On March 12th, 2009, there was panic in the currency streets. Safe haven investors and speculators alike were hiding from canon fire being launched out of the Swiss National Bank (SNB). Meanwhile, they were selling every Swiss franc in sight. For the first time since about 1996, Switzerland was actively intervening in the currency markets, buying Euro bonds and reducing interest rates. All of it sent an ominous message to speculators: Beware!
The news sent shudders down the spines of shocked investors. Was this first salvo in a series of currency wars? Would our future be filled with “beggar thy neighbor” economic policies and serial debasement of paper money, from one central bank to another? Swiss bank officials were quick to follow up their minor canon fire, with warnings. “Don’t mess with the SNB!” they proclaimed, “Don’t you dare pump up the value of our franc against the Euro!” With great bravado and fanfare, then, the actions of the Swiss shocked the overleveraged speculators, and triggered their stop loss orders. The Swiss will soon learn, however, that shock value can only go so far. They’ve got a huge problem in their quest to become currency debasers. Unfortunately, banking is their primary industry. Italy, Greece, Portugal and the other members of the “Club Med” bloc of the Eurozone central banks were widely perceived as currency debasers in the days of the lira, drachma and escuedo. They joined the Eurozone in order to help them escape from a lack of self-discipline. People from around the world would never think of putting their assets into the hands of an Italian bank with an eye to long term investing. However, the wealthier citizens of Italy were quick to deposit their funds in places like Switzerland. If the public begins to perceive Switzerland as a currency debaser, its banking industry will quickly die.
Euro-zone members, Ireland, Greece, and Italy are reeling, and close to insolvency. With fast collapsing real estate markets, Spain and Portugal are not far behind. Eastern Europe is in even worse condition. Defaults are mounting and may eventually total $1.7 trillion. About 4% of these loans were denominated in Swiss francs. That doesn’t sound like a lot, but it amounts to $69 billion, and the total GDP of Switzerland is only a little over $300 billion. Additional Swiss franc denominated loans exist all over western Europe, in even larger amounts. For a tiny country like Switzerland, the number of franc denominated loans are huge. The number of defaults is likely to explode in the very near future. But, the loans were not made by Swiss banks. Almost all of the loans to the east were made by Austrian, Italian, Belgian bankers. In places like Denmark, the Swiss franc loans were made by native Danish banks. Banks at great risk from defaults include Raiffaisen Bank (Austria), Erste Bank (Austria), Unicredit (Italy), and a number of other Eurozone and Scandinavian banks. The total Swiss franc loans, made by the Austrian banks, for example, total close to 70% of Austria’s entire GDP.
Lucky for the Swiss, they are not in the unenviable position of the Austrians. Big losses will not be suffered by Swiss banks. Eurozone banks will suffer. They made the loans. The Eurozone banks owe the money to Swiss banks, and the borrowers, in turn, owe the money to the Eurozone banks. Bankers are adept at making fearsome predictions to get what they want out of politicians. That’s how they got the American politicians, like Ben Bernanke, to bend over and let them have their lusty greed mongering way with him. Given the penchant of Europeans for socialistic economic behavior, there is more than a 99.9% chance that stricken Eurozone bankers will be even more successful in having their way with the ECB, when push comes to shove.
In the end, the Eurozone banks will not fail. Instead, the Swiss banks will be repaid with freshly printed Euros. But, the Swiss bankers know that defaulting loans neither create nor destroy money. The money that was loaned out, over the past 3 years, has not been burned in a big bonfire. It has merely changed hands, from bank to bank, from bank to borrower, and from borrower to the person who sold him his overpriced flat. It is well known to anyone familiar with Eastern Europeans, that the flat sellers don’t trust banks. So, most of the Swiss francs (as well as other currencies received) from overpaying buyers has gone directly into the flat sellers’ mattresses. Euros, francs and dollars will sit safely in those mattresses, in the form of so called “black day money”, until better times arrive. That’s just the way Eastern Europeans are. In places like Denmark, the francs are still actively circulating, so the effect of printing new money will be immediate when some of those loans default. But, even the mattress money cash, in Eastern Europe, will eventually make its way back into the monetary base. If Switzerland debases its currency, now, by printing a lot of new francs, as they threatened to do last Thursday, when the old francs return, incredibly high levels of inflation will be the result. Heavy inflation and/or the possibility of hyperinflation is anathema to an economy filled with a population composed of the world’s most affluent creditors, most of whose income is, in large part, dependent upon maintaining the world’s trust in the Swiss currency and its banks.
When Swiss franc denominated loans implode, and it won’t be long before they do, we will see a temporary, but severe, reduction in the velocity of circulation of the Swiss franc monetary base. This will raise the value of Swiss currency. When the Eurozone banks repay their obligations in newly printed Euros, the partial substitution of Euros for Swiss francs, on balance sheets of Swiss banks, will create further upside pressure on the franc. These are the considerations which prompted the SNB to launch a preemptive strike last week. The move was a “warning shot” across the bow, to speculators. The SNB fears the sudden astronomical rise in the franc exchange value, and rightfully so. The action they took was for the purpose of shocking the speculators. That is why they made it such a public spectacle. They want to reduce the likelihood that speculators will jump on the franc bandwagon, overwhelming the SNB’s ability to control the situation.
Even if they are successful, the Swiss franc will still rise against the Euro. The only difference will be that it won’t double or triple against the Euro, almost overnight. The fear of that happening is what drove the actions of the Swiss National Bank. The ECB is about to follow the British into quantitative easing, and they know that currency speculators are quite likely to jump into Swiss francs. Couple that with Swiss franc denominated loan defaults, and a continuing repatriation of carry trade Swiss francs, and it is easy to see that the long term upward pressure cannot be controlled by anything within the practical ability of the SNB. Take one look at the oil markets, in the first half of 2008, and you will see the type of sudden, irrational and erratic movement, driven by speculators, that the Swiss, who value stability, fear most. If speculators are allowed free rein, when the default situation hits critical mass, the franc would suddenly double or triple. Then, it would promptly collapse back to a slightly higher level than where it is right now. The havoc that this would create, is what the SNB intervention is designed to stop.
The SNB doesn’t want a suddenly soaring franc, or a suddenly falling franc, but it is willing to tolerate a slow rise in the Swiss franc exchange rate, as illustrated by the franc’s rise against the dollar, beyond parity, prior to July 15, 2008. Nevertheless, the market doesn’t realize that, at this moment. They managed to frighten the wits out of leveraged long buyers, as was their intention. The market is now in a state of shock, and, therefore, in a state of flux. There is no telling what the franc might do over the next few days or weeks. A fiat money bank, like the SNB, has the theoretical power to crash its own currency. However, except for the shock value, as a practical matter, the bank’s intervention, on the 12th of March, was not very meaningful. Although the SNB could crash its own currency, it would be forced to crash its own economy in order to do it.
The internal political situation, within Switzerland, won't allow the SNB to act in a much more forceful manner, lest the central bankers be turned out on their ears. The Swiss don’t like inflation, and are proud of and reverent of their currency. They won’t tolerate a central bank that debases it. Switzerland hasn’t had much inflation in the last 100 years, and was the last nation in the world to break its currency tie to gold. Banking is the main industry in Switzerland. Investors from Dubai, Saudi Arabia, the U.K., Brazil, Chile, India, the USA and a host of other countries, choose Swiss banks (including branches in Singapore, Hong Kong, New York, London, etc.), precisely out of fear that their own countries are prone to devaluaing their own currencies. The stability of Switzerland and the Swiss franc’s status as “hard” currency gives customers faith in the Swiss banks. Debase the Swiss currency, and that faith will be destroyed. A light reading of the speeches, papers and other documents published by Swiss National Bank economists, over the years, indicates that they are well aware of this.
Debasing the Swiss franc, even in the face of a falling Euro, would result in a mass exodus of banking customers, doing irreparable damage to the banks. In the end, Switzerland would collapse the way Iceland did. The SNB cannot afford to have this happen. On March 12, 2009, the SNB drew a “line in the sand” against currency speculators, and it was intentionally and heavily publicized. They are clearly anticipating a major event that will temporarily reduce the exchange value of the Euro. Their actions, on Thursday, were MOST unwelcome. However, short of masochistic self destruction, there is little the SNB can do. Even a central banks dead set on debasing its fiat currency is not always successful. Japan, in 2003, for example, attempted to unilaterally devalue the yen. Aside from a few months of downward movement, about a year later, the yen was 6% higher. The Swiss have much less freedom to act than the Japanese. They cannot buy an unlimited number of Euro denominated bonds without triggering heavy inflation. The public spectacle we have seen, over the past few days, is a “put on”, arising out of weakness, NOT strength.
The Swiss franc will rise as the fundamentals become clearer. Loan defaults will not harm Swiss banks, but will interrupt Swiss franc money flows. The end result will be a massive substitution of Euros for Francs, on the balance sheets of most Swiss banks. That will reduce the number of francs available to be loaned out. Most Swiss bank lending activity, for this reason, in the near future, will denominated in Euros. In addition, the Swiss franc is part of the same “carry” trade whose unwinding led to the massive rise in the Japanese yen. The Swiss are eventually going to follow the Japanese lead, and start repatriating overseas assets. The funds returning to Switzerland will be converted to francs, lifting demand even further, at a time when Euros, not Francs, will dominate the lendable assets on Swiss balance sheets. The Swiss franc is oversold, in the midst of a lot of factors that are remarkably bullish for the exchange value of the franc. It is amazing what bluff and bluster can do to the confidence of speculators. The Swiss franc will, inevitably, rise substantially against both the Euro and the dollar, no matter what the Swiss National Bank does.
Disclosure: Long FXF