The Danish krone problem
In the wake of the turmoil surrounding the Swiss Franc, the Danish krone has become the subject of speculative attack. Unlike the Swiss, the Danes have a peg to the euro that is permanent and long-lasting. They also have a backstop via a legal obligation from the ECB to prevent the peg from coming unstuck. Nonetheless, the peg will be tested Some thoughts on the Danish krone problem below
As oil prices stabilize in the range just under $50 a barrel, a new source of market volatility has emerged in Europe, due in large part to the ECB’s desire to ease policy. While the latest problems involve countries outside of the eurozone like Switzerland and Denmark, all of this goes back to the poor institutional framework of the eurozone’s design. Here’s why.
Right now we are in a strong dollar period. Much of this has to do with global growth differentials that make interest rate products in the United States more attractive than interest rate products in the eurozone. I found it striking that the Irish Independent carried a headline today that read “IMF cuts global growth outlook, US only bright spark”. This is indicative of the growth prospects of the US compared to other developed economies, which are even less robust. The result then has been policy divergence, with the US Federal Reserve making noises that it would start a rate hike campaign starting as soon as June. I wrote last week why the Fed should take pause on its thinking here. And Tim Duy has a smart take on this as well that I recommend. Irrespective, the Fed is in a tightening mode and it has opened up a tremendous interest rate differential between US dollar safe assets and eurozone safe assets that makes the euro weak by comparison to the US dollar.
Now, every major currency area is over-relying on the central bank to effect cyclical policy. Cullen Roche has a bead on why the primacy of monetary policy is so acute. And this owes to the predominance of Friedmanite thinking in policy circles. But even so, fiscal authorities with sovereign currencies have degrees of policy freedom that national governments in the eurozone do not. And that means that fiscal policy in the eurozone, due to the fear of bond vigilantes, must be tighter than elsewhere, where sovereignty is greater. With fiscal policy tighter and debt deflationary forces still waiting in the wings, the ECB is forced to provide a monetary offset that puts downward pressure on the euro. And it is this monetary offset due to a lack of fiscal policy room that is making the euro weak. It is not surprising then that countries like Switzerland and Denmark, which have more degrees of policy freedom than the eurozone, find their currencies under upward appreciation pressure vis-a-vis the euro in that situation.
In short, the lack of a fiscal agent at the ECB level creates a policy quagmire which ties fiscal agents’ hands, weakens growth, makes debt deflation a more pressing problem and thus creates the need for monetary offset at a time when other economies have recovered more fully from the financial crisis. This weakens the euro and makes pegging one’s currency to it a difficult road to hoe. As an addendum, I should add that the poor institutional framework in Euroland is also causing problems with the ECB’s QE program since it has to figure out what to do with the Greeks. Right now it looks like QE will proceed with every country having a green light to be a part of the bond buying program except for Greece. And this is not going over well.
We have seen what happened in Switzerland. I wrote about it here on Thursday and gave a more complete accounting on Friday at Foreign Policy’s website. Read the Foreign Policy take. But now Denmark is in the speculators’ sights.
Officially, Denmark has set a band between 762.824 per 100 euro and 729.252 per 100 euro. In practice, the fluctuation has been even less, about 1%. ‘
Source: Danish National Bank
And the Danish peg to the euro, and its precursor the ECU has stood the test of time, lasting 30 years so far.
Giving that peg more weight is the fact that the ECB is obligated by law along with Denmark’s central bank, the Danish National Bank, to buy or sell currency in order to support the exchange rate peg if currency market moves make the cross-rate bang up against the exchange rate band. The Danish National Bank put it this way last year when Lithuania was still a part of ERM 2 with Denmark:
Facts about ERM 2
The euro is at the core of ERM 2, and the currencies of participating EU member states have central rates against the euro, but not against each other. The obligation to intervene – that is, to buy or sell currency to support the exchange rate – if a participating currency reaches a fluctuation limit rests solely on the central bank of the relevant member state and the ECB. The other participating member states have no obligation to intervene. ERM 2 includes a provision on unlimited intervention credit between the ECB and the participating central banks in connection with intervention at the fluctuation limits.
At present Denmark participates in ERM 2 together with Lithuania. One of the convergence criteria for joining the euro area is to observe the normal fluctuation band within ERM 2 without severe tensions for at least two years. In the same period, the member state in question may not devalue its currency against the euro.
Here’s the thing though. In economics, there is a widely known concept called the impossible trinity. It basically says it’s impossible to have fixed exchange rates, a free flow of capital and sovereign monetary policy at the same time. One of the three things has to give. And in a world in which capital controls are still seen as bad, it means having a true sovereign monetary policy is what you sacrifice if you peg your currency.
So Denmark effectively has to follow the ECB’s lead. If the ECB is doing QE as everyone thinks that it will be come January 22nd, the Danes need to come up with a way to credibly mimic the currency effects of that policy so as to prevent their currency from rising and the peg coming under pressure. In the meantime, the speculators are going to hold the Danes’ feet to the fire.
My view: Pegging the currency will be expensive. Denmark is one of three countries that was a part of the EU when the euro was formed, which have still not joined the euro. The others are Sweden and Britain. And both of these countries have flexible, free floating exchange rates now. No one is talking about the Swedish Krona or the British pound now exactly because those currencies float. In fact, the Swedish krona has even depreciated against the euro as the euro has itself depreciated against the US dollar.
I expect, despite the Danes having instituted more negative interest rates today, that speculative attacks will continue until the ECB and the Danish National Bank are forced to intervene in a massive way. And they will do so because the Danish central bank’s balance sheet is only 27.6% of GDP whereas the Swiss National Bank’s balance sheet is already 85% of GDP after massive intervention. This works at cross purposes with quantitative easing because intervening will mean the ECB will be actively buying euro in order to hold the Danish peg even though it wants the euro to weaken. Such are the outcomes of a poor institutional setup. Moreover, because pegging a currency eliminates a market signal that is useful in conducting economic policy, one ends up with the kind of mess caused by the Swiss National Bank’s recent move, where the currency adjusts violently and the outcome creates collateral damage and contagion.
There is no one left to attack except Denmark and Bulgaria. Everyone else has either left ERM or ERM2 to join the euro or they have flexible exchange rates with a free-floating currency.
In a world dominated by the shrinking pie mentality of beggar thy neighbor economic policy and currency wars, we are likely to see more currency volatility as time goes along. And fixed pegs are a particularly attractive target for speculation because the fruits of a winning bet can be that much greater.