The currency peg in Denmark is under stress. A key pressure point is the repatriation of assets by domestic pension funds, which are concerned about currency risk. The authorities will continue with deposit rate cuts and direct currency intervention. This cannot go on forever, however. Another rate cut of 25bp is looming, taking the deposit rate to -1.0%. We think rate cuts should start to have more bite from here and see -1.25% as a likely stopping point. The collapse of the peg is not imminent, in our view, though we can see pressure being maintained on the central bank for weeks, if not months.
If rate cuts and intervention fail to ease pressure, Danish QE looks fraught with problems and political hurdles make joining the euro difficult. A re-peg looks likely in that scenario. The Danish central bank has been headline news in the financial pages, in light of its varied and repeated efforts to defend its currency peg against the euro. In some ways, it has its Swiss neighbours to blame, as the end of the peg there put the sustainability of the Danish peg firmly in the spotlight, but ECB policy was arguably the catalyst for both. The Swiss dropped the peg one week before the widely anticipated announcement of sovereign QE in the eurozone. In recent weeks, the Danish central bank has cut its deposit rate four times, most recently by 25bps to -75bps (Chart 1), it has supressed issuance of Danish bonds and it has intervened heavily in the FX market (Chart 2).
Despite all this, the central bank remains under pressure to the extent that its governor Lars Rohde gave a press conference last Thursday outlining the bank’s determination to defend the peg. He mentioned QE targeted at either government or mortgage bonds as additional policy instruments that could be deployed and said that “we can go on forever” with measures to defend the peg. In theory, this is true but the Swiss case shows there are some practical limits in terms of just how far the authorities can go. Institutional investors face difficult situation The current situation differs from the currency crises which plagued the early days of ERM. Then, the main pressure on the currency came from speculators.
While speculative flows are undoubtedly part of the current pressures on the DKK, significant flows are coming from the domestic pension and insurance funds. These funds have liabilities in DKK but hold significant amounts of euro assets. If the DKK appreciates, euro assets cover fewer DKK liabilities so risk management concerns are prompting a repatriation of these euro assets, increasing demand for domestic assets and putting upward pressure on the DKK. The collapse of the Swiss peg, despite the more ephemeral character of that arrangement, could lead to a structural change in demand for Danish assets simply because markets perceive a non-zero probability of currency revaluation. A lot done … Chart 1: Danish deposit rate Chart 2: Central bank FX reserves Source: Macrobond, Riksbank, BNP Paribas Source: Macrobond, Riksbank, BNP Paribas … but more to do. Risk management by institutional investors 1
The problem for pension funds or insurers looking to move back into domestic assets is the lack of suitable assets. The two largest asset markets are the government debt market at approximately DKK 650bn and the market for mortgage bonds which is considerably larger at DKK 2.9trn. There are two problems in terms of buying big in these two markets. First, the duration of these assets is relatively short in many cases. Indeed, roughly two-thirds of the mortgage market is less than five years in maturity, which makes these assets less attractive for pension funds. In the sovereign market, there is only one bond beyond 10-years in duration. The second problem is that pension funds and insurers already own a significant chunk of these markets and may be reluctant to buy more. More cuts in the deposit rate The central bank certainly has a number of options still on the table to defend the peg. They can continue on the path that they trod to date and continue with cuts in the deposit rate.
A target zone in terms of the currency implies a target on the interest rate differential between the two countries. The repeated cuts in the deposit rate are an attempt to realign this rate differential to depress the currency. The Danish deposit rate is now at its lowest on record relative to its eurozone equivalent. We believe that the central bank can and will go further in terms of reducing its deposit rate, with another 25bp cut likely anytime in the coming days, most likely on Thursday. The negative carry on 2-year government bonds, a key spread in FX markets (Chart 3), should eventually provide some sort of anchor to the currency. As with previous cuts in the deposit rate, this will pull down on the entire term structure of rates in Denmark. There are, of course, concerns on how further moves into negative territory will impact on banks and the mortgage (bond) market. Indeed, mortgage banks met with officials last week to discuss a response to the new rates environment. What’s more, this looks set to start impacting bank customers soon with FIH Erhvervsbank A/S saying on Friday that it will start charging some retail customers for deposits, according to a Bloomberg report.
Negative deposit rates combined with a lack of domestic assets amount to a headache for pension funds. They are reluctant to hold the same proportion of euro assets in their portfolios as before, considering the risk, however small, of revaluation, as this could impair their ability to meet future pension liabilities. Things aren’t much better at home, though, as negative deposit rates and negative yields mean that domestic asset growth could also be insufficient to meet future liabilities. This means there is a natural limit to how negative deposit rates can go on a sustained basis. Deeply negative rates, of say -2.0% or less, would probably cause serious problems for both the pension industry and for bank profitability, leading to disintermediation problems. To the extent that these rates are also passed on to depositors, it could lead to a shrinking and narrowing of the funding base of banks. Direction intervention will continue Intervention has formed a central plank of the policy
response to date and is likely to continue. In most currency crises, a country faces a collapse in the value of its currency, forcing it to deplete FX reserves to push up the currency. The dynamics are different here in that the Danish central bank is trying to push down the value of the krone. In this sense, the central bank can expand its balance sheet, in theory without limit, creating domestic currency and use this to purchase euro assets. The size of the central bank balance sheet is approximately 30% of GDP, well below the 75% level reached by the SNB when it abandoned the peg. At face value, it seems that the central bank in Denmark has a lot more room to manoeuvre relative to the position the SNB found itself in early last month.
However, the size of the balance sheet is not necessarily the relevant metric. In Switzerland, the prospect of wiping out the central banks’ capital underscored the decision to abandon the peg, in our view (Switzerland: The SNB cuts its losses). The Danish central bank has capital and reserves of approximately DKK 63bn. If there was a revaluation of say 10%, the central bank could hold approximately DKK 630bn in foreign reserves before its realised loss would wipe out existing capital. Foreign reserves are already quite close to this level at DKK 565bn. What’s more, DKK 106.6bn, or 23%, of this was added in January alone, meaning FX reserves are now being accumulated at an extraordinary pace. The central bank is probably not yet close to the point where it would stop intervening. The accumulation of large FX reserves is not a problem as long as it views revaluation of the peg as off the table.
The Danish sovereign is not heavily indebted, with a debt-to-GDP ratio of less than 45%. It could agree to backstop the central bank to replenish capital. Indeed, a central bank can operate with negative capital for some time so long as confidence is maintained in the currency, as its liabilities are mainly notional (ECB: The hawks and the red herring). For these reasons, we think intervention will continue to play a key part of the policy response but the central bank cannot intervene indefinitely at a rate of DKK 100bn a month. QE looks difficult to implement Beyond these two instruments which have been widely deployed already, there are other responses, some of which are more palatable than others. The central bank has already flagged the possibility of QE. While this is a possibility, there are clear drawbacks. It would only serve to worsen existing distortions in domestic capital markets by pushing yields further into negative territory and, therefore, further hamper the ability of asset holders to generate returns.
The ability to purchase in large quantities is also questionable, considering that pension funds are already struggling to find domestic assets to purchase. Given that these funds already own a significant chunk of domestic assets, they are very unlikely to divest existing asset holdings. ECB to the rescue? The ECB might also become involved to render assistance to the Danish authorities, as the ERM2 agreement between the ECB and the Danmarks Nationalbank does provide for ECB involvement of potentially unlimited volume, as long as it does not conflict with the ECB’s own price stability goals. The central bank has shrugged off this suggestion, saying there is no need for help from the ECB. Still, if the ECB does intervene, it’s not clear how bad the situation needs to be before this happens. Would the ECB wait for the currency to get close to the 2.25% fluctuation band? It’s also unclear whether or not the ECB has a large stock of Danish assets or currency which it could sell into the market