Monetary and
Exchange-Rate Policy
As a consequence of Denmark's fixed‑exchange‑rate policy the krone has beenstableagainst the euro and close to the central rate in recent years.
After lowering its interest rates significantly in 2001, the European Central Bank, ECB, reduced the rates by 0.50 per cent in December 2002. Danmarks Nationalbank followed suit.
The Danish foreign‑exchange market was relatively calm in 2002, with an underlying tendency for the krone to strengthen. At intervals Danmarks Nationalbank intervened in the foreign‑exchange market to stabilise the krone, and unilaterally lowered the lending rate on three occasions by a total of 0.15 per cent. The spread between Danmarks Nationalbank's lending rate and the minimum bid rate for the ECB's main refinancing operations thereby narrowed by 0.15 per cent to 0.20 per cent at end‑2002.
Foreign‑exchange purchases by Danmarks Nationalbank in 2002 increased the foreign‑exchange reserve by kr. 45 billion. This mainly reflected a current‑account surplus of kr. 39 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 without imbalances in the foreign‑exchange markets the Danish monetary‑policy interest rates follow those of the ECB so as to maintain an unchanged interest‑rate differential. If the krone tends to strengthen or weaken, Danmarks Nationalbank intervenes 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.
Since the introduction of the euro in 1999 Denmark has participated in the exchange‑rate mechanism, ERM II. 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. As a consequence of Denmark's high degree of economic convergence with the euro area, Denmark has entered into an agreement with the ECB and the euro area member states whereby the krone's rate against the euro is kept within a narrow band of +/‑ 2.25 per cent around the central rate of kr. 746.038 per 100 euro.[1] Participation in ERM II requires that the economic policy in general supports the fixed exchange rate. Throughout the period the krone has been close to its central rate, cf. Chart 8. So far, the agreement has acted as a safety net which has not been used.
| Kroner vis-à-vis euro |
Chart 8
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| Note: Daily observations. | |
Denmark is currently the only participant in ERM II, but with the forthcoming enlargement of the EU, cf. p. 73, more countries must be expected to become part of the exchange‑rate mechanism. The future participants are expected to enter into agreements at the standard fluctuation band of +/‑ 15 per cent.
The ECB's monetary policy
The monetary‑policy objective
The ECB's primary objective is to maintain price stability. This is defined as an annual rate of inflation, measured by the annual growth in the harmonised index of consumer prices (HICP), of less than 2 per cent in the medium term. The ECB regularly assesses the inflationary prospects by analysing the growth in the monetary aggregate, M3, and performing a broad assessment of the impact of other real‑economic and financial indicators on the future development in prices and the related risks.
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.
Monetary‑policy instruments
The ECB's monetary‑policy instruments comprise refinancing operations, reserve requirements and standing facilities. The practical implementation is to a large extent handled by the national central banks.
Via refinancing operations the ECB provides liquidity to the banks in the euro area. In the weekly main refinancing operations the banks may raise 14‑day 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, and the liquidity which the ECB wishes to provide is determined once bids have been submitted. The bids with the highest interest rates are complied with first, and the ECB then accepts successively lower rates, until the amount that the ECB deems suitable has been granted. The lowest rate at which liquidity is provided is known as the marginal rate.[2] The minimum bid rate is the ECB's monetary‑policy signal rate, and the marginal rate is normally very close to the minimum bid rate. The very short‑term money‑market interest rates follow the marginal rate.
In addition, the ECB once a month provides liquidity via long‑term refinancing operations. These loans against collateral with a maturity of three months amount to around 25 per cent of the total liquidity provided by the ECB.
The banks in the euro area are subject to a reserve requirement which entails that during a reserve maintenance period from the 24th of one month to the 23rd of the following month they must have a certain average deposit on their reserve accounts with the national central banks. This amount accrues interest at the average marginal interest rate during the reserve maintenance period. Since it is an average requirement over a period, banks may operate with a low deposit on the account if they require liquidity and do not wish to borrow in the overnight market, e.g. because interest rates are considered excessively high. The reserve accounts thus give the banks an alternative to the money market. The ECB evaluates that the reserve requirements contribute to stabilising overnight rates, which is seen as a key success criterion for the monetary‑ policy instruments.
The ECB also offers standing deposit and lending facilities which allow banks to deposit or borrow liquidity against collateral on an overnight basis. The interest rate on the deposit facility is 1 per cent lower than the minimum bid rate, while the interest rate on the lending facility is 1 per cent higher than the minimum bid rate.
The framework for the open market operations entails that the banks' expectations concerning future changes in the monetary‑policy interest rates may affect their bidding behaviour. For instance, if a bank expects the ECB to lower its interest rate in a week's time, that bank will have a relatively small incentive to bid at the current week's tender. In order to reduce such effects, in the 1st quarter of 2004 the ECB will implement two adjustments of its monetary‑policy instruments.
Firstly, the main refinancing operations will be shortened from two weeks to one week. Secondly, the reserve maintenance period will be synchronised with the meetings of the Governing Council where the monetary‑policy interest rates are discussed.
Monetary policy in 2002
After having lowered its interest rates on a number of occasions in 2001, the ECB held the rates unchanged throughout most of 2002, cf. Chart 10. At the beginning of 2002 inflation (HICP) for the overall euro area exceeded 2 per cent, although the ECB expected it to fall to below the 2‑per‑cent threshold during the year. M3 growth was somewhat higher than the reference value of 4½ per cent, but since this was attributed to special temporary factors it was assessed that the development in the money supply did not evidently indicate increasing inflationary pressure. Real economic growth was slowly recovering towards the end of 2001, and the development in a number of indicators in the first months of 2002 increasingly supported the ECB's expectations of an upswing later in the year.
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.
| Money-market interest rates in the euro area |
Chart 9
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| Note: EURIBOR money-market interest rates. | |
| Source: EcoWin. | |
During the 2nd half of 2002 it became clear, however, that the expected upswing would not be forthcoming, and the ECB gradually became less optimistic about any evident reversal of the economy. Towards the end of the year the ECB assessed that growth would continue to be moderate and that the inflationary pressure would ease. Growth in the money supply still exceeded the reference value, but in the light of the weak real economy little weight was attached to this circumstance on assessing the level of the monetary‑policy interest rates. Against this background the ECB's Governing Council on 5 December decided to reduce its leading interest rates by 0.50 per cent, bringing the minimum bid rate to 2.75 per cent.
The money‑market interest rates had already fallen prior to the lowering of interest rates. The vain hopes of an upswing and the prospect of continued moderate growth at the beginning of 2003 contributed to a flatter money‑market yield curve again during the autumn. At the end of the year the slope of the yield curve was slightly negative, and market interest rates appeared to reflect expectations that the ECB would lower interest rates rather than raising them.
The monetary policy of Danmarks Nationalbank
In response to the ECB's reduction of interest rates on 5 December 2002 Danmarks Nationalbank on the same day lowered both the lending rate and the discount rate by 0.50 per cent to respectively 2.95 per cent and 2.75 per cent. A review of the monetary‑policy instruments of Danmarks Nationalbank is presented in Box 2.
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Box 2
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The monetary‑policy instruments remained unchanged in 2002. Danmarks Nationalbank makes two facilities available to the banks and mortgage‑credit institutes that are its monetary‑policy counterparties. Firstly, the counterparties can place funds in certificates of deposit or raise loans against collateral. These transactions are normally subject to a maturity of 14 days, and the relevant interest rates, called respectively the rate of interest on certificates of deposit and the lending rate, are identical. The transactions take place on the last banking day of each week. Secondly, the counterparties have access to place funds as overnight current‑account deposits. Such deposits accrue interest at the discount rate, which is lower than the lending rate. There is a limit to the counterparties' total current‑account deposits. Each counterparty has been allocated a proportion of the total current‑account limit in accordance with its relative size and level of activity in the money market. The total limit is around kr. 20 billion. If it is exceeded each counterparty's current‑ account deposit exceeding the individual limit will be converted automatically to certificates of deposit. So far this has not been necessary since the overall limit has been respected. On 2 January 2003 Danmarks Nationalbank made a minor adjustment to the overall ceiling for counterparties' current‑account deposits and to the limits allocated to each counterparty. The adjustments were a response to the development in the financial sector since the previous adjustment of the current‑account limits in 2001. |
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Earlier in the year Danmarks Nationalbank had lowered the lending rate on three occasions by a total of 0.15 per cent without simultaneous reductions by the ECB, cf. Chart 10. On 1 February Danmarks Nationalbank thus reduced the lending rate by 0.05 per cent in view of the krone'stendencytostrengthenagainsttheeuroin January, at the same time as Danmarks Nationalbank made considerable foreign‑exchange purchases. In the following months the foreign‑exchange market was calm. The krone remained stable on the strong side of its central rate against the euro and there was no need for Danmarks Nationalbank to intervene any further in the foreign‑exchange market. During the summer Danmarks Nationalbank again had to buy foreign exchange in order to stabilise the krone against the euro. In view of a more sustained tendency for the krone to strengthen Danmarks Nationalbank lowered the lending rate by 0.05 per cent on 9 August, and again on 30 August, thereby reducing the spread between Danmarks Nationalbank's lending rate and the minimum bid rate for the ECB's main refinancing operations to 0.20 per cent.
| Lending rates of the ECB and Danmarks Nationalbank |
Chart 10
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| Note: Prior to 28 June 2000, the ECB's fixed allotment rate. | |
Since the ECB's main refinancing operations are conducted as variable‑rate tenders, the spread between the ECB's marginal rate and Danmarks Nationalbank's lending rate may vary. During most of 2002 the marginal rate was very close to the minimum bid rate. In December 2002, however, the ECB's marginal rate briefly exceeded Danmarks Nationalbank's lending rate. The background was that the banks in the euro area had not secured sufficient liquidity to cover the reserve requirements either via the ordinary allotment or by an extraordinary fine‑tuning operation. This led to tight liquidity in the money market, which was reflected in the market interest rates.
The narrow interest-rate differential to the euro area reflects sustained robust development in the Danish economy in 2002, and a high degree of credibility in relation to the fixed‑exchange‑rate policy. These are also the key factors underlying the stable development in the krone rate.
Danmarks Nationalbank's foreign‑exchange purchases in 2002 contributed to increasing the foreign‑exchange reserve by kr. 45 billion to kr. 193 billion at end‑2002. The purchases were offset by an expansion of the net position of the banks and mortgage‑credit institutes vis‑à‑vis Danmarks Nationalbank during the year, cf. Chart 11.
| The foreign-exchange reserve and the net position of the banks and mortgage-credit institutes |
Chart 11
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The money market and the short‑term interest rates
The money market
In 2002 the Danish money‑market interest rates matched the overall movements in the euro‑area money-market interest rates. The decline in money‑market interest rates during the year was mainly a result of the lowering of the monetary‑policy interest rates. The interest‑rate spreads between money‑market interest rates in Denmark and the equivalent euro‑are a interest rates narrowed by and large in line with the narrowing of the differential between the monetary‑policy lending rates. At the beginning of 2003 the level of the spreads between the money‑market interest rates in Denmark and the euro area for maturities of 1‑12 months broadly corresponded to the spread between the monetary‑ policy interest rates.
The money market is important in many contexts, e.g. in relation to the banks' liquidity management and as the basis for the securities market. In the spring of 2002 Danmarks Nationalbank conducted a survey of the Danish money market, inter alia on the basis of a questionnaire completed by a number of banks.[3] The conclusion of the survey was that the Danish money market functions satisfactorily. There is a good degree of accordance in the price formation for various money‑market instruments, and the bid‑offer spreads are generally stable and relatively narrow. Both of these factors help to create an efficient market.
The banks' interest rates and interest rates for short‑term mortgage‑credit bonds
The banks' average deposit and lending rates typically fluctuate in line with the monetary‑policy interest rates. This was also the case in 2002. The decline in both deposit and lending rates at the beginning of 2002 is attributable to the sluggish pass-through from the reductions of monetary‑policy interest rates at the end of 2001, cf. Chart 12. Subsequently, both deposit and lending rates remained constant up to the 3rd quarter, in accordance with the stable development in the monetary‑policy interest rates and in the money‑market interest rates. In the 4th quarter the average lending rate fell slightly.
| The banks' interest rates |
Chart 12
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The interest-rate margin, i.e. the spread between the average lending rate and the average deposit rate, fell from the 4th quarter of 2001 to the 1st quarter of 2002, and a minor drop was also seen from the 3rd to the 4th quarters of 2002. This is presumably attributable to the very low level of interest rates, entailing that the interest rate on certain deposit accounts cannot be lowered further.
In line with other short‑term interest rates, interest rates for short‑term mortgage‑credit loans also declined. The statistics of the Association of Danish Mortgage Banks show that the short‑term mortgage rate fell by approximately 0.9 per cent in 2002, to a level of 3.1 per cent at year‑end. This will entail lower interest expenditure in 2003 for homeowners with adjustable‑rate loans.
Capital flows and the foreign‑exchange reserve
The surplus on the balance of payments was kr. 39 billion in 2002, while capital imports totalled kr. 6 billion, cf. Table 3. This was offset by Danmarks Nationalbank's foreign‑exchange purchases totalling kr. 45 billion, thereby increasing the foreign‑exchange reserve. At the end of 2002 the foreign‑exchange reserve after value changes was kr. 193 billion.
Net purchases of foreign shares amounted to kr. 1 billion in 2002, which is considerably less than in the preceding years. However, the trend varied greatly during the year. The period from January to May saw net purchases of foreign shares for kr. 30 billion, while net sales of foreign shares in June to December were kr. 29 billion. Net purchases of foreign bonds totalled kr. 33 billion in 2002. Bonds were mainly purchased during the period when shares were sold. This restructuring of foreign portfolios from shares to bonds in the latter half of 2002 was among other things driven by pension companies. This should be seen in the light of the increased pressure on the financial reserves of these companies, in view of the falling interest rates and stock prices in recent years, leading to a requirement to reduce the financial risks.
Since net sales of Danish bonds to non‑residents totalled kr. 32 billion, portfolio investments overall contributed to capital imports. The same was the case for direct investments, as foreign investments in Denmark exceeded Danish investments abroad.
[1] The underlying principles of ERM II are described in detail in Danmarks Nationalbank's 1998 Annual Report.
[2] For a further description, see Kim Abildgren, Experience with the Eurosystem's Weekly Open Market Operations, Danmarks Nationalbank, Monetary Review, 4th Quarter 2002.
[3] For a detailed description of the conclusions of the survey and of the Danish money market, see Anders Mølgaard Pedersen and Michael Sand, The Danish Money Market, Danmarks Nationalbank, Monetary Review, 2nd Quarter 2002.