Sterling pound and weak European currencies in the crises

In the post Lehman period, the interest rate of the US dollar became low on the forward contract because of its role as international currency. However, in the Euro crisis, that of the Sterling pound became equally low, while the other European currencies increased its liquidity premium. The purpose of this paper is to explore what made the interest rate so different between the Sterling pound and the Danish kroner in the twin crises. By using secured rates, we examine why the Sterling pound and the Danish kroner showed asymmetric features in the two crises. The regression results suggest that there was a structural break in the determinants of deviations from the covered interest parity (CIP) condition across the European currencies during the crises. Currency-specific money market risk was critical in explaining the deviations in the global foreign currency (GFC), while EU banks’ credit risk was useful in explaining the deviations in the Euro crisis. The asymmetry explains different features between the Sterling pound and the Danish kroner in the two crises.

The role of the Euro as a regional liquidity in Europe might explain why the Euro’s interest rate was lower than those of the Danish kroner and the Swiss franc in the crises. In contrast, the lower interest rate of the Sterling pound may be attributable not only to the UK’s reduced reliance on the Euro but also to the role of London market as a money center. One important implication of this paper is that the degree of liquidity risk is not necessarily related to economic fundamentals such as banking sector’s soundness. Denmark and Switzerland are European countries that had relatively sound economic fundamentals in the Euro crisis. However, due to strong linkages to the Euro, they suffered from Euro’s liquidity shortage in the Euro crisis. In contrast, due to the UK’s reduced reliance on the Euro, the Sterling pound did not suffer from a liquidity shortage in the Euro crisis.

JEL codes: G15, G12, F36

Keywords: Covered interest parity, Liquidity risk, Euro crisis, Global financial crisis