The European Central Bank's quantitative easing program is now in its seventh month, and there are signs it may ramp up in the medium term. When the bank announced plans to undertake this program on Jan. 22, it became the last to do so among the Big Four central banks, following the United States, Japan and United Kingdom. The ECB program began in March and is at least partly responsible for the growth rebound in parts of the eurozone, coupled with continued low oil prices.
But not everyone has benefited from the bank's generosity. For Switzerland, Sweden and Denmark, the ECB's monetary policy has caused nothing but problems. The heads of these countries will undoubtedly have misgivings after watching ECB President Mario Draghi's press conference last month, particularly as he made clear that the bank is willing to consider increasing monetary easing in the coming months.
Weathering the Storm
Denmark, Sweden and Switzerland are all struggling with economic difficulties. The causes are various: deflation, asset bubbles and bond market problems. But at the root is one problem — all three are adjacent to the eurozone but do not actually share its currency. In today's globalized world, the flow of capital from market to market imitates surges of bad weather, and smaller countries must decide how best to ride out the storm. This means choosing whether to risk the volatility of freely floating their currency or to peg its value to that of a larger player, which many countries choose to do with the U.S. dollar.
Choosing to peg a currency is a commitment that comes with drawbacks. Once the choice is made, the country can no longer set its interest rate policy independently, and speculators may challenge the central bank's willingness or ability to follow through on its policies. This is because a central bank must expend foreign exchange reserves to support a weakening currency and build them up to anchor a strengthening one. Even if a country chooses not to adopt a peg, it must keep a close eye on the value of its currency in relation to that of major trading partners. Otherwise it risks the currency becoming so weak that imports are impacted, or so strong that its exports become uncompetitive. More expensive imports can drive up inflation, while cheaper ones can cause deflation.
Denmark, Sweden and Switzerland have each carved out different paths in their relationships with their shared regional heavyweight, the eurozone, and its expansionary monetary policy. Yet all of them have suffered nonetheless.
Denmark has chosen to peg its currency to the euro. When the 1992 Maastricht Treaty established the euro, Denmark held a referendum. To the Continent's consternation, the Danish people decided to reject the single currency. Instead, Denmark tied its currency, the krone, to the euro. This mirrored the country's historical strategy, which saw it peg its currency to that of other nations and, during the 1970s and 1980s, to the various exchange rate mechanisms that presaged the euro.
When the ECB announced its intention to undertake quantitative easing, the krone came under a great deal of pressure. Speculators suspected that tiny Denmark would not be able to match the European Central Bank's "bazooka" policy of purchasing 1 trillion euros worth of bonds. This belief resulted in a large inflow of capital as investors bet that the Danish peg would break. Denmark's own central bank had to take extreme measures. Interest rates were dropped to -0.75 percent in an attempt to make it uncomfortable for investors to hold Danish krone. Copenhagen was so determined to keep speculators from buying into the krone that it curtailed issuing government debt, which is the easiest and safest instrument for speculators to buy. Instead it chose to rely on its relatively small quantity of outstanding debt (44.5 percent of GDP) and what had been a prudent pre-financing of the year's dues.
Through these maneuvers, the government managed to maintain the peg, which is popular with the Danish people, but the bond market was dealt a sizable blow. It has not yet recovered. The number of available bonds plummeted as intended but this made Danish government bonds less attractive to the markets in general. (Low liquidity inhibits investors' ability to sell an instrument, discouraging them from buying it in the first place.) Denmark is now approaching 2016 with a financial shortfall that the government would like to finance through the bond markets. It will attempt to do so Oct. 9 but markets seem set to charge much more for lending into such an illiquid market. In essence, Denmark has increased its borrowing costs. Meanwhile its ability to pursue the same policy in the event of another shock from the ECB is now inhibited. This could be problematic if the bank decides to extend quantitative easing.
Switzerland has been locked in a constant battle with the strength of its currency. The country's underlying wealth has long made it a traditional safe haven for investors fleeing uncertainty elsewhere in the world. The 2008 financial crisis was no different. In September 2011 the Swiss National Bank decided to peg its currency to the euro, and the subsequent three years saw the bank's balance sheet balloon in size as it fought to keep the peg from appreciating. Critics, especially by the United States, viewed the peg as an attempt to unfairly increase Swiss export competitiveness. This has some foundation: the Swiss current account surplus was healthy in these years and ranged from 8.5 to 15.6 percent.
But one week before the ECB announced quantitative easing, almost certainly pre-warned, the Swiss National Bank de-pegged the Swiss franc from the euro. The franc gained 8.4 percent immediately. This created problems with deflation, however. Consumers, of course, love falling prices, but they can be extremely harmful. A deflationary trend can convince these same consumers to delay their purchases if they know that the same items will be cheaper in the future, thus slowing down the entire economy. Since January, Switzerland has been unable to reverse its gradually growing problem with deflation.
Sweden does not peg its currency to the euro, but neither has it remained immune to quantitative easing. Sweden's proximity to the bloc and relative economic health makes it a haven when times are rough for its southern neighbors. This is what happened in the summer of 2012. Then, the sovereign debt crisis in the eurozone saw the value of the Swedish krona soar against the euro, an effect exacerbated by the Riksbank's decision to raise interest rates the year before — a move famously described by economist Paul Krugman as "an act of sado-monetarism." The high relative rate and the strong krona plunged Sweden into deflation.
Since that time, Sweden's central bank policy has been a steady succession of interest rate cuts. These attempts to weaken the currency and stimulate inflation have been complicated by the eurozone's equally accommodative policies. Sweden even introduced its own quantitative easing program to rival that of the ECB, though on a significantly smaller scale. Nothing has been able to drag the country out of deflation.
Theory of Negativity
These three countries are also linked by another element: they are all pioneers in the world of negative interest rates. All three central banks have had to take extreme measures to keep their exchange rates in line with the euro. As a result they have broken into new economic territory that had once been largely theoretical.
Due to the nature of physical cash, there is a theoretical floor that limits how low interest rates can be set. A negative interest rate is essentially charging a lender for the privilege of depositing money in a bank. When this charge reaches a certain level it will make more economic sense for the lender to rent a strongbox of some kind and keep their savings in physical form rather than taking it to the bank. This would be disastrous for the general economy because it would cut the banks out of the monetary system, severely inhibiting authorities' control.
This hard limit has yet to be reached anywhere in the world. Denmark, Switzerland and Sweden, however, are leading the way in the quest. With interest rates at -0.75 percent in Denmark and Switzerland and -0.35 percent in Sweden, these central banks are extremely constrained in how much further they can push the envelope. (Eradicating paper money would remove the theoretical limit of negative interest rates and has been suggested recently, by the Bank of England for example, but this will not happen any time soon.)
Meanwhile, these super low rates create problems of their own. Loose monetary policy, when sustained over a long period, often has the result of inflating asset bubbles. Borrowers take advantage of cheap credit and drive up the prices of speculative assets such as shares and real estate. All three of these countries have seen rises in property prices over the past year: Swedish property is up 10.3 percent, Danish owner-occupied flats are up 10 percent and in August, UBS described Switzerland's real estate bubble risk as being at its highest since 1991. Sweden's situation is particularly complicated because of its generous immigration policy, since high numbers of newcomers are combining with a low rate of housing construction to drive prices ever higher. Since the traditional technique for tackling bubbles — raising interest rates — is not available, all three countries have now introduced "macro-prudential" policies. These are designed to curtail credit levels in a more targeted manner, but the Swedish Riksbank governor recently cast doubt on their effectiveness. The fact that low interest rates are inflating housing bubbles could prove disastrous later on.
All three countries have suffered significant problems as a result of ECB policy. Switzerland and Sweden are struggling against deflation, while Denmark's bond market has been impacted by measures it adopted to maintain its euro peg. Meanwhile all three countries have plumbed the depths of attainable interest rates, extending the boundaries into negative territory, possibly inflating bubbles in their housing markets.
The ECB's next monetary policy meeting is set for Oct. 22. Some commentators have suggested that President Draghi and the Governing Council may choose this moment to increase the ECB's program of monetary easing. Considering his previous willingness to use the full power of words before following up with actions, it is more likely that Draghi will continue to just talk the euro down at this stage. Whichever course of action he does choose, some of those paying the closest attention are likely to be watching from Copenhagen, Bern and Stockholm.