FX International Payments
By Frances Coppola
The European Central Bank (ECB) imposed negative rates on central bank deposits in June 2014, and has since cut interest rates to zero on its own lending to banks.1 But it is not the only central bank in Europe that has imposed negative rates. The central banks of Denmark and Sweden have, as well, and, like other central banks, are now considering when to end them.
Economic theory says that higher interest rates can mean stronger currency exchange rates. So, if Denmark and Sweden raise their interest rates, import-export businesses in those countries could enjoy an improvement in terms of trade (the ratio of export prices to import prices) that might offset higher borrowing costs. This is of some interest to U.S. businesses, because although the Eurozone is each country's largest trade partner, Denmark and Sweden both have significant U.S. trading relationships. The U.S. is Denmark's largest non-European trading partner: in 2016, two-way trade in goods totaled just over $10 billion.2 Sweden's exports to the U.S are estimated at $10.2 billion (approximately 7.1 percent of its total exports), making the U.S. its fourth-largest export market.3
Import-export businesses hoping for a trade boost might want the end of negative rates to come sooner rather than later. However, there are good reasons why Denmark and Sweden might wait for the ECB to end negative rates before raising rates themselves. If they do, then ending negative rates might have little effect on their currency exchange rates, and consequently on import-export trade.
The European Union's (EU) statistical authority, Eurostat, shows that the euro's exchange rate weakened against most currencies when negative rates were introduced. In particular, the euro's exchange rate fell versus other reserve currencies, notably the U.S. dollar, the Japanese yen, the Swiss franc, and the British pound.4 This is consistent with economic theory, which states that investors would be likely to sell the currency with the negative rates and buy currencies of countries with positive rates, thus weakening the currency exchange rate of negative-rate countries.
Since early 2017, however, the euro's exchange rate has been strengthening versus most currencies, despite negative rates. Inflation remains below target in the Eurozone, and raising interest rates too quickly could cause an even faster appreciation of the euro's exchange rate, which could depress inflation still more.5 The ECB has therefore expressed caution about the timescale for ending quantitative easing (QE) and raising rates. It is considering ending QE in 2018, though the timetable for this is uncertain,6 but as yet has given no indication when interest rates might start to rise.
The ECB's "lower for longer" interest rate signals create a dilemma for the central banks of Denmark and Sweden. Should they wait for the ECB to act before raising their own interest rates, or should they go ahead anyway?
Although the Swedish krona has a floating currency exchange rate versus the euro, Sweden's strong trade links to the Eurozone create a form of economists' "trilemma," which states that a country which has a fixed currency exchange rate and free movement of capital cannot have an independent monetary policy. In practice, it means small countries that have strong trade links with a much larger neighbor can be forced to follow that neighbor's monetary policy, because the currency exchange rate effects of divergence can be very negative for import-export trade.
Sweden's central bank (the Riksbank) followed the ECB in imposing negative rates on central bank deposits in June 2014. It then continued to cut the deposit rate over successive months, reaching a low of minus 1.25 percent in February 2016.7 The deposit rate has remained at that level ever since. The Riksbank additionally cut its lending rate to minus 0.1 percent in February 2015, and has since cut it further. Currently, the lending rate stands at minus 0.5 percent.8
The Riksbank is the only central bank that has negative rates on both central bank deposits and central bank lending. Eurostat's analysis shows that since the Riksbank started undercutting the ECB's negative rates, the euro's currency exchange rate has appreciated steadily versus the Swedish krona.
Now, the Swedish economy is growing strongly, and inflation is close to the Riksbank's 2 percent target.9 This creates a dilemma for the Riksbank. If it raises interest rates earlier than the ECB, the krona's exchange rate versus the euro could strengthen. This could make Sweden's exports to the Eurozone less competitive, while encouraging imports from the Eurozone. Higher interest rates could also encourage U.S. investors to choose the krona in preference to the euro, which would tend to raise the krona's exchange rate versus both the euro and the U.S. dollar. This could make exports not only to the U.S. but also to the rest of the world less competitive.
The krona's exchange rate is extremely sensitive to interest-rate signals. In January 2018, when the Riksbank hinted that interest rates could start to rise in 2018, the krona's exchange rate shot up;10 in February 2018, when the Riksbank reversed this guidance, the currency's exchange rate sank like a stone.11 The minutes of the Riksbank's February 2018 meeting reveal that several policymakers expressed concern about raising interest rates ahead of the ECB, because of the possibility that the krona's exchange rate might strengthen, which could cause difficulties for Sweden's export businesses.12
Denmark is currently a member of the EU's Exchange Rate Mechanism (ERM II). This forces the Danish krone to stay in fluctuation bands of +/- 2.25 percent around its fixed exchange rate of 746.038 to 1 euro.13 Remember, the "trilemma" stipulates that a country with a fixed currency exchange rate and free movement of capital cannot have an independent monetary policy. Denmark has free movement of capital because of its EU membership. To keep the krone within its fluctuation bands, therefore, the Danish central bank has ceded some independence and followed the ECB in imposing negative interest rates on deposits.14
Denmark's economy is now growing at about 2 percent per annum and inflation, though still very low, is expected to rise.15 This might raise expectations of interest rate rises. However, Denmark's central bank says the sole purpose of interest-rate policy is to maintain the krone within its narrow ERM II fluctuation bands.16 When the central bank warned recently that the Danish economy was entering a "moderate boom," it called on the Danish government to impose "preventative fiscal tightening" if the economy showed signs of overheating.17 Thus, it appears that, despite Denmark's strong economy, interest rates could remain negative until the ECB starts to raise rates.
The economies of Denmark and Sweden are both growing more strongly than the Eurozone, which might suggest that their central banks could start to raise interest rates earlier than the ECB. But there are very good reasons why both central banks might choose to wait until the ECB signals the start of interest rate rises. In the case of Denmark, it is because earlier rate rises could break the krone's ERM II currency exchange rate peg to the euro. For Sweden, it is because diverging significantly from ECB monetary policy could have a serious impact on its exports to the Eurozone. The "trilemma" helps show that the interest rates of these European countries are likely to remain closely aligned to those of the Eurozone.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “ECB interest rates history,” European Central Bank; https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html
2. “U.S. Relations with Denmark,” U.S. Department of State; https://www.state.gov/r/pa/ei/bgn/3167.htm
3. “U.S. Relations with Sweden,” U.S. Department of State; https://www.state.gov/r/pa/ei/bgn/2880.htm
4. “Exchange rates and interest rates, April 2017,” Eurostat; http://ec.europa.eu/eurostat/statistics-explained/index.php/Exchange_rates_and_interest_rates
5. “Euro exchange rates under close scrutiny at ECB,” Pound Sterling Live; https://www.poundsterlinglive.com/eur/8330-euro-could-be-too-strong-to-support-inflation-say-eurozone-central-bankers
6. “Eurozone growth has peaked, data suggest, amid mounting tension over economic policies,” Telegraph; https://www.telegraph.co.uk/business/2018/03/27/eurozone-gdp-growth-has-peaked-data-suggest-amid-mounting-tension/
7. “Repo rate, deposit and lending rate,” Sveriges Riksbank; https://www.riksbank.se/en-gb/statistics/search-interest--exchange-rates/repo-rate-deposit-and-lending-rate/
9. “Economic Forecast for Sweden,” European Commission; https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-performance-country/sweden/economic-forecast-sweden_en
12. “Minutes of the monetary policy meeting held on 13 February,” Sveriges Riksbank; https://www.riksbank.se/en-gb/press-and-published/notices-and-press-releases/press-releases/2018/minutes-of-the-monetary-policy-meeting-held-on-13-february-2018/
13. “Foreign Exchange Rate Policy and ERM 2,” Danmarks Nationalbank; http://www.nationalbanken.dk/en/monetarypolicy/fixed_exchange_rate_and_ERM2/Pages/Default.aspx
14. “Monetary and exchange rate policy,” Danmarks Nationalbank; http://www.nationalbanken.dk/en/monetarypolicy/implementation/Pages/default.aspx
15. “Economic Forecast for Denmark,” European Commission; https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-performance-country/denmark/economic-forecast-denmark_en
16. “Monetary and exchange rate policy,” Danmarks Nationalbank; http://www.nationalbanken.dk/en/monetarypolicy/implementation/Pages/default.aspx
17. “Outlook for the Danish economy,” Danmarks Nationalbank; http://www.nationalbanken.dk/en/publications/Pages/2018/03/Moderate-boom-in-the-coming-years.aspx