Denmark is unleashing huge amounts of ammunition in its battle to prevent the krone from appreciating. The cost of the campaign, though, suggests that any renewed assault by speculators could require an even more aggressive response -- capital controls.
The nation revealed yesterday that its foreign currency reserves soared by 173 billion kroner ($26 billion) in February -- the biggest increase ever. The central bank has been cranking up the printing presses, minting domestic currency for sale on the foreign exchange market to stop the krone from straying too far from its target rate of about 7.46 per euro.
As it offloads kroner, the central bank buys foreign currencies, which go into a reserve account that held a record 737 billion kroner last week. Those sales, combined with four rate cuts this year -- driving the benchmark deposit rate to minus 0.75 percent -- are deterring traders from betting they can make money pushing the currency higher:
The initial pressure on Denmark's currency came after Switzerland abandoned its currency peg in January, and as the European Central Bank's plan to unveil a government bond-buying program discouraged investors from wanting to own the euro. The Danish government says it's determined not to let its exports take a hit from currency appreciation.
But, as the chart below shows, prices in the derivatives market suggest the war isn't over. Traders who buy and sell contracts to speculate on where the krone will be in a year's time are still anticipating it will strengthen. The current bet is for a 0.8 percent variation from the target rate, which is still within the official 2.25 percent range the central bank says it will tolerate, but outside the 0.5 percent band it has typically maintained. Moreover, the red line is moving in the wrong direction:
Jens Nordvig, the New York-based head of currency research at Japanese bank Nomura, says that although Denmark's foreign exchange efforts are more credible than Switzerland's were, it may find itself under renewed attack:
The battle may not be over. The inflows may reappear, especially if the euro is on a global weakening trend. To cement the credibility of the Danish peg arrangement, the authorities may seek to explore extreme options, at least as a temporary measure.
In theory, Denmark's membership in the European Union prohibits it from restricting the free movement of capital among member states. Also in theory, that would outlaw any move to lock money in the country, or to unilaterally tax currency trading. In practice, however, EU rules are a moveable feast. With the euro already the third-worst performer against the dollar this year, out of the world's 16 most-traded currencies, Denmark may need more than rate cuts and krone sales to defend itself.
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