What if Denmark was part of EMU?

For analysing the crisis in Europe, it is useful to divide it into three kinds of regions.

  • One, is East Europe which is not part of EMU. These are all emerging economies and most have been devastated in this crisis (Poland is one exception, even Czech Republic). There is lots of analysis on this (see this excellent interview for a snapshot). The primary reason is the same as seen in most crisis – excessive consumption financed by foreign funds, poor fiscal management, foreign banks lending  in euro currency, etc.
  • Second, West Europe which is part of EMU. The list is now of 16 countries. These are mostly advanced economies.
  • Third, West Europe which is not part of EMU. It is part of EU but has preferred to retain its monetary policy and currency. These include – Sweden, UK and Denmark. Even within this, there are differences. Sweden and Bank of England follows a flexible exchange rate and Denmark follows a fixed exchange rate.

How has crisis impacted all these three regions? In particular the role of EMU is a fascinating point of research?

  • Would joining EMU have helped economies liek Latvia etc?
  • Would leaving EMU help economies like Greece etc?
  • Would joing EMU helped economies like Sweden, Uk and Denmark?

Clearly there are no easy answers.

In a super speech, Danish Central Bank Governor Nils Bernstein looks at the third question:

The really interesting question is, perhaps, what difference it would have made, if we had been part of the euro area. That is difficult to say, as other things might not have been equal. For example: who knows whether Denmark’s economic policy would have been the same, if we had not been governed by the fixed-exchange-rate policy?

Since the euro was rejected in a referendum in 2000, it has been a widespread view, that Danish membership of the euro area is first and foremost a political question. Combined with the other three opt-outs, the issue is whether Denmark wants to participate fully in the important political decisions on the future of Europe.

From a purely economic point of view, Danish participation in the euro can be expected to lead to slightly lower interest rates, a small increase in foreign trade and lower transaction costs. In normal, calm periods, interest rates will only be marginally lower than under the current fixed-exchange rate regime.

Over a longer horizon, adopting the euro will have a certain positive overall effect on growth in Denmark. But it is difficult to quantify this effect, which is hardly likely to be felt in the short term. Danmarks Nationalbank’s rough estimate is that, in the long term, euro area membership would permanently boost GDP by between 0.5 and 1 per cent.

He then says despite Denmark performing well since Euro in 1999, they knew model would be tested in times of crisis:

Since the introduction of the euro in 1999, Denmark has performed well outside the euro area. This is due to our long-standing stability-oriented economic policy with a focus on medium-term objectives and structural reforms, not least in the labour market. It is important that Denmark continues along this path – even if we eventually join the euro. The current economic policy discussion should be viewed in that context. 

All along, we have been aware that the advantages of euro area membership would be accentuated in periods of financial turmoil. The lessons from the financial crisis have more than confirmed this.

Bernstein had made a case for joining ECB earlier as well.

 He then looks at the pressure on Denmark after Lehman fell. It led to drying up of liquidity in both USD and Euro markets. This was followed by setting up Swap lines with ECB and Fed.

There was capital outflow from Denamrk and the Central Bank was forced to raise rates. But nothing happened initially as ECB rates were higher.

Developments in the euro area were particularly significant for the krone. In late September and early October 2008, extensive demand for euro liquidity meant that the average allotment rate, in the ECB’s weekly main refinancing operations, exceeded Danmarks Nationalbank’s lending rate. In other words, the interest-rate spread turned negative. Usually the spread is positive to compensate for the exchange-rate risk. In early October, just before the ECB began to offer unlimited liquidity at a fixed rate of interest (the lending rate), the ECB’s average allotment rate was observed to be a full 39 basis points higher than Danmarks Nationalbank’s lending rate. As a result, the krone came under pressure.

 He then like Greece PM looks at the role of speculators for undoing much of the action by policymakers.

 At the peak of the crisis, many market rumours were circulating, claiming that Danmarks Nationalbank was in difficulties. A large foreign bank wrote that Danmarks Nationalbank no longer had any reserves for intervention and that the exchange rate was approaching its limit, i.e. a deviation of 2.25 per cent from the central rate. If that situation does occur, the ECB has an obligation to intervene in support of the krone. So far this has never happened.

The ERM II agreement includes a provision on unlimited intervention credit between the ECB and the participating central banks, including Danmarks Nationalbank. Such credit must be repaid within three months. There was extensive market focus on the size of our foreign-exchange reserve.

More specifically, a limit of DKK 100 billion was mentioned for  Danmarks Nationalbank to be able to defend the krone. There was anecdotal “evidence” that certain foreign investors were speculating against the krone (Chart 4). The first speculation rumours concerned options, with a strike price outside the implicit narrow band around the central rate. For example, a large hedge fund was reputed to have bought options against the krone weakening. The size of the financial backing behind this speculation is, however, uncertain. “Out-of-the-money” options involve little cost, but hedging by sellers of such options may have led to considerable sales of kroner.

Generally speaking, international speculators had a certain interest in testing the strength of the support for the fixed-exchange-rate policy. This caused further uncertainty about the krone.’

This was followed by Central Bank intervention and further rate hikes to defend pressure on krone. Other central banks were cutting rates but Denamrk ws raising them. It was only after setting swap lines with Fed and ECB, the problems were kind of solved. It led to a positive signal as well that ECB would back Denmark Cemtral Bank and Euro funding concerns will not remain.

Other factors were government issuing a 30 year bond which helped pension funds move into Danish securities. Then Govt support to guarantee all bank deposits also helped.

Denmark could return to normal situation in 6 November 2008, when it lowered rates. The months of September and October 2008 were very tough.

In the end he sums up the lessons:

So, in many ways the situation has normalised. But we have learnt what it means to be outside the euro area when you are a small economy with a fixed-exchange-rate regime. This should give food for thought.

We made it through. I will not ponder upon – at least not openly – what could have happened if speculation against the krone hadn’t subsided. We are still in a fixed exchange rate regime.

As recent developments have shown, euro membership is not – and should not – be a guarantee for easy access to foreign borrowing. That depends on one’s ability to keep its own house in order. There is no substitute for sound economic policy inside or outside the euro.

But when you are a small open economy and a storm of this magnitude sweeps through the markets – you would rather not have your own currency to worry about.

Very insightful speech from Denmark Central Banker.  It looks as if Denmark would have been better off with Euro.  Willem Buiter had already made a similar case for UK.

Rephrasing Milton Friedman- We are all Europeans now. Just to add, we might be for sometime to come. The European crisis experience shows there is so much to learn and reform. Everyone is talking about the European economic situation and possible remedies. 

One Response to “What if Denmark was part of EMU?”

  1. The European Debt Crisis – from a Danish Perspective « Mostly Economics Says:

    […] This led to problem in the crisis as when ECB was cutting rates, Denmark Central Bank was raising rates to prevent capital outflows (fixed exchange rates are messy most of the time). This prompted Denmark Central Bank chief to suggest that Denmark should join the Euro. He even looked at what would have happened if Denmark was part of Euro. […]

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