Thomas Gade | London Strong growth and substantial risks
The Nordic economies (Denmark, Finland, Norway and Sweden) continued to pace ahead during 2006. On aggregate, we expect the Nordic region to expand by a staggering 4.2% this year, slowing to 2.9% in 2007 and further to 2.4% in 2008. Despite variations within the Nordic economies, growth in the Nordic region remains above that of the euro area on our forecasts. The Nordic economies in general have benefited from high productivity growth, strong foreign demand and increasing domestic demand, fuelled by a prolonged period of expansionary monetary policy and significant wealth effects. The key risk factors going into 2007 are increasingly stretched housing markets in Denmark, Norway and Sweden, as well as very tight labour markets in Denmark and Norway and a still loose but tightening labour market in Sweden.
Three factors suggests slower growth
With the exception of Norway, we expect the Nordic economies to slow during over the forecast horizon. The three main factors driving the slowdown will be a continued withdrawal of monetary stimulus, a gradual currency strengthening and — more fundamentally — the increasingly scarce labour resources. As small open economies, the Nordic economies are sensitive to developments in the global economy, in particular to developments in the euro area. On the upside — although it is not our baseline case — sustained structural productivity growth and increased immigration could subdue some of the expected growth slowdown and abate otherwise increasing wage pressures. On the downside, a more abrupt slowdown in house price growth — not to mention a drop in house prices — could significantly hamper household consumption going forward.
Loose monetary policy still fuels demand
Although monetary policy is still expansionary and spare production capacity increasingly scarce in the Nordic region, the continued withdrawal of monetary policy by Riksbanken, Norges Bank and the ECB is likely to gradually slow investment spending growth throughout the region. Despite ongoing monetary policy during 2006, monetary policy remains accommodative in all the Nordic countries. As Finland is a member of the euro area and Denmark has a fixed exchange rate towards the euro, the monetary tightening will be determined by the ECB (see Elga Bartsch’s note in this publication). In Norway and Sweden, we expect Norges Bank and Riksbanken to outpace the ECB through 2007 and to continue to withdraw monetary stimulus possibly through 2008 also. Financial conditions are likely to tighten further by a gradual currency strengthening. This will particularly be evident in Norway and Sweden, we think.
Tight labour markets and little immigration
Labour markets are tightening across the Nordic region. Labour markets in Denmark and Norway look particularly tight, while some slack remains in the labour markets in Sweden and Finland, we estimate. In Denmark and Norway, a rising proportion of companies are reporting labour shortage in several sectors ranked from construction and financial services through manufacturing. It is striking that the tight labour markets in Denmark and Norway has not led to a higher degree of wage inflation yet. Part of the explanation can be found in an increasing degree of flexibility in the labour markets, which has also resulted in a low rate of structural unemployment. Second, parts may be assigned to a higher degree of off-shoring. On our measure of structural unemployment (NAIRU), only the unemployment rates in Sweden and Finland are above the structural unemployment rate at present. Unemployment below the NAIRU in Denmark and Norway will likely cause upward pressure on wage growth over the forecast horizon.
Whether labour markets remain tight and result in increasing wage pressure will also depend on the labour supply from the new EU member states in particular. In recent years, a rise in the inflow of labour supply has been significant in Sweden only. Obtaining larger inflows of labour supply from the Central and Eastern European economies will become increasingly important to abate some of the labour market pressure in Norway and Denmark. On our baseline scenario, we would however still expect wage compensation and unit labour costs growth in Denmark and Norway to outpace wage growth in Sweden and Finland. Increasing the labour supply is especially important today. Facing an aging society across the Nordics, it is not a short-term issue. Depending on the developments in labour supply, we see significant downside risks to growth in the years ahead — particularly in Denmark and Norway.
Stretched housing markets a major risk factor
Housing markets in the Nordics look increasingly stretched, with the exception of Finland. In a recent OECD study, three of the Nordic countries are unfavourably ranked in the top-seven with respect to the probability of house prices ‘nearing a peak.’ In particular, the Danish housing market — ranked first among the OECD countries — looks prone for a potentially sharp adjustment. Across the Nordics, the rise in house prices over the last 10 years has been accompanied by a similar build up in household debt. Meanwhile, interest payments as a percent of disposable income have declined over the same period of time.
The drop in the ratio of interest payments to disposable income may not only be explained by decreasing interest rates over this period of time. Particularly in Denmark, the drop may have been exacerbated by an increasing share of short-term maturity and flexible rate borrowing. As such, Danish households, with the highest debt to income ratio in the Nordics, have become increasingly sensitive to developments in short-term interest rates. In Denmark, the unwinding of the house price bubble could be severe. As our colleagues David Miles and Melanie Baker recently pointed out in a study on the UK housing market, a large part of current UK valuations can be explained by expectations of further price rises only. Valuations are therefore very much dependant on expectations and could potentially be volatile (See UK Economics: How Did We Get Here? Nov. 22, 2006). Although this may also be the case in Denmark, a revaluation would still need a trigger. The massive rise in the number of houses for sale during recent months and stagnating sales prices may be exactly such a trigger. On balance, the potential abrupt slowdown in house prices constitutes a significant downside risk to consumption demand for Sweden and Denmark in particular. Meanwhile, our baseline case for Sweden and Norway remains for a gradual slowdown in house price appreciation. This may hamper consumption growth, but in Sweden this will likely be offset by the expected rise in household disposable income growth, induced by lower income taxes and employment growth.
Bottom line — Sweet Dreams or Nightmare?
The Nordic economies have shown impressive growth rates during recent years. In particular, demand has been fuelled by a very expansionary stance of monetary policy, but also productivity growth has been impressive on the supply side. Monetary policy is being gradually tightened, and the currencies are gradually strengthening. We therefore expect the economies to gradually slow, but for aggregate growth to remain above that of the euro area. Two risk factors in particular need to be addressed: labour markets and housing markets. Labour supply will need to be increased. In Sweden, this is already happening through increased immigration flows and changes in the tax base. The remaining Nordic economies are lagging behind in this respect. Housing markets look increasingly stretched; in particular, for Denmark, the unwinding of the housing bubble could be severe. There is still scope for sweet dreams in Sweden, but be prepared for potential nightmares in Denmark.