Switzerland Threatens to Start a Currency War

| About: CurrencyShares Swiss (FXF)

Let the currency wars begin.
– Chris Turner, head of FX strategy, ING Financial Markets

Practically by definition, Switzerland is a “neutral” country. The Swiss have avoided war for centuries – ever since the Congress of Vienna re-established Swiss independence in 1815.

Neutrality has served the country well. Rich men and women of all stripes – from Russian oligarchs to four-star generals to industrial magnates – have long stashed their wealth in secret Swiss bank accounts, in full confidence their arrangements would be kept safe and discreet.

Bloomberg notes that banking secrecy has been enshrined in Swiss law for 75 years. Thanks to that commitment, plus a nearly 200-year track record of not choosing sides in conflict, Switzerland has long held the crown as “the world’s largest offshore tax haven” (per The Wall Street Journal).

But nothing lasts forever. And so in recent days, Switzerland has threatened to start a war.

Not a shooting war, mind you, but a currency war. Let me explain...

It all goes back to the banks. As just noted, Switzerland is a big very player – quite likely the biggest – in the offshore banking business. This is a business that rests on the twin pillars of absolute discretion and absolute trust.

Thanks to the credit crisis, the old Swiss business model is under siege. Governments all over the world, and the U.S. government in particular, have begun coming down hard on tax havens in an effort to claw back some of the precious revenues that have been lost.

As a result of this, tax havens everywhere are cracking under the strain. The New York Times reports:

Bowing to international pressure, Switzerland announced on Friday that it would move toward a more rigid definition of tax evasion and help global authorities pursue tax cheats.

The surprise announcement came after a similar shift by two other European tax havens, Liechtenstein and Andorra, on Thursday.

Together the moves deal the biggest blow yet to European traditions of banking secrecy and come amid a global crackdown on tax evasion. The three governments agreed to cooperate with authorities in the United States and elsewhere in investigating tax evasion and, under certain circumstances, to turn over data on accounts at banks headquartered within their jurisdictions.

The change could hardly come at a worse time for the Swiss. As if the crackdown was not bad news enough, the major Swiss banks, like UBS AG (NYSE:UBS), have been pummeled and bloodied by toxic asset write-downs and subprime-related losses.

The recently released UBS annual report showed an $18 billion loss for 2008 – the largest in Swiss history. (That loss included a $780 million black eye from the United States... a fine levied against UBS for crossing the line in helping rich Americans dodge the tax man.)

No Secrecy, No Neutrality

Switzerland is one of the most stable and prosperous countries in the world, but in relative terms their economy is quite small. Based on a measure known as “Purchasing Power Parity,” the CIA World Factbook estimates Swiss GDP at a mere $309.9 billion for 2008. That’s less than what the U.S. Fed and Treasury have already pumped into Bank of America (NYSE:BAC), AIG and Citi (NYSE:C).

So, in that context, an $18 billion bank loss is bad news indeed. The long-term fallout from the permanent erosion of bank secrecy laws is even worse. All of the above threatened (and still does threaten) to send the Swiss economy into a tailspin.

The wise men who toil in the vaults of the Swiss National Bank saw all this coming. They also saw that, even given Switzerland’s deep troubles, the Swiss franc was dangerously strong relative to the euro.

When a country is forced into painful economic contraction, an overly strong currency is a serious burden. (Just ask Japan.) This is because export sales become that much more important when the homefront is hurting. A too-strong currency makes it harder for exporters to compete and bring in desperately needed revenue.

Relaxing the bank secrecy laws must have been a very painful decision for the Swiss. Surely they thought about the consequences before deciding to do it. And, given that, they also decided to do something else at the same time – devalue the currency.

The chart above shows the relative value of the Swiss franc versus the euro. Without looking for the red arrow, can you guess the point at which the Swiss National Bank chose to intervene last week?

The arrow is pretty much redundant. It’s not hard to see that for one moment the Swiss franc was climbing to new multi-month highs relative to the euro, and in the next moment it was falling off a cliff. The Swissie (nickname for the Swiss franc) saw its biggest weekly decline against the euro since 1999 as a result of the intervention.

Again, the reason that Switzerland decided to intervene, in a process known as “competitive devaluation,” is because the Swiss are in a real bind. Their economy is in trouble. One of the best hopes for getting the Swiss economy out of trouble is by increasing export revenues – and the way you do that is by engineering a cheaper currency.

Princip’s Ghost

Remember your European history? Here’s a quick pop quiz: who is Gavrilo Princip?

Princip, in case you don’t recall, was the troubled son of a postman who assassinated Archduke Franz Ferdinand of Austria (and his wife) on June 28, 1914.

That untimely event, which happened in part because the archduke’s driver took a wrong turn, led to a domino-chain of events that touched off World War I.

So what does this have to do with currency devaluation, you ask? Well, it’s all about setting wheels in motion.

No doubt the Swiss bankers had good intentions in deciding to force down their currency. It seemed the rational thing to do, given the hard circumstances. The trouble is, in times like these everyone wants a lower currency... and that just isn’t possible.

Beijing wants a lower currency so that Chinese companies can sell more “stuff” to Americans and maintain a steady pace of economic growth. Japan wants a lower currency so that Japanese exporters can help save the country from collapse. Germany wants the same thing, though cosseted by the euro... as do many other export-driven nations. The list goes on and on.

Bottom line: Many countries would love to devalue. They are all itching to do it – and that includes the U.S. too. (You think American exporters, and the unions behind them, wouldn’t love a weaker greenback?)

The reason we haven’t seen a runaway stampede of competitive devaluations yet is because it’s just international bad etiquette. No one really wanted to be the first to say “Sorry guys, but we have to do this.”

Now Switzerland has broken that taboo. They are the first through the door, so to speak, and all the other countries are eyeballing each other, wondering who might break for the door next.

Not Guaranteed – But Watch Out

Of course, a full on “currency war” is not a foregone conclusion just yet. A devaluation move from a small country like Switzerland is not a sure-fire war starter.

And yet, like the assassination of a hapless archduke at a particularly troubled time, the Swiss move comes against an ominous backdrop. As John Authers recently wrote in the Financial Times, “If the world is really following the script of the 1930s, then we are due for competitive devaluations, as nations attempt to make themselves more competitive at the expense of everyone else.”

“The problem,” Authers goes on to add, “is that not everyone can devalue at once – someone has to be left with an overvalued currency.”

All of this adds up to increased volatility in the major currencies – and trading opportunity to go with it. I will be monitoring the situation accordingly, and Macro Trader members will be taking advantage. Just last week we took partial profits on our short yen position, for example (while still expecting further gains on the remaining half).

The good news behind all this global turmoil is that now, thanks to the wide array of ETF-style vehicles available, investors and traders can move beyond equities. They can profit from movements in things like commodities, currencies, bonds and international indices without leaving the safety of their traditional stock accounts.