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"Report and Accounts 1998"



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Monetary and Exchange-Rate Policy

The introduction of the euro as from 1 January 1999 will not imply any real change in Denmark's foreign-exchange policy. The fixed-exchange- rate policy will be maintained, but the objective will now be to maintain a stable krone rate against the euro, within the framework of the new exchange-rate mechanism, ERM II.

The krone fluctuated little against the D-mark in 1998. The Nationalbank sold foreign exchange in periods when the krone was subject to pressure and purchased foreign exchange in other periods. In net terms intervention in the foreign-exchange market reduced the foreign-exchange reserve by kr. 29 billion.

The Nationalbank raised its official interest rates when the krone came under pressure in May and September 1998. In the final months of 1998 and the beginning of 1999 the interest rates were lowered on several occasions in step with the Nationalbank's purchases of foreign exchange. In December 1998 the Nationalbank also lowered the interest rates after a coordinated lowering of interest rates in the 11 euro area member states.

Foreign-Exchange Policy after the Introduction of the Euro

The fixed-exchange-rate policy has been a cornerstone of Denmark's economic policy since the beginning of the 1980s. Stabilising the krone against the currencies of low-inflation countries creates a framework for low inflation in Denmark. The fixed-exchange-rate policy entails a clear dividing line between monetary and fiscal policy. Monetary policy is designed to maintain a stable krone rate, while it is up to fiscal policy to stabilise the development in wages and prices.

Up to the introduction of the euro on 1 January 1999 the exchange-rate mechanism, ERM, of the European Monetary System, EMS, was the formal framework for Denmark's fixed-exchange-rate policy. The foreign-exchange-policy objective was stated more clearly as a result of the widening of the ERM fluctuation band in 1993. The objective applied until 31 December 1998 was to maintain a stable krone rate against the core currencies of the EMS: the D-mark, the Dutch guilder, the Belgian franc, the French franc and as from 1995, the Austrian schilling.

As a consequence of the introduction of the euro, as from 1 January 1999, the EMS was replaced by a new voluntary exchange-rate mechanism, ERM II. The purpose of ERM II is to ensure exchange-rate stability between the euro area and the EU member states not adopting the single currency. ERM II is described in more detail on p. 83ff.

As a natural continuation of the fixed-exchange-rate policy Denmark has concluded an agreement on participation in ERM II with the euro area member states and the European Central Bank, ECB. This means that monetary policy is designed to maintain a stable krone rate against the euro. Denmark participates in ERM II with a central rate against the euro of kr. 746.038 per 100 euro and a fluctuation band of +/-2.25 per cent, cf. the press release on p. 130. The krone's central rate against the euro in ERM II is calculated on the basis of the krone's previous central rate against the D-mark and the conversion rate from D-mark to euro.

The ERM II agreement is the formal basis for the continuation of the fixed-exchange-rate policy. However, the agreement cannot in itself guarantee the krone's stability. This requires a consistent, stability-oriented economic policy. By entering into this agreement the Danish government has signalled its intention to pursue an economic policy in accordance with the requirements set by the fixed-exchange-rate policy.

In recent years the Nationalbank has stabilised the krone close to its central rate against the D-mark. This policy will be continued within the framework of ERM II, but now with the euro as the "anchor" currency. The fixed-exchange-rate policy entails that any unrest involving the krone will be countered by purchase or sale of foreign exchange and/or adjustment of the Nationalbank's interest rates.

Greece also participates in ERM II, while the UK and Sweden did not wish to conclude an agreement. Greece participates in ERM II with the system's standard fluctuation band against the euro of +/-15 per cent.

The European Monetary System in 1998

Up to the irrevocable fixing of the exchange rates on 31 December 1998 and the transition to the euro, the exchange-rate relations between the ERM currencies were characterised by continued convergence towards the central rates, cf. Chart 10.

The convergence which has characterised the exchange rates within the ERM for the last 2-3 years accelerated after the formal decision in May 1998 on the countries to participate in the third stage of Economic and Monetary Union as from 1 January 1999. At the same time, the bilateral conversion rates between the participating countries' currencies were announced. As expected it was decided that the previous central rates would be the basis for the conversion rates to euro.

Throughout 1998 the krone was very close to its central rate against the D-mark.

The Greek drachma joined the ERM on 16 March 1998 with a central rate of kr. 2,11276 per GRD 100, cf. the press release on p. 128. The background to Greece's decision to join the ERM is the country's wish to participate in the third stage of EMU in 2001.

At the same time the central rate of the Irish pound was written up by 3 per cent against the other ERM currencies, as the market rate had been higher than the central rate for a prolonged period. The market rate for the Irish pound was thereafter close to the new central rate vis- à-vis the D-mark.

Chart 10 Selected ems currencies vis-à-vis the d-mark
Picture of Chart 10 Selected ems currencies vis-à-vis the d-mark
Note: Deviations from central rate. 5-day moving average.

Trading of the euro began on 4 January 1999 when currency markets opened after New Year. The practical changeover to the euro was smooth. During the first days the euro strengthened marginally against the dollar and the yen, but then weakened somewhat.

Development in interest rates

After the designation in May 1998 of the 11 euro area member states and up to the close of the year the official interest rates of the other participating countries were aligned to the level in Germany, France, the Netherlands, Belgium and Austria, cf. Chart 11. On 3 December the central banks of the future euro area member states lowered their interest rates as a coordinated measure. This brought the central official interest rates in the euro area down to 3 per cent. In Italy, however, the interest rate was lowered to the common level with effect from 23 December 1998.

Chart 11 Official interest rates in selected ems countries
Picture of Chart 11 Official interest rates in selected ems countries

On 1 January 1999 the ECB took over responsibility for the single monetary policy and commenced its monetary-policy operations by fixing the rate of interest for the main refinancing operations, the central official interest rate, at 3 per cent.

The adjustment of the official interest rates to a common level led to equivalent convergence in the short-term money-market interest rates among the future euro area member states.

Throughout 1998 the Danish inter-bank interest rate was above the level in the former core EMS countries, and was subject to considerable volatility in connection with unrest involving the krone and the other Scandinavian currencies. During the currency unrest in September the short-term interest-rate differential to Germany widened to around 2 per cent for a brief period. In February 1999 the interest-rate differential had narrowed to around 0.5 per cent.

Inthefirsthalf of 1998 the long-term yields of the former high-interest countries, Spain, Portugal and Italy, continued to converge towards the German level, while the yield differentials for the other member states were relatively unchanged, cf. Chart 12. The unrest on the international financial markets in August and September led to a general widening of yield differentials to Germany, cf. p. 51. Towards the end of the year the yield differentials narrowed back to the level before the unrest.

Chart 12 Long-term yield differentials to Germany
Picture of Chart 12 Long-term yield differentials to Germany
Note: 10-year government bonds.

Yield differentials between government bonds issued by the euro area member states after the introduction of the single currency can still occur. This is due to varying evaluation of the credit risk and liquidity of the various issues.

Interest rates in Denmark

At the beginning of 1998 the krone showed a tendency to weaken against the D-mark, particularly as a consequence of market uncertainty concerning the outcome of the referendum on the Amsterdam Treaty on 28 May, and the Nationalbank sold foreign exchange. As from the beginning of April this tendency gained momentum and the krone weakened further to a level close to its central rate, since uncertainty in the foreign-exchange market had been augmented by the labour-market dispute, cf. Chart 13. In April the Nationalbank sold currency for kr. 16 billion in support of the krone.

The Nationalbank continued to sell foreign exchange in May and on 6 May 1998 raised the discount rate by 0.5 per cent to 4.00 per cent. At the same time the interest rate on certificates of deposit and the repo rate were raised equivalently to 4.25 per cent.

After the elimination of the uncertainty which had arisen in the foreign-exchange market prior to the referendum the Nationalbank on 29 May lowered the discount rate and the rate of interest on certificates of deposit and the repo rate by 0.25 per cent to respectively 3.75 and 4.00 per cent.

Chart 13 The Nationalbank's net purchases of currency
and the krone rate against the d-mark

Picture of Chart 13 The Nationalbank's net purchases of currency and the krone rate against the d-mark
Note: Weekly observations.

After interest rates were lowered in May and up to the end of August the Nationalbank's intervention in the foreign-exchange market was negligible. The situation changed when, in response to sustained pressure against the Norwegian krone, Norges Bank on 24 August in reality allowed the Norwegian krone to float, after repeated interest-rate increases. The Danish krone came under shortlived pressure and the Nationalbank intervened for considerable amounts. The inter-bank interest rates rose strongly, cf. Chart 14, putting a premium on speculation against the krone. This helped to stabilise the krone rate and the pressure soon subsided.

Chart 14 Official interest rates and 3-month inter-bank
interest rate in Denmark

Picture of Chart 14 Official interest rates and 3-month inter-bank

In September the Danish foreign-exchange market was affected by the unrest on the international financial markets and the krone came under pressure again. The Nationalbank again had to intervene. The intervention requirement proved to be more persistent than in August and the official interest rates were raised with effect from 21 September. The discount rate was lifted by 0.5 per cent to 4.25 per cent and the rate of interest for certificates of deposit and the repo rate by 1.00 per cent to 5.00 per cent.

The pressure against the krone continued on the day after interest rates were raised due to uncertainty concerning the Scandinavian currencies after the election in Sweden and the Nationalbank again had to intervene. The pressure soon subsided, however, and the Nationalbank could buy currency in the market as the krone strengthened. In the last three months of the year the Nationalbank repurchased a considerable proportion of the foreign exchange used to support the krone in August and September, cf. Chart 13. This made it possible to lower the official interest rates on several occasions during the autumn. The rate of interest for certificates of deposit and the repo rate were lowered by 0.25 per cent on 8 October, by 0.10 per cent on 22 October, by 0.25 per cent on 5 November and finally by 0.15 per cent on 26 November, to 4.25 per cent. Simultaneously with the reduction of the repo rate on 5 November the discount rate was lowered by 0.25 per cent to 4.00 per cent.

On 3 December the central banks of the future euro area member states as a coordinated measure lowered the central official interest rates to 3.00 per cent, i.e. by 0.30 per cent with regard to the Bundesbank and most other central banks. In view of the continued strong and stable krone and the good progress towards normalisation of Danish interest-rate conditions the Nationalbank followed the euro area member states' lowering of interest rates with an equivalent reduction of the repo rate and the rate of interest on certificates of deposit by 0.30 per cent to 3.95 per cent. The discount rate was lowered by 0.5 per cent to 3.5 per cent. The adjustment took effect on 4 December.

Chart 15 The banks' average lending and deposit rates
Picture of Chart 15 The banks' average lending and deposit rates
Note: Quarterly averages.

On 7 January 1999 the Nationalbank lowered the rate of interest for certificates of deposit and the repo rate by 0.20 per cent to 3.75 per cent. In view of the continued inflow of currency the Nationalbank on 4 February lowered the discount rate by 0.25 per cent to 3.25 per cent. The rate of interest for certificates of deposit and the repo rate were also lowered by 0.25 per cent to 3.5 per cent.

The banks' deposit and lending rates
From the 4th quarter of 1997 to the 3rd quarter of 1998 the banks' average lending and deposit rates rose by respectively 0.1 per cent and 0.3 per cent. Interest-rate statistics for the 4th quarter of 1998 are not yetavailable.Thebanks'interestratesvis-à-viscustomershereby matched the Nationalbank's discount rate which - measured as a quarterly average - rose by 0.3 per cent in the same period.

The interest margin declined further in both 1997 and in 1998, cf. Chart 15. In the preceding years the falling level of interest rates was a significant factor behind the narrowing of the interest margin since the deposit rates for a number of deposit categories were so low that they could not fall in step with lending rates. In 1997 and 1998 there was an, albeit modest, increase in interest rates which might have led to a widening of the interest margin is unchanged deposit rates were maintained. This did not happen, however.

Bond yields
In 1998 the yield to maturity on 10-year government bonds fell by 1.4 per cent to 4.2 per cent. The decline continued in 1999 and at end- January the bond yield reached a historic low of around 4 per cent. Up to mid-July 1998 the decline was accompanied by a narrowing of the yield differential to Germany to 0.2 per cent. For a period the yield differential widened to 1 per cent in connection with the unrest on international financial markets in August and September. However, the yield differential then narrowed and was 0.4 per cent in February 1999.

Chart 16 Yield to maturity on 30-year mortgage-credit bonds
Picture of Chart 16 Yield to maturity on 30-year mortgage-credit bonds

The yield to maturity on 30-year mortgage-credit bonds with a coupon rate of 6 per cent maturing in 2029 fell by 0.3 per cent from 6.6 per cent at the beginning of 1998 to 6.3 per cent at the beginning of 1999, cf. Chart 16. In the same period the yield on equivalent 5-per-cent bonds fell from 6.3 per cent to 5.8 per cent. The development in bond yields has made it advantageous in many cases to convert mortgage-credit loans to loans at a lower coupon rate. The volume of conversions in 1998 and at the beginning of 1999 was close to the level during the conversion wave in 1993-94, although the increase in home owners' disposable income due to the conversions was less than during the first conversion wave. Thedropinmortgage-credit-bondyieldswaslowerthan for government bonds, even after adjustment for the greater conversion risk. Other factors contributing to the widening of the yield differential are described on p. 60.

Capital flows and the foreign-exchange reserve

The deficit on the current account of the balance of payments is estimated to be kr. 16 billion in 1998. Private capital flows entailed net capital exports of kr. 13 billion. The Nationalbank sold currency for kr. 28.7 billion and for the year as a whole the foreign-exchange reserve decreased by kr. 29.2 billion excluding value adjustments, cf. Table 5.

Table 5 CAPITAL FLOWS
Net receipts, kr. billion 1997 1998
The current account of the balance of payments 6.1 - 16.0
Capital transfers 0.7 0.1
Private capital flows:    
Portfolio investments1) 33.9 - 41.8
Direct investments2) - 9.3 - 4.5
Financial derivatives - 1.6 - 0.4
Lending and deposits3) 32.2 26.2
Estimate of unrecorded commercial credits 4.1 8.8
Errors and omissions - 21.7 - 1.2
The Nationalbank's net purchase of foreign exchange 44.4 - 28.7
Used as follows:    
To reduce the central government's foreign debt 1.3 21.7
For the central government's sale of Tele Danmark shares to abroad   - 21.2
To increase the foreign-exchange reserve 43.0 - 29.2
Note: Excluding value adjustments, etc.
1) Excluding the central government's foreign bond issues.
2) Excluding the central government's sale of Tele Danmark shares.
3) Excluding the central government's foreign bank loans.

From January to August the foreign-exchange reserve was affected by the central government's sale in January 1998 of Tele Danmark shares to abroad for kr. 21.2 billion. During 1998 the proceeds from this sale were used to reduce the central government's foreign debt which overall fell by kr. 21.7 billion.

In 1998 portfolio investments led to net capital exports of kr. 42 billion. Non-residents' net purchases of krone-denominated bonds were kr. 2 billion, while their net purchases of Danish bonds denominated in foreign exchange amounted to kr. 22 billion. Non-residents' net sales of Danish shares totalled kr. 15 billion. Residents' net purchases of foreign securities amounted to kr. 52 billion, comprising shares for kr. 31 billion and bonds for kr. 22 billion.

Non-residents often hedge the krone-rate risk on portfolios of krone-denominated bonds by raising loans in kroner or via the forward foreign-exchange market. Hedging eliminates the exchange-rate risk on the overall position. Any fluctuations in the krone rate will equivalently affect the value of assets and liabilities, so that the investor is subject only to an interest-rate risk in Danish kroner (a short-term debt denominated in kroner against a long-term asset in kroner). These transactions mean that the supply of and demand for kroner will increase or decrease by exactly the same amount, and the transactions therefore do not affect the exchange rate of the krone.

Chart 17 Change in non-residents' holdings of krone-denominated bonds
and krone position since the beginning of 1996

Picture of Chart 17 Change in non-residents' holdings of krone-denominated bonds and krone position since the beginning of 1996

Adjustment of the fluctuation in non-residents' holdings of krone-denominated bonds for Danish banks' krone-denominated lending to non-residents and positions in the forward foreign-exchange market gives an indicator of non-residents' (net) krone position. An increase in non-residents' position in kroner reflects an increase in non-residents' demand for kroner which - viewed in isolation - will exert upward pressure on the krone.

For certain periods of 1998 non-residents' holdings of krone-denominated bonds fluctuated against non-residents' overall position in kroner, cf. Chart 17. This does not necessarily reflect changes in the hedging of the exchange-rate risk associated with non-residents' holdings of krone-denominated bonds. It may for example also be due to open positions being taken with or against the krone in the forward foreign-exchange market.

The banks' liquidity

When the Nationalbank sells foreign exchange and purchases kroner the banks' net position with the Nationalbank is reduced. The Nationalbank's sales of foreign exchange during the spring of 1998 contributed to the gradual reduction in the banks' net assets with the Nationalbank, cf. Chart 18. This trend was reinforced by the Nationalbank's sales of foreign exchange in August and September. On the other hand, the foreign-exchange purchases in the 4th quarter of 1998 improved the banks' net position so that the net balance was again positive at the end of the year.

Chart 18 The banks' accounts with the Nationalbank
Picture of Chart 18 The banks' accounts with the Nationalbank

The substantial day-to-day fluctuations in the banks' net position are related to the central government's receipts and disbursements. The central-government payments do not affect the overall liquidity of the banks for the year as a whole. This is because the central government's gross domestic borrowing requirement (the gross borrowing requirement excluding redemption of foreign loans) is financed in full by issuing krone-denominated government securities.

The monetary-policy instruments

The Nationalbank conducts monetary policy via the terms for overnight current-account deposits and for the weekly market operations whereby the banks can borrow by entering into repurchase agreements or by placing funds in certificates of deposit. The weekly market operations have a maturity of 14 days.

The Nationalbank provides liquidity to the banks via weekly repurchase agreements. Liquidity is supplied against government bonds as collateral. The Nationalbank absorbs liquidity by weekly sale of certificates of deposit to the banks. In connection with the weekly market operations the banks taken as one normally tailor their net position to providing current-account balances to cover the expected liquidity requirement for the following week. If large central-government receipts or disbursements are already foreseen the Nationalbank will as an extraordinary measure repurchase/sell certificates of deposit during the week.

Adjustment of the monetary-policy instruments
The terms for the Nationalbank's monetary-policy operations will be changed in a number of respects during the spring of 1999. These technical adjustments will not entail any changes in the overall framework. The instruments will still comprise interest-bearing current accounts and operations with 14 days' maturity.

Under the amended regime the collateral basis for the counterparties' intra-day borrowing from the Nationalbank and in connection with monetary-policy transactions will be harmonised and amalgamated in one shared collateral pool. In practice, the harmonisation will take place by expanding the collateral basis in connection with monetary-policy operations to include mortgage-credit bonds and certain other bonds. Certificates of deposit can still only be used as collateral for intra-day credit. The group of counterparties in connection with the monetary- policy operations is extended to also include mortgage-credit institutes.

In order to be able to handle the expanded collateral basis lending against collateral will replace repurchase agreements in the Nationalbank's monetary-policy operations. Furthermore, a uniform set of guidelines is introduced for the counterparties' provision of collateral to the Nationalbank. Today, the banks may borrow against the full market value of the underlying bonds on entering into repurchase agreements with the Nationalbank. In future the borrowing ratio will be less than 100 and will depend on the market risk associated with the securities used as collateral.

As a consequence of the expansion of the collateral basis a ceiling for current-account deposits with the Nationalbank at the end of the day is introduced. Should this individual ceiling be exceeded the Nationalbank will automatically convert any excess amounts to certificates of deposit. However, this measure will be used only in cases where the total ceiling for banks and mortgage-credit institutes taken as one is exceeded.





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Version 1.0 Maj 1999 Nationalbanken.
Published by Danmarks Nationalbank Maj 1999, http://www.nationalbanken.dk