cnBlog – Denmark’s monetary policy: Permanently halfway to the euro?
Denmark is one of the European Union Member States that are not members of the euro area but use their own currency. Denmark has a negotiated opt-out for the acceptance of the euro, nevertheless the Danish krone is strongly bound to the euro as part of the chosen fixed exchange rate regime with the euro that this country has been using for over 40 years (it was pegged to the German mark before the euro was created). Denmark is also a member of the ERM II exchange rate mechanism. However, Danish monetary policy is best defined as a fixed exchange rate regime rather than ERM II membership, as the exchange rate fluctuates much less than corresponds to the fluctuation band associated with the mechanism. This article describes the Danish choice of exchange rate regime, the instruments used for implementing it, the reasons behind its high stability, and the differences between the fixed exchange rate regime and actual euro area membership. The article concludes that although Denmark has been successfully operating with a fixed exchange rate, its experience is not easily transferable to other countries.
Published in Global Economic Outlook – March 2024 (pdf, 590 kB).
The mandate of Danmarks Nationalbank (DN), the Danish central bank, is to ensure price stability, a safe payment system and a stable financial system. Although Denmark has its own currency, the Danish krone, it does not use an inflation-targeting regime to fulfil its price stability mandate, but a fixed exchange rate regime against the euro, a relatively unique case among developed countries. As regards financial stability, the Danish central bank has a considerable, though formally only an advisory role.[1],[2]
Fixed exchange rate and ERM II
Denmark has been operating under its current fixed exchange rate regime since 1982. It was initially pegged to the German mark and, since the creation of the euro in 1999, the single European currency. Despite close integration with the euro area, however, Denmark is not seeking to adopt the euro. On the contrary, it has negotiated a permanent opt-out from it. The roots of this opt-out coincide with the period of negotiations on the Maastricht Treaty, the ratification of which Denmark initially rejected with a small majority in a referendum in 1992. The country then negotiated several opt-outs, among them in relation to entering the euro area after it was established. In this modified form, Danish citizens expressed their consent to the ratification of the Maastricht Treaty in a referendum in 1993 (which came into force throughout the then EU in November of the same year). After the creation of the euro area, Denmark held another referendum in 2000, this time directly on adopting the euro (and thus abolishing the agreed opt-out), but with 53.2% of voters voting against, it was decided to keep the Danish krone.[3]
However, Denmark joined ERM II when it was established in 1999 (it was also in its predecessor, the ERM). Denmark is currently one of the two non-euro-area ERM II member states, Bulgaria being the other. However, while Denmark has long been a member of ERM II with a vision of remaining outside the euro area, Bulgaria joined the mechanism in 2020 with the aim of quickly adopting the euro (at least two years of successful ERM II membership is one of the Maastricht criteria necessary for joining the euro area).
The currencies participating in ERM II have a fixed central rate against the euro, which has a fluctuation band. In the event of pressure to exceed the limit of this band, both the national central bank and the ECB are obliged to intervene to defend the fluctuation band boundaries (although interventions may be suspended in the event of a conflict with the objective of price stability).[4] Although the standard band for exchange rate fluctuation within ERM II is ±15% from the central rate (parity), [5] Denmark concluded an agreement (external link) with the other participants when it joined to maintain the exchange rate within the narrower band of ±2.25% from the central rate.[6] With parity set at 7.46038 Danish krone per euro, this would allow the Danish currency to fluctuate between around 7.29 and 7.63 krone per euro. In practice, however, the Danish currency fluctuates significantly less and remains very close to the central rate – since 2010 it has practically never left the range of 7.43 to 7.473.[7] Therefore, rather than ERM II membership, it is the fixed exchange rate regime that best characterises Danish monetary policy.
By using the fixed exchange rate regime conceived in this manner, Denmark has de facto given up on an autonomous monetary policy, effectively delegating the issue of price stability to the European Central Bank. The advantage of this approach is a significant reduction in exchange rate risk and a related facilitation of international trade with euro area countries. The main disadvantage is that it is impossible to react to current developments in the domestic economy and adjust the domestic monetary conditions to the inflation outlook, as well as the impossibility to contribute to decision-making in issues of the ECB’s monetary policy. The DN (2022) describes three main factors helping to stabilise the economy in such a regime. First, given its high interdependence and alignment with the euro area, the Danish economy’s needs are mostly similar to those of the euro area, and the ECB's monetary policy thus usually helps to stabilise developments in Denmark as well (see Chart 1). However, if the cyclical position of the Danish economy deviates from that of the euro area, two other factors come into play.
Chart 1 – Inflation (above) and GDP growth (below) in Denmark and the euro area
Note: The average annual inflation rate measured by the HICP index, year-on-year growth of real GDP.
Source: Eurostat.
One of these is adjustment through competitiveness – for example, if there is a greater increase in inflation in Denmark compared to the euro area (which, with a fixed nominal exchange rate, means an appreciation of the real exchange rate), there is a relative increase in the price of goods from Danish producers compared to foreign ones, thus reducing the demand for Danish goods, the profits of Danish companies, and the room for wage increases, leading in turn to a dampening of the economy and a fall in inflation. In a situation of initial lower inflation compared to the euro area, the whole mechanism is, of course, similar, only in the opposite direction. However, this adjustment process takes some time, and there may be different developments in Denmark and the euro area in the meantime. Fiscal policy is the remaining important adjustment mechanism. If conducted appropriately, it can smooth the business cycle and at least partly offset the absence of an autonomous monetary policy. An emphasis on the role of fiscal policy is also apparent from the aforementioned DN article (2022), in which fiscal policy is given considerable attention. The DN also regularly assesses the performance of fiscal policy as part of its economic analyses and publishes recommendations on how restrictive or expansionary it should be. In addition, automatic fiscal stabilisers are more important than in most other countries owing to the design of the tax and transfer system in Denmark.
Fixed exchange rate maintenance instruments
To keep the Danish krone exchange rate in the immediate vicinity of the set parity, the Danish central bank uses two main instruments – foreign exchange interventions and interest rates.[8] If market developments lead to appreciation pressures on the Danish krone, the central bank will first sell krone and buy euros, while if the DN is under downward pressure, it will start selling euro foreign exchange reserves. At the beginning of each month, the DN publishes the volume of interventions performed in the previous month. The relatively large volume of foreign exchange reserves[9] gives the central bank plenty of room to intervene, and also helps it maintain a high level of credibility with financial markets, thus preventing speculative attacks. The DN does not have a specific target for holding foreign exchange reserves, but considers it important to keep their volume high enough.
In order for foreign exchange reserves to serve their primary purpose – namely maintaining a fixed exchange rate – high liquidity is a key aspect for their placement. Making a profit under acceptable risk levels is a secondary goal.[10] Foreign exchange reserves are therefore predominantly deposited in foreign central banks or invested in foreign government bonds, while only a small proportion is invested in potentially more profitable yet riskier assets like equities or corporate bonds.
Interest rates are another instrument available to the DN alongside foreign exchange interventions. Unlike inflation-targeting central banks, however, they are not set according to the current outlook for inflation and cyclical developments in the economy, but with the goal of stabilising the exchange rate. In light of the similarity of the fundamental development of the Danish economy with the euro area, Danish interest rates usually follow ECB rates (see Chart 2) very closely – if the ECB decides to change interest rates at its meeting, the Danish central bank usually announces the same rate change on the same afternoon (for the past decade, Denmark has been one of the countries applying negative interest rates – similar to the euro area). However, if a longer-term appreciation/depreciation trend is apparent on the market, the DN can adjust interest rates unilaterally (i.e. without this step being preceded by a change in ECB rates) in addition to using foreign exchange interventions. Changing the interest rate differential vis-à-vis the euro area increases or decreases the attractiveness of the Danish krone, offsetting the pressures for deviation of the exchange rate from the central parity rate.
Chart 2 – Monetary policy interest rates
Note: The values as of the last day of the month. For Denmark the interest rate is given for deposit certificates, for the euro area the minimum rate for tenders with a variable rate (which stopped being used in October 2008) is given until September 2008 and the deposit rate from October 2008.
Source: ECB and Danmarks Nationalbank.
Stability of the exchange rate regime
Eichengreen (2023) denotes the long-term high exchange rate stability of the Danish krone against the euro as exceptional (compared to other fixed exchange rate regimes in other countries). He then analyses several hypotheses that try to explain this unusual stability. He mentions, for example, the high volume of foreign exchange reserves, which gives the central bank enough room for intervention – although the volume of foreign exchange reserves is no longer particularly high relative to the amount of short-term debt. Good conduct of fiscal policy is another hypothesis. Denmark has an unusually low ratio of general government debt to GDP among developed countries (around 30%) and a relatively strict approach to fiscal policy, and thus enjoys high credibility among foreign lenders. According to Eichengreen, on the other hand, in practice there is no indication that Denmark uses fiscal policy more actively than other countries, although active use of countercyclical fiscal policy is one mechanism through which a country can at least partially compensate for the lack of its own monetary policy in theory, and the central bank itself refers to it (see above).[11]
The Danish labour market could be another reason for the stability of the exchange rate regime. It is known for its model (referred to as flexicurity) of high flexibility in hiring and firing employees, a generous safety net in the form of support for laid-off employees, and a sophisticated active labour market policy. In good times, this model leads to lower unemployment compared to the EU average. Low unemployment, meanwhile, limits speculation that the Danish authorities will change the exchange rate regime in an effort to start using monetary policy more actively to support the economy (as could be the case under conditions of high unemployment and recession). However, the post-2008 rise in unemployment was one of the most severe among OECD countries, so we cannot say that this argument is unconditionally valid in the labour market either.
In his article, Eichengreen discusses several other hypotheses (including the banking system, institutional interconnection with the ECB, and the fact that the DN has historically more often faced pressures to appreciate the krone, against which it can intervene indefinitely in principle – while it is limited in the opposite direction by the volume of foreign exchange reserves). To sum up, there are a number of possible reasons for the high stability of the current Danish krone exchange rate regime, but each is subject to certain caveats and none offers a complete explanation. Rather, it is their combination that gives the fixed exchange rate its high degree of credibility.[12]
The duration of the fixed exchange rate regime itself can be one of the key factors. The longer the regime works and the longer the Danish authorities maintain their commitment to a fixed exchange rate, the higher the reputational and economic costs of exit, and the market would have greater confidence that it will be maintained in the future. Of course, this argument alone does not explain the initial stability of the exchange rate regime in the period after its introduction, but its importance has grown over time.[13] The fixed exchange rate regime survived the ERM crisis of 1992 and 1993, the Global Economic Crisis and the subsequent euro area debt crisis, the period after the exit from the Swiss exchange rate commitment in 2015,[14] the Covid pandemic and the subsequent inflationary wave, even though during them it faced pressures to strengthen or weaken the Danish krone from the central parity rate. This increases confidence that the regime will be maintained in the event of future crises.
Own currency with a fixed exchange rate or the euro?
Denmark is closely linked to the euro area through its choice of monetary policy and consequently its exchange rate regime. It can thus take advantage of some of the benefits of the single European currency (minimisation of exchange rate risk and the related facilitation of international trade), although this is at the cost of giving up its independent monetary policy and a floating exchange rate as a possible stabilisation mechanism. However, some of the benefits of joining the euro area are not present under this regime. There are still transaction costs from currency conversion, and Denmark is not part of the Governing Council of the ECB and has no representative on it. Moreover, there is still some exchange rate risk in the form of a possible exit from the fixed exchange rate regime or an adjustment to the central parity rate (although, given the long-standing high credibility of the current regime, this risk can be considered low). The question is therefore whether it would be better for Denmark to adopt the euro instead of maintaining a fixed exchange rate against the euro.
The effects of potential entry into the euro area compared to a fixed exchange rate regime were analysed, for example, in a report by the Danish Economic Council (2009).[15] The article discusses the individual areas affected by euro adoption and concludes that the economic impact of joining the euro area would probably be small (as Denmark is already getting most of the advantages and disadvantages of the single currency via the fixed exchange rate), but slightly positive overall (as Denmark would start to fully implement the advantages of the euro). Codogno and De Grauwe (2015) also argue that it is not important for Denmark to retain its own currency in a situation where its exchange rate is firmly pegged to the euro and the country refuses to adjust this exchange rate regime in any future circumstances (which is what the Danish authorities communicate). According to the authors, maintaining an own currency with a fixed exchange rate – despite its current stability – may be unnecessarily prone to speculative attacks and, sooner or later, may cause a necessary adjustment of the central parity rate with significant economic costs.
On the other hand, the Danish exchange rate regime continues to operate solidly thanks to its high credibility. It is difficult to find economic arguments in favour of keeping an own currency at the same time as permanently pegging it to the euro, nevertheless there is no indication that Denmark is at a significant economic disadvantage due to this regime. In any event, Denmark does not seem to be giving any indications it is ready to reconsider its position on the euro.
Denmark as a model?
Denmark is a thriving Western economy closely connected to the euro area and its fixed exchange rate regime can be described as well-functioning. Could it therefore serve as inspiration for other countries (for example for the Czech Republic in the context of the Czech public debate on the euro in recent months)? This question can be divided into two parts – ERM II membership and the fixed exchange rate itself. With regard to ERM II, as discussed above, what defines Denmark’s monetary and exchange rate policy is not so much the formal membership of the mechanism itself as the fixed exchange rate regime applied over the long term. If a country were to enter ERM II with the intention of remaining in it for a long time without a credible prospect of quick entry into the euro area, and allowed the exchange rate to fluctuate more significantly than the Danish krone (whether in the ±15% range from the central parity rate or in the narrower band), it would risk that over time the maintenance of the fluctuation band could become inconsistent with the inflation target. Such a country would thus be gambling with the credibility of its monetary policy. The advantages and disadvantages of individual exchange rate regimes and the sub-optimality of mixed regimes without a clear nominal anchor were discussed in the CNB blog (only available in Czech), while a recent article (only available in Czech), among others, by Janis Aliapulios and Eva Zamrazilová warned against the Czech Republic’s entry into ERM II without a specific plan to join the euro.[16]
If we now consider the actual fixed exchange rate regime applied in the Danish manner, this is a more comprehensible monetary policy regime than maintaining a wider fluctuation exchange rate band in the long run. However, even such a regime would first need to build credibility and could be prone to speculative attacks, especially in the initial phase. Changes in monetary policy regimes tend to be costly and should therefore take place only on an exceptional basis and for clear reasons. In the absence of a monetary policy, a fixed exchange rate regime would also place high demands on the remaining economic policies, and Denmark implements them at an above-standard level (i.e. it maintains sufficient fiscal room using a low share of indebtedness of the public sector). Moreover, it has been building the credibility of its fixed exchange rate regime for several decades. Its fixed exchange rate experience cannot therefore be considered simply transferable to other countries.
Conclusion
The Danish central bank does not conduct an independent monetary policy, but ensures a fixed exchange rate for the Danish krone against the euro over the long term, thus de facto accepting the ECB monetary policy. Denmark has negotiated a permanent opt-out for the adoption of the euro, but has been a member of the ERM II exchange rate mechanism since 1999. Meanwhile, in practice the Danish krone fluctuates in close proximity to the central parity rate, thus it is far from using the standard fluctuation band of ±15% ensuing from ERM II membership, and not even the narrower ±2.25% band from the central parity rate that Denmark has agreed with the other members of the mechanism. The central bank uses two main instruments – foreign exchange interventions and interest rates – to ensure a stable exchange rate.
The Danish exchange rate regime has weathered a number of crises without major changes and can be considered highly stable. A number of possible explanations for this stability can be found (e.g. a quality fiscal policy, high stocks of foreign exchange reserves, a flexible labour market...). However, each of these explanations also has its limitations and it is most likely their combination that helps explain the successful operation of the fixed exchange rate regime. Moreover, the increasing period of the existence of this exchange rate regime is further strengthening confidence that it will continue in the future, so exchange rate stability is also aided by a self-fulfilling expectations mechanism. Thus, an economic case for keeping its own currency in a situation where it is firmly and permanently pegged to the euro is difficult to find in the case of Denmark. Nevertheless, Denmark has been operating relatively successfully under this regime for a long time and there is no indication that it plans to reconsider its position on the euro. However, in view of the Danish specificities described, the positive experience with a fixed exchange rate regime (and the long-term participation in ERM II) cannot be considered easily transferable to other countries.
Literature
Bizuneh, M. (2022). “Are We Floating Yet? Duration of Fixed Exchange Rate Regimes,” Eastern Economic Journal, No. 48, 63–89. (external link)
Codogno, L., & De Grauwe, P. (2015). “Why Denmark should either abandon its peg to the euro or join the single currency,” London School of Economics Blog. (external link)
Danish Economic Council (2009). “Chapter II: Denmark and the EURO,” Danish Economy, Spring 2009, English Summary. (external link)
DN (2014). “Fixed Exchange Rate Policy in Denmark,” Monetary Review Q1 2014, Danmarks Nationalbank, by M. Spange and M. W. Toftdahl. (external link)
DN (2016). “Effects of Danmarks Nationalbank’s Interventions in the Foreign Exchange Market,” Monetary Review Q4 2016, Danmarks Nationalbank, by M Spange and J. Sorensen. (external link)
DN (2022). “Monetary and fiscal policy in Denmark,” Danmarks Nationalbank, Analysis No.12, October 2022, by M. Spange. (external link)
Eichengreen, B. (2023). “The Danish problem,” Economia Politica, No. 40, 781-794. (external link)
Marcussen, M., & Zolner, M. (2001). “The Danish EMU Referendum 2000: Business as Usual,” Government and Opposition, Vol. 36(3), 379–402. (external link)
[1] Denmark’s major financial stability body is the Systemic Risk Council (external link), headed by the chairman of the three-member Committee of Directors of the central bank (currently Christian Kettel Thomsen) and whose other members include, in addition to the representatives of other institutions, one other representative of the DN. However, the Systemic Risk Council is an advisory body – financial stability measures fall within the remit of the Minister of Industry, Business and Financial Affairs. However, the minister is obliged to provide an explanation of the reasons for not following the Council’s recommendations. In addition, the central bank’s role in financial stability in the event of a crisis may also lie in providing liquidity to the banking sector.
[2] The DN is also the central bank of Greenland and the Faroe Islands, two autonomous territories of the Kingdom of Denmark whose official currency is also the Danish krone (although the Faroese króna is the official currency of the Faroe Islands, it is actually only a local version of the Danish krone, with which it is exchangeable in a ratio of 1:1). The Faroese króna also does not have its own coins, but uses Danish ones). The DN therefore regularly analyses these two territories.
[3] The referendum of 2000, held in the context of the political and social debate in Denmark at that time, is described in more detail by Marcussen and Zolner (2001).
[4] ERM II is described in more detail, for example, in the CNB blog post (only available in Czech).
[5] See the contract (external link) between the ECB and the central banks of the EU countries outside the euro area about ERM II or the description of the mechanism (external link) on the European Commission website.
[6] For countries intending to join the euro area, maintaining an exchange rate within the standard band of ±15% might not be sufficient when the Maastricht criterion for participation in the exchange rate mechanism is assessed. Based on historical experience with the Commission’s approach to assessing compliance with the exchange rate stability criterion, it can be stated that on the weakening side, the threshold of 2.25% relative to the central rate can be considered unproblematic. See the article from the previous footnote.
[7] In the first decade of the euro’s existence, the exchange rate deviations from central parity were somewhat larger in some periods, but not significantly. Exchange rate volatility was more pronounced when it was pegged to the German mark, especially in connection with the ERM crisis in 1992 and 1993.
[8] The functioning and effectiveness of foreign exchange interventions in Denmark is discussed in more detail in DN (2016). The DN (2014) discusses the implementation of the interest rate instrument in the environment of the local exchange rate regime.
[9] As of January 2024 around SEK 630 billion (external link) (approx. EUR 84.5 billion ), or approximately 23% of GDP (external link) for 2023.
[10] In 2022, the DN recorded a loss of around DKK 8.4 billion (external link) (approx. EUR 1.1 billion), mainly due to the decrease in the price of bonds held by the bank at that time. As of February 2024, its capital was around DKK 73 billion (external link) (approx. EUR 9.8 billion ).
[11] The aforementioned relatively significant automatic fiscal stabilisers may play a certain role, though Eichengreen does not discuss them in his article.
[12] Many of the areas discussed – e.g. fiscal policy and the labour market – are also important adjustment mechanisms for countries that lose their own monetary policy as a result of adopting the euro. Denmark’s situation is different in that it is easier to leave a fixed exchange rate regime than to leave the euro area, and thus this regime is by definition more prone to speculation and less stable than the almost irreversible accession to the monetary union. Maintaining its stability thus places higher demands on other areas of economic policy.
[13] There is also empirical support for this argument. For example, Bizuneh (2022) shows, on an analysis of fixed exchange rate regimes since 1970, that with the adoption of a fixed exchange rate regime the probability of exit from that regime initially increases. However, if the regime is maintained and market confidence is built, the likelihood of exit from the regime will start to decrease as time goes on.
[14] Between 2011 and 2015, in response to the previous significant appreciation of the Swiss franc, the Swiss central bank maintained its exchange rate at a minimum of 1.2 to the euro (i.e. it did not allow it to appreciate beyond this level). Following the exit from this policy in 2015, there was speculation that the Danish central bank could also exit its exchange rate regime, which created pressure on the Danish krone to rise, leading the DN to intervene extensively and also to lower its interest rates.
[15] Although this article is 15 years old, most of the arguments presented are relatively timeless and can thus be considered still valid.
[16] In addition to the discussed monetary policy aspect of ERM II membership, we can also mention the question of the banking union. Denmark is not a member of the banking union, although the country’s possible entry was discussed before the Covid pandemic. On the other hand, given the experience of Croatia and Bulgaria, potential new candidates for ERM II could be required to join the banking union at the same time, although EU law does not provide for this as a condition for joining ERM II.