Sweden Raised Rates to Five Hundred Percent and Still Lost
During the 1992 European currency crisis, Sweden's central bank raised its marginal lending rate to 500 percent defending the krona. It devalued weeks later.
The Defence
During the European currency turmoil of 1992, Sweden maintained a peg linking the krona to a European currency basket. As speculative pressure mounted, the Riksbank raised its marginal lending rate progressively, ultimately to 500 percent.
That figure is not a typographical curiosity. It represents an annualised rate on overnight lending, meaning the daily cost was extraordinary but survivable for a short period, which is precisely the point of setting it there.
The Logic
The reasoning behind extreme short term rates is to make speculation prohibitively expensive.
A speculator shorting a currency must borrow it. If borrowing costs 500 percent annualised, holding the position for even a few days consumes any plausible gain from a devaluation.
The strategy is to raise the cost of the attack above its expected reward, forcing speculators to abandon positions before the peg breaks.
Extreme rates are a bet that speculators will run out of patience before the domestic economy runs out of tolerance. Sweden lost that bet.
Why It Failed
The defence held briefly and then collapsed, with Sweden abandoning the peg in November 1992.
The reason is that the cost is not borne only by speculators. Rates of that magnitude, even briefly, transmit into the domestic economy through the banking system and through the pricing of every domestic loan.
Sweden was already experiencing a severe banking crisis arising from a property collapse. Extreme interest rates worsened it directly, and the government eventually faced a choice between defending an exchange rate and preserving its banking system.
That is the same choice Britain faced in September of that year, and both resolved it the same way.
The Broader Episode
The 1992 and 1993 crisis affected the European system broadly. Britain and Italy left the exchange rate mechanism, several currencies devalued, and the permitted fluctuation bands were eventually widened substantially, which effectively abandoned narrow pegging.
The underlying cause was consistent. German rates were high following reunification, and other members were obliged to maintain rates their own economies could not support in order to hold their pegs.
The Enduring Principle
The transferable lesson is that a central bank defending a peg has finite ammunition in a way speculators do not.
Reserves can be exhausted. Interest rates high enough to deter speculation are also high enough to damage the domestic economy, and that damage accumulates daily while speculators can wait.
Successful defences generally require either genuine economic fundamentals supporting the rate, or the ability to intervene in unlimited quantities of a currency the authority actually issues, which is what distinguished Hong Kong's 1998 outcome from Sweden's in 1992.
The Bottom Line
Sweden imposed the most extreme rate defence on record and devalued weeks later. High rates hurt speculators and the domestic economy simultaneously, and only one of them has to keep living there.