Dog days for small country currencies

Peter Warburton - 21 December 2017

These are perilous times for those smaller nations that have clung to their sovereignty and insisted on the retention of a separate currency. The broad context is that the prevailing US-centric world order is being shaken up and countries are jostling for position in the emerging world order. While the G20 nations continue to gather for annual summits, the sense of communal purpose that arose out of the global financial crisis has evaporated. Multilateral trade deals have been replaced by regional trade agreements, but even these are vulnerable to vetoes and unilateral withdrawals. It is, truly, every nation for itself.

The dissolution of a world order based loosely around free market capitalism is troubling from several angles, but especially so for independent nations with small populations. Smaller countries have flourished in a world of capital liberalisation, gaining similar terms of access to global supply chains as the dominant economic powers. Conversely, the advent of capital protectionism inflicts disproportionate damage on these nations. While we associate wild capital movements and currency volatility with emerging currencies, there have been plenty of rich-country examples also. The suppression of volatility in the bond and equity markets does not hold for currencies. Monthly movements of 5 per cent in nominal currency indexes are not uncommon.

The obvious and immediate test for small currencies is how quickly and fully their central banks feel obliged to mimic the actions of the dominant central bank in their universe, typically the US Federal Reserve or the ECB. Whatever attractions there are in exerting independence of action, the dangers are significantly greater. Capital flight scenarios are particularly relevant in a zero interest rate world, where leverage can be readily attached to a carry trade. Switzerland has endured two episodes of explosive currency appreciation, but may now be facing its antithesis.

In last week’s blog Yvan highlighted the deterioration in Swedish housing market conditions which might incline the Riksbank to leave interest rates at their extreme setting (-0.5 per cent) even as the ECB is preparing to normalise theirs. The use of forward guidance becomes a hindrance to efficient policymaking in these circumstances. In figure 1, below, we suggest 5 countries whose currencies are becoming marginalised by global developments: Switzerland, Sweden, Norway, Iceland and New Zealand.

If, indeed, the global world order is disintegrating and fragmenting, it will become progressively harder for these nations to attract capital inflows as a counterweight to current account deficits. The notion of a pool of global capital that would readily finance budget and external deficits, for countries large and small, is impaired. In future, smaller countries that run current account deficits may need to offer interest rates that embody larger risk premia to attract banking flows.

It is easy to envisage a time when the costs of managing an independent currency for small nations will outweigh the benefits. If monetary policy independence is a mirage, and local rates are forced to mirror those of the Fed or ECB, then why not adopt, or link to, their currency instead?

Figure 1

Data source: Bank for International Settlements

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