Defending a Peg: Theoretically weighing the benefits of Denmark’s Fixed Exchange Rate

This week, Denmark’s Central Bank promised the market to defend the Krone’s unilateral currency peg against the Euro. The methodology and the phraseology came directly out of the standard Central Banker’s playbook in an attempt to solidify and engage market sentiment. The Central Bank governor Lars Rohde said:

There is no upper limit to the size of the foreign exchange reserve… The Danish National Bank has the necessary instruments to defend the fixed exchange rate policy for as long as it takes.”” [BBC; 2014 – emphasis added]

In parallel, the bank simultaneously lowered interest rates from -0.5% to -0.75% on top of the $16 billion of Open Market Operations already actioned. To put this into some context, this is the fourth time that Denmark has lowered its interest rates in three weeks and to a rate lower than even the most serious point of the Global Financial Crisis.

The immediate impetuses of this situation is fairly clear – in reaction to the ECB’s increasingly loose 2014-2015 monetary policy and surprisingly large promised figure of QE (€1.1 trillion), and Switzerland’s unforeseen retraction of its own currency peg, Denmark has been pressured to assure the market that “We’re not next”. The Danish National Bank (DNB) will uphold the status quo, no matter the cost.

In these circumstances however, it must be asked – is it worth it? Many nations have vainly attempted to defend currency pegs in the past, with varying policy success -vs- uniform punishment of foreign exchange reserves, employment rates and output costs. Famously, the UK (1992 – £3.3 billion) and Thailand (1997 – $5 billion) provide the counterfactuals of failure and success.

This piece will attempt to weigh the theoretical benefits of maintaining a currency peg against the practical costs that the policy incurs.

What is a currency peg?
A currency peg describes a policy decision to fix the value of a nation’s currency to another nation’s currency. Slight variations of the policy dictate if the rate is fixed absolutely to a given value or allowed to fluctuate within an agreed range. Nonetheless, the policy’s machinations dictate that the central bank loses independent supremacy over monetary policy (as it now must mirror its target) and may need to intervene directly into markets direct currency valuations one way or the other.

Nations voluntarily enter this framework for one main theoretical reason – an expected reduction in volatility. Under the opposite “floating” arrangements, exchange rate volatility is potentially high. These oscillations discourage domestic and foreign investment, as actors are unsure of their real returns. Thus money may be inefficiently invested and used as the market signals are confused by external exchange rate oscillations.

Where there are large sums of debt in foreign denominated currencies, the peg helps lock private debt to a domestic value and reduces the chance of sudden shocks to repayment plans. Similarly, it locks prices of essential foreign goods or commodities to a given domestic value, thus easing/encouraging further investment and spending.

Depending on the rate set, a fixed rate may also create an short-term trade advantage in foreign markets. As domestic goods may be priced at a widespread lower rate than competitors in international markets. The extent of the benefit however will be dictated by the Marshall-Lerner condition, as the elasticity/inelasticity of individual goods will actually dictate the trade benefit to the nation and actual benefit can not be thought of as given.

There are also psychological reasons for a nation to desire a stable currency: it can suggest internal domestic stability and prestige. Whilst also harks back to the pre-1970’s international economy, either under the Gold Standard or the Bretton Woods landscape.

The fine line between successful defence and costly collapse
There is a level of arbitrariness upon the rates at which currencies are set. A successful currency peg has been the HK$/US$ peg of HK$7.75-7.85:US$1. This rate was settled upon through trial and practice (the HKMA has largely maintained some kind of currency peg since its inception), market sentiment and the credibility of the HKMA of continuing to defend the pegged rate.

This does not mean all pegs are inter-temporally optimal however, and this leaves currencies open to speculative attack. If a currency is over/under-valued, speculators attempt to force central banks to expend so much reserves that they cannot defend a peg. As previously stated, the Bank of England’s failed 1992 defence cost $3.3 billion, whilst Thailand’s successful 1997 defence cost $5 billion. These vast expensive sums can run independently of market sentiment and beyond official credibility – and may only cease when the speculators have run out of liquidity.

Even where there is no legitimate/general acceptance of a mis-matched valuation, speculators of sufficient means can potentially force a self-fulfilling prophecy. No matter the tools raised in defence (interest rates, OMO, Repo rates, etc.), speculators relentlessly continue to target the currency until forcing its collapse.

The fact that authorities have potentially numerous parallel objectives, besides maintaining the peg, further weakens their position. For example, they may defend a peg to defend export prices and therefore jobs. Or they may defend a peg to maintain low interest rates to continue to encourage investment. This means that policy makers must attempt to work cohesively across all toolsets, even if their priorities are multi-faceted. Speculators meanwhile are subject only to the drive for profit, as such their actions and priorities are singularly driven, and can act in simplistic concert. [Rogoff, K., & Meltzer, A.; 1998]

Standing theoretical principles further argue against maintaining a currency peg. Where floating exchange rates are maintained, the Mundell-Fleming model suggest that the shifting market rates for currencies will act to automatic counter-cyclical effect. National currencies depreciating to lower the price of exports out of the nation, and giving a aggregate demand boost to the economy. The thought however forgets the stickiness of prices and wages however – which suggests that price adjustments will not be as instinctive as suggested. Furthermore where nations have high import content of exports and domestic goods, the impact of depreciation will actually heighten problems. Obvious examples include modern car manufacturers – where components are sourced on a global scale to a single site for assembly, and electronics manufacturers – who may rely on raw materials such as rare earths to create microchips. Thus Denmark, who has almost consistently managed a trade surplus since the last millennium, is highly liable to such impacts.

This piece has focused on the theoretical merit of a Krone peg to the Euro. Overall the theoretical evidence contradicts Danish practice, suggesting that it would be better for Denmark to relinquish the peg and allow a free-floating currency.

At this point however, the context of the Krone peg can provide the deciding factor. The high level of bilateral between Denmark and Eurozone heavily weighs in favour of the Euro peg. The psychological benefit of keeping the link surpasses the theoretical benefits of abandonment.

Furthermore the political objectives are keen here. Although vigorously debated, maintaining the status quo will benefit a future adoption of the Euro – if desired. This is as it provides the gradual impetus for the two economic areas becoming increasingly aligned and potentially a greater optimal currency area. If the the peg were removed, it would weaken the inter-connectivity of the region.

Yet rising from these prospects is admitting that maintenance of Denmark’s status quo can, and has, demanded a high cost. The point at which they can be seen too high depends on a massive decrease in reliance on bilateral eurozone trade, a more explicit desire to move away from the EU economically, and perhaps most importantly – whenever the DNB’s currency reserves run out.


– BBC. (2014).
– Rogoff, K., & Meltzer, A. (1998). The Risks of Unilateral Exchange Rate Pegs. The Implications of Globalization of World Financial Markets.

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