Since the start of 2016, there has been a rule in the EU that no bank can be “bailed out” by an EU state without first attempting a”bail-in”. That is EU regulations now ensure that those who own a bank’s capital (bond holders) and those that own the bank (shareholders) must first sacrifice before those who do not directly profit from the bank (taxpayers) can intervene.
This is different from 2008, when no such rules existed. During that time, state bailouts would rescue private investors at the cost of the public purse. Private investors were not responsible for being the first responders to protect their investments. Now however, EU rules dictate that bondholders must sacrifice first. These are individuals who are owed payment first. Then shareholders, who generally sacrifice from tangential collapsing share prices – and the loss of any dividends.
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.