One of the themes of this blog concerns the issue of what have become called the currency wars as countries try to gain a competitive advantage by pushing their currency lower. For example the classic case of this in recent times is Japan where the policy of Abenomics involves a lower value for the Japanese Yen which is supposed to reinvigorate both inflation and the economy. If we look at it in Euro terms then it soon pushed through the 100 Yen barrier in late 2012 on its way to around 145. However this then gets awkward as we then entered a phase where the European Central Bank wanted the Euro lower too and they obviously both cannot fall! In this new phase of the currency war it is the ECB which is winning so far as the Euro has dipped to 134 Yen as I type this.
Looked at like this with two major currency blocs both trying to depreciate there is not only an Orwellian theme but also a reminder of the competitive devaluations which so disfigured the Great Depression of the last century.
The catch here is of course the fact that if a currency falls there has to be another one which rises. The only real exception is if you value your currency against a precious metal like gold or something similar. In a world of fiat currencies though that game is relatively rare. So someone has to take the strain and see their currency rise. We saw this for a sustained period for the Swiss Franc and the Japanese Yen as the “carry trade” swept them higher and it is therefore no surprise to find them regularly firing salvos in the currency war. But there is one currency bloc which is causing particular trouble right now and it is the Euro. I have written often about Switzerland’s struggles but now it is the time of Denmark to find itself in a currency battle as we mull how many economic casualties there will be from the fall-out.
But Denmark is not a Euro member
This is true but it does have a currency peg to it which its central bank calls a fixed exchange rate which is nearly but not quite true.
Denmark participates in ERM 2 at a central rate of 746.038 kroner per 100 euro.
The standard ERM 2 fluctuation band is +/- 15 per cent. Because of the high degree of convergence, Denmark has concluded an agreement with the European Central Bank (ECB) and the euro area member states on a narrower ERM 2 fluctuation band of +/- 2.25 per cent. This means that the krone can only fluctuate between 762.824 per 100 euro and 729.252 per 100 euro.
I have to confess that as someone who experienced at the sharp end (markets went wild) the 1992 ejection of the UK from the original ERM it does send something of a shiver down the spine to be reminded of it. Oh and as I shall recount in a minute I bet they wish now that they had stayed with the 15% band!
Currency reserves are rising
Unlike the UK and the pound in 1992 the problem for Denmark is a weak Euro so it is finding that the Krone is rising. Or as its Monetary Review puts it.
In recent months, the krone has been stable vis- à-vis the euro at a slightly stronger level than its central rate in ERM 2.
Seems so calm and orderly doesn’t it? Well perhaps the image of a Swan sailing serenely but kicking vigorously underwater applies as we note yesterday’s data release.
In January 2015 the foreign-exchange reserve increased by kr. 106.6 billion to kr. 564.1 billion. The increase reflects Danmarks Nationalbank’s net purchase of foreign exchange for kr. 106.5 billion,
So a 19% rise in one month as we mull the word “stable”. Perhaps it was stable because the central bank made it so!?
This poses a familiar problem as we consider the situation that Switzerland found itself in. A country in such a position finds itself getting ever more of a currency which is not wanted by others at that price. Therein lies the beginning of the issue which for a while a central bank can ignore as it can let its balance sheet grow and to an extent it can ignore reality. However unless things move in its favour reality catches up in the end even with central banks.
The first issue that needs to be faced is what to do with the Euros that are purchased. This is a problem that Switzerland attempted to deal with by converting the Euros it bought into other currencies by buying Euro area bonds and even by buying equities as the numbers and size of the inflow became too great. Right now Denmark does not need to do that but if this carries on then it will find itself in the same situation. So far the foreign currency reserves amount to about 30% of Denmark’s GDP so more than UK QE for example but still a long way short of the Swiss Position. However there is an eerie echo of the Swiss position.From Bloomberg.
The bank can produce an “unlimited supply of Danish kroner” to weaken the currency, Karsten Biltoft, head of communications at the central bank in Copenhagen, said in a phone interview said.
How did that work out for Switzerland?
In another attempt to deal with the problem Denmark has plunged itself into the world of negative interest-rates.
Effective from 30 January 2015, Danmarks Nationalbank’s interest rate on certificates of deposit is reduced by 0.15 percentage point to -0.50 per cent.
Again we see a tactic from the Swiss play book which has an ominous ting to it. You see it was not that long after it announced its move into negative interest-rates that Switzerland capitulated on its Euro cap.
A domestic problem for Denmark
If we look at domestic monetary conditions then there is a clear issue with lower interest rates. Let me take you back to April 2014.
During the most recent boom, borrowing by households surged, rising more sharply than ever before…….. But high loan-to-value ratios amplify cyclical fluctuations in the Danish economy.
Why is this being mentioned? Well according to Statistics Netherlands the ratio of household debt to GDP was 240% at the end of 2012. So higher than that of the Netherlands where as regular readers of my blogs will know it has proved to be a problem. As ever housing based debt is at the heart of it and even the Danish central bank has its worries. The emphasis is mine.
Loans with deferred amortisation make it possible to reduce other debt and can be used as an instrument to smooth consumption over a lifetime. However, there may also be considerable risks linked to deferred amortisation loans at high LTV ratios, e.g. if house prices fall and the deferred amortisation period expires.
Now if we move to the moral hazard arena what do we think will happen to this boom as negative interest-rates spread through the system?
They are spreading as highlighted here.
The yield on 1-year mortgage bonds reached a historical low of just under 0.1 per cent in mid-September. Since then it has risen, to almost 0.2 per cent in early December.
So 0.2% is a rise? I think we get the idea as we wonder what mortgage offers will be available soon in Denmark and what that will do to household borrowing and house prices.
Government bond yields
These too have plunged and the ten-year yield is now 0.25%. In the media rush to see if those of Germany would fall below those of Japan it was missed that Denmark had got there first (h/t @DShahTR).
In these times you may not be surprised to read that inflation is low (0.1% in December) but there is something to mull in the fact that Denmark has a reputation for a high price level. According to the Big Mac Index of the Economist it is the 3rd most expensive and one of the only 5 countries which are overvalued.
There is much to consider here in economic terms as we look at the way that a currency peg has implications for domestic monetary conditions. In essence monetary policy instruments are busy with external issues and may be and in this instance are inappropriate for the level of household debt. A clue to the size of the issue is found in this from Bloomberg.
Including the insurance industry, Denmark’s financial system is 650 percent of gross domestic product, the IMF estimates. Banks alone have assets that are four times the size of the $310 billion economy.
I will leave for another day the full debate over whether the Euro peg is a good idea partly because it would be such a big change for Denmark as it has operated such policies for decades now.
However as I wrote this blog I was reminded of Switzerland and my forecast back in the day that its link to the Euro would eventually go. So let me hand you over to Dame Shirley Bassey to sun it up.
The word is about, there’s something evolving,
whatever may come, the world keeps revolving
They say the next big thing is here,
that the revolution’s near,
but to me it seems quite clear
that it’s all just a little bit of history repeating