Currency wars: What country is the next victim?
On 15 January the Swiss National Bank (SNB) abandoned its exchange rate floor against the euro, “the cornerstone of Swiss monetary policy” up to that point. Since this tumultuous event, not a single day has passed without clients asking me what country might be the next victim in the ferocious global currency war, i.e. which central bank could be forced to throw in the towel, unable to resist the mighty market forces?
One currency has been particularly scrutinized as the next candidate to succumb: the Danish krone (DKK). There are indeed many similarities, besides flying a red flag with a white cross (albeit of a different shape), between Denmark and Switzerland. Both are small European countries. And the Eurozone is the main trading partner of each, so the euro is their reference currency.
However, there are also major differences. Switzerland until recently had a currency floor at 1.20, while Demark has a currency peg at 7.46. While the SNB would only defend the Swiss franc against appreciation, the Danish National Bank (DNB) has intervened to prevent its currency from both strengthening and weakening too much. Also the DKK is in the Exchange Rate Mechanism II. It is de jure allowed to fluctuate within a +/-2.5% band of the peg, meaning between 7.29 and 7.63. De facto, the DNB has kept the band much tighter, between 7.42 and 7.47.
Another difference is that the decision by the SNB to introduce the EURCHF floor was taken unilaterally, leaving it alone to defend it. Denmark, as a full EU member and because of the ERM II, is in my view likely to receive help from the European Central Bank (ECB) if the pressures become unbearable - which they are not at the moment. Moreover, the DKK peg is well established, set more than thirty years ago against the former Deutschmark. Despite growing skepticism about the euro and the Eurozone, the Danish population still fully supports it. This situation contrasts with the one that prevailed in Switzerland, where the former floor policy confronted increasing public reservations before the SNB decided to abandon it.
Many pundits, I among them, assume that the sheer size of its currency reserves, which had exceeded 80% of GDP, had started to give the SNB vertigo. The reserves of the DNB are only 30% of GDP. If the SNB has become a kind of benchmark, the DNB still has plenty of room to maneuver. Finally, the DNB recently commented that it has the means available to defend the peg “to the last drop of blood.” Though Switzerland had some of Europe’s fiercest soldiers in the 14th and 15th centuries, the SNB would never issue such a Viking-like statement.
While asking “who’s next?” is indeed apropos in the wake of the SNB’s action, I doubt one will find the answer by looking only at currency pegs and regimes, which might or might not face attack. The official narrative is that the SNB introduced the floor in 2011 to avoid a massive shock to Swiss exporters, and since, as its communiqué spelled out on the day it lifted the floor, Swiss exporters were now both better prepared and facing a friendlier environment, the floor no longer made sense. But abstracting for a second from the currency, one can also pursue a deeper current of thought. By introducing the floor in 2011, the SNB enabled Switzerland to escape deflation.
Indeed, despite experiencing falling prices after 2011 due to the still-strong franc, Switzerland didn’t suffer from falling wages, which very well could have triggered a deflationary spiral. With the floor now lifted, deflation has become a plausible scenario again. Therefore, I wouldn’t focus only on the central banks fighting “the currency war” when asking the “who’s next?” question. I would consider those officially trying to combat deflationary pressures as well. Did someone just mention the ECB?