Exchange rate dominance will ensure the Danish peg to the Euro will deliver continued good economic outcomes, and hence neither the Danish central bank or the government won’t consider abandoning the peg, argues Goldman Sachs.

Huw Pill and team at Goldman Sachs in their March 19, 2015 research report titled: “Will the Danish peg survive?” note the peg has delivered ‘good’ economic outcomes over the past 30 years.

Danish peg under severe pressure

The Goldman Sachs analysts note appreciation pressure on the Danish peg rose to an unprecedented degree around mid-January 2015 in the immediate aftermath of the Swiss National Bank’s decision to abandon its exchange rate floor and as anticipation of an ECB QE programme increased.

The analysts note the renewed DKK appreciation pressure in January / February 2015 stems from foreign investors seeing potential gains from holding DKK assets, and domestic investors seeking to hedge exchange rate risk related to having EUR assets and DKK liabilities.

Huw Pill and team point out that the Danish central banks intervened in the foreign currency market in January, buying FX worth DKK 106.3 billion, translating to around 6% of GDP. As can be deduced from the following graph, the recent response in defence of the peg has been the central bank’s largest. Moreover the Danish central bank’s FX reserves now stand at 40% of GDP, whereas the pre-2008 FX reserve average was around 10%-15% of GDP:

Largest FX intervention Danish Peg

Tracking the history of Danish peg, the analysts note since 1982, as part of the newly elected government reform package, Denmark committed to refrain from further devaluations. The GS analysts point out that since around 1997, the DKK has traded very tightly to central parity, with less than +/-½% deviation:

Stable Danish peg

Pill et al. point out that to avoid having to continuously intervene in the FX market, the central bank would want to discourage inflows. The primary tool to achieve this objective is to cut the policy rate to make investing in domestic assets less attractive. The Goldman Sachs analysts note the Danish central bank’s 7-day deposit rate currently stands at -0.75%, and as a result, short-term market rates in Denmark are considerably below Euro area short-term rates:

Danish Peg Vs Euro swap spread in negative territory

Danish central bank will vigorously defend the peg

The GS analysts believe the Danish central bank will continue to vigorously defend the peg. They note the central bank can cut its deposit rate if required. Moreover, the analysts point out that FX interventions by the Danish central bank can, at least in principle, be infinite, as the FX interventions are profitable and the DKK peg is permanent in nature.

The GS team also poses the question of whether whether Danish Real Exchange Rate (RER) is currently mis-valued. The analysts mapped out the RER misalignment over time and computed the misalignment for the most recent observations using various alternative assumptions. The analysts note Danish RER appears somewhat undervalued:

Danish Peg RER undervalued

Moreover, their computations reveal that the Danish RER appreciation requirement is currently around 10%.

Danish Peg RER valuation about 10pc

The Goldman Sachs team also points out that there are risks of cyclical and, in particular, financial instability issues building over the medium/longer term. They note avoiding this requires ‘exchange rate dominance’. The analysts note ‘exchange rate dominance’ remains in place in Denmark, which would ensure that the peg delivers continued ‘good’ economic outcomes and high public support.

Thus the analysts conclude that neither the Danish central bank nor the government will consider abandoning the Danish peg. On the contrary, the analysts anticipate that future debate in Denmark will focus on maintaining the peg or possible a Euro area membership.