The Swiss Franc: From Virtue to Disaster

by: Evariste Lefeuvre

Peg or no peg, the Swiss economy will be doomed for being too virtuous.

What is a safe haven currency?
There are no genuine properties that define a safe haven currency. Yet, some simple features are required:
  1. sound economic situation (structural balances);
  2. credible institutions and policy mix;
  3. liquidity (depth of the market).
As we show in a recent Special Report (The Swiss Franc – Monetary Policy Decisions and Impact on the Economy), the CHF possesses at least 2 out of 3 of those properties:
  1. Economic situation: To list a few, the debt-to-GDP ratio stands at 36.5% with a AAA rating, the current account surplus at 14% of GDP and the unemployment ratio at 3.2%. The high level of liquidity may create an unwelcome mix of near-deflation CPI trend and a looming housing bubble.
  2. Credibility Even though the institutions are deemed solid, the recent FX intervention policy has negatively impacted the credibility of the Swss National Bank. The failure of FX intervention to limit the appreciation of the EUR/CHF in 2010 translated into quasi fiscal losses and did not prevent the pair from falling close to parity recently.
  3. Liquidity is a necessary property in case of fat tail events. The CHF makes up, according to the BIS, 6.4% of the global FX market turnover (6th rank).
In comparison with the traditional candidates (USD, JPY), the CHF has sound properties to be a safe haven (see chart against gold and the stability of CHF).
However, economic virtue can bring us to the brink of economic collapse when times are turning sour globally: exports (50% toward the eurozone) have been resilient so far but it won’t last.

Failed past sterilization has spurred a liquidity-driven housing price boom. FX interventions are sterilized when the purchase of foreign currencies denominated assets is offset by the sale of domestic currency denominated assets.
Monetary base is defined as the total balance sheet of the central bank (currency in circulation and bank required and excess reserves). FX reserves are part of the asset side in addition to government bonds and other loans. The previous chart shows that the SNB failed to sterilize as the monetary base rose in accordance with FX reserves.
The FX intervention option is no longer relevant as capital inflows make up to 5% of GDP whereas the current account remains high (12.4% of GDP). Note that gross foreign capital inflows in mid-2010 (data are available up to Q1 2011 only) reached 8.5% of GDP. We may be above that level now.
Huge capital inflows and the associated FX appreciation could trigger a sharp economic slowdown for an economy whose inflation rate is already very low. The SNB is therefore skewed in an imperfect equilibrium:
  1. Avoiding a sharp appreciation without resorting to massive FX intervention (‘trauma’ of 2010, lack of tools…);
  2. Sterilizing huge capital inflows as domestic liquidity is plentiful and triggers asset demand, not goods and services purchases.
Economic textbooks make it clear: dedicating monetary policy to a peg precludes any control of the monetary base, hence domestic liquidity. As a result, any inflation target (2% for SNB) would be neither credible nor relevant.
History tells that a peg is much easier to adopt than to maintain – especially when a country faces an external shock. Interestingly, most of the literature is dedicated to emerging markets and the depreciation/devaluation that such a mechanism precludes.
Initially implemented to anchor domestic inflation, pegs hinder crucial currency depreciation when economies are affected by a negative shock. Higher rates and downward pressure on wages will generally bring the economy into recession and force an involuntary exit.
In the case of Switzerland, any external shock should be compared with a rise in risk aversion and the associated increase in capital inflows. As we’ve seen recently, appreciation of the currency calls for reflationary measures as higher terms of trades (exports to imports price ratio) and lower growth (through the export channel notably) impact GDP on the downside.

The peg would be aiming at avoiding an appreciation of the CHF, but it would come (as we’ve seen in 2010 with the unsuccessful FX interventions) with huge increase in domestic liquidity. The outcome would be an overload of liquidity that could eventually become inflationary (the loss of competitiveness would not come through a stronger currency but higher domestic prices).

Conclusion: Is It Really Worth a Peg?

First, there is always massive uncertainty on the length of a financial crisis but history shows that safe haven trades barely last. As the cost of the peg exit increases with the duration of the peg, is it really worth arbitraging long-term pain against short-term pain?
Second, if not fought with capital controls (unlikely), a peg would translate into growing domestic liquidity, asset price bubbles and possibly higher inflation.
Third, in the case of emerging market experience, most of the economic cost of the defense of the regime came through overly high interest rates. In the case of Switzerland, the zero bound of interest rates would limit the scope for intervention and turn inflationary.
Peg or no peg, the Swiss economy will be doomed for being too virtuous.
One way to limit the appreciation would be to turn into a less virtuous economy: increase public spending (lower current account surplus) and wages (unemployment stands at 3.2% but consumer spending posted a low 0.6% year-over-year growth last quarter. Higher wages would also help households to deleverage as their debt-to-income ratio stands at 109% of GDP).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.