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"Report and Accounts 2001"

Monetary and Exchange-Rate Policy

As a consequence of Denmark's participation in ERM II, the krone is held within a narrow band vis-à-vis the euro. The new government has confirmed that the fixed-exchange-rate policy will be continued unchanged.

During 2001 official interest rates were lowered in many countries, including the euro area and Denmark. The European Central Bank (ECB) cut its interest rates on four occasions by a total of 1.5 per cent. On each occasion, Danmarks Nationalbank followed suit by lowering its official interest rates. The discount rate was reduced in step with the ECB's interest rates, while the lending rate was lowered further in view of the krone's strength and stability. Since the beginning of 2001, the spread between the lending rates of Danmarks Nationalbank and the ECB has narrowed by 0.35 per cent.

The foreign-exchange market was very stable throughout the year, and Danmarks Nationalbank only intervened on rare occasions. The foreign- exchange reserve was kr. 27.5 billion higher at the end than at the beginning of 2001. This was primarily related to a large inflow of foreign exchange at the end of September.

The current-account surplus was kr. 34 billion in 2001. Denmark's inward and outward capital flows were considerable, resulting in net capital exports of kr. 5 billion from the private sector.

The fixed-exchange-rate policy

The objective of Denmark's monetary and exchange-rate policy is to keep the krone stable against the euro. In view of the primary objective of monetary policy in the euro area to maintain price stability the linking of the krone to the euro creates a framework for the economic policy that ensures a sound basis for stable economic development in Denmark. In its policy statement the new government that took office in November 2001 has confirmed that the fixed-exchange-rate policy will be maintained, and that the stance of economic policy will be designed to maintain the linking of the krone to the euro within the narrow fluctuation band.

Since the start of the third stage of EMU Denmark has participated in the exchange-rate mechanism, ERM II. After Greece joined the euro area on 1 January 2001 Denmark is the sole participant. The ERM II agreement stipulates a standard fluctuation band for each participating currency vis-à-vis the euro of +/-15 per cent around the central rate. Denmark has entered into an agreement whereby the krone participates in the exchange-rate mechanism with a narrower fluctuation band of +/-2.25 per cent around the central rate of kr. 746.038 per 100 euro. In order to maintain a stable krone rate Danmarks Nationalbank may both intervene in the foreign-exchange market and adjust the official interest rates.

As a consequence of the fixed-exchange-rate policy Denmark's official interest rates are adjusted in step with the ECB's adjustments of interest rates for as long as the foreign-exchange market is stable. If the krone comes under pressure, or there are sustained inflows or outflows of foreign exchange, Danmarks Nationalbank unilaterally adjusts its official interest rates in order to stabilise the krone.

The krone's rate against the euro was close to the central rate throughout the year, cf. Chart 9. At the beginning of 2001 the krone was marginally weaker than the central rate. During the summer it strengthened a little, and closed the year on the strong side of the central rate. Since the krone was stable, Danmarks Nationalbank only rarely intervened to stabilise the krone in the foreign-exchange market, cf. Chart 10. The market has thus to a high degree ensured the stability of the krone.

The stability of the foreign-exchange market was maintained in the period immediately after the 11 September terrorist attacks in the USA. The foreign-exchange market reacted calmly to this uncertain situation. In order to meet the increased demand for kroner in late September, Danmarks Nationalbank bought foreign exchange and sold kroner in the market.

Monetary policy and the short-term interest rates

The year was characterised by relaxations of monetary policy in Europe, the USA and Japan. The European Central Bank (ECB) lowered the official interest rates on four occasions in the course of the year by a total of 1.5 per cent. At the close of 2001 the minimum bid rate was 3.25 per cent. Danmarks Nationalbank likewise reduced its official interest rates. Box 1 presents a review of the Danish monetary-policy instruments.

In the spring, the ECB's Governing Council evaluated the risks to price stability in the medium term to be in greater balance than was the case at the end of 2000. The background was partly the declining growth in the monetary aggregate, M3, which was approaching the reference value of 4.5 per cent. Moreover, the economic and financial indicators of the future development in prices indicated in overall terms that inflationary pressure was diminishing, especially because the inflationary effects of the preceding oil-price increases and the depreciation of the euro were considered to be subsiding.

On 10 May, the Governing Council cut the official interest rates by 0.25 per cent, reducing the minimum bid rate for the main refinancing operations to 4.5 per cent, while the rates of interest for the deposit facility and the marginal lending facility were set at respectively 3.5 and 5.5 per cent. The Governing Council stated several factors as the grounds for the reduction: firstly, monetary developments were no longer considered to present a risk to price stability. Secondly, the demand pressure on consumer prices had declined as a consequence of the international slowdown. Thirdly, maintained wage moderation was considered to be a factor that positively influenced the prospects of price stability. On the same day, Danmarks Nationalbank lowered the discount rate by 0.25 per cent to 4.5 per cent, and the lending rate by 0.3 per cent to 5 per cent, cf. Table 3.

Box 1 Monetary-policy instruments of Danmarks Nationalbank

On 30 August the Governing Council again lowered the ECB's interest rates by 0.25 per cent with reference to the improved outlook for price stability. In addition to weak international demand there were now also signs of dampened consumption in the euro area. Both factors also had a negative impact on investment. Growth in the money stock began to increase during the summer, as the relatively flat yield curve and weak stock markets made it more attractive to hold short-term deposits and marketable paper, which are included in the money stock. Since growth in lending to the private sector still continued to decline, a tendency which commenced at the beginning of the year, the Governing Council considered monetary developments to be consistent with the target of price stability in the medium term. In Denmark, the lowering of interest rates was matched by a reduction of the discount rate by 0.25 per cent, while the lending rate was cut by 0.3 per cent.

Table 3 Interest rates of Danmarks Nationalbank and the ECB

Note:   Publication dates.
¹        The minimum bid rate in the Eurosystem's main refinancing operations.
²         Danmarks Nationalbank's lending rate is equivalent to the rate of interest on certificates of deposit.
³        The spread is the differential between Danmarks Nationalbank's lending rate and the minimum bid rate
           in the Eurosystem's main refinancing operations.

In the wake of the terrorist attacks in the USA, on 17 September the Federal Reserve cut the fed funds target rate by 0.5 per cent to 3 per cent. Later on the same day, the ECB's Governing Council reduced the official interest rates by 0.5 per cent. On the next day Danmarks Nationalbank followed suit with an equivalent lowering of interest rates. A number of other central banks also reduced their official interest rates in order to counter the greater economic uncertainty that was a consequence of the terrorist attacks.

On 8 November, the ECB's Governing Council cut the official interest rates by 0.5 per cent.^[6] The reasons given were in line with those applying to the lowering of interest rates in August. Once again, especially the economic and financial indicators for the future development in prices indicated lower inflationary pressure. There were still signs of weak aggregate demand, which was attributable partly to the general uncertainty after the terrorist attacks on 11 September. A further decline in demand- driven pressure on prices could therefore be expected. The Governing Council also assessed that the accelerating growth in the money stock still did not present any risk to price stability, since it primarily reflected investors' increased preference for liquidity as a consequence of the flat yield curve, developments in global stock markets, and greater uncertainty in the financial markets. The data also showed a continued decline in the growth of credit to the private sector. On the same day, Danmarks Nationalbank lowered the discount and lending rates by 0.5 per cent.

Since the beginning of 2001 Danmarks Nationalbank has lowered the lending rate by more than the discount rate, cf. Table 3. The background to this difference is that immediately after the referendum on Denmark's participation in the third stage of EMU Danmarks Nationalbank raised the lending rate by 0.5 per cent in order to counter uncertainty concerning the krone, but maintained the discount rate unchanged. The krone then strengthened against the euro, and in October 2000 the lending rate was reduced on two occasions by a total of 0.2 per cent. In connection with the ECB's lowering of interest rates on four occasions, Danmarks Nationalbank, as stated, also reduced the lending rate, in two cases by 0.05 per cent more than the ECB, in view of the krone's stability in the preceding months. In addition, Danmarks Nationalbank also unilaterally lowered the lending rate on three occasions, again as a consequence of the krone's strength and stability. Danmarks Nationalbank lowered the lending rate further by 0.05 per cent on 1 February 2002 in view of a substantial inflow of foreign exchange. As a consequence of these unilateral interest-rate reductions, the spread between Danmarks Nationalbank's lending rate and the minimum bid rate for the Eurosystem's main refinancing operations determined by the Governing Council has narrowed to 0.3 per cent.

As the ECB's main refinancing operations are conducted as variable- rate tenders, the marginal rate (the lowest interest rate at which liquidity is allotted) will sometimes exceed the minimum bid rate. In these cases the spread between Danmarks Nationalbank's lending rate and the ECB's marginal rate will not be as wide as the spread between the lending rate and the minimum bid rate. In 2001, the spread between the marginal and minimum bid rates was usually only a few basis points. The deviations were short-lived and mainly of a technical nature.

The money market
The Danish money market was calm in 2001. The money-market interest rates fell during the year, and the 3-month money-market interest rate was generally around the level of Danmarks Nationalbank's lending rate.

Intheperiodafter11Septemberthefunctioningofthemoney market drew considerableattention.ThedestructioninNewYorkimmediatelyledto great uncertainty in especially the US money market. Employees of several banks were reported missing, and documents and computers had been destroyed. Doubt also arose as to how quickly the market participants would be able to close agreed deals via their back-up facilities. Payment systems are highly dependent on the punctual settlement of all payments, and just a few lacking payments can present settlement problems. In order to avoid this situation the Federal Reserve immediately made available considerable amounts of liquidity. Several central banks established temporary agreements with the Federal Reserve in order to be able to supply their own financial institutions with liquidity in dollars. Danmarks Nationalbank also made dollar liquidity available to the banks and in this connection lent 400 million dollars (against collateral) for a period of one day at the current market interest rate. Moreover, severalcentral banks, among them Danmarks Nationalbank, conducted liquidity- providing operations to facilitate the functioning of the money markets. The outcome was that the money markets functioned without major difficulties, despite the devastation in New York.

Note: Quarterly averages.

The banks' interest rates
The banks' average deposit and lending rates decreased in line with falling short-term interest rates, cf. Chart 11. The banks' interest rates have been falling since the 4th quarter of 2000. The total decrease in lending rates up to the 3rd quarter of 2001 was 0.6 per cent, while deposit rates fell by 0.5 per cent in the same period. The banks began to reduce their interest rates before Danmarks Nationalbank lowered the discount rate for the first time midway through the 2nd quarter of 2001.

Interest rates for short-term mortgage-credit bonds
Interest rates for mortgage-credit loans also fell during the year. The statistics of the Association of Danish Mortgage Banks show that the yield on short-term mortgage-credit bonds fell by just over 1 per cent to a levelofapproximately 4 per cent at end-2001. In December the mortgage- credit institutes held auctions of the short-term mortgage-credit bonds on which variable-rate loans are based. The result of the auctions was that borrowers who have opted for annual interest-rate adjustment pay interest at approximately 4 per cent in 2002, while the interest rate for an equivalent euro loan is around 0.5 per cent lower.

Capital flows and the foreign-exchange reserve

Thebalanceofpaymentsimprovedin2001asaconsequenceofthe growing surplus on the balance of goods and services. The surplus on the current account was kr. 34 billion, cf. Table 4. The private sector's capital exports amounted to kr. 5 billion, and Danmarks Nationalbank purchased foreign exchange for kr. 28 billion. In 2001 the central government repaid foreign loans for kr. 1 billion, and the foreign-exchange reserve increased by kr. 28 billion.

Private capital flows leading to net capital exports totalling kr. 5 billion reflect substantial, to some extent offsetting, amounts for a number of sub-items, cf. Table 4. From contributing net capital imports of kr. 57 billion in 2000, direct outward investments exceeded direct inward investments in 2001, and resulted in net capital exports of kr. 17 billion. This item has become highly volatile in recent years, and the underlying gross movements have increased significantly. The same applies to the portfolio investments, which led to net capital exports of kr. 27 billion. Danish investors' purchase of foreign shares and bonds for a total of kr. 118 billion, as well as non-residents' sale of krone-denominated bonds for kr. 18 billion, contributed to the capital exports. However, these were partly set off by non-residents' purchase of Danish shares for kr. 8 billion, and of Danish bonds issued in foreign currencies for a total of kr. 102 billion. In 2001 loans and deposits led to capital imports of kr. 7 billion.

Portfolio adjustments after 11 September led to substantial international capital flows. In September Danish pension funds and insurance companies sold back foreign shares for a value of kr. 22 billion, and in October and November bought foreign bonds for kr. 31 billion. Other sectors also bought foreign bonds in October and November, so that Danish investors' total purchases of foreign bonds reached kr. 64 billion in these two months. The extensive divestment of foreign shares in September took place in the course of a few days, and led to strong demand for kroner. To counter fluctuations in the krone rate, Danmarks Nationalbank sold kroner in the foreign-exchange market and thereby increased the foreign-exchange reserve.

Table 4 Capital flows

Note:  Excluding value adjustments, etc.
⁴        Excluding the central government's foreign bond issues.
⁵        Excluding the central government's foreign bank loans.
⁶        Compensation for the hurricane in December 1999 is included as capital exports in 1999 and as capital imports in 2000.

Even if the current account of the balance of payments shows an increasing surplus, the foreign-exchange market is still dominated by capital flows between Denmark and abroad. The significance of capital flows to price formation in the foreign-exchange market is, however, reduced by the fact that one type of private capital flow is often set off by another type in the opposite direction. A Danish investor's purchase of bonds denominated in foreign currency will naturally not affect the foreign-exchange market if the investor simultaneously hedges the purchase. However, the case is different for the growing volume of Danish bonds issued in foreign exchange which are purchased predominantly by non-residents. A proportion of these are mortgage-credit bonds, which underlie variable-rate loans denominated in euro, but most of the issues originate from Danish banks and business enterprises. Where the Danish borrower converts the proceeds to kroner and assumes the exchange-rate risk, issues of Danish bonds in foreign exchange will contribute to supporting the krone rate.

Footnotes

^[6]  At this meeting, the Governing Council also decided that in future, as a rule, the level of the official interest rates will only be assessed at the first meeting of the month.

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Version 1.0 March 2002 Nationalbanken.
Published by Danmarks Nationalbank March 2002, http://www.nationalbanken.dk/