Something Afoot in Denmark?
I am not sure how familiar my readers are with my home country but recent events suggests that what hitherto has been an extraordinary expansion is now decisively coming to an end. The ingredients are well known in the form of a collapsing housing market and a endemic shortage of labour which means that Denmark basically has been (and is) bumping against a lowering ceiling for potential growth. As my readers will also know (perhaps) Denmark is not a part of the Eurozone in the sense that we opted out of the third phase and thus the transition from national coins (the Danish krone) to the Euro. However we are firmly tied up, in terms of monetary policy, to the whims of the ECB where the Danish krone is tightly bound to the Euro through a fixed rate exchange regime.
In this light, the spread between the Danish central bank's lending rate and the corresponding rate at the ECB has almost dissapeared since the advent of the credit crisis at times even running negative. This has lead to a pressure on the Krona which is what the central bank is now reacting on.
With effect from 16 May 2008 the lending rate and the interest rate for certificates of deposits are raised from 4.25 per cent to 4.35 per cent. The discount rate and the interest rate on banks' current ac-counts with Danmarks Nationalbank remain unchanged at 4.0 per cent. Since August 2007 the spread between Danmarks Nationalbank's lending rate and ECB's marginal rate has been reduced with 15-20 basis points, thus the spread has more or less disappeared. In short periods of time the interest-rate spread has been negative. The development of the interest-rate spread has led to a weakening of the Danish krone, and in accordance with the fixed-exchange-rate policy Danmarks Nationalbank has intervened to support the krone.
Now, this is hardly breaking news or anything and I am not envisioning an Iceland style run on the Krona but clearly I feel that general jitter in markets are what prompted the bank to react in the first place in a somewhat preemptive manner. What is more pertinent to mention is this case I think is the situation in the Baltics where we have just confirmed with a fair amount of probability that we are now in a recession. As we know, the Baltics also themselves have a fixed exchange rate regime and thus need to put a floor below any rapid tendencies of depreciation. Given the fact that credit is already tightening rapidly and that real economic activity is heading down it is not for the faint of heart to imagine what would happen if the Baltics had to increase interest rates sharply to defend the peg. Let us hope it does not come to that.