The Swiss currency bombshell – cause and effect
Gavyn Davies
Jan 18 16:21
The completely unexpected decision of the Swiss National Bank (SNB) to remove the 1.20 floor on the Swiss franc against the euro on Thursday was one of the biggest currency shocks since the collapse of the Bretton Woods system in 1971. The decision has been heavily criticised, both for its tactical handling of the foreign exchange market, and for the collapse of the centrepiece of its monetary strategy, without (apparently) any overriding cause. The credibility of a central bank that has traditionally been hugely respected by the markets has clearly been dented.
The decision has already caused severe stress and bankruptcies in the currency market, and it is far too early to judge whether this has now settled down. More importantly, the deflationary shock to the Swiss economy will be severe. And there are concerns that the failure of the SNB’s policy of unlimited market intervention may have much more profound implications for the credibility of the wider market interventions by global central banks, on which asset prices currently depend.
It is important to keep this in perspective. The SNB decision may have been driven to a large degree by the fear of losses on the central bank’s balance sheet, which are peculiar to the ownership structure of the central bank in Switzerland. Furthermore, other major central banks are not operating currency pegs, where large balance sheet losses tend to occur. Even so, this event will clearly make investors question whether the central banks can indefinitely exert as much control over the financial markets as the period of quantitative easing has suggested.
First, the causes of the SNB’s decision.
At his press conference on Thursday, SNB Chairman Thomas Jordan said that the limit on the franc/euro rate was an “exceptional and temporary measure” that had protected the Swiss economy from “serious harm”. And it did indeed prevent a large loss of competitiveness for Swiss exporters, and a severe deflationary impetus to the Swiss economy. But it is hard to agree with Mr Jordan that the need for this measure is now over. The real exchange rate is only slightly lower than it had been when the limit was imposed in 2011, and inflation is still negative.
More significantly, Mr Jordan added that “divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced.” Clearly, the SNB did not want to remain hooked to the ECB’s monetary policy in the context of its expected launch of QE in the eurozone next week.
Why not? Given their traditional close links with the Bundesbank, it would not be surprising if the SNB were very sceptical about QE as a matter of principle. But they probably also feared that the currency risk on the SNB balance sheet would become intolerable with a further dose of “unlimited” intervention.
The SNB balance sheet at the end of December was about 85 per cent of GDP, mostly in foreign currencies, and we do not know whether this has increased markedly during the bout of euro weakness in January. The SNB’s mark-to-market currency losses on Thursday were probably around 13 per cent of GDP (SFr75bn). Paul Meggyesi of JPMorgan says that “the SNB would have been bankrupted by this de-pegging had it not made such a large profit last year”. The SFr38bn profit in 2014 was announced only last week, which is surely not a coincidence.
Many economists believe that balance sheet losses are irrelevant for a central bank, so they should play no role in policy. But the SNB is 45 per cent owned by private shareholders, many of whom are individuals, who receive dividends from the SNB. The rest is owned by the cantons, which have been complaining recently about insufficient cash transfers from the SNB.
This ownership structure contrasts sharply with most other central banks, which are in effect government departments, wholly owned by the treasury and therefore the taxpayer. The Swiss set-up makes the SNB particularly concerned about balance sheet losses, especially since disgruntled citizens can directly force changes in monetary and reserves policy via referendum.
Given this structure, the SNB’s repeated pledges to intervene in unlimited quantities to enforce the euro peg were always subject to political risk and, in retrospect, likely to prove hollow.
Markus Brunnermeier and Harold James of Princeton University have pointed to the parallels to the German political decision to overrule the Bundesbank and abandon the Deutschemark’s peg against the dollar in May 1971, a decision that “destroyed the entire international monetary system within three months”. Central bank promises are always beholden to the political system within which they reside.
What will be the fallout this time? Many active investors were heavily short Swiss francs before last week, with JPMorgan estimating that Swiss franc borrowing by non residents is around SFr150-175bn. This will need to be unwound, with attendant losses. There could be some pockets of large losses by leveraged investors, though the market did not seem too worried about this on Friday.
Longer term, central banks’ forward guidance of all types may lose some of its earlier lustre. Global confidence may be shaken in asset prices that have been bloated by an increase in central bank balance sheets in excess of 20 per cent of GDP since 2008.
But the immediate response of the markets last week was telling: equity prices in the eurozone rose sharply, because investors took the SNB’s decision to mean that the ECB was on the brink of a larger-than-expected bout of QE. It seems that the markets’ Pavlovian response to every twist and turn in the central banks’ thinking has not ended quite yet.
One more thought. The SNB has now set a negative interest rate on sight deposit accounts of -0.75 per cent. This is much lower than the -0.25 per cent that had previously been assumed to be the effective lower bound on interest rates. If this proves effective, other central banks may follow suit. And, over time, that may take global bond yields even further into negative territory.
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