Monetary and
Exchange-Rate Policy
As a consequence of Denmark's fixed-exchange-rate policy the krone has been stable against the euro and close to the central rate for a number of years.
In 2003 there was a tendency for the krone to strengthen in the 1st half of the year and weaken towards the end of the year. Danmarks Nationalbank intervened at intervals in the foreign-exchange market to stabilise the krone, and it unilaterally lowered its lending rate by 0.05 per cent in May. The spread between Danmarks Nationalbank's lending rate and the minimum bid rate for the ECB's main refinancing operations thereby narrowed to 0.15 per cent.
The European Central Bank, ECB, lowered its interest rates on two occasions in 2003, by a total of 0.75 per cent. Danmarks Nationalbank followed suit.
Foreign-exchange purchases by Danmarks Nationalbank in 2003 increased the foreign-exchange reserve by kr. 31 billion. This reflected a current-account surplus of kr. 39 billion and capital exports of kr. 8 billion.
The fixed-exchange-rate policy
The objective of Denmark's monetary and foreign-exchange policy is to keep the krone stable against the euro. In periods of calm in the foreign-exchange markets the Danish monetary-policy interest rates follow those of the ECB implying that a constant interest-rate differential is maintained. Danmarks Nationalbank can intervene in the foreign-exchange market in order to stabilise the exchange rate. If the tendency for the krone to strengthen or weaken is more prolonged, Danmarks Nationalbank unilaterally adjusts its monetary-policy interest rates.
Denmark's fixed-exchange-rate policy is conducted within the framework of the European exchange-rate mechanism, ERM II. ERM II stipulates a fluctuation band for the participating currencies vis-à-vis the euro of +/- 15 per cent around the central rate. As a consequence of Denmark's high degree of economic convergence with the euro area, a narrower fluctuation band has been agreed, whereby the krone may fluctuate by +/- 2.25 per cent around the central rate of kr. 746.038 per 100 euro. The fixed-exchange-rate policy entails that the economic policy is arranged in accordance with the fixed exchange rate. For a number of years the krone has been close to its central rate, usually slightly stronger, cf. Chart 8.
| Kroner vis-à-vis euro |
Chart 8
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| Note: Daily observations. | |
On 1 May 2004, 10 new member states will join the EU. A few of these will immediately apply for membership of ERM II with a view to introducing the euro as their currency. One of the convergence criteria for joining the euro is participation in ERM II for at least two years without severe tensions, including unilateral devaluation. Membership of ERM II does not require compliance with formal treaty-bound economic criteria. The central rates for the currencies of the participating countries are fixed by mutual agreement between government ministers from the euro area member states, the ECB and government ministers and central-bank governors from the non-euro-area member states participating in ERM II.
To ensure future confidence in the fixed-exchange-rate system and to support economic convergence, it is important that the new EU member states adjust their monetary and fiscal policies prior to participation in ERM II to bring their stabilisation-policy frameworks in line with the requirements of a fixed-exchange-rate policy. The new member states are at different stages of the convergence process, and fixing an exchange rate prematurely may lead to currency unrest, which can spread to other participants.
The ECB's monetary policy
The ECB's primary objective is to maintain price stability. In addition, the ECB's monetary policy must support the euro area's general economic policies, provided that this does not conflict with the primary objective.
In the spring the ECB published the result of an evaluation of its monetary-policy strategy. The definition of price stability was maintained as a year-on-year increase in the EU Harmonised Index of Consumer Prices, HICP, of below 2 per cent in the medium term, but the Governing Council emphasised that the implementation of monetary policy would be aimed at maintaining the inflation rate close to 2 per cent.
Monetary-policy decisions will still be based on extensive analyses of threats to price stability. The analyses are structured within two pillars, economic analysis and monetary analysis. In the economic pillar the ECB analyses a wide range of economic and financial indicators and the resulting risks to price stability in the short and medium term. The monetary pillar comprises an analysis of the development in a wide range of monetary indicators, including the money stock, with a view to assessing inflation prospects in the medium to long term. The monetary analysis is thus used to cross-check the short- and medium-term data from the economic analysis.
Since the reference value of the monetary aggregate growth rate, which is used to assess the monetary development, is applied in a more long-term perspective, the Governing Council decided that it was no longer necessary to determine the reference value on an annual basis. The underlying conditions will, however, be assessed by the Governing Council on a current basis.
On 1 August 2003 the ECB announced that the monetary-policy instruments would be adjusted with effect from the refinancing operation on 9 March 2004. The maturity of lending in the weekly refinancing operations was reduced from 14 to 7 days, and the reserve maintenance period was restructured to start on the settlement date of the first weekly tender after the monthly meeting of the Governing Council, at which monetary-policy interest rates are discussed. Box 1 elaborates on the ECB's monetary-policy instruments and the background to the changes.
The slope of the money‑market yield curve, which was almost flat at the beginning of 2002, became positive during the first months of the year, cf. Chart 9. An interpretation might be that the market increasingly expected the ECB to raise its interest rates within the coming year.
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Box 1
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The ECB's monetary-policy instruments comprise refinancing operations, reserve requirements and standing facilities. Refinancing operations are partly conducted as weekly main refinancing operations, and partly as longer-term refinancing operations. In the weekly operations the euro area banks can raise loans against collateral. The operations are conducted as tenders, whereby the banks submit bids for both the interest rate and the amount of liquidity required. The ECB has determined a minimum bid rate in advance. The ECB allots liquidity successively so that bids with the highest interest rates are complied with first. The marginal rate is the lowest rate at which liquidity is allotted, and pro-rata allotment may take place at the marginal rate. The marginal rate is normally close to the minimum bid rate, which is the ECB's signal rate. In the monthly longer-term refinancing operations, loans with a maturity of three months are provided against collateral. The reserve requirement entails that during a reserve maintenance period banks in the euro area must have a certain average deposit on their reserve accounts with the national central banks. The amount accrues interest at the average marginal interest rate during the reserve maintenance period. So far a reserve maintenance period has run from the 24th of one month to the 23rd of the following month. Consequently, the expectations of the minimum bid rate in the reserve maintenance period have affected the banks' bidding pattern since e.g. expectations of a raising of interest rates towards the end of a reserve maintenance period have given an incentive to bid for relatively more liquidity in the tenders at the beginning of the period and thus meet a larger percentage of the reserve requirement while interest rates are low. This bidding pattern can lead to undesirable fluctuations in the marginal rate. These considerations, among others, are the reason for reducing the maturity of loans in the weekly refinancing operations from 14 to 7 days and restructuring the reserve maintenance period, cf. the body text. In future, monetary-policy interest rates will normally not be changed during a reserve maintenance period. The impact of interest-rate expectations on bidding patterns can thus be expected to recede. The standing deposit and lending facilities give the banks access to deposit or borrow against collateral on a day-to-day basis. The rate of interest on the deposit and lending facilities are 1 per cent lower and 1 per cent higher, respectively, than the minimum bid rate. In connection with the transition to 7-day loans in the weekly operations, changes in the interest rate on the standing facilities will not take effect until the first day of the new reserve maintenance period. Previously they have come into force the day after their announcement. Future changes in interest rates will normally be announced on the first Thursday of the month, with effect from the Wednesday of the following week. |
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Monetary policy in 2003
Towards the end of 2002 there were expectations that the upturn in economic activity in the euro area would accelerate at the beginning of 2003. However, modest indications in this respect were not seen until the 2nd half of the year, when GDP growth picked up a little. Against this background the ECB lowered its monetary-policy interest rates on two occasions in 2003, cf. Chart 9. Money-market interest rates fell in the weeks prior to the announcements of the actual changes in interest rates, an indication that the financial markets were prepared for the lowering of the interest rates.
| The ECB'sminimum bid rate and the euro money-market interest rate |
Chart 9
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| Note: Uncollateralised money-market interest rate. | |
At its meeting on 6 March 2003, the Governing Council decided to lower the monetary-policy interest rates by 25 basis points so that the minimum bid rate was 2.5 per cent. In the assessment of the ECB the prospects of economic growth in the euro area had worsened, inter alia due to the uncertainty concerning war in Iraq, and the prospects of price stability in the medium term had therefore improved. The subsiding inflationary pressure was also a result of the strengthening of the euro vis-à-vis the dollar.
At its meeting on 5 June 2003 the Governing Council decided to lower the monetary-policy interest rates by 50 basis points. The background to this decision was that overall economic growth in the 1st half of 2003 was expected to be very weak. The development in inflation would be sluggish owing to a favourable trend in import prices as a result of the oil-price pattern and the stronger euro, as well as expectations of lower domestic price pressure in connection with a moderate economic upswing. Overall the ECB found that the prospects of price stability had improved significantly since the reduction in interest rates in March.
The rate of growth in the monetary aggregate, M3, has been somewhat above the reference value in recent years. This is e.g. attributable to the low level of interest rates, as well as portfolio shifts. The ECB does not currently see the high rate of M3 growth as a threat to price stability in the medium term since the period of high M3 growth has so far coincided with a recession, and the upturn in economic activity is expected to materialise gradually.
The annual rate of HICP growth in the euro area was very close to 2 per cent in 2003, most of the time slightly higher.
The monetary policy of Danmarks Nationalbank
In response to the ECB's reductions of interest rates, Danmarks Nationalbank lowered the discount rate and lending rate on 7 March and 6 June 2003 by 25 and 50 basis points, respectively, cf. Chart 10. In addition, on 23 May 2003 Danmarks Nationalbank lowered its lending rate by 0.05 per cent without an equivalent change on the part of the ECB. The spread between Danmarks Nationalbank's lending rate and the ECB's minimum bid rate was thus reduced to 0.15 per cent. After the lowering of the interest rates, the discount rate was 2 per cent and the lending rate 2.15 per cent.
In the weeks prior to the lowering of the interest rate on 23 May 2003 the krone had shown a sustained tendency to strengthen, and Danmarks Nationalbank had intervened in the foreign-exchange market. The inflow of foreign exchange was to some extent driven by hedging of dollar claims on the part of business enterprises and pension funds. In the following months the exchange rate of the krone remained stable, with one intervention in October, however. Towards the end of 2003 and in early 2004 the krone weakened slightly, but remained on the strong side of the central rate vis-à-vis the euro. Danmarks Nationalbank sold foreign exchange in the market at the beginning of 2004. The sale of foreign exchange could be attributed mainly to the purchase of foreign securities by pension funds.
The narrow interest-rate differential and the stable development in the krone rate in 2003 indicate a continued high degree of credibility in Denmark's fixed-exchange-rate policy and can be attributed to stable economic conditions and government surpluses.
In 2003 the foreign-exchange reserve grew by kr. 31 billion to kr. 224 billion, reflecting Danmarks Nationalbank's purchases of foreign exchange. The purchases were offset by an expansion of the net position of the banks and mortgage-credit institutes vis-à-vis Danmarks Nationalbank.
The ECB's transition to 7-day loans in the weekly refinancing operations will not affect Danmarks Nationalbank's monetary-policy instruments. Danmarks Nationalbank has decided to maintain a maturity of 14 days for its monetary-policy lending and certificates of deposit. This has proved to be a suitable maturity period for managing krone liquidity, and in general the experience with Danmarks Nationalbank's instruments has been good.[1]
In June 2003 Danmarks Nationalbank published a revised edition of "Monetary Policy in Denmark", cf. p. 166. The publication gives an overall presentation of the Danish approach to monetary policy and the relationship between monetary policy in theory and in practice.
The money market and the short-term interest rates
The money market
In 2003 Danish money-market interest rates matched the development in the euro-area money-market interest rates, cf. Chart 11. In the 1st half of the year, when monetary-policy interest rates were lowered, money-market interest rates showed a declining trend. The 1-month interest rates remained practically unchanged in the 2nd half of the year, while the 12-month interest rates showed a slight increasing trend. The spread between 1-month and 12-month money-market interest rates thus gradually widened in the 2nd half of the year, to approximately 0.2 per cent at year-end. At the beginning of 2003 the 12-month interest rate was less than 0.1 per cent below the 1-month interest rate, indicating expectations of falling interest rates in 2003.
| Money-market interest rates in Denmark and the euro area |
Chart 11
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The spread between the money-market interest rates in Denmark and the euro area broadly matches the development in the ECB's and Danmarks Nationalbank's monetary-policy interest rates. The 12-month spread was fairly stable at around 0.15 per cent in the 1st half of the year. The spread narrowed to 5-8 basis points in July-October after the spread between Danmarks Nationalbank's lending rate and the ECB's minimum bid rate had narrowed to 0.15 per cent on 23 May 2003. In the autumn and towards the turn of the year the spread widened by a few basis points.
The money market was affected by two major unexpected events in 2003. On 10 March and the following days Danske Bank experienced an IT failure, and on 23 September southern Sweden and eastern Denmark were hit by an extensive power outage, although Danmarks Nationalbank and most money-market players remained operational. In these situations Danmarks Nationalbank provided extraordinary liquidity via buy-backs of certificates of deposit. The events show that the flexibility of Danmarks Nationalbank's range of instruments is sufficient to tackle even larger problems in the money market.
The public sector's payment system, OBS, for processing payments between central government and local governments was commissioned at the end of June 2003. OBS has affected the volume of in- and outgoing central-government payments on certain days, and thereby the liquidity in the Danish money market. Thus far, Danmarks Nationalbank has normally opened for sale of certificates of deposit on the first banking day of the month because large-value central-government disbursements increased liquidity in the money market. However, as a consequence of the changed payment pattern this requirement has been reduced. In connection with the introduction of OBS forecasts for in- and outgoing central-government payments during the month could not be prepared with the usual degree of precision.
The banks' interest rates and interest rates for short-term mortgage-credit bonds
In 2003, the banks' average deposit and lending rates fluctuated in line with the monetary-policy interest rates with a minor lag, which is the normal pattern. The deposit rate displayed a marginally falling trend throughout the year with a slightly more significant fall in connection with the interest-rate reductions in May and June, cf. Chart 12. In spite of the low level of interest rates, the deposit rate was thus fully downwards adjustable. The lending rate showed an almost identical falling trend in the 1st half of the year, but a more constant trend in the autumn. Overall the interest-rate margin, measured as the spread between the average lending rate and the average deposit rate, thus remained more or less constant in the 1st half of the year, but showed an increasing trend in the 2nd half.
| The banks' average interest rates |
Chart 12
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| Note: Monthly observations. The banks' interest rates in 2002 have been interpolated from quarterly observations. | |
| Source: Danmarks Nationalbank. | |
Interest rates on short-term mortgage-credit loans also fell in 2003. The statistics of the Association of Danish Mortgage Banks show that the short-term mortgage rate fell by approximately 0.5 per cent in 2003, to 2.5 per cent at year-end. This entailed lower interest expenditure in 2004 for homeowners with adjustable-rate loans.
Capital flows and foreign-exchange reserve
The current-account surplus was kr. 39 billion in 2003, while capital exports totalled kr. 8 billion, cf. Table 3. This was paralleled by Danmarks Nationalbank's foreign-exchange purchases for kr. 31 billion. The foreign-exchange reserve thus increased and was kr. 224 billion at end-2003 after value changes.,
In 2003 the banks raised substantial loans abroad. These capital imports were offset by the capital exports of other sectors. The driving force behind the capital exports was net purchases of foreign bonds for kr. 122 billion, a continuation of the considerable net purchases seen in recent years, cf. Chart 13. The value of the total Danish holding of foreign bonds in investment portfolios was just over kr. 400 billion at the end of the 3rd quarter of 2003, approximately twice the level in 1999 and 2000.
| Portfolio investments, capital imports |
Chart 13
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| Source: Danmarks Nationalbank. | |
Net purchases of foreign shares amounted to kr. 22 billion. This is an increase on 2002, but still far from the level in 2000 and 2001. Net purchases of shares rose significantly in the 2nd half of the year, mainly driven by pension funds. As regards the development in the pension funds' net purchases of foreign shares and bonds, it should be noted that the pension funds reduced their financial risks considerably following the plummeting stock prices in 2000 and 2001. The value of the total Danish holding of foreign shares in investment portfolios had thus fallen from a peak of just over kr. 450 billion at end-2000 to just over kr. 260 billion at the end of the 3rd quarter of 2003, mainly reflecting capital losses.
Net sales of Danish bonds in kroner and foreign exchange contributed to capital imports by kr. 17 billion. In total, portfolio investments contributed to capital exports of kr. 117 billion, while capital imports as a result of direct investments amounted to kr. 9 billion.
[1] Experience with the use of monetary-policy instruments in Denmark in recent years is described in Use of Monetary-Policy Instruments, Danmarks Nationalbank, Monetary Review, 1st Quarter 2003.