September 27, 2012
Over a year ago the Swiss National Bank (SNB) took drastic action to halt the massive appreciation of the Swiss franc, by introducing an explicit floor of CHF 1.20 per euro. With its measure the SNB has sought to stem the huge tide of capital inflows. This policy may offer an interesting insight into the also increasingly unorthodox policies being pursued to address the crisis in the euro area.
Since the outbreak of the euro crisis many investors have been seeking refuge in Swiss assets. Moreover, many investors correctly assumed that the franc would appreciate against the euro and wanted to benefit from this appreciation via CHF-denominated assets. The original flight to the safe haven of Switzerland was thus intensified by speculative capital flows. As a consequence the value of the Swiss franc has at times risen by more than 30% against the euro and is thus jeopardising the competitiveness of the Swiss export industry.
This exchange rate movement is even stronger than the percentage change suggests: compared with the EUR/CHF exchange rate prior to the euro crisis the franc has moved up to 9½ standard deviations (SDs) away from its historic mean. Even the current floor is still 6½ SDs away from the mean. By comparison, the (more volatile) EUR/USD rate has never been more than 2 SDs away from the mean since 2000.
The consequences can be seen in the Swiss current account balance: whereas Switzerland has traditionally managed to widen its current account surplus despite the franc appreciating in real terms, the dramatic appreciation since 2010 has been a major handicap (see chart 1) and has weighed on the already weak economy in Switzerland. It is no wonder that the Swiss National Bank (SNB) is trying to buck this trend.
Although previous interventions by the SNB managed to slow the appreciation of the CHF they could not stop it. In the end the SNB announced in September 2011 that it would make unlimited purchases of euros at the rate of CHF 1.20 – thus setting a floor against the euro. “Unlimited” is the key word in this case: if the intervention were to be limited to a certain volume, foreign exchange dealers could quickly exhaust this volume and force a further appreciation. By issuing the credible declaration that it would make unlimited interventions if necessary the SNB, however, had to do very little initially – market participants quickly accepted the new lower limit. Although the SNB cannot prevent forex transactions being made at a rate below CHF 1.20, those who accept less than the SNB offers have themselves to blame.
In fact it took seven months before the SNB had to back up its words with serious action in spring 2012. Only the recent escalation of the euro crisis – clearly reflected in the skyrocketing CDS premia for Spain – provoked a new wave of capital inflows into Switzerland. As a result of the thereby necessitated forex market interventions the SNB's foreign exchange reserves swelled from CHF 296 bn in April to CHF 479 bn in August (see chart 2). Relative to economic output, Switzerland's cushion of forex reserves is larger than China's.
This shows the degree to which the floor leads to macroeconomic risk being transferred to the central bank balance sheet. This is disturbing because occasionally conflicts of interest arise with general monetary policy. In addition, the risks on the central bank balance sheet are less prominent and can provoke rash interventions. Above all, an increase in the money supply brings with it inflationary risks. Although Switzerland is currently suffering from falling consumer prices, the area of concern, however, is the development of some asset prices, e.g. of real estate.
The ECB's new crisis management measures have resulted in the risk premia in the peripheral countries narrowing considerably. CDS premia for Spain have fallen from 640 bp in July to 369 bp recently. Less concern about the euro also means less demand for safe havens. The Swiss franc traded weaker – at around CHF 1.21 per euro most recently (as at September 24). Indeed there are calls once again for the SNB to raise the floor in order to boost Swiss exports. Such a move is unlikely, however, as an adjustment would immediately trigger speculation about further adjustments. The credibility and thus the effectiveness of the floor would be impaired. It is more likely that the SNB will wait for a normalisation of the EUR/CHF exchange rate and only then abandon the policy of an explicit floor or let it become superfluous. At the moment, however, it is still too early to sound the all-clear.
The CHF floor is an unorthodox intervention. Hence, it may offer an interesting insight into the also increasingly unorthodox policies being pursued to address the crisis in the euro area. The SNB's floor is one example that in the face of huge and self-reinforcing capital flows, unorthodox measures can be appropriate and effective. A credible announcement can be enough to make a significant contribution to calming capital flows. This view is not altered by the fact that the SNB did after all have to intervene extensively from spring onwards to stay on track. After all, the risk situation did again deteriorate significantly in spring.
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