Deflation is negative inflation: a general decrease in the average price level and an increase in the purchasing power of money. Every school of economics considers deflation negative for economies. However the standard explanation of why deflation is terrible for economies is incorrect. The correct explanation is understanding the impact of deflation on the real rate of interest, and thus the ability for private firms and individuals to manage debt repayments.
From August 2013, the Brazilian Central Bank (BCB) began a novel strategy of currency intervention. The BCB directly auctioned forward contracts in the shape of currency swaps to market participants. Every week until December 2013, the bank released US$2 billion worth of swaps that were priced in US dollars and paid out in Brazilian Real. The programme was then extended from January 2014 until the 31st March 2015, albeit at a reduced rate of US$100 million a day from the previous rate of US$200 million a day.
These contracts completely contravened orthodox economic recommendations of non-intervention and the traditional methods used by emerging economies to manage exchange rates. The swaps were explicitly built to provide additional foreign exchange hedging opportunities to stimulate participants and provide additional liquidity in the domestic market. Their careful design meant that the BCB did not need to use their valuable foreign exchange reserves nor demand sterilisation. Furthermore, as the auctions were in US dollars, the swaps were actively attracting valuable foreign exchange into Brazil to help smooth the path of the Real during the peak of the “Taper Tantrum”, reversing the pattern of currency outflows away from Brazil.
This piece shall evaluate the performance of Brazil’s experimental intervention tool and contrast it against the traditional tools available to central banks. Whilst undertaking its analysis, the essay will consider the development path of the Brazilian financial sector and whether such foreign exchange swaps offer other emerging economies a revolutionary way to manage their exchange rates.
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.