DBRS Confirms the Kingdom of Denmark at AAA, Stable Trend

DBRS Ratings Limited (DBRS) has today confirmed the long-term foreign and local currency ratings of the Kingdom of Denmark at AAA, and the short-term foreign and local currency ratings at R-1 (high). All ratings have a Stable trend.

The Stable trend reflects DBRS’s baseline scenario in which the country’s credit metrics remain strong. As a result, DBRS does not anticipate changes to the ratings in the near term. The trend on the ratings could be changed to Negative if some of the challenges faced by Denmark prove structural, or if domestic or external shocks materially impair the trajectory of the country’s public debt ratio. Also, a migration of liabilities from the financial sector onto the sovereign balance sheet that substantially increases the debt stock would undermine the credibility of the current resolution framework for banks, thus putting downward pressure on the ratings.

The AAA ratings of Denmark are underpinned by sound public finances, characterised by low structural deficits and a moderate debt burden. In addition, the ratings benefit from Denmark’s net creditor position vis-à-vis the rest of the world, a wealthy and resilient economy, and a reliable and transparent institutional framework. The main challenges faced by the economy are related to (i) the domestic financial sector that remains in recovery mode and vulnerable to shocks, (ii) the weaknesses in the financial position of the domestic private sector, and (iii) the slow recovery in employment.

Denmark’s ratings benefit from a sound fiscal framework based on a countercyclical fiscal stance and a moderate public debt burden. In the years before the 2008 financial crisis, when the economy was growing at an average annual rate of 1.9%, the fiscal surplus averaged 2.5% of GDP. The surpluses thus accumulated were used to reduce public debt to a low of 27.1% of GDP in 2007, thus leaving the country with ample fiscal space to counteract the downturn in 2009, when output dropped 5.7%. DBRS believes that the fiscal stance adopted during the crisis has largely run its course, and that additional fiscal easing beyond 2014 is unlikely. The government deficit in 2013 is estimated at 1.3% of GDP, moving to 1.2% and 2.9% in 2014 and 2015. Deficits in 2013 and 2014 would be 1.9% and 3.0% of GDP if the one-off impact of the reclassification of capital pension schemes and of the receipts from the pension yield tax are excluded. The government’s structural deficit was 0.2% of GDP in 2013, and it will remain within the Medium-Term Objective of 0.5% of GDP also in 2014 and 2015. Gross government debt stood at a moderate 42.4% of GDP in 2013, and is expected to peak at 43.2% of GDP in 2016.

On the back of accommodative monetary and fiscal policy and resilient net exports, the Danish economy is gradually recovering. GDP is expected to expand by 1.6% and 1.9% in 2014 and 2015, respectively, driven by domestic demand and in particular by renewed investment activity. The contribution from net trade is expected to remain positive, but become less significant over time as higher investment activity translates into stronger imports of machinery and other equipment, of which Denmark is a net importer.

In spite of these strengths, several challenges weigh on the ratings. The Danish financial sector, although better capitalised than before the crisis, is only partially benefitting from the economic recovery, showing weak and uneven profitability, and remains exposed to changes in the regulatory environment. The economy is also exposed to shocks coming from a highly indebted private sector and from dependence on external funding. In particular, the implementation of the Basel 3 framework in Europe via the Capital Requirements Directive IV (CRD IV) and the Capital Requirements Regulation (CRR) over the coming years, and the Danish Bank Rescue Package 6, will likely materialise in a gradual but potentially significant cost to the country’s lenders, both in terms of higher capital requirements and higher liquidity ratios.

Full adherence to the liquidity requirements may be particularly challenging for Danish banks because of their significant holdings of mortgage covered bonds. The European Banking Authority (EBA) has recommended that these be considered “Level 2” assets in the calculation of the Liquidity Coverage Ratio (LCR). This will reduce their value in the calculation of the LCR. The European Commission (EC) will determine in June 2014 whether to endorse the EBA recommendation or grant derogation. Mortgage bonds in Denmark represent 57% of systemic banks’ liquid assets, and it is estimated that in case of an adverse ruling by the EC, the LCR for systemic banks could amount to approximately 60%. In this case, banks are unlikely to undergo sudden stress, because Denmark authorities will require domestic banks to initially apply the minimum regulatory requirement of a LCR ratio of 60% from January 2015 onward, which will be gradually increased to 100% by 2019. However, the market for mortgage bonds could become less appealing as a result. Further potentially reducing the appeal of these instruments to investors is legislation that will come into force next April. This will impose an automatic extension of the maturities and terms of certain categories of mortgage bonds in case of severe market distress. Should the mortgage bond market become less attractive to investors, it may lose liquidity at the margin and result in higher borrowing costs. These would eventually be passed on households, thus weighing on domestic demand.

Other challenges relate to the country’s high private sector gross debt, estimated at 266% of GDP in 2013. While early signs of deleveraging observed at the beginning of 2013 have persisted throughout the year, the highly leveraged structure of the Danish economy is unlikely to change over the medium term. The high private sector debt level will represent a challenge when interest rates will rise, although this seems unlikely in the near term as monetary policy in Denmark is linked to developments in the Euro area where interest rates are expected to remain low for an extended period of time. Finally, the labour market in Denmark remains strained as job losses since the beginning of the crisis have only been partly recovered. Employment in 2013 was still 6.0% below the peak reached in the third quarter of 2008, and the employment rate, at 76%, is 4.5 percentage points below the peak. Raising the employment rate will be crucial to achieve the long-term growth rate of 1.7% per annum, 18% of which is expected to be composed of growth in the labour input.

Notes:
All figures are in Danish kroner (DKK) unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website under Rating Scales.

These can be found on www.dbrs.com at: http://www.dbrs.com/about/methodologies

The sources of information used for this rating include Ministry of Finance of the Kingdom of Denmark, the Ministry of Business and Growth of the Kingdom of Denmark, Danmarks Nationalbank, Danmarks Statistik, European Commission, European Central Bank, Statistical Office of the European Communities, IMF, OECD, BIS, and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period while reviews are generally resolved within 90 days. DBRS’s trends and ratings are under constant surveillance.

Lead Analyst: Claudio Columbano
Rating Committee Chair: Roger Lister
Initial Rating Date: 4 October 2013
Most Recent Rating Update: 16 November 2012

For additional information on this rating, please refer to the linking document under Related Research.