILITIES Chart 6

Kr. billion Per cent 3,500 240

3,000 220

2,500 200

2,000 180

1,500 160

1,000 140

500 120

0 100 1999 2000 2001 2002 2003 2004 2005 2006 External assets External liabilities External assets as a ratio of GDP (right-hand axis) Source: Denmark's external assets and liabilities, Danmarks Nationalbank. Statistics Denmark.

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The development in Denmark's external assets and liabilities reflects, among other things, increasing cross-border investments. Business enterprises seek to gain an advantage by setting up in export markets or to reduce their costs by relocating some of their activities abroad. This is reflected in direct investments. Danish outward direct investments and direct investments into Denmark have both risen considerably over the last three years. Danish outward direct investments as a ratio of GDP rose from just over 30 per cent at the end of 2003 to around 45 per cent at the end of 2006. A similar trend has been registered in direct investments into Denmark. 1 International diversification is also seen within portfolio investments. According to BIS (2007), large institutional investors with long investment horizons tend to invest in more internationally diversified portfolios, which may have contributed to the rise in global foreign- exchange trading. To some extent, this also applies to Danish institutional investors, since they have increased their aggregate portfolios of external assets from approximately kr. 770 billion at end-2004 to almost kr. 1,180 billion in the 1st quarter of 2007. This development is primarily attributable to investment associations2, but in recent years the Danish insurance and pension sector has also increased its portfolios of securities denominated in foreign currency3.

Currency breakdown of foreign-exchange turnover A currency breakdown of the Danish foreign-exchange market shows that it is increasingly dominated by the euro. In the 2007 survey, 46 per cent of turnover in the Danish foreign-exchange market had one leg in euro, compared with 38 per cent in 20044. At the global level, the euro's share remains unchanged at around 37 per cent, cf. Table 2. The rising importance of the euro in the Danish foreign-exchange market is e.g. attributable to confidence in Denmark's fixed-exchange-rate policy and the fact that the fluctuations of the krone around its central rate have diminished since the 2004 survey. This may have affected the business enterprises' choice of invoicing currency. Furthermore, investment associations, among

1 Total direct investments into and from OECD countries almost doubled from 2003 to 2006, cf. OECD (2007). 2 The Danish investment associations' assets denominated in foreign currency have risen from just under kr. 300 billion at end-2004 to more than kr. 500 billion in the 1st quarter of 2007, when external assets accounted for 54 per cent of the investment associations' total assets, cf. Balance-sheet statistics for investment associations, Danmarks Nationalbank. 3 The Danish insurance and pension sector increased its holdings of securities denominated in foreign currency from just over kr. 400 billion at the beginning of 2005 to approximately kr. 480 billion in April 2007, cf. Securities statistics, Danmarks Nationalbank. 4 Note that there are two legs to a foreign-exchange transaction, each of which is included in the turnover, which thus adds up to 200 per cent.

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TURNOVER IN THE FOREIGN-EXCHANGE MARKET BROKEN DOWN BY CURRENCY Table 2

Turnover involving foreign exchange (percentage) 2001 2004 2007

Denmark Dollars ...... 84 84 75 Euro ...... 34 38 46 Danish kroner ...... 34 28 28 Other ...... 48 50 51 Globally Dollars ...... 90 89 86 Euro ...... 38 37 37 Danish kroner ...... 1 1 1 Other ...... 71 73 76

Note: The total foreign-exchange turnover adds up to 200 per cent as all trades are registered twice – once for each currency leg. others, have restructured their portfolios in favour of euro-denominated securities1. Market participants also point to portfolio restructuring in the pension sector as a factor behind the rising share of the euro in the Danish foreign-exchange market. In spite of the increasing importance of the euro in the Danish market, the dollar remains the dominant currency, in Denmark and globally. The dollar's share of total foreign-exchange turnover has been declining, but globally 86 per cent of all foreign-exchange transactions still had one leg in dollars in April 2007, while the equivalent figure for Denmark was 75 per cent. The dominance of the dollar in the foreign-exchange market reflects the fact that many currency pairs are traded with the dollar as an intermediary currency. In the Danish market, 28 per cent of the foreign-exchange turnover in April 2007 had one leg in kroner. This was unchanged compared with 2004.

THE OTC MARKET FOR FOREIGN-EXCHANGE AND INTEREST-RATE DERIVATIVES

Foreign-exchange derivatives Average daily turnover in the Danish OTC foreign-exchange derivatives market (currency swaps and options) has risen by 75 per cent in relation to 2004, cf. Table 3, and thus somewhat less than the traditional foreign- exchange market. With average daily turnover of 2.1 billion dollars per banking day, the market remains very limited in size. Globally, the foreign-exchange derivatives market has increased by 111 per cent in

1 At the end of the 2nd quarter of 2007, assets in euro constituted 15 per cent of the assets held by Danish investment associations, compared with 10 per cent in the 1st quarter of 2004.

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TURNOVER IN THE OTC DERIVATIVES MARKET IN APRIL BROKEN DOWN BY INSTRUMENT TYPE Table 3

Denmark Globally

Billion dollars per banking day 2001 2004 2007 2001 2004 2007

Currency swaps ...... 0.1 0.2 0.7 7 21 80 Currency options (OTC) ...... 0.4 1.0 1.4 60 117 212

Foreign-exchange derivatives, total 0.5 1.2 2.1 67 140 291

Forward rate agreements (FRAs) 4.1 2.9 3.7 129 233 258 Interest-rate swaps ...... 1.5 7.2 4.9 331 621 1,210 Interest-rate options (OTC) ...... 0.2 0.7 1.4 29 171 215

Interest-rate derivatives, total ...... 5.8 10.8 10.0 489 1,025 1,686

OTC derivatives, total ...... 6.3 12.0 12.1 575 1,220 2,090

Note: "OTC derivatives, total" for global turnover does not match the sum of the individual transaction types as the total includes an estimate of unreported transactions.

terms of average daily turnover, i.e. a higher growth rate than the traditional foreign-exchange market. In both the Danish and the global survey, currency options account for three quarters of the foreign-exchange derivatives market, but the highest growth rates are seen for currency swaps, which have more than trebled since 2004. According to BIS (2007), the high global growth is partly attributable to hedging in connection with bond issuance in foreign currency1. Similar conditions may apply in the Danish market, where issuance abroad by Danish residents more or less doubled from the 1st quarter of 2004 to the 1st quarter of 20072. Danish market participants also indicate that currency swaps are increasingly used by banks for long-term financing in foreign exchange, which is in line with the fact that growth in currency swaps in Denmark is primarily attributable to reporting dealers and to a lesser extent to other financial institutions. Non-financial customers, on the other hand, constitute a negligible share. For currency options, the entire increase is attributable to other financial institutions and non-financial customers, while trading between reporting dealers has declined. According to the market participants, this reflects the increasing use of foreign-exchange derivatives in risk management and portfolio management.

1 In April 2007, large volumes of bonds denominated in dollars were issued by non-residents, some of which may have been hedging their commitments in the swap market, cf. BIS (2007). 2 Cf. Securities statistics, Danmarks Nationalbank.

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Interest-rate derivatives At 10 billion dollars per banking day, OTC trade in interest-rate derivatives by way of forward rate agreements (FRAs), interest-rate swaps and interest-rate options in the Danish market is by and large unchanged compared with 2004. These figures mask opposite trends for the various instruments, since turnover in FRAs and interest-rate options has risen while a decline has been registered for interest-rate swaps. The latter decline – primarily in trading between reporting dealers – is to a small extent attributable to geographical relocation of a reporting dealer's trading desk so that part of its trade is no longer registered as turnover in Denmark. Otherwise, the development should presumably mainly be viewed in the light of unusually high growth in turnover in the 2004 survey. Non-financial customers account for the largest share of the increasing turnover in the other two interest-rate derivative instruments. The global survey shows higher turnover in interest-rate derivatives for all three counterparty categories. Total turnover in interest-rate derivatives averaged 1,686 billion dollars per banking day in April 2007, an increase of 64 per cent over 2004.

GEOGRAPHICAL DISTRIBUTION OF TURNOVER IN FOREIGN EXCHANGE AND DERIVATIVES

As the preceding surveys also showed, trade in foreign-exchange and OTC derivatives is still concentrated in the UK. Turnover in the UK accounts for 34 per cent of total turnover in the foreign-exchange market and 42 per cent of turnover in the OTC derivatives market, cf. Table 4. The USA and the euro area are the second and third largest markets. Denmark's share of the global foreign-exchange market increased from 1.7 per cent in 2004 to 2.2 per cent in 2007. The Danish market for OTC derivatives is, however, more limited, particularly when it is taken into account that other countries often have a substantial organised derivatives market alongside the OTC market. The limited size of the Danish OTC derivatives market may, for example, reflect that large institutional investors trade derivatives with foreign banks, so that their turnover is excluded from the Danish part of the survey.

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TURNOVER PER BANKING DAY IN APRIL 2007 IN THE LARGEST 20 MARKETS Table 4

OTC derivatives turnover Foreign-exchange turnover (foreign-exchange and interest-rate derivatives)

Billion dollars Percentage Billion dollars Percentage

UK ...... 1,359 34.1 UK ...... 1,081 42.5 USA ...... 664 16.6 USA ...... 607 23.8 Euro area ...... 431 10.8 Euro area ...... 478 18.8 Of which: Of which: France ...... 120 3.0 France ...... 183 7.2 Germany ...... 99 2.5 Germany ...... 93 3.7 Belgium ...... 48 1.2 Ireland ...... 85 3.4 Luxembourg ...... 43 1.1 Italy ...... 32 1.3 Italy ...... 36 0.9 Netherlands ...... 28 1.1 Netherlands ...... 24 0.6 Belgium ...... 23 0.9 Switzerland ...... 242 6.1 Spain ...... 18 0.7 Japan ...... 238 6.0 Japan ...... 88 3.5 Singapore ...... 231 5.8 Switzerland ...... 73 2.9 Hong Kong SAR ... 175 4.4 Singapore ...... 69 2.7 Australia ...... 170 4.2 Australia ...... 29 1.2 Denmark ...... 86 2.2 Canada ...... 25 1.0 Canada ...... 60 1.5 Hong Kong SAR ... 24 0.9 Russia ...... 50 1.3 Sweden ...... 14 0.6 Sweden ...... 42 1.1 Denmark ...... 12 0.5 India ...... 34 0.9 India ...... 8 0.3 Korea ...... 33 0.8 Norway ...... 7 0.3 Norway ...... 32 0.8 Korea ...... 7 0.3

Source: BIS (2007).

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LITERATURE

BIS (2007), Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2007, September.

Danmarks Nationalbank (2007), Survey of the Danish foreign-exchange and derivatives market turnover in April 2007, Financial statistics, Special statement, 25 September.

Natorp, Lone, and Tina Skotte Sørensen (2006), Settlement of Foreign- Exchange Transactions, Danmarks Nationalbank, Monetary Review, 4th Quarter.

OECD (2007), Trends and recent developments in foreign direct investment, June.

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Speech by Nils Bernstein at the Annual Meeting of the Danish Bankers Association on 5 December 2007

For some years, the global financial system has been characterised by high growth and increasing business volumes. There has been considerable innovation, many new products and business concepts have emerged. Earnings have been high. The largest global banks' return on equity has been steadily increasing for a number of years and exceeded 20 per cent on average in the 1st half of 2007. A sudden setback came over a few days in the summer. For a while the US housing market had been regarded as vulnerable. Losses on subprime mortgages were increasing, but this market was not assessed to be sufficiently large to have an impact on global financial stability. Moreover, the launch of new financial instruments seemed to have helped to spread the subprime risk among many different investors. This assessment proved to be wrong. Via structured credit products, investment vehicles had invested in subprime mortgages. To finance these investments, they had issued short-term securities. It turned out that large banks were closely linked to these investment vehicles via liquidity lines and/or ownership. Conse- quently, it was also difficult to assess the banks' potential losses on subprime mortgages, and uncertainty arose as to who ultimately bore the subprime risk. In next to no time, some of the most liquid markets with the highest ratings came to a standstill and it became difficult to issue short-term securities guaranteed by gilt-edged banks. Throughout most of the world, banks concentrated on securing their own liquidity and were hesitant to lend excess liquidity to other banks – especially if the maturities exceeded a few days. Two German banks experienced difficulties as a result of exposures to investment vehicles. One UK bank was brought to its knees, not by subprime mortgages, but because its business model was based on regular access to financing in the financial and money markets. We even saw the unusual sight of depositors queuing outside a bank to withdraw their deposits! This marked the beginning of the liquidity crisis that has – to varying degrees – characterised the financial and money markets in large parts of the world since July. Over the last four months, the central banks in

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130 the USA, the euro area and the UK have regularly provided collateralised liquidity to the market in order to stabilise short-term interest rates and smoothe the functioning of the money market. There is still considerable uncertainty regarding the size of the losses and the future development. Now and then new skeletons rattle out of the closets as banks announce further subprime losses. Share prices have dropped for banks exposed to subprime mortgages. In the financial markets, there are fears that the losses will spread to other segments of the US mortgage market. Consequently, the spread between uncollat eralised and collateralised money-market interest rates at long maturities remains unusually wide in many countries. Finally, the liquidity crisis has led many euro area and US banks to tighten their credit terms for several customer groups. What are the consequences of the financial turmoil for Denmark? I will focus on two issues. Firstly, how has the development affected the Danish financial system? And secondly, what is the cyclical impact of the turmoil? At the very short end of the money market, the international financial turmoil has not reduced the Danish banks' readiness to lend kroner to each other. There are indications of a certain increase in precautionary liquidity, but there have been no signs of tension in the short end of the money market, and Danmarks Nationalbank has not had to conduct extraordinary open market operations in this connection. Danmarks Nationalbank's normal open market operations take place via a so-called open window. The demand for loans and certificates of deposit is met at the rate of interest determined by Danmarks National- bank. In other words, the counterparties have a fairly wide scope for structuring their liquidity vis-à-vis Danmarks Nationalbank. The development in the banks' and mortgage-credit institutes' accounts with Danmarks Nationalbank does not indicate any substantial increase in precautionary liquidity via this channel. Longer-term uncollateralised money-market interest rates in kroner have increased due to the international turmoil. The fluctuations in the spread between uncollateralised and collateralised money-market interest rates have, however, been less pronounced in Denmark than in the euro area and especially the USA. Even in normal circumstances the turnover in this segment of the Danish money market is relatively limited, but naturally the higher interest rates have affected the numerous financial products linked to CIBOR and similar interest rates. From time to time, Danish banks have had difficulties in raising dollar- denominated loans. This is not an isolated Danish phenomenon; banks in other European countries have experienced the same difficulties. Dan-

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131 marks Nationalbank cannot provide liquidity facilities to cover borrowing requirements in foreign exchange since its role is primarily linked to krone-denominated liquidity. Banks with large business volumes in foreign exchange must themselves ensure adequate contingency funding plans in the relevant currencies. Overall, the Danish money market has navigated fairly successfully through these rough waters, which ultimately shows that the Danish financial system is in good shape. Nevertheless, Denmark has been affected by the international turmoil. Financial statements for the 3rd quarter showed that Danish banks were also exposed to investment vehicles, liquidity lines and structured credit products. The exposures and losses were, however, relatively small in size. Lending by Danish banks has increased substantially in recent years, and some have seen growth rates in excess of 30 per cent. Earnings have been high and losses low. Particularly mortgage loans to homeowners have grown significantly. Growth in lending has been so strong that a large deposit-loan gap of more than kr. 400 billion has accumulated. This is the amount by which the banks' lending exceeds the deposits from customers. Consequently, the Danish banks have to rely on the financial and money markets as sources of financing. Developments abroad over the summer have shown that it can be risky to base one's business on such financing. The price of market financing may change rapidly, and the markets may "dry up". The international liquidity crisis has provided an opportunity to test the contingency funding plans and review the business strategy in the light of the findings. It is not as easy as it used to be for the Danish banks to finance their growth via the financial and money markets. Financing has become more expensive, and the rising costs of financing will undoubtedly be reflected in the banks' earnings and the prices charged to customers. Growth in lending remains high, but declining. Some banks have adopted a less aggressive business strategy and put their expansion plans on hold. Others have expressed intentions to reduce their commitments to international investment vehicles, liquidity lines and structured credit products due to reputational risk. Developments have shown that strategies based on double-digit growth rates cannot simply be extended. The strong growth in lending to the corporate sector entails a greater risk of losses to the banks. This risk is rising, but from a very low level. Unpleasant surprises can never be ruled out, but the economy is still favourable. And the financial statements for the 3rd quarter also showed that the banks' earnings remain high. Solvency is generally

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132 sound, and writedowns are low. Viewed in that perspective, Danmarks Nationalbank is currently of the opinion that the international turmoil may serve as a "useful" wake-up call for the Danish banks. The necessary adaptations to the changing circumstances can be made in a timely manner without any serious costs to the large majority of the banks or to the economy as a whole. What is the cyclical impact of the turmoil? Growth in the global economy has been unusually high in recent years. However, the turmoil in the financial markets has given rise to concern about the future development. Growth has declined in the USA, although the crisis in the US mortgage market and the derived financial turmoil has not yet been fully reflected in the rest of the economy. So far, the upswing is set to continue in Europe and Asia, and the outlook is also positive for Africa and Latin America. Oil prices have risen strongly in recent months and have put a damper on growth prospects while also adding to inflationary pressures. Until now, the international organisations have reduced their growth forecasts only moderately – except in respect of the USA, where growth in 2008 is now predicted to be less than 2 per cent – but no recession is foreseen. Clear concerns are expressed as to whether the uncertainty linked to the financial markets and the downturn in the housing market – not only in the USA – will spread to the rest of the economy, thereby further curbing growth in the USA and also affecting Europe. In a Danish perspective, the outlook for the export markets remains positive, but with a downward trend. Denmark is still in a strong boom with a hot labour market and cap acity pressures on large parts of the economy. The rate of unemployment remains surprisingly low. The tight labour market means that the capacity pressure will remain high, although growth in demand is expected to moderate somewhat. This pressure has led to a surge in imports and in recent quarters also to a higher rate of wage increase and higher domestic price pressure, reflecting the fact that wages and prices normally react to cyclical developments with a substantial time lag. A potential setback may therefore be prolonged if the cost level at the outset is too high compared with abroad. The high temperature in the economy at the moment entails a major risk that this will be the case. On account of the fixed-exchange-rate policy, interest rates in Den- mark are aligned with those of the euro area, which is not as far into the economic cycle as Denmark is. Contrary to expectations, interest

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133 rates have not risen recently. This is due to the turmoil in the financial markets. In this situation it would be somewhat remarkable if the Danish government still proposes an expansionary fiscal policy in 2008. When preparing the new Finance Bill for 2008, the government should reassess its fiscal policy with a view to easing the pressure on the economy. Omit- ting to do so may entail tougher requirements at a later stage. Next spring will bring collective bargaining within the public sector. Among public-sector employees there are expectations of sizeable pay rises, supported by recent years' shortage of labour and focus on the quality of public-sector services. Several political parties have spoken in favour of an extraordinary wage boost for large or small groups of public-sector employees via a special pool of funds earmarked for this purpose. I would like to issue a strong warning against making wage bargaining in the public-sector labour market a parliamentary issue at this stage. The risk that the parties will attempt to outdo one another is im- minent, and premature intervention by the politicians prevents genuine bargaining. This could set a very unfortunate precedent. As if that was not enough, next spring will also see collective bargaining in the financial sector. I therefore take this opportunity to point out that the results in this sector may send a signal to the rest of the labour market. Finally, I would like to thank the Danish Bankers Association for our fine cooperation. I look forward to continuing along the same positive lines.

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Press releases

25 SEPTEMBER 2007: TURNOVER IN THE DANISH FOREIGN-EXCHANGE MARKET HAS DOUBLED SINCE 2004

According to a survey conducted by Danmarks Nationalbank, turnover in the Danish foreign-exchange market more than doubled from April 2004 to April 2007, reaching 86 billion dollars per day. Trade in foreign-exchange derivatives has also increased substantially, while trade in interest-rate derivatives has fallen back slightly after a significant increase in 2004. While foreign-exchange transactions are increasingly denominated in euro, the US dollar remains the most frequently traded currency. FX swaps still account for the vast majority of transactions in the foreign-exchange market. For all instrument types, turnover has increased since 2004. The survey forms part of a triennial international survey of foreign- exchange and derivatives market activity conducted under the auspices of the Bank for International Settlements (BIS). The Danish figures are collected from six banks that account for more than 95 per cent of the turnover in the instruments covered by the survey. Further information about the survey can be found in a special publication at Danmarks Nationalbank's website www.nationalbanken.dk under Statistics, Download statistics – Publications.

1 OCTOBER 2007: DANMARKS NATIONALBANK'S DATA MOVES TO STATISTICS DENMARK

From now on, users of Danmarks Nationalbank's and Statistics Den- mark's economic and financial statistics need only visit one website. Danmarks Nationalbank's data will be transferred to statistikbanken.dk. The purpose is to facilitate access to all economic and financial statistics. In addition, StatBank Denmark functionality can be applied to Danmarks Nationalbank's tables. For example, users of the economic and financial time series will be able to download series directly from StatBank Denmark – including data from both Danmarks National- bank and Statistics Denmark.

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Governor Torben Nielsen emphazises the economic perspective, "In recent years we have expanded our financial statistics substantially and it has become increasingly important for us to ensure that users have easy and coherent access to detailed data. The transfer to sta-tistikbanken.dk is the right solution – also from an economic point of view." National Statistician Jan Plovsing is pleased on behalf of the users, "I am pleased that users of statistikbanken.dk will have access to a broader range of statistical data in the same system as all the official statistics compiled by Statistics Denmark. In future, statistikbanken.dk will comprise nearly all statistics on the Danish economy, so that users can get a general overview of economic developments in Denmark." Danmarks Nationalbank's tables will be available under the following subjects: statistikbanken.dk/14, statistikbanken.dk/15 and statistik-banken.dk/16. Users who need to access Danmarks Nationalbank's tables only can find them at nationalbanken.statistikbank.dk

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Tables

Interest rates and share-price index ...... 1

Selected items from the Nationalbank's balance sheet ...... 2

Factors affecting the banks' and the mortgage-credit institutes' net position with the Nationalbank...... 3

Selected items from the consolidated balance sheet of the MFI sector 4

Money stock ...... 5

Selected items from the balance sheet of the banks ...... 6

Selected items from the balance sheet of the mortgage-credit institutes...... 7

Lending to residents by the banks and the mortgage-credit institutes. 8

The mortgage-credit institutes' lending broken down by type ...... 9

The banks' effective interest rates...... 10

Selected items from the balance sheet of the investment associations. 11

Securities issued by residents by owner's home country...... 12

Households' financial assets and liabilities ...... 13

Companies' financial assets and liabilities ...... 14

Current account of the balance of payments ...... 15

Financial account of the balance of payments ...... 16

Portfolio investments of the balance of payments ...... 17

Denmark's external assets and liabilities ...... 18

GDP by type of expenditure...... 19

EU-harmonized index of consumer prices (HICP) and underlying inflation (IMI) ...... 20

Selected monthly economic indicators...... 21

Selected quarterly economic indicators...... 22

Exchange rates ...... 23

Effective krone rate ...... 24

Danmarks Nationalbank's Statistical Publications

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Symbols and Sources

0 Magnitude nil or less than one half of unit employed.

… Data not available or of negligible interest.

Some of the most recent statistics may be provisional. Due to rounding- off there may be small differences between the sum of the individual figures and the totals stated.

Date of going to press: 14 January 2008.

The Tables section of this publication is thus based on more recent information than the equivalent section of the Danish edition.

Danmarks Nationalbank is the source for Tables 1-14, 16-18 and 23-24, while the Copenhagen Stock Exchange is the source for series of bond yields and the share-price index in Table 1. Statistics Denmark is the source for Tables 15 and 19-22. The calculations in Tables 20 and 24 have been made by Danmarks Nationalbank on the basis of data from Statis- tics Denmark and OECD.

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INTEREST RATES AND SHARE-PRICE INDEX Table 1

The Nationalbank's interest rates Bond yields

Inter-bank Lending interest 10-year 30-year Share- and rate, central- mort- price certifi- The ECB's 3-months govern- gage- index Discount cates of minimum uncollat- ment credit OMXC20 rate deposit bid rate eralized bond bond (prev.KFX) Effective end-of-year/ 3.7.89 from Per cent per annum End of period Per cent per annum =100

2003 ...... 2.00 2.15 2.00 2003 ...... 2.16 4.46 5.45 244.35 2004 ...... 2.00 2.15 2.00 2004 ...... 2.16 3.87 5.07 286.66 2005 ...... 2.25 2.40 2.25 2005 ...... 2.46 3.30 4.39 393.52 2006 ...... 3.50 3.75 3.50 2006 ...... 3.81 3.95 5.24 441.48 2007 ...... 4.00 4.25 4.00 2007 ...... 4.65 4.48 5.61 464.14 2006 6 Oct ... 3.25 3.50 3.25 Jun 07 ..... 4.31 4.61 5.63 483.69 8 Dec .. 3.50 3.75 3.50 Jul 07 .....4.37 4.42 5.59 499.66 2007 9 Mar .. 3.75 4.00 3.75 Aug 07 ..... 4.60 4.37 5.54 496.30 7 Jun ... 4.00 4.25 4.00 Sep 07 ..... 4.65 4.51 5.56 499.93 Oct 07 ..... 4.61 4.31 5.48 507.92 Nov 07 ..... 4.65 4.18 5.49 471.76 2008 14 Jan .. 4.00 4.25 4.00 Dec 07 ..... 4.65 4.48 5.61 464.14

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SELECTED ITEMS FROM THE NATIONALBANK'S BALANCE SHEET Table 2

The banks' and the mortgage-credit The institutes' net position with the central Nationalbank govern- The ment's foreign- Notes and account exchange coin in with the Certifi- Deposits reserve circula- National- cates of (current Total net (net) tion bank deposit account) Loans position

End of period Kr. billion

2002 ...... 193.2 47.7 50.3 160.7 10.1 81.2 89.6 2003 ...... 224.2 49.7 44.0 157.3 12.9 48.0 122.2 2004 ...... 217.6 52.0 60.8 160.4 6.9 72.6 94.6 2005 ...... 212.3 56.2 56.4 207.6 12.8 135.3 85.1 2006 ...... 171.7 59.8 73.8 163.2 8.8 153.7 18.2 Jul 07 ...... 184.3 59.7 35.3 153.4 21.0 103.0 71.5 Aug 07 ...... 194.1 59.1 61.8 197.1 4.7 147.7 54.1 Sep 07 ...... 184.7 58.8 70.4 185.2 7.6 155.4 37.4 Oct 07 ...... 181.6 58.7 69.3 167.5 22.5 154.4 35.5 Nov 07 ...... 179.2 59.4 102.7 153.3 10.7 168.1 -4.1 Dec 07 ...... 166.8 61.6 87.1 200.5 9.4 216.8 -6.9

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FACTORS AFFECTING THE BANKS' AND THE MORTGAGE-CREDIT INSTITUTES' NET POSITION WITH THE NATIONALBANK Table 3

The banks' and the mortgage-credit institutes' net position with the Central-government finance Nationalbank Net purchase Sales of of The Domestic domestic foreign National- gross central- exchange bank's financing govern- by the net Change in requirement Liquidity National- bond Other net End of ment securities effect bank purchases factors position period

Kr. billion

2003 ...... 99.7 94.1 5.6 31.0 -1.0 -3.1 32.5 122.2 2004 ...... 75.5 92.6 -17.1 -6.4 -2.6 -1.2 -27.3 94.6 2005 ...... 39.5 30.9 8.6 -15.4 -2.2 -0.5 -9.5 85.1 2006 ...... -14.5 16.2 -30.6 -30.0 -4.9 -1.2 -66.7 18.2 2007 ...... -26.2 2.9 -29.1 5.5 -0.4 -1.4 -25.3 ... Jul 07 ...... 27.6 3.5 24.1 6.2 0.1 -0.1 30.2 71.5 Aug 07 ...... -30.8 -4.3 -26.5 9.8 -0.1 -0.5 -17.4 54.1 Sep 07 ...... -6.2 3.8 -10.0 -8.4 0.8 0.9 -16.7 37.4 Oct 07 ...... 3.8 5.6 -1.8 -0.1 0.4 -0.3 -1.9 35.5 Nov 07 ...... -30.2 5.2 -35.4 -1.0 -2.5 -0.7 -39.6 -4.1 Dec 07 ...... 7.2 -7.8 15.0 -12.0 -3.2 -2.7 -2.8 -6.9

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SELECTED ITEMS FROM THE CONSOLIDATED BALANCE SHEET OF THE MFI SECTOR Table 4

Assets Liabilities

Domestic Domestic lending securities

Foreign Total Public Private Bonds, Shares, Domestic Bonds, assets, balance sector sector etc. etc. deposits etc. issued net 1

End of period Kr. billion

2002 ...... 3,198.5 79.9 1,944.6 142.8 36.5 723.3 1,125.9 -66.8 2003 ...... 3,359.0 89.6 2,062.0 123.3 43.3 754.7 1,157.9 -70.7 2004 ...... 3,684.5 97.5 2,246.2 100.8 46.3 848.9 1,222.1 -65.7 2005 ...... 4,228.2 107.8 2,584.2 75.9 53.5 971.3 1,318.2 -172.9 2006 ...... 4,682.1 116.8 2,956.0 51.8 60.3 1,077.0 1,433.7 -222.8 Jun 07 ...... 5,077.6 118.2 3,143.0 43.2 63.7 1,140.5 1,451.9 -259.4 Jul 07 ...... 5,081.1 117.1 3,142.9 44.9 62.4 1,154.2 1,472.6 -245.2 Aug 07 ...... 5,149.5 115.9 3,172.7 56.0 62.4 1,179.8 1,469.2 -288.5 Sep 07 ...... 5,282.5 115.1 3,220.2 52.9 63.3 1,182.8 1,480.7 -256.9 Oct 07 ...... 5,321.3 117.9 3,235.3 54.3 65.0 1,201.2 1,485.8 -285.1 Nov 07 ...... 5,422.3 117.7 3,281.5 39.4 63.4 1,240.0 1,484.6 -285.0

Change compared with previous year, per cent 2002 ...... 6.6 5.1 7.3 -1.4 5.4 7.4 ... 2003 ...... 12.1 6.0 -13.7 18.6 4.3 2.8 ... 2004 ...... 8.8 8.9 -18.2 7.0 12.5 5.5 ... 2005 ...... 10.6 15.0 -24.7 15.4 14.4 7.9 ... 2006 ...... 8.3 14.4 -31.8 12.8 10.9 8.8 ... Jun 07 ...... 2.5 13.0 -22.9 15.6 11.4 8.9 ... Jul 07 ...... 2.7 12.7 -29.3 14.0 11.7 8.6 ... Aug 07 ...... 3.8 12.5 1.9 12.4 12.6 7.9 ... Sep 07 ...... 3.0 12.8 -14.6 11.5 12.5 7.2 ... Oct 07 ...... 4.2 12.5 -7.5 11.0 11.8 7.6 ... Nov 07 ...... 1.6 12.3 -5.0 8.2 13.2 7.2 ...

Note: The MFI sector includes Danish monetary financial institutions, i.e. banks and mortgage-credit institutes, other credit institutions, money-market funds and Danmarks Nationalbank. 1 The net foreign assets of the MFI sector has been compiled as the difference between all assets and liabilities vis-a-vis non-residents.

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MONEY STOCK Table 5

Bonds, Time Deposits etc. Bank- deposits at notice issued notes with with with and original original Repur- orginal coin in Deposits maturity maturity chase maturity circula- on =<2 =< 3 agree- =< 2 tion1 demand M1 years months M2 ments years M3

End of period Kr. billion

2002 ...... 39.0 399.1 438.1 102.7 18.5 559.3 6.6 45.2 611.2 2003 ...... 41.0 428.1 469.1 112.2 19.2 600.5 2.7 77.3 680.5 2004 ...... 43.7 492.8 536.5 119.2 21.0 676.7 2.0 20.2 699.0 2005 ...... 47.3 596.3 643.5 114.1 18.4 776.0 14.2 8.4 798.7 2006 ...... 50.7 648.6 699.3 143.0 17.9 860.2 8.0 21.3 889.5 Jun 07 ...... 51.1 696.5 747.6 168.4 16.6 932.6 7.0 27.1 966.9 Jul 07 ...... 50.6 715.1 765.7 187.3 16.3 969.4 8.1 28.0 1,005.7 Aug 07 ...... 50.9 698.3 749.2 201.1 16.2 966.5 11.7 27.7 1,006.1 Sep 07 ...... 50.3 692.3 742.6 198.1 17.5 958.3 9.7 27.0 995.1 Oct 07 ...... 50.1 696.0 746.0 211.8 17.3 975.1 11.0 24.1 1,010.3 Nov 07 ...... 51.4 697.0 748.3 214.1 17.7 980.1 12.1 20.9 1,013.3

Change compared with previous year, per cent 2002 ...... 3.9 ...... 4.6 ...... 11.8 2003 ...... 8.8 ...... 8.8 ...... 11.3 2004 ...... 14.4 ...... 12.7 ...... 2.7 2005 ...... 19.9 ...... 14.7 ...... 14.3 2006 ...... 8.7 ...... 10.8 ...... 11.4 Jun 07 ...... 8.8 ...... 11.0 ...... 12.5 Jul 07 ...... 10.8 ...... 13.2 ...... 14.8 Aug 07 ...... 10.5 ...... 13.6 ...... 15.6 Sep 07 ...... 10.1 ...... 13.8 ...... 14.9 Oct 07 ...... 9.5 ...... 13.0 ...... 13.5 Nov 07 ...... 9.3 ...... 13.2 ...... 13.9

1 Notes and coin in circulation, excluding the banks' holdings.

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SELECTED ITEMS FROM THE BALANCE SHEET OF THE BANKS Table 6

Assets Liabilities

Domestic lending

of which:

Non- financial Holdings Total Lending House- compa- of Loans balance to MFIs Total holds, etc. nies securities from MFIs Deposits

End of period Kr. billion

2002 ...... 2,040.1 419.8 599.2 253.5 231.3 620.9 685.6 764.7 2003 ...... 2,204.4 468.7 662.9 271.5 285.7 764.4 823.8 795.1 2004 ...... 2,418.4 495.6 754.8 324.8 309.6 780.3 823.1 908.0 2005 ...... 2,867.3 652.0 920.1 396.6 370.0 862.1 975.7 1,065.6 2006 ...... 3,242.0 715.0 1,124.3 475.0 458.0 889.6 1,133.8 1,148.3 Jun 07 ...... 3,587.8 825.3 1,222.1 507.9 511.5 943.1 1,187.5 1,264.4 Jul 07 ...... 3,567.0 822.9 1,204.1 509.0 496.4 940.0 1,118.3 1,306.7 Aug 07 ...... 3,663.9 787.9 1,216.2 513.0 508.3 1,023.4 1,208.0 1,297.8 Sep 07 ...... 3,790.4 870.0 1,249.1 527.4 517.4 1,010.5 1,279.3 1,307.7 Oct 07 ...... 3,810.6 885.7 1,250.2 527.3 513.4 1,025.9 1,292.8 1,324.1 Nov 07 ...... 3,893.2 902.9 1,280.7 533.8 532.7 1,026.6 1,335.1 1,334.3

Change compared with previous year, per cent 2002 ...... 18.9 1.9 0.1 1.1 7.2 9.3 6.5 2003 ...... 10.7 2.5 7.1 3.1 21.8 18.8 3.9 2004 ...... 5.6 13.8 19.6 8.4 2.1 -0.1 14.2 2005 ...... 31.7 21.9 22.1 19.5 10.5 18.5 17.3 2006 ...... 9.7 22.2 19.8 23.8 3.2 16.2 7.8 Jun 07 ...... 30.5 18.3 18.4 21.7 4.4 13.6 14.7 Jul 07 ...... 26.7 18.0 18.2 19.4 5.8 7.6 18.6 Aug 07 ...... 19.9 17.7 18.0 21.7 18.0 21.2 17.2 Sep 07 ...... 19.7 18.3 17.7 20.2 12.1 14.4 18.4 Oct 07 ...... 30.3 17.8 17.4 19.8 11.9 22.2 17.7 Nov 07 ...... 29.0 16.7 17.4 20.0 9.8 21.3 17.2

Note: Excluding Danish banks' units abroad. As from 2003 the lending is affected by an addition to the group of banks. The calculation of the rate of increase has been amended accordingly.

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SELECTED ITEMS FROM THE BALANCE SHEET OF THE MORTGAGE-CREDIT INSTITUTES Table 7

Assets Liabilities

Domestic lending

of which:

Non- financial Holdings Total Lending House- compa- of Loans Bonds, balance to MFIs Total holds, etc. nies securities from MFIs etc. issued

End of period Kr. billion

2002 ...... 1,721.8 77.3 1,285.1 988.0 259.2 338.5 58.9 1,584.2 2003 ...... 1,863.8 100.9 1,394.6 1,072.1 284.4 342.6 32.6 1,729.0 2004 ...... 2,097.4 91.2 1,489.9 1,141.3 307.9 481.2 26.1 1,952.5 2005 ...... 2,519.9 101.4 1,664.4 1,281.5 334.2 645.0 151.7 2,237.0 2006 ...... 2,699.9 245.1 1,834.8 1,407.7 370.8 574.1 226.5 2,297.9 Jun 07 ...... 2,370.0 248.9 1,920.9 1,469.8 392.5 163.0 209.5 1,933.6 Jul 07 ...... 2,378.4 237.1 1,937.9 1,482.0 397.4 160.1 214.2 1,945.8 Aug 07 ...... 2,419.5 262.1 1,954.4 1,493.1 401.1 152.1 231.9 1,970.1 Sep 07 ...... 2,454.9 288.5 1,967.4 1,500.4 407.4 156.6 244.2 1,985.1 Oct 07 ...... 2,479.6 276.5 1,983.0 1,509.3 414.4 171.5 249.6 2,017.1 Nov 07 ...... 2,523.6 285.9 1,998.2 1,519.8 418.3 177.9 258.2 2,045.7

Change compared with previous year, per cent 2002 ...... -12.5 7.8 8.9 5.0 20.6 6.7 11.5 2003 ...... 30.6 8.5 8.5 9.7 1.2 -44.8 9.1 2004 ...... -9.6 6.8 6.5 8.3 40.4 -19.9 12.9 2005 ...... 11.1 11.7 12.3 8.5 34.0 481.5 14.6 2006 ...... 141.7 10.2 9.9 10.9 -11.0 49.3 2.7 Jun 07 ...... 54.1 9.5 8.9 10.9 2.1 73.4 7.6 Jul 07 ...... 80.0 9.4 8.8 10.4 3.2 76.9 7.0 Aug 07 ...... 69.8 9.4 8.9 10.8 -4.4 72.2 6.7 Sep 07 ...... 63.6 9.3 8.7 11.8 -4.4 76.8 5.8 Oct 07 ...... 64.8 9.4 8.5 12.8 4.1 73.7 7.2 Nov 07 ...... 57.0 9.3 8.3 13.0 -4.8 54.4 6.7

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LENDING TO RESIDENTS BY THE BANKS AND THE MORTGAGE-CREDIT INSTITUTES Table 8

The mortgage-credit insti- Total lending The banks' lending tutes' lending

House- House- House- holds, holds, holds, Total etc. Business Total etc. Business Total etc. Business

End of period Kr. billion

2002 ...... 1,917.0 1,241.6 619.2 631.8 253.5 353.0 1,285.1 988.0 266.2 2003 ...... 2,087.7 1,343.6 683.1 693.2 271.5 392.3 1,394.6 1,072.1 290.9 2004 ...... 2,276.0 1,466.1 741.0 786.0 324.8 426.8 1,489.9 1,141.3 314.2 2005 ...... 2,614.5 1,678.0 852.2 950.2 396.6 510.4 1,664.4 1,281.5 341.7 2006 ...... 3,000.8 1,882.7 1,015.2 1,166.0 475.0 636.9 1,834.8 1,407.7 378.3 Jun 07 ...... 3,177.7 1,977.6 1,095.61,256.8 507.9 695.3 1,920.9 1,469.8 400.3 Jul 07 ...... 3,178.0 1,991.0 1,083.5 1,240.1 509.0 677.6 1,937.9 1,482.0 405.9 Aug 07 ...... 3,206.5 2,006.1 1,096.4 1,252.1 513.0 686.3 1,954.4 1,493.1 410.1 Sep 07 ...... 3,252.4 2,027.8 1,121.0 1,285.0 527.4 705.4 1,967.4 1,500.4 415.5 Oct 07 ...... 3,269.2 2,036.6 1,127.3 1,286.2 527.3 704.4 1,983.0 1,509.3 422.9 Nov 07 ...... 3,314.9 2,053.6 1,155.7 1,316.7 533.8 729.2 1,998.2 1,519.8 426.5 Change compared with previous year, per cent

2002 ...... 5.7 6.9 4.1 1.5 0.1 3.1 7.8 8.9 5.5 2003 ...... 6.1 8.2 2.7 1.5 7.1 -1.7 8.5 8.5 9.3 2004 ...... 9.0 9.1 8.5 13.4 19.6 8.8 6.8 6.5 8.0 2005 ...... 14.9 14.5 15.0 20.9 22.1 19.6 11.7 12.3 8.8 2006 ...... 14.8 12.2 19.1 22.7 19.8 24.8 10.2 9.9 10.7 Jun 07 ...... 12.8 11.2 16.0 18.1 18.4 19.2 9.5 8.9 10.7 Jul 07 ...... 12.5 11.1 15.2 17.6 18.2 18.3 9.4 8.8 10.4 Aug 07 ...... 12.4 11.1 15.1 17.4 18.0 17.7 9.4 8.9 10.9 Sep 07 ...... 12.6 10.9 16.3 18.0 17.7 19.1 9.3 8.7 11.8 Oct 07 ...... 12.1 10.7 15.1 16.6 17.4 16.6 9.4 8.5 12.8 Nov 07 ...... 11.7 10.6 14.5 15.6 17.4 15.4 9.3 8.3 12.9

Note: Including lending in Danish banks' units abroad. As from 2003 the banks' lending is affected by an addition to the group of banks. The calculation of the rate of increase has been amended accordingly.

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THE MORTGAGE-CREDIT INSTITUTES' LENDING BROKEN DOWN BY TYPE Table 9

Adjustable-rate lending of which:

Index- Lending Instal- linked Fixed-rate of which in foreign ment-free lending lending Total =<1 year Total currency lending1

End of period Kr. billion

2002 ...... 103.6 816.0 365.0 200.4 1,284.6 82.5 ... 2003 ...... 99.5 795.0 499.0 250.0 1,393.5 85.7 44.4 2004 ...... 94.6 733.9 659.8 382.2 1,488.4 84.9 170.5 2005 ...... 88.6 735.9 838.3 600.5 1,662.8 80.5 315.5 2006 ...... 83.5 838.4 910.8 679.6 1,832.7 85.7 432.2 Jun 07 ...... 81.7 957.5 879.3 645.7 1,918.6 96.8 486.4 Jul 07 ...... 81.6 1,029.6 824.0 589.2 1,935.2 99.8 498.2 Aug 07 ...... 81.6 1,041.3 828.7 592.2 1,951.6 102.6 507.9 Sep 07 ...... 81.6 1,048.1 834.7 595.6 1,964.4 105.9 516.7 Oct 07 ...... 81.5 1,058.9 839.7 597.7 1,980.1 108.0 526.1 Nov 07 ...... 80.7 1,069.0 845.6 592.5 1,995.4 111.7 535.4

Note: The Table includes the mortgage-credit lending to residents only, whereas Tables 7 and 8 include the institutes' total lending to residents. 1 The mortgage-credit institutes' instalment-free lending to owner-occupied dwellings.

THE BANKS' EFFECTIVE INTEREST RATES Table 10

Lending Deposits

Non- Non- financial Financial financial Financial All House- compa- compa- All House- compa- compa- sectors holds, etc. nies nies sectors holds, etc. nies nies

Per cent, per annum

Q1 06 ...... 4.8 6.2 4.5 2.8 1.9 1.5 2.0 2.4 Q2 06 ...... 5.0 6.4 4.7 3.1 2.1 1.8 2.3 2.6 Q3 06 ...... 5.2 6.6 5.0 3.3 2.4 2.1 2.5 2.8 Q4 06 ...... 5.4 6.8 5.2 3.5 2.7 2.4 2.9 3.2 Q1 07 ...... 5.7 7.1 5.5 3.6 3.1 2.8 3.2 3.4 Q2 07 ...... 5.9 7.2 5.7 4.0 3.4 3.1 3.4 3.8 Q3 07 ...... 6.1 7.4 6.0 4.1 3.6 3.3 3.6 4.0 Jun 07 ...... 6.0 7.3 5.8 4.1 3.5 3.2 3.6 3.9 Jul 07 ...... 6.1 7.4 5.9 4.2 3.6 3.3 3.6 3.9 Aug 07 ...... 6.1 7.4 5.9 4.0 3.6 3.3 3.6 4.0 Sep 07 ...... 6.2 7.5 6.0 4.2 3.6 3.3 3.6 4.0 Oct 07 ...... 6.2 7.4 6.0 4.2 3.7 3.4 3.7 4.1 Nov 07 ...... 6.2 7.5 6.1 4.3 3.7 3.4 3.7 4.1

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SELECTED ITEMS FROM THE BALANCE SHEET OF THE INVESTMENT ASSOCIATIONS Table 11

Assets Liabilities

Holdings of Certificates issued by investment associa- securities tions by owner

Insurance companies and Total Bonds, Shares, House- pension Other balance etc. etc. holds, etc. funds residents Abroad

End of period Kr. billion

2002 ...... 288.9 180.8 89.5 153.6 68.9 52.7 8.9 2003 ...... 367.1 237.2 108.7 188.2 103.2 60.4 12.3 2004 ...... 574.2 326.5 164.6 213.1 163.4 180.1 15.3 2005 ...... 794.7 412.1 286.4 265.7 236.5 263.0 24.4 2006 ...... 924.7 431.8 385.4 294.3 289.4 305.3 28.8 Q3 06 ...... 879.0 424.7 351.6 282.4 272.6 292.6 25.9 Q4 06 ...... 924.7 431.8 385.4 294.3 289.4 305.3 28.8 Q1 07 ...... 952.2 437.2 393.6 297.2 302.6 312.0 29.6 Q2 07 ...... 980.2 429.8 426.7 299.4 319.8 321.0 30.0 Q3 07 ...... 1,002.2 442.6 428.8 299.8 340.9 322.8 31.1

Quarterly transactions, kr. billion Q3 06 ...... 9.7 5.8 4.6 1.0 3.8 0.2 Q4 06 ...... 9.2 5.3 1.7 3.3 0.0 1.2 Q1 07 ...... 7.5 1.3 -0.1 9.9 5.5 0.5 Q2 07 ...... 5.5 9.2 2.6 12.8 6.8 -3.4 Q3 07 ...... 17.7 8.4 -0.1 22.5 0.3 0.0

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SECURITIES ISSUED BY RESIDENTS BY OWNER'S HOME COUNTRY Table 12

Bonds, etc.

of which:

Central-government Mortgage-credit Total securities bonds Shares

Denmark Abroad Denmark Abroad Denmark Abroad Denmark Abroad

End of period Market value, kr. billion

2002 ...... 1,999.0 414.6 476.4 224.3 1,414.2 188.1 396.0 168.5 2003 ...... 2,143.3 400.0 505.9 191.1 1,525.5 207.2 506.6 209.6 2004 ...... 2,379.2 434.4 498.8 213.6 1,768.7 218.4 604.3 245.2 2005 ...... 2,559.7 461.2 434.9 205.1 2,002.9 252.5 845.2 300.5 2006 ...... 2,548.0 457.9 380.4 172.2 2,041.2 279.5 988.5 361.8 Jun 07 ...... 2,093.3 461.5 327.8 176.4 1,640.0 275.8 1,081.8 436.6 Jul 07 ...... 2,189.5 474.0 338.3 170.9 1,726.0 293.0 1,118.6 452.3 Aug 07 ...... 2,230.6 451.9 337.5 167.0 1,766.8 275.4 1,103.5 446.3 Sep 07 ...... 2,234.1 463.5 327.8 175.8 1,777.9 278.4 1,099.8 457.0 Oct 07 ...... 2,268.8 465.7 327.8 179.4 1,812.8 277.0 1,110.6 460.9 Nov 07 ...... 2,280.7 477.2 306.2 186.1 1,839.4 278.8 1,024.5 442.0

Note: Comprise quoted and unquoted securities registered with the VP Securities Services (VP).

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HOUSEHOLDS' FINANCIAL ASSETS AND LIABILITIES Table 13

Assets Liabilities

Shares and certific- Life- ates insurance Currency issued by and and invest- pension- bank ment scheme Net deposits, Bonds, associa- savings, Loans, financial etc. etc. tions, etc. etc. Total etc. assets Total

End of period Kr. billion

2002 ...... 583 188 319 1,171 2,261 1,426 835 2,262 2003 ...... 620 166 399 1,262 2,448 1,505 944 2,449 2004 ...... 668 174 472 1,403 2,718 1,639 1,080 2,718 2005 ...... 753 172 612 1,616 3,153 1,827 1,327 3,153 2006 ...... 805 180 709 1,681 3,375 2,025 1,350 3,375 Q2 06 ...... 786 169 629 1,555 3,140 1,917 1,223 3,140 Q3 06 ...... 789 175 672 1,643 3,278 1,972 1,306 3,278 Q4 06 ...... 805 180 709 1,681 3,375 2,025 1,350 3,375 Q1 07 ...... 822 177 727 1,699 3,426 2,078 1,348 3,426 Q2 07 ...... 855 181 743 1,687 3,467 2,104 1,363 3,467

COMPANIES' FINANCIAL ASSETS AND LIABILITIES Table 14

Assets Liabilities

Debt Shares and Curren- certific- cy, bank ates deposits issued by and invest- granted ment Bonds, Shares, Net credits, Bonds, associa- Loans, etc. etc. financial etc. etc. tions, etc. Total etc. issued issued assets Total

End of period Kr. billion

2002 ...... 531 117 640 1,288 1,138 96 941 -886 1,288 2003 ...... 664 121 643 1,428 1,159 109 1,131 -971 1,428 2004 ...... 652 164 746 1,562 1,221 142 1,249 -1,050 1,562 2005 ...... 739 167 972 1,876 1,354 143 1,491 -1,111 1,876 2006 ...... 754 147 1,077 1,978 1,569 140 1,569 -1,300 1,978 Q2 06 ...... 800 142 979 1,922 1,485 146 1,431 -1,140 1,922 Q3 06 ...... 785 147 1,029 1,961 1,530 145 1,499 -1,213 1,961 Q4 06 ...... 754 147 1,077 1,978 1,569 140 1,569 -1,300 1,978 Q1 07 ...... 796 141 1,103 2,040 1,645 139 1,631 -1,375 2,041 Q2 07 ...... 886 134 1,167 2,188 1,661 134 1,754 -1,361 2,188

Note: Companies are defined as non-financial companies.

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CURRENT ACCOUNT OF THE BALANCE OF PAYMENTS (NET REVENUES) Table 15

Wages and Total Goods Goods and property Current current (fob) Services services income transfers account

Kr. billion 2002 ...... 64.3 17.8 82.1 -24.7 -23.3 34.1 2003 ...... 65.9 23.2 89.2 -16.8 -24.0 48.3 2004 ...... 54.5 19.8 74.4 -2.4 -27.7 44.2 2005 ...... 44.7 38.1 82.8 9.9 -24.7 68.0 2006 ...... 16.0 38.6 54.6 16.1 -27.1 43.6 Dec 05 - Nov 06 ...... 17.1 39.8 56.9 16.7 -26.8 46.7 Dec 06 - Nov 07 ...... -0.6 37.4 36.8 11.4 -26.8 21.3 Jun 07 ...... 2.1 3.1 5.2 2.0 -1.5 5.7 Jul 07 ...... 0.2 3.2 3.5 1.5 -2.1 2.8 Aug 07 ...... -0.5 6.4 5.9 1.2 -2.0 5.1 Sep 07 ...... 0.9 4.3 5.2 0.0 -2.0 3.2 Oct 07 ...... -0.6 4.8 4.2 1.4 -2.0 3.5 Nov 07 ...... 0.7 2.9 3.6 0.6 -2.4 1.7

Note: As of 2005 the compilation is based on new sources and methodologies resulting in breaks in data.

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FINANCIAL ACCOUNT OF THE BALANCE OF PAYMENTS (NET PAYMENTS FROM ABROAD) Table 16

Capital import Current Danmarks account Direct National- and investments bank's capital Portfolio Other transac- account, Danish Foreign in invest- capital tions with etc., total abroad Denmark ments import Other 1 abroad2

Kr. billion

2002 ...... 35.3 -44.9 52.3 1.2 21.3 -19.8 45.4 2003 ...... 48.3 -8.0 17.8 -98.3 72.5 -1.5 30.8 2004 ...... 44.4 62.1 -62.6 -87.1 -22.5 59.4 -6.2 2005 ...... 69.7 -97.1 77.3 -67.6 23.7 -17.7 -11.8 2006 ...... 43.3 -50.5 21.5 -110.9 82.4 -24.1 -38.3 Dec 05 - Nov 06 ...... 46.6 -89.1 66.9 -62.0 41.6 -30.3 -26.3 Dec 06 - Nov 07 ...... 21.0 -59.3 32.6 3.0 -37.7 42.9 2.5 Jun 07 ...... 5.8 -8.8 -1.6 36.1 -31.1 6.2 6.6 Jul 07 ...... 2.8 -2.6 -7.5 -8.6 12.2 9.7 6.1 Aug 07 ...... 5.1 -2.3 12.9 -11.5 11.6 -5.7 10.2 Sep 07 ...... 3.2 -13.4 11.5 13.9 -42.5 18.2 -9.0 Oct 07 ...... 3.5 -2.2 8.9 -44.8 43.9 -11.9 -2.6 Nov 07 ...... 1.7 -2.0 14.6 -10.2 -13.2 7.9 -1.1

1 Including errors and omissions and until end-December 2004 unrecorded trade credits. 2 As from 2005 transactions on all Danmarks Nationalbank's accounts with abroad. Until end-2004 only transactions on accounts included by compilation of the foreign-exchange reserve, published by press release on the 2nd banking day of each month and included in Table 2 of this section.

PORTFOLIO INVESTMENTS OF THE BALANCE OF PAYMENTS (NET PAYMENTS FROM ABROAD) Table 17

Danish securities Foreign securities

Foreign currency Krone- denom- denominated inated bonds, etc. bonds, etc. Shares Bonds, etc. Shares Total

Kr. billion

2002 ...... 8.5 24.0 4.9 -34.8 -1.4 1.2 2003 ...... -30.3 66.3 9.1 -121.5 -21.9 -98.3 2004 ...... -6.2 56.9 9.7 -104.4 -43.0 -87.1 2005 ...... 20.8 122.5 -19.2 -107.5 -84.3 -67.6 2006 ...... 9.4 69.3 -34.6 -21.8 -133.2 -110.9 Jun 07 ...... 15.5 2.8 0.1 -10.2 28.0 36.1 Jul 07 ...... 8.9 -20.6 4.9 1.4 -3.2 -8.6 Aug 07 ...... -22.3 17.3 -5.9 9.4 -9.9 -11.5 Sep 07 ...... 13.2 7.9 -0.4 -0.7 -6.0 13.9 Oct 07 ...... -1.1 -0.6 0.2 -37.6 -5.6 -44.8 Nov 07 ...... -9.1 16.1 -4.8 -18.0 5.7 -10.2

Note: A negative sign (-) indicates residents' net purchase of foreign securities, or non-residents' net sale of Danish securities.

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DENMARK'S EXTERNAL ASSETS AND LIABILITIES Table 18

Direct Portfolio investments investments Other investments Finan- Inter- cial Dan- compa- deriva- Loans marks ny debt, Shares, Bonds, tives, Trade and Natio- Equity etc. etc. etc. net credits deposits Other nalbank Total

End of period Kr. billion

Assets 2002 ...... 465 148 253 359 14 57 451 34 199 1,979 2003 ...... 413 198 309 446 17 57 518 31 230 2,220 2004 ...... 471 220 369 547 48 34 584 20 223 2,515 2005 ...... 567 253 556 684 85 37 720 19 217 3,136 2006 ...... 589 255 739 669 47 41 826 30 178 3,374 Q3 06 ...... 580 308 675 641 60 40 809 27 185 3,325 Q4 06 ...... 589 255 739 669 47 41 826 30 178 3,374 Q1 07 ...... 624 255 802 653 19 46 881 31 185 3,496 Q2 07 ...... 630 279 821 683 -2 49 943 29 181 3,613 Q3 07 ...... 628 292 824 664 7 47 1,035 32 191 3,719

Liabilities 2002 ...... 393 194 146 756 ... 30 669 13 4 2,206 2003 ...... 434 162 186 762 ... 28 801 13 4 2,391 2004 ...... 429 208 241 857 ... 20 816 20 2 2,593 2005 ...... 503 231 311 1,019 ... 27 968 22 3 3,082 2006 ...... 496 270 358 1,059 ... 32 1,138 34 4 3,391 Q3 06 ...... 519 277 298 1,055 ... 30 1,107 33 2 3,322 Q4 06 ...... 496 270 358 1,059 ... 32 1,138 34 4 3,391 Q1 07 ...... 504 277 387 1,125 ... 33 1,221 35 1 3,583 Q2 07 ...... 514 268 425 1,141 ... 34 1,246 34 1 3,663 Q3 07 ...... 523 255 440 1,138 ... 32 1,311 37 3 3,738 Net assets 2002 ...... 73 -45 106 -397 14 27 -218 20 195 -225 2003 ...... -21 36 123 -315 17 29 -283 19 226 -170 2004 ...... 42 12 128 -310 48 14 -233 0 221 -78 2005 ...... 64 22 245 -335 85 10 -248 -3 214 54 2006 ...... 93 -15 381 -390 47 9 -312 -4 174 -17 Q3 06 ...... 62 31 377 -414 60 10 -298 -6 182 3 Q4 06 ...... 93 -15 381 -390 47 9 -312 -4 174 -17 Q1 07 ...... 120 -22 415 -472 19 13 -340 -4 184 -87 Q2 07 ...... 116 11 396 -459 -2 15 -303 -5 180 -50 Q3 07 ...... 105 37 384 -474 7 15 -277 -5 188 -19

Note: As a key principle, the market value has been used for the compilation.

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GDP BY TYPE OF EXPENDITURE Table 19

Final domestic demand

General- govern- Gross Exports Imports Private ment fixed Change in of goods of goods consump- consump- capital invent- and and GDP tion tion formation ories Total services services

Kr. billion

2002 ...... 1,372.7 652.3 360.2 270.8 9.3 1,292.6 648.3 568.2 2003 ...... 1,400.7 666.9 371.2 271.8 3.2 1,313.1 635.1 547.6 2004 ...... 1,459.4 708.5 388.5 285.5 4.9 1,387.4 666.8 594.8 2005 ...... 1,552.0 754.1 401.4 319.2 3.9 1,478.6 757.1 683.8 2006 ...... 1,642.2 793.5 419.6 370.8 9.6 1,593.6 853.1 804.5 Q3 06 ...... 410.2 193.8 104.8 91.4 3.7 393.6 217.3 200.7 Q4 06 ...... 426.6 207.7 108.8 102.7 0.6 419.8 222.4 215.6 Q1 07 ...... 408.6 200.5 106.1 96.4 5.7 408.7 211.0 211.1 Q2 07 ...... 422.3 205.6 108.7 100.6 3.2 418.1 216.3 212.1 Q3 07 ...... 424.3 202.2 109.4 97.5 3.0 412.1 226.7 214.5

Real growth compared with previous year, per cent 2002 ...... 0.5 1.5 2.1 0.1 ... 1.7 4.1 7.5 2003 ...... 0.4 1.0 0.7 -0.2 ... 0.0 -1.0 -1.6 2004 ...... 2.1 4.7 1.6 5.6 ... 4.1 2.2 7.0 2005 ...... 3.1 4.2 1.1 9.6 ... 4.4 7.3 10.8 2006 ...... 3.5 3.1 1.5 13.0 ... 5.3 10.1 14.4 Q3 06 ...... 3.0 1.5 1.3 13.0 ... 5.5 7.9 13.3 Q4 06 ...... 3.5 2.6 1.9 12.1 ... 5.1 9.6 13.2 Q1 07 ...... 3.0 2.2 1.7 13.2 ... 5.7 5.0 10.0 Q2 07 ...... 0.4 1.3 1.6 2.4 ... 1.7 1.6 4.3 Q3 07 ...... 1.8 3.2 1.6 3.4 ... 2.6 5.2 6.9

Real growth compared with previous quarter (seasonally adjusted), per cent Q3 06 ...... 0.1 -1.1 0.6 1.3 ... -0.1 -0.1 0.6 Q4 06 ...... 0.6 0.7 0.8 1.9 ... 1.0 2.0 3.4 Q1 07 ...... 0.4 1.2 0.1 2.7 ... 1.3 0.2 1.0 Q2 07 ...... -0.6 0.4 0.2 -3.4 ... -0.6 -0.4 -0.8 Q3 07 ...... 1.3 0.9 0.5 2.2 ... 1.1 3.4 3.4

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EU-HARMONIZED INDEX OF CONSUMER PRICES (HICP) AND UNDERLYING INFLATION (IMI) Table 20

HICP Index of net retail prices1

Subcomponents:

Index of Administered net retail 4 prices Split into : HICP prices excl. excl. energy, energy, food food and and Core admini- admini- infla- Public stered stered Import Total Energy Food tion2 Rent services prices3 prices3 content5 IMI6

Weights, per cent

100 10.8 19.6 69.6 7.7 4.5 57.4 50.7 16.2 34.5

Year-on-year growth, per cent

2002 ...... 2.4 2.1 1.8 2.6 2.6 5.0 2.5 2.5 0.1 3.6 2003 ...... 2.0 0.9 0.7 2.6 2.7 8.1 2.1 1.9 0.4 2.6 2004 ...... 0.9 2.6 -2.1 1.5 2.8 4.8 1.1 0.8 1.1 0.6 2005 ...... 1.7 7.6 1.0 1.0 2.4 3.2 0.6 0.7 3.4 -0.6 2006 ...... 1.9 5.3 2.2 1.2 2.1 0.9 1.1 1.3 3.1 0.4 Q1 05 ...... 1.1 4.6 0.3 0.7 2.4 4.0 0.2 0.3 2.8 -0.9 Q2 05 ...... 1.6 6.7 0.6 1.0 2.3 3.2 0.7 0.7 3.5 -0.6 Q3 05 ...... 2.2 10.1 1.5 1.1 2.3 3.0 0.8 0.8 3.9 -0.6 Q4 05 ...... 2.0 8.9 1.5 1.0 2.3 2.6 0.7 0.9 3.3 -0.2 Q1 06 ...... 2.0 8.9 0.9 1.2 2.2 2.6 1.0 1.1 3.7 -0.1 Q2 06 ...... 2.0 8.3 1.9 1.0 2.0 0.4 1.0 1.1 3.8 -0.2 Q3 06 ...... 1.8 3.9 2.6 1.3 2.0 0.2 1.2 1.6 3.2 0.8 Q4 06 ...... 1.6 0.4 3.5 1.3 2.0 0.4 1.3 1.3 1.9 1.0 Q1 07 ...... 1.9 1.1 4.1 1.3 2.0 0.3 1.3 1.3 1.7 1.1 Q2 07 ...... 1.5 -1.7 3.6 1.5 2.1 0.2 1.5 1.4 0.9 1.7 Q3 07 ...... 1.0 -1.4 2.0 1.2 2.2 0.8 1.0 1.2 0.9 1.4

Note: The weights reflect the weighting basis as of January 2006. 1 Prices in the index of net retail prices are compiled excluding indirect taxes and subsidies. 2 Core inflation is defined as the increase in HICP excluding energy and food. 3 Goods and services excluding energy, food and administered prices constitute 57.4 per cent of HICP's weight basis and 50.7 per cent of the index of net retail prices. The difference reflects that the same goods and services do not count equally in the two indices, and does not express the indirect taxation content of the consumer prices. 4 The division of the index of net retail prices into import and IMI is based on Statistics Denmark's input-output table. 5 The indirect energy content is included in the import content. 6 IMI expresses the domestic market-determined inflation. For a detailed presentation of IMI, see Bo William Hansen and Dan Knudsen, Domestic Market-Determined Inflation, Danmarks Nationalbank, Monetary Review, 4th Quarter 2005.

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SELECTED MONTHLY ECONOMIC INDICATORS Table 21

Composite cyclical indicator Quantity index for

New Con- Unem- Forced passen- sumer Building ployment sales of ger car confi- Manu- and Manu- real registra- dence facturing construc- facturing Retail Per cent 1 property tions indicator industry tion Service industry trade of labour force 2000=100 2000=100 Number Balance per cent

2002 ...... 5.2 102.9 103.6 3,041 111,598 1 -4 -14 5 2003 ...... 6.2 102.5 107.8 3,039 96,501 1 -6 -18 -2 2004 ...... 6.4 102.1 113.4 2,640 122,543 7 3 -5 13 2005 ...... 5.7 103.8 120.1 1,874 148,578 9 1 7 20 2006 ...... 4.5 108.0 124.0 1,231 156,718 10 9 21 24 2007 ...... 1,392 ... 7 4 9 20

Seasonally adjusted Jul 07 ...... 3.3 114.3 127.3 118 14,238 9 1 8 15 Aug 07 ...... 3.3 111.0 126.2 117 14,337 4 3 8 18 Sep 07 ...... 3.1 110.1 127.5 132 14,214 6 1 8 20 Oct 07 ...... 3.0 116.4 125.2 126 15,032 6 3 7 21 Nov 07 ...... 2.8 113.0 125.8 130 15,237 6 2 4 19 Dec 07 ...... 123 ... 5 5 4 21

1 Excluding shipbuilding.

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SELECTED QUARTERLY ECONOMIC INDICATORS Table 22

Employment Hourly earnings Property prices (purchase sum, one- family All sectors Manufac- Manufac- dwellings) in turing turing Denmark, industry industry As a per- Total Private total in Denmark abroad centage of property value 1995 1,000 persons 1996=100 2002 ...... 2,784 1,932 128.5 128.5 120.4 168.0 2003 ...... 2,748 1,909 133.3 133.8 124.1 173.2 2004 ...... 2,748 1,908 137.4 138.0 127.5 188.6 2005 ...... 2,767 1,930 141.4 141.8 130.7 221.9 2006 ...... 2,822 1,987 145.8 146.2 134.0 269.7

Seasonally adjusted Q3 06 ...... 2,829 1,994 146.5 146.6 134.3 277.2 Q4 06 ...... 2,854 2,019 147.4 147.9 135.2 276.2 Q1 07 ...... 2,885 2,050 148.9 149.3 136.4 279.7 Q2 07 ...... 2,879 2,043 150.2 151.3 137.2 281.4 Q3 07 ...... 2,900 2,063 152.3 152.9 137.9 ...

Change compared with previous year, per cent 2002 ...... -0.1 -0.4 3.9 4.0 2.9 3.7 2003 ...... -1.3 -1.2 3.7 4.2 3.0 3.1 2004 ...... 0.0 0.0 3.1 3.1 2.7 8.9 2005 ...... 0.7 1.2 2.9 2.7 2.5 17.6 2006 ...... 2.0 2.9 3.1 3.1 2.5 21.6 Q3 06 ...... 2.0 3.0 3.1 3.1 2.6 21.6 Q4 06 ...... 2.5 3.5 3.1 3.2 2.6 14.9 Q1 07 ...... 3.2 4.6 3.3 3.4 2.6 9.8 Q2 07 ...... 2.5 3.5 3.7 3.9 2.7 4.0 Q3 07 ...... 2.5 3.5 4.0 4.3 2.7 ...

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EXCHANGE RATES Table 23

EUR GBP SEK NOK USD JPY CHF

Kroner per 100 units

Average 2003 ...... 743.07 1,074.99 81.45 93.03 658.99 5.6840 488.88 2004 ...... 743.98 1,096.69 81.54 88.90 598.93 5.5366 481.96 2005 ...... 745.19 1,090.02 80.29 93.11 600.34 5.4473 481.30 2006 ...... 745.91 1,094.32 80.62 92.71 594.70 5.1123 474.22 2007 ...... 745.06 1,089.81 80.57 92.99 544.56 4.6247 453.66 Jul 07 ...... 744.10 1,103.37 81.02 93.74 542.54 4.4627 449.15 Aug 07 ...... 744.29 1,098.33 79.84 93.35 546.40 4.6817 454.32 Sep 07 ...... 745.06 1,081.78 80.26 95.15 536.25 4.6629 452.26 Okt 07 ...... 745.34 1,070.69 81.25 96.85 523.90 4.5190 446.15 Nov 07 ...... 745.43 1,051.63 80.25 93.76 507.70 4.5772 452.20 Dec 07 ...... 745.99 1,036.87 79.12 93.07 511.99 4.5649 449.62

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EFFECTIVE KRONE RATE Table 24

Real Real Consumer-price indices effective effective Nominal krone rate krone rate Consumer- effective based on based on price index krone consumer hourly in the rate Denmark Abroad prices earnings euro area

Average 1980=100 2005=100

2003 ...... 101.2 234.7 220.3 107.9 108.4 95.8 2004 ...... 102.2 237.4 224.0 108.3 109.8 97.9 2005 ...... 101.6 241.7 228.2 107.6 109.4 100.0 2006 ...... 101.6 246.2 232.7 107.7 110.2 102.2 2007 ...... 103.2 250.5 ...... Jul 07 ...... 103.2 249.7 237.8 108.3 ... 104.3 Aug 07 ...... 103.2 249.3 238.0 108.0 ... 104.3 Sep 07 ...... 103.4 250.6 238.7 108.4 113.6 104.7 Oct 07 ...... 103.7 251.5 239.5 108.7 ... 105.2 Nov 07 ...... 104.5 253.2 240.7 109.6 ... 105.8 Dec 07 ...... 104.6 253.0 ......

Change compared with previous year, per cent 2003 ...... 3.6 2.1 1.7 3.9 4.7 2.1 2004 ...... 1.0 1.2 1.7 0.4 1.3 2.2 2005 ...... -0.6 1.8 1.9 -0.6 -0.3 2.2 2006 ...... 0.0 1.9 2.0 0.0 0.7 2.2 2007 ...... 1.6 1.7 ...... Jul 07 ...... 1.3 1.2 1.9 0.4 ... 1.8 Aug 07 ...... 1.3 1.1 1.8 0.4 ... 1.7 Sep 07 ...... 1.4 1.2 2.1 0.4 2.8 2.1 Oct 07 ...... 1.8 1.7 2.5 0.7 ... 2.1 Nov 07 ...... 2.5 2.5 3.0 1.7 ... 3.1 Dec 07 ...... 2.3 2.3 ......

Note: The nominal effective krone rate index is a geometric weighting of the development in the Danish krone rate against currencies of Denmark's 27 most important trading partners. However, only 25 countries are included in the calculation of consumer prices abroad and the real effective krone rate based on consumer prices and hourly earnings, respectively. The weights are based on trade in manufactured goods in 2002. An increase in the index reflects a nominal or a real appreciation of the krone.

17-01-2008 16:41:00 Antal sider: 24 Rev. nr. 10 H:\kvo\ENG\2007\4qt\faerdige\tabtill_4qtr_07.doc Oprettet af Palle Lorentzen Monetary Review - 4th Quarter 2007

Danmarks Nationalbank's Statistical Publications

Periodical publications (electronic publications) Upon compilation of financial statistics, Danmarks Nationalbank releases these to the public in electronic publications. The publication of new statistics on a specific topic comprises 2 elements: • "Nyt" (News) with text and charts to illustrate key development trends, as well as a 1-2 page tables section. The contents of the "Nyt" publications will also include in-depth commentary in order to give users greater scope to interpret and apply the statistics. • Tabeltillæg (Tables Supplement) containing tables with detailed speci- fications and descriptions of the sources and methodologies applied in the compilation of the statistics.

The text of all tables and charts as well as the descriptions of the sources and methodologies are translated into English.

Statistics databank The above statistical publications are supplemented by a statistics database that comprises all time series included in the financial statistics. When a topic is published the corresponding time series are updated, and they include data as far back in time as possible. As from 1 October 2007 Statistics Denmark and Danmarks Nationalbank have entered into a cooperation according to which the statistical data from Danmarks Nationalbank are published through Statistics Denmark's "StatBank Denmark". Danmarks Nationalbank's part of the "StatBank Denmark" is available directly via: nationalbanken.statbank.dk.

Special Reports In Special Reports are published statistics of a thematic character that are not prepared on a regular basis.

Release calendar A release calendar for the statistical publications, covering the current month and the following quarter, is shown on the website.

17-01-2008 16:41:00 Antal sider: 24 Rev. nr. 10 H:\kvo\ENG\2007\4qt\faerdige\tabtill_4qtr_07.doc Oprettet af Palle Lorentzen