Small European Currencies Are Just a Headache

Currency pegs have outlived their usefulness. Countries should embrace floating exchange rates or join the euro.

Let it float.

Photographer: Bartek Sadowski/Bloomberg

Turmoil continues for small currencies on Europe's periphery: The Czech Republic finally may be about to drop the koruna's peg to the euro, and Iceland is looking for a currency to use to value the krona. The agony of these decisions may give central bank governors an illusion of control, but currency pegs appear to be outliving their usefulness. Countries that don't feel comfortable with freely floating exchange rates shouldn't have their own currencies at all.

International Monetary Fund says that 59 percent of its members had their currencies anchored to another country's legal tender in 2008. That's down to less than 43 percent now. It's mostly the U.S. dollar pegs that are being dropped, although the euro has lost some adherents, too. 

The Decline of Pegs

Percentage of IMF members using other countries' currencies as anchors for their own

Source: International Monetary Fund

Pegs are a pain to defend when they stop performing as originally planned. But getting rid of a peg can be even more painful. The "Swiss surprise" in January, 2015, when Switzerland abruptly abandoned the franc's euro peg, has put a damper on the country's economic growth and boosted unemployment: The rocketing franc was the last thing the export-oriented economy needed, no matter how hard it was for the Swiss National Bank to maintain the peg.

QuickTake Currency Wars

Now, the Czech Republic faces a similar situation. Since 2013, it has kept the koruna down by pegging it to the euro. This has lead to a steadily increasing positive trade balance. Last year, however, speculative money started pouring into the country. The Czech National Bank's international reserves soared by 59 percent in the 12 months ending Feb. 29. As the central bank rushed to buy euros, inflation went up to 2.5 percent, the highest level since 2012. 

On the surface, the country looks ripe for what sensationalist observers have dubbed "Czexit": It sounds nice and can loosely be described as a step away from the euro area. But what will the koruna's unpegging do to the Czech economy? Most likely, the same as the 2015 surprise did to the Swiss one: The currency will soar, exports will contract, tourists will reconsider plans, jobs will be lost and the government will be left looking for new, non-export-related sources of growth.

Icelanders know well what happens when a tsunami of foreign money washes over a country, drawn by high interest rates. Recently, the island nation removed most of the currency restrictions left over from its valiant attempt to fix the consequences of the global financial crisis.

The Central Bank of Iceland still has controls in place to mitigate new foreign currency inflows -- there are reserve requirements for foreign portfolio investors -- yet the krona has appreciated by 16 percent since the beginning of 2016. That's a threat to Iceland's single biggest growth driver, tourism. Travelers fell in love with Iceland as it recovered from the crisis because its exotic beauty suddenly got cheap thanks to capital controls. With the controls gone, Iceland needs other means to keep the krona down. It also needs a means to reduce exchange-rate volatility, which makes it hard to make any kind of plans.

At first glance, a peg makes sense. Yet, as Iceland's finance minister, Benedikt Johannesson, has made it clear he understands, picking an anchor currency will affect Iceland's trade flows. "Once you decide on a currency, that will also change the future," he told the Financial Times. "You will do more business with that area."

That's what happened to Denmark, which, for more than 30 years, has pegged its krone to the deutsche mark and then the euro. The country's economy became closely interconnected with that of Germany and the rest of the euro area. As for the peg, it's been hard to defend at times -- especially over the last two years, when the krone was often treated as a safe-haven currency against the euro's perceived weakness. It's unclear what the benefits are for Denmark if it's committed to defend the peg no matter what -- as its monetary authorities have often stressed -- but it's not formally a euro member.

Keeping one's own currency isn't all it's cracked up to be. Although, theoretically, it allows a country to improve competitiveness by devaluing, the downside can be greater in a world of global finance and massive trade blocs. Managing the competing currency flows requires nimbleness from regulators and underlying economic strength that makes a country less dependent on rate fluctuations. One solution is to set the currency free; in recent years, that's served Russia and Poland well, allowing them to deal effectively with economic turbulence.

But it takes courage and political resilience to float a currency. Voters may feel left behind by an economy that depends on price competition, and in Poland, the populist PiS party has used that discontent to win power. In Russia, an autocratic state has found ways to suppress economic protest, but those methods can only work temporarily.

For small European countries, joining the euro outright is a better idea than a peg. It makes sense to recognize that one's biggest trade partners are in the eurozone and stop wasting energy on the maintenance of tiny currencies -- the defense against speculators, the configuration of pegs, the painful consequences of their removal. Slovakia, which adopted the euro in 2009, has done as well economically, better lately than neighboring countries that have kept their own currencies. Bulgaria clearly noticed: It is now considering a move from a euro peg to the next step toward formally adopting the common currency. 

No Need to Fear the Euro

Quarterly year-on-year economic growth, constant prices

Source: Data compiled by Bloomberg

Such momentous decisions, of course, aren't taken lightly. But if the eurozone's monetary policy continues to facilitate an economic recovery and help drive down unemployment, doubts about the euro will eventually give way to the realization that it's better to be part of the common currency than to keep looking for temporary crutches and then wondering how to discard or fix them.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.