Copenhagen: Denmark’s economy has continued to expand despite shocks from the war in the Middle East. Strong pharmaceutical exports have been an important driver of growth, while the rest of the economy has expanded at a more moderate pace. Expansionary fiscal policy has also supported aggregate demand. Public finances, the external position, and the financial system remain robust. While growth is expected to moderate as pharmaceutical exports normalize from exceptionally high levels, the economy remains at full employment. Elevated geopolitical and trade tensions and heightened uncertainty continue to cloud the outlook. Denmark’s main policy challenge is to leverage its strong fundamentals to boost medium-term growth. Against this background, staff’s main recommendations are as follows:
- Aim for a broadly neutral fiscal policy stance in 2027 to contain capacity pressures. Fiscal measures to address cost-of-living pressures should be targeted and temporary, while rising medium-term spending pressures require continued policy attention.
- Uphold financial stability by maintaining appropriately tight capital-based macroprudential safeguards, strengthening borrower-based measures, and closely monitoring vulnerabilities, especially those potentially arising from bank-nonbank financial institution (NBFI) linkages.
- Advance structural reforms to boost labor supply and broaden productivity growth beyond pharmaceuticals, thereby sustaining high incomes and preserving fiscal space.
Economic outlook and risks
1. Staff expect growth to moderate as pharmaceutical exports normalize. Output growth is projected to strengthen from 3.5 percent in 2025 to 3.7 percent in 2026, above potential, reflecting strong pharmaceutical exports alongside moderate expansion in the rest of the economy. Beyond 2026, growth is projected to moderate to around 2 percent in 2027 and further to 1.5 percent annually by 2030, below the 2.2 percent average in 2010–25. This reflects weaker global growth prospects—due to greater geoeconomic fragmentation and a more volatile global environment—as well as a declining working-age population. Labor market pressures have eased, although the economy remains at full employment. After falling sharply to below 1 percent in early 2026, due to cuts in electricity taxes, inflation is expected to rise slightly above 2 percent by end-2026, reflecting higher energy and services prices.
2. Risks to growth are tilted to the downside, while risks to inflation are tilted to the upside. Geopolitical tensions and intensification of conflicts, including in the Middle East, could weaken global growth, raise energy prices, disrupt supply chains, and tighten financial conditions. Higher trade barriers and geoeconomic fragmentation could also weigh on the outlook. Domestic demand could prove weaker if uncertainty remains elevated. Conversely, a faster-than-expected easing of geopolitical tensions and recovery in global energy supply could strengthen confidence and support growth.
Calibrating fiscal policy amid full employment and rising spending needs
3. Fiscal policy should aim for a broadly neutral stance in 2027. The planned fiscal expansion in 2026 is sizable and procyclical, driven by higher defense spending and transfers to local governments, a temporary reduction in the electricity tax, and the full phase-in of personal income tax cuts. Given lagged effects, it is likely to continue adding to capacity pressures in 2027. Such pressures could prove stronger than currently expected, particularly if (i) defense expenditures have high domestic content or (ii) tax cuts translate more strongly into private consumption as household confidence recovers. With the economy operating slightly above potential, a broadly neutral fiscal stance next year would help contain capacity pressures. If downside risks materialize, Denmark’s strong automatic stabilizers should be allowed to operate fully.
4. Fiscal measures to address cost-of-living pressures should be targeted and temporary.
- Reducing the VAT rate on food items would be poorly targeted, difficult to reverse, and fiscally and operationally costly, with a large share of benefits accruing to higher-income individuals. Moreover, food prices have fallen since the beginning of the year, reducing the urgency for such a measure. Targeted lump-sum transfers to low-income households would be more efficient and less costly.
- The temporary reduction in above-minimum excise taxes on electricity will help correct the over-taxation of clean energy, given Denmark’s high renewable share in electricity generation and existing carbon prices. Making the reduction permanent could preserve these efficiency gains.
5. Denmark’s fiscal position remains strong, but medium-term spending pressures require continued policy attention. Public debt remains low, and the authorities project that the structural balance would remain above the -1 percent of GDP floor over the medium term, consistent with Denmark’s fiscal rules and a stable debt ratio. However, the longer-term fiscal trajectory is highly dependent on labor supply projections, which, in turn, are sensitive to assumptions about labor force participation and net migration. Spending pressures related to aging, health and long-term care, climate adaptation, and potentially defense could also prove larger than currently anticipated. Should adjustment become necessary, both expenditure and revenue measures should be considered. Maintaining the link between retirement age and life expectancy remains important for long-term fiscal sustainability.
Upholding financial stability
6. The financial sector remains resilient, but continued vigilance is warranted. Banks and insurers maintain strong capital and liquidity buffers, sound asset quality, and robust profitability. Nevertheless, adverse shocks, including weaker growth, tighter financial conditions, or corrections in global capital markets, could test resilience. With greater competition in mortgage lending, supervisors should continue to ensure that banks maintain prudent lending standards. Efforts to strengthen operational and cyber resilience should continue, including through regular stress testing, robust contingency planning, and close coordination across institutions, supported by the Financial Sector Forum for Operational Resilience.
7. The capital-based macroprudential policy stance should remain tight, and borrower-based measures (BBMs) should be strengthened.
- Maintaining current capital buffer requirements, including the countercyclical capital buffer at 2.5 percent and the sector-specific systemic risk buffer at 7 percent on commercial real estate exposures, appropriately support resilience.
- BBMs should play a more prominent role in addressing housing-related vulnerabilities. Lowering the maximum loan-to-value ratio below the current 95 percent would strengthen household resilience. There are signs that house price pressures are rising beyond Copenhagen to other urban areas. If these pressures become more widespread and are accompanied by an increase in credit-related vulnerabilities, the geographical calibration of BBMs should be reassessed.
- The plan to gradually lower the tax deductibility of mortgage interest is welcome, as it should help limit incentives for excessive household leverage.
- Staff caution against the proposal to expand the mandate of the Systemic Risk Council by including competitiveness and entrepreneurship. The Council’s primary objective should remain the identification and monitoring of systemic financial risks. Broadening the mandate could blur institutional priorities and create tensions between financial stability objectives and other policy goals.
8. Vulnerabilities in the NBFI sector and its linkages with banks should continue to be monitored closely. The ongoing joint Nordic-Baltic solvency-liquidity stress testing exercise should help to strengthen assessments of system-wide resilience to cross-border liquidity and market shocks and identify supervisory data needs, including on bank-NBFI linkages. Given the extensive interconnectedness, efforts to develop an integrated framework for systemic risk assessment covering both banks and NBFIs should continue. Building on ongoing work, the Danish Financial Supervisory Authority should also continue to closely monitor banks’ exposures to leveraged investment funds and consider further strengthening supervisory tools, such as margining practices, stress-scenario haircuts on collateral, and leverage limits, where appropriate.
9. Some of the 2020 FSAP recommendations still need to be addressed. Several recommendations regarding systemic risk oversight and the governance of the resolution authorities remain unaddressed. The ongoing 2027 FSAP provides an opportunity to reassess these issues, identify remaining gaps, and strengthen resilience.
Advancing structural reforms to boost growth and resilience
10. Structural reforms should continue to be pursued vigorously to sustain high incomes and preserve fiscal space. The government is planning to introduce several initiatives to strengthen labor supply and productivity gains beyond the pharmaceutical sector.
- Expanding labor supply should remain a priority. Population aging will make it harder to secure the workforce needed to sustain growth while increasing demand for health and long-term care services. The new government’s objective of increasing full-time equivalent employment by 35,000 by 2035 would help address this challenge, but additional policy measures will be needed to achieve it. Improving efficiency in health and elderly care and enhancing public-sector digitalization can help free up labor resources. Immigration policies should continue to be reviewed to ensure that firms have access to needed skills, and the recent decision to lower the salary threshold for recruiting foreign employees is a step in the right direction.
- Promoting the diffusion of artificial intelligence (AI) and digitalization is key to enhancing productivity. Denmark is well positioned to benefit from these technologies, supported by strong infrastructure and policy frameworks. However, adoption remains uneven, particularly among small and medium-sized enterprises (SMEs), which often face challenges in hiring, retaining, and upskilling IT specialists. Policies should focus on accelerating adoption among SMEs, addressing digital skill shortages, and strengthening lifelong education and training in advanced digital and AI skills.
- Strengthening business dynamism would support broader productivity growth. Denmark has a strong startup ecosystem, particularly in biotech and fintech, but relatively few firms scale up domestically after early-stage financing. In this context, staff support efforts to improve access to growth capital, reform corporate income tax and capital taxation, reduce regulatory burdens, and strengthen the scale-up ecosystem, including through the planned Entrepreneurship Package 2.0. Advancing EU single-market initiatives would help Danish firms scale up in Europe.
11. Increasing housing supply is critical to address affordability pressures, especially in Copenhagen and other high-demand urban areas. Strong population growth, rising incomes, and agglomeration effects in urban areas have increased demand, but housing supply has not kept pace. Recent increases in the cap on construction costs for social housing, expansion of the transport infrastructure, and land development could ease pressures over time, but further action is needed. There is scope for (i) accelerating planning and permitting procedures, (ii) repurposing underutilized suburban land for housing, and (iii) rationalizing rental regulations to preserve incentives for new construction while protecting vulnerable tenants.
