DKK: Danish CB With Knife In The Banks Guts by Thomas Borgsmidt
For the last couple of month the Danish currency (DKK) has been under pressure for at revision upwards in relation to the EUR. The story is more complicated than a simple speculation rush as happened to the CHF. The CHF is probably more connected to the crisis in Russia than other currencies.
The background is that due to a referendum Denmark is not member of the common currency and has for 30 years maintained a fixed exchange rate relative to the EUR. The reason is obvious when you notice a GDP of 1800 bio. DKK has im- and exports of 1000 DKK – exports higher than imports. It is probably underrated at the peg; but with a trade that large – and much of it with Germany – in which the EUR is also underrated, it calls for constant vigilance from the Danish CB (Nationalbanken) to maintain the peg.
The task is not made easier by the fact, that the Danish national debt is modest (8-900 bio. In circulating sovereign bonds). Historically the money supply has been mainly in real estate bonds. This has however been compromised by the issue of flexible interest on non-repayment on principle loans. To put it bluntly: Investors won’t touch the stuff.
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The situation in 2008 created a panic that called for extraordinary measures such as emergency credits from the USA and EU to shore up the banks. The CB did turn to pension funds for their German sovereign bonds, which they were willing to part with – at a price.
What has happened?
- The deposit rate in the central bank was lowered from -0.05% to -0.75% in January/February 2015 in four cuts. What has escaped the attention is that the Swedish Central Bank (Riksbanken) from September to December had preempted with a similar cut from -0.0% to -0.75% (now -0.85%). The Danish CB lending rate has remained constant.
- Nationalbanken has regularly intervened by selling DKK in increasing amounts to keep the peg to the EUR. During the past half year.
- On January 30th 2015 the issue of sovereign bonds was suspended to cut the inflow of foreign currency.
- The ECB announced a quantitative easing to “Whatever it takes” promising massive liquidity.
- Nationalbanken published an ignored research paper some time back that investigated more than 250 years of currency fluctuations. The gist of it was:
The banks risk models assume that the fluctuations are normally distributed, which is NOT the case. The hight of conscripts are reasonably normally distributed, but it is doubtful if there ever has been conscripts shorter than a foot or taller than 10 feet. Catastrophic shifts in exchange rates or the stock are rare, but relative to a normal distribution reasonably so common that a banker will experience them once or twice in his carrier.
I.e. the entire risk assessment of banks is fundamentally flawed – not to say downright wrong.
- At the annual meeting of the banks, the Nationalbanken CEO Lars Rohde sneered: “What are You waiting for?” Referring to the procrastination of Denmark joining the Bankunion of the EU!
- Around Christmas Danske Bank was caught red-handed using a dummy cooperation in the Cayman Island to keep their junk bonds off balance and hiding they were indeed buying their own bonds – this time nothing to do with tax-evasion – just ordinary cooking the books.
Precautions against rare events
The crucial event is the one no one noticed: The obscure research paper pointing out the basic risks of currency fluctuations: Rare events are rare; but not that rare. This throws away any conventional financial wisdom.
The recognition of that led last year to an emergency legislation concerning the variable interest real estate bonds: In the event of a sudden and significant rise in interest rate, the maturity of the bond would be prolonged automatically. There was a risk that these bonds financing real estate loans of long maturity could not be refinanced without an interest burden that would make the financial structure collapse.
After the desperate failure in 2008 precautions has been taken by Nationalbanken to avoid a similar crisis.
In 2008 Nationalbanken was caught out with a currency reserve of about 150 bio. DKK and a market that gobbled up hard currency sales of 15 bio. DKK in one single day without any discernable effect – at all. The DKK at that stage was going down the tube. That was not to be repeated under any circumstance.
- The currency reserve has been beefed up to triple size making a forced debasement of the DKK that much more unlikely.
- Picking the timing is essential. The refinancing of the flexible interest loans at the years end was not without problems in so far as 35 bio. DKK in short term emergency credit was extended. The first cut in deposit rate came as those emergency loans had been reduced to 7 bio. DKK. Thus the inflow of capital would not be due to refinancing of the real estate loans, and a synergic effect that could have come if a speculative inflow coincided with the refinancing was avoided by a repeated lowering of deposit rate.
The 2015 situation is fundamentally different from 2008 (if potentially just as dangerous) in so far as there is no upper limit to the currency reserve.
The chasing off of the investors into – probably USD – and the cancellation of sovereign bond sales meant that there was only one way to go for the inflowing capital: Into the vaults of the Central Bank. Any sale of DKK would produce the desired effect of lowering the exchange rate – so a fine (through negative interest rates) is imposed on purchase of foreign currency.
Nationalbanken actually makes money on the pressure to revalue the DKK.
- The negative interest rate is a factor, but actually small potatoes.
- Given time the pressure will subside as – again – the CB is in the market for cheap foreign currency paid by deposits in the CB.
- The banks will have bought DKK dearly and will have to sell cheaply – that normally makes banks consider their business acumen.
- The securities that has been bought by the Nationalbanken carries a higher interest rate than the deposit rate – which is difficult not
So Nationalbanken can keep this up as long as it takes – given the responsible economic policy performed by the Danish government. Characteristically: The PM Helle Thorning-Schmidt has been able to dedicate her full attention to pick up the pieces from the terrorist attack and murder of a participant in a meeting with one of the cartoonist so unpopular with fundamentalist terrorists and a member of the Jewish community – whose death incidentally probably prevented a large-scale massacre in the synagogue. (Five wounded police officers – all out of hospital by now).
The currency has been in safe hands.
The usual suspects
In a speculative rush, the culprits are generally difficult to point out, as there is a considerable bandwagon-effect. The mere size of the deposit increase and augmentation of the currency reserve does give a hint:
The deposits have tripled to 375 bio. DKK and the currency reserve gained 100 bio. DKK to 564 bio. DKK at the end of January – what it is now is any ones guess as we are still in February – but we could be talking 700 bio. DKK. Admitted not an estimate based on inside information or divine perspicacity – the only guide is the fact that CB CEO Lars Rohde on TV had a hard time keeping the evil grin from his face, as he stated that Nationalbanken could take a lot – a lot!
But again: The mere size of the amounts indicate the involvement of Danske Bank (as the largest – by far – of the Danish banks) and Nordea (the only Globally Systemic Important Bank in Scandinavia and the Baltic).
It does, however involve two other currencies: The NOK and SEK. The relational developments between the USD and EUR have far more plausible explanations in the restructuring of currencies and investments in the Far East, where capital is “parked” in USD awaiting clarification. The USD has gone up – not only relative to EUR; but also to all other currencies, which are floundering in deep confusion as to the ramifications of the halving of energy prices.
The banks have been playing/manipulating the market for a considerable time. The SEK has regularly slided from 90 DKK/100 SEK to 77 DKK/100 SEK over the last couple of years. This probably reflects the refinancing of real estate loans in Denmark and Sweden. What the banks have not made on the interest rate they have (at least tried) to make on manipulating the currency which does respond to day-to-day transfers of amounts 10-20 bio. USD.
The NOK took a bashing with the oil-price being halved – that is natural considering the importance of oil exports to Norway; but a 10-15% drop is out of all proportion relative to a currency that is similarly (though not to the same extend) associated to oil production. Indeed the push towards a revaluation of the DKK is in the opposite direction of what was to be expected – so other factors have played the leading role in the assault on the DKK.
Without knowing the composition of the Danish currency reserve – except in the vaguest possible terms – it is a plausible guess that the vast increase is mainly in NOK and SEK. Interestingly enough: Riksbanken had at the end of 2013 22% of their currency reserve in NOK and none in DKK.
This incidentally puts Nationalbanken in a power-play situation: By buying and selling NOK and SEK against each other – and against the USD and EUR – Nationalbanken is in control of the NOK and SEK – where the trend is revaluation (or rather regaining equilibrium) of the NOK’s value and the continued fall of the SEK. In this way, Nationalbanken can keep the capital flows and manipulations of Danske Bank and Nordea in check by playing it three or four ways.
Whatever is going to give way – it is not going to be the DKK and the banks are in for a bloody nose.
The ploy with the “rescue” of the variable rate mortgages has made them into pre-financed mortgages somewhat on the same lines as a convertible, fixed rate annuity. That it has made them utterly uninteresting to investors is just collateral damage as investors are prone to frown on bonds not being paid on time – that is of small moment as far as the banks are the owners of their own junk bonds anyway and have to finance them elsewhere anyhow.
Financing of own issues are not strange or abnormal before they are sold to investors that is normal investment bank procedure. The problem is however, when the bonds find no buyer and the bank has to carry the baby for a prolonged period. During that time, the bank not only has to finance the bonds, but they also have to carry the ugly twin sister: Risk.
When the inflow of capital recedes, the banks will have to borrow money to finance the loans they have extended to themselves. That may be the most costly part of the festivities. As credit dries up or become more costly the only way to raise the funds is to sell off the bonds in their possession. There is no way the pension funds and other institutional investors are going to return form the exile in the USA if they are not offered securities at a fair price.
The investors are not going to touch the flexible interest loans – except at a nasty discount to cater for the very dubious maturity. What the investors will buy are fixed interest, convertible annuities – provided the price is right – and the investors do not care what is principal or what is interest: They care about the amounts that regularly drop into their accounts. That the issue does not carry interest is semantics to the investors, and the bonds will be priced accordingly.
So the banks are caught between a rock and a hard place – the debtors could not care less, as long as they keep paying according to schedule the loan has been extended. When and where the banks choose to take the loss – that is the problem of the bank. The loss is certain, as negative interest on a loan is unlikely to be financed at anything but a positive interest. For the foreseeable future inflation does not enter the equation.
Bankunion of the EU
Whether Denmark converts to EUR or not. If Denmark joins the Bankunion credit may be extended by the central bank and resold to the ECB; but the Danish Central bank will not issue sovereign bonds unless there is collateral – that may be in flexible interest bonds – but that will involve a hefty “haircut” – say 30%. The question is, at what price the Danish CB will resell the bonds in the rather likely event of non-compliance of the issuing bank that is a clean and well-ironed loss to the bank. Not only that, but the refinancing by the central bank will not likely be at the issued interest rate.
The Draghi-plan is not: “Whatever it takes” – it is “whatever it hurts” – and that will be the banks.
The alternative to the Bankunion and scrutiny of the books by a hateful EU-official is even worse. Danske Bank has already experienced the working of Danish CB emergency loans – credit has been extended – sure but the collateral was “good loans” – and they have all been refinanced in various ways (notably with business bonds). It is highly unlikely that the Danish CB will accept securities of worse grade.