In a report released yesterday entitled "How The Swiss National Bank Is Driving Down Yields for The Eurozone Core," S&P accuses Switzerland of exacerbating the disparity between the eurozone periphery and core. The idea here is straightforward and demonstrates how easily vicious circles can form in the midst of a crisis.
Last September, the Swiss National Bank (SNB) introduced a currency ceiling to ensure the franc did not appreciate beyond CHF 1.20 per euro (FXE) -- safe haven flows into the country had caused the franc to appreciate rapidly, a scenario which threatened the Swiss economy by making its exports more expensive. In order to defend the ceiling, the SNB simply buys euros with francs. These currency market interventions have resulted in a dramatic increase in the SNB's foreign currency holdings -- foreign currency reserves now amount to 73% of Switzerland's GDP with euros accounting for 60% of the total. To put this in perspective, as of the end of August, foreign currency reserves had increased 64% over the course of a year.
Of course the problem with this policy is that it forces the SNB to hold ever increasing amounts of a rather risky asset: euros. As the Financial Times (FT) notes, prior to the coordinated easing efforts of the world's central banks, it wasn't at all clear that the economic benefits of the currency ceiling outweighed the risks associated with owning mass quantities of the weakening euro:
"[Initially] The mark-to-market losses on the euro reserves [the SNB] accumulated were seen as far from justifiable."
By way of explaining why the ceiling makes more sense now, the FT quotes Barclay's:
"By contrast now, central banks around the world are on hold or loosening and with a renewed risk of Swiss deflation (CPI printed at 0.2%y/y today, cons 0.3%), loose policy is not an obstacle."
Additionally, the ECB's move to backstop periphery sovereign debt has served to stabilize the common currency. Even so -- that is, even if the policy makes more sense now and even if the losses on the reserves do not pile up quickly -- the SNB will still have a powerful incentive to do something with all its euros. This is where S&P's analysis comes in.
S&P alleges that over the course of the first seven months of 2012, the SNB has used its euros to purchase 80 billion worth of debt issued by eurozone core countries. If true, this would mean that the SNB has funded nearly half of the core's 2012 deficit -- with the periphery's money.
Essentially, as euro deposits flee the periphery into Switzerland, they pile on top of euros the SNB purchased to maintain the franc ceiling, creating a glut of euros which the SNB uses to buy top quality debt issued by the eurozone core, resulting in a further widening of spreads between core debt and periphery debt. While one can debate the exact mechanics, the end result is that the SNB's foreign currency (euro) holdings are being used to purchase core (Germany, Austria, Netherlands, France) debt thus making the eurozone debt crisis worse by partially offsetting the best efforts of the ECB to bring periphery borrowing costs back inline with those of the core.
Of course, the SNB claims that S&P's allegations are unfounded. This is easy to say but the correlation between the performance of core debt and SNB foreign currency holdings is quite inconvenient for the SNB. Consider the following graphic from S&P which shows changes in SNB foreign exchange reserves and the yield on French 10-year bonds:
While correlation should never be mistaken for causation, the observed relationship would be quite a coincidence if those two variables (change in SNB foreign exchange reserves and yields on 10-year French bonds) weren't related.
The important thing to note here is that this is yet another example of central bank quantitative easing gone wrong. As the Financial Times notes, when the SNB buys euros, it is essentially undertaking a QE program -- that is, it creates francs and swaps them for euros. The end result is balance sheet expansion.
But inadvertently, the SNB has put pressure on the very assets it is purchasing (euros) by using them to purchase core debt. By exacerbating the divide between the eurozone core and the periphery, the SNB made it appear as though periphery bonds were performing worse than they would otherwise have performed, thus signaling funding stress that otherwise would not have existed. This in turn, put pressure on the euro and, concurrently, on the foreign currency reserves (euros) held by the SNB.
From a theoretical and prescriptive perspective, this is further evidence that central banks should avoid intervening in markets via balance sheet expansion as the unintended consequences can outweigh the benefits or, in the SNB's case, be self-defeating. In terms of an actionable recommendation, investors can be confident that safe haven flows aren't going to cease anytime soon in Europe and as such, the franc (FXF) will continue to rally in times of uncertainty and distress despite the SNB's best efforts to contain its appreciation.