Monetary and Exchange-Rate Policy

In 1997 the EU's foreign-exchange and capital markets were characterized by greater convergence. The ERM currencies drew closer to the central rates against the D-mark and both the short-term and long-term interest-rate differentials between the countries narrowed.

After more than one year of unchanged interest rates the Nationalbank in October raised the official interest rates by 1/4 per cent as a consequence of the Bundesbank's raising of the repo rate. The other core countries also raised their official interest rates.

The Objective of the Monetary and Exchange-Rate Policy

The objective of the monetary and exchange-rate policy is to maintain a stable krone rate against the other core currencies: the D-mark, the Dutch guilder, the Belgian franc, the French franc and the Austrian schilling. The basis for the fixed-exchange-rate policy is the central rates of these currencies, which have been unchanged for more than 10 years.¹⁾ Pursuing a fixed-exchange-rate policy against a group of countries with traditionally low inflation creates a framework for low inflation in Denmark.

The fixed-exchange-rate policy entails a clear division of labour between monetary and fiscal policy. Monetary policy is designed to maintain a stable krone rate based on the central rate. It is therefore up to the other elements of economic policy, primarily fiscal policy, to stabilize the economic development.

The introduction of the single currency, the euro, in a number of EU member states on January 1, 1999 will not in reality lead to any change in Denmark's exchange-rate policy. As a natural continuation of the present policy the objective will be to maintain a stable krone rate against the euro. The framework for this will be the new exchange-rate mechanism, ERM2, cf p. 80ff.

The European Monetary System

In 1997 the EU foreign-exchange and capital markets were characterized by greater convergence. At the beginning of 1998 virtually all currencies in the EU exchange-rate mechanism, ERM, were very close to the central rates against the D-mark. In 1997 the krone was more stable against the D-mark than ever before within the EU exchange-rate system. This brought the krone in line with the Dutch guilder, the Austrian schilling and the Belgian franc, which have all for a long time followed the D-mark very closely, cf. Chart 10. From the middle of the year the French franc strengthened against the D-mark and at the end of 1997 was stronger than the central rate for the first time in seven years.

From mid-1997 the fluctuations in the Italian lira and the Spanish peseta vis-ā-vis the D-mark diminished gradually, and at the same time these currencies drew closer to the central rate. However, the currencies continued to fluctuate more against the D-mark than the core currencies, and the deviation from the central rate was also slightly higher.

In 1996 and for extended periods of 1997 the Irish pound rose strongly against the D-mark as a consequence of the strengthening of the pound sterling, which is very important to Ireland's foreign trade. At the end of 1997 this development was reversed and the Irish pound weakened

significantly. At the beginning of 1998 the Irish pound was just under 3 per cent stronger than its central rate against the D-mark, compared to just under 12 per cent in mid-1997.

At the informal meeting of the Council of Ministers of Economic Affairs and Finance, the ECOFIN Council, in September 1997 it was decided that the conversion rates to apply between the currencies of the euro countries as from January 1999 would be announced in May 1998 when the participating countries are nominated, cf. p. 78. The expectation in the foreign-exchange market is that the central rates will be the basis for the conversion rates between the currencies of the euro countries. This has stimulated the convergence towards the central rates.

The interest-rate differentials between the EU member states narrowed further during 1997. The short-term market interest rates in Italy and Spain gradually drew closer to the German level and throughout 1997 differentials between the short-term market rates in the core countries were only moderate, cf. Chart 11.

A stronger conviction that the third stage of EMU will commence with a broad group of participating countries led to a continued narrowing of the differentials between long-term interest rates to below 50 basis points (1/2 per cent) for most EU member states at the beginning of 1998, cf. Chart 12. Concurrently, the long-term German interest rates dropped further, cf. p. 44. There was a considerable narrowing of the yield differentials to Germany of Italy and Spain, while interest-rate differentials narrowed less in the member states, including Denmark, which have declared their non- participation in EMU on its commencement in 1999.²⁾

The Development in Interest Rates in Denmark

On October 9, after a period of one and a half years with the lowest discount rate since the 1930s, the Nationalbank raised the official interest rates, cf. Chart 13. The discount rate and the rate of interest on the banks' current-account deposits with the Nationalbank were raised by 1/4 per cent to 31/2 per cent. The interest rates on the Nationalbank's certificates of deposit and repurchase agreements (the repo rate) were raised equivalently to 33/4 per cent.

This increase in interest rates was a consequence of the Bundesbank's raising of the repo rate from 3.0 to 3.3 per cent. The grounds for raising the repo rate from a historically low level were stated to be the greater inflationary pressure arising from inter alia the weakening of the D-mark against the dollar, cf. p. 41. Timely measures would help prevent the build-up of inflationary pressure in the period up to the start of the third stage of EMU. Immediately after the announcement of the German raising of interest rates the Banque de France put up its repo rate to 3.3 per cent and the other core countries also raised their official interest rates.

As a consequence of the interest-rate adjustments the differential between the Danish and German repo rates narrowed by 5 basis points. The differential between Danish and German 3-month inter-bank rates dropped from approximately 50 basis points in mid-year to 40 basis points at the beginning of 1998.

Inter-bank interest rates in both Germany and Denmark rose after the augmentation of interest rates as a consequence of market expectations of further increases. At the beginning of 1998 the inter-bank interest rates fell again when expectations of an imminent raising subsided. One particular reason was a dampening of growth prospects in the industrialized countries as a consequence of the problems faced by the economies of Southeast Asia.

The banks' average deposit and lending rates declined from 1995 to mid-1997, cf. Table 23 of the Appendix of Tables. Since lending rates fell most the banks' interest margin was reduced. The drop in interest rates ceased in October when most banks increased their deposit and lending rates by 1/4 per cent as a consequence of the Nationalbank's raising of its interest rates.

The yield on 10-year government bonds fell from 6.6 per cent at the beginning of 1997 to 5.2 per cent at the beginning of 1998, while the yield on 30-year mortgage-credit bonds decreased from 8.0 per cent to 7.1 per cent.³⁾ In 1997 the decline in the long-term mortgage-credit-bond yield brought it down to the level of the beginning of the 1960s, cf. Chart 14. This indicates that the expectations that Denmark and the other industrialized countries can maintain the low inflation of recent years - equivalent to the price increases of the 1950s - are becoming firmer.

The yield on short-term bonds, e.g. 2-year Treasury notes, rose from the middle to the end of the year, but at the beginning of 1998 dropped back almost to the level at the beginning of 1997.

The relatively strong decline in the long-term yields resulted in a flatter term structure on the bond market, cf. Chart 15 which shows the zero- coupon-yield structure for government bonds with a maturity exceeding 2 years. The same development in the term structure was seen for yields in Germany.

Denmark's long-term yield differential to Germany narrowed slightly throughout 1997 from 70 basis points at the beginning of 1997 to 30 basis points at the beginning of 1998, which is the smallest differential since the beginning of 1994. The narrow yield differential in 1994 was shortlived, whereas the differential to Germany was low for the whole of 1997.

(to be continued)

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