Few traders have forgotten the morning of Jan. 15, 2015.
A few hours into the European trading day, the Swiss National Bank revealed out of the blue that it would no longer peg the Swiss franc CHFEUR, -0.0513% CHFUSD, +0.1008% to the euro. Instead, it would let it float free like other major currencies.
The surprise move sparked market mayhem. The franc soared from €0.83 to €1.17 in a matter of minutes, an unprecedented jump of 40%. The Swiss stock market plummeted. A number of hedge funds around the world suffered big losses, and some smaller currency traders even went bust.
As the shockwaves spread, attention quickly turned further north to Denmark, as a burning question sprang into speculators’ minds: If the Swiss — without warning — could abandon their peg, would the Danes be next?
The Danish krone EURDKK, +0.0188% USDDKK, -0.1424% has been pegged since 1982, first to the German Deutsche Mark, and then to the euro from 1999. That makes it the longest running current fixed-exchange regime in Europe.
Lars Rohde, governor of the Danish central bank, remembers that day in 2015 extremely clearly. Up until 10:30 a.m., it had been a quiet Thursday morning at the bank’s headquarters in central Copenhagen — but in a flash, his world was turned upside down, and he was caught in the middle of his biggest challenge as central bank boss: Defending the krone against all costs.
“It was the beginning of some very turbulent weeks,” he said in an interview with MarketWatch recently.
“We saw a massive inflow into the krone in a matter of just a few days. In a situation like that, no one knows the depth or the duration of the speculation. You don’t know if there’s another trillion kroner out there, or it’s 100 billion, or nothing more at all,” he said.
Those speculative investors turned out to be very determined. Over the following three weeks, they continued to aggressively attack the krone, hoping to build up enough pressure to force the central bank to de-peg. That would likely consign the Danish currency to the same destiny as the Swissy — soaring against the euro and returning a hefty profit to traders positioned on the right side.
Do whatever it takes
That buying of the krone forced Rohde to act quickly and reach for the extremes in his monetary-policy tool box.
Over the course of those three weeks, Danmarks Nationalbank cut its deposit rate four times — a highly unusual move — to end at negative 0.75%; temporarily suspended the issuance of government bonds; and boosted its foreign currency reserves by 275 billion kroner, or $43.9 billion. (To put that in context, Denmark’s entire gross domestic product stood at $306 billion last year.)
Still scrambling to fend off the inflows, Rohde resorted to the ultimate monetary policy tool: The “do-what-ever-it-takes” speech.
“On that famed Feb. 5, when I appeared on numerous TV channels, I tried to send a signal to the market the same way [European Central Bank President Mario] Draghi would articulate it: We will do whatever it takes. We can go on forever. And we are ready to drive our foreign-exchange reserves into the sky,” he said.
It worked. The attackers pulled back, and the Danish central bank was able to draw a line under its rate cuts.
Read: Danish central bank gets windfall in krone defense
Nevertheless, the episode sparked an international discussion about the longevity and viability of the Danish peg. And that debate returned to the limelight in April this year, when the Czech central bank gave up its euro peg and traders once again started to ponder which fixed currency regime could be the next to fall.
But if one does, it won’t be Denmark, said Rohde, chief of the country’s central bank since 2013.
Introduced in 1982 to help stabilize a struggling Danish economy, the fixed-exchange scheme continues to enjoy enormous broad backing from politicians, the public and financial institutions. It’s now ingrained into the culture, and Danes rarely question whether it’s a good idea.
For one thing, the eurozone is Denmark’s largest trading partner, and the fixed exchange rate keeps Danish companies competitive and predictable within that market. The krone is pegged to trade within a 2.25% band of 7.46038 krone to the euro.
“It’s become the cornerstone of Danish economic policy. It works like an anchor,” Rohde said. “The benefits are, in my opinion, overwhelming, because it provides a predictable framework for everyone.”
Reducing moral hazard
The Danish central bank can defend its peg in several ways, depending on where the pressure is coming from.
If money is flowing in, as it did after the Swiss upset in 2015, the bank can lower interest rates until it reaches a somewhat unknown lower bound. When rate cuts no longer seem sensible, the bank can print unlimited amounts of kroner to buy enough euros until the peg is back in balance.
On the flipside, if speculators are hitting the sell button, Rohde said the bank is willing to raise rates until the outflow stops. In either case, there are no constraints — the bank can literally do whatever it takes.
Rohde also explained that the peg helps to reduce moral hazard in the financial system, because companies and politicians can’t go crying for help to the central bank and hope for large stimulus packages if the economy turns sour. That means it’s up to the Danish government to tackle housing bubbles, high unemployment and inflation through fiscal policy and structural reforms.
“Everyone, regardless of political party and who’s in government, completely understands and accepts that monetary policy in Denmark is reserved for the fixed-exchange rate policy,” Rohde said.
That’s in contrast to the eurozone, where the ECB can use interest-rate cuts — and other tools — to help an ailing economy. But Draghi has argued repeatedly that monetary policy alone can’t fix the eurozone, and has urged national governments to do some of the heavy lifting via fiscal and structural reforms.
Project Syndicate: ECB has won this battle, but it’s out of ammo for the next one
“Monetary policy has been the only game in town [in the eurozone.] But if fiscal policies had been more supportive, if tax, structural and labor market reforms had been implemented quicker, then the recovery would have been easier,” Rohde said.
“There’s a risk [in Europe] that because monetary policy has done a lot, there’s been less urgency to push through structural reforms. That’s the downside, that it creates moral hazard,” he added.
Brutal burst of housing bubble
Rohde admits, however, that there are downsides to the Danish model. As the krone peg has to always come first in any situation, the central bank finds it sometimes has to react counter-intuitively to economic shocks.
One example is during the onset of the financial crisis in Denmark in 2008. Back then, the central bank battled with a currency crisis as traders rushed into big safe-haven alternatives such as the U.S. dollar DXY, -0.15% and the Japanese yen JPYUSD, +0.075850% That forced the national bank to hike interest rates to maintain the exchange rate, at a time where the obvious thing to do would have been to ease policy to support a flagging economy.
“It probably contributed to the housing-bubble burst being more brutal than it otherwise would have been,” he said. Denmark’s house prices collapsed more than 30% from peak to trough once the bubble burst.
“I still firmly believe the benefits outweigh the disadvantages, but there are incidents where — had you been in another regime — you would have eased monetary policy and you can’t, and vice versa,” the central banker noted.
Today, almost three years after the Swiss surprise, Denmark’s deposit rate stands at negative 0.65% — one of the lowest in the world — as Rohde and his team continue the fight to keep the krone stable against the euro. Its low rates have partially been blamed for the rapid rise in housing prices in large Danish cities such as Copenhagen and Aarhus, which have led several economists to warn of a new bubble. In November, the fixed rate on a 30-year mortgage dropped to 1.5%.
Read: Opinion: How negative interest rates take money out of your pocket
A long engagement
Denmark’s peg is like a 35-year engagement, first with Germany, then with the eurozone. Many think it’s now time to decide: Should it end in marriage to the euro, or a breakup?
Being outside the eurozone means Denmark gets no say in ECB policy, but still is heavily impacted by its decisions. Economically, it makes sense to be part of the club, Rohde explained — but adds that ultimately, it’s a decision for voters.
In a referendum in 2000, the Danes rejected membership of the monetary union, voting 53% against and 47% in favor.
“I don’t think it’s been rejected based on an economic argument, but rather that people think there are some countries where their economies are not up to scratch, and there would be risks associated with joining that club somehow. That risk hasn’t materialized, but that’s the logical answer,” he said.
All things considered, Rohde tends to back joining the euro rather than just abandoning the peg.
“If you keep a fixed-exchange rate policy for more than 30 years, it must be because you mean it. So it would be logical to enter into a euro membership,” he said.