How the ECB forced Switzerland’s hand


Almost as soon as it happened last Thursday, nearly every economist in the world started asking — just why, after three years of maintaining a currency floor for the Swiss franc, did the Swiss National Bank suddenly declare that it would no longer intervene in currency markets to keep the franc‘s value artificially low?

The truth is that we won’t fully know until Thursday, when the European Central Bank is expected to announce a bond-buying scheme that ECB president Mario Draghi has been pushing for months — according to reports, a €550 billion program that amounts to Europe’s first major attempt at introducing quantitative easing into its monetary policy as the threat of deflation creeps across the eurozone. But it’s becoming clearer that the two events are related.

Draghi’s announcement that Europe will join the Bank of England, the US Federal Reserve and the Bank of Japan by dipping its toes into the waters of quantitative easing almost certainly forced the SNB’s hand last week. The looming ECB decision set into motion a set of domino actions throughout the world, starting with the SNB’s decision last week, which in turn caused a mini-crisis in Poland, where nearly half of the country’s mortgages are denominated in francs. It’s essentially the first major political challenge for Poland’s new prime minister Ewa Kopacz, who succeeded Donald Tusk last year when he became the president of the European Council.  Kopacz faces a tough election hurdle in elections that must be held this year before October.

Meanwhile, Denmark is now under pressure, too, with its central bank forced to lower interest rates in the face of speculation that, like Switzerland, it might be forced to abandon its permanent policy of pegging the Danish krone to the euro, under which the krone trades within a 2.25% band of a rate of 7.46 krone to the euro.

Suffice it to say we’ll know a lot more in 24 hours. For now, we’ve had almost a week to piece together our best understanding of the Swiss bombshell.

Since 2011, the Swiss National Bank has attempted to peg the Swiss franc to a price level of €1.20 per franc. That’s because, at the height of the eurozone sovereign debt crisis, many investors bought Swiss francs in an effort to shield themselves from the upheaval of a possible eurozone crack-up, due in part to Switzerland’s reputation as a country with some of the world’s most stable political and economic institutions. But a stronger currency harms Switzerland for a lot of reasons, especially if its strength comes chiefly because global investors think that the Swiss franc is a safe haven. It makes Swiss exports more expensive and, therefore, less competitive. It makes travel to Switzerland costlier, discouraging tourists.

Initially, the SNB’s plan worked. A currency that had gone from around €1.50/euro to euro parity fell back down to the targeted level of €1.20, and that’s where it stayed for over three years. Though it’s often a losing game for a central bank to intervene to keep a currency’s value artificially strong (e.g., Argentina tried and failed in the late 1990s to maintain parity with the dollar), it’s a different story when you’re trying to keep a currency artificially weak. The Swiss National Bank could literally print as many francs as it wanted, and then it could go out into the markets to buy as many euros as it needed to maintain the currency floor. The SNP diversified its holdings, using euros to buy other currencies and bonds denominated in currencies like the South Korean won and the Australian dollar.

Over time, however, the SNB amassed a balance sheet approaching 75% of the country’s entire GDP. And unlike the Federal Reserve, which can purchase bonds and assets all denominated in dollars, there simply aren’t enough franc-denominated holdings for the SNB to pursue a similar strategy. That made the SNB, increasingly, an asset manager exposed to currency risks that it can’t control. What’s more, the currency floor essentially pegged the franc to the euro, such that as the euro itself has fallen against the US dollar and other currencies in the last year, so has the Swiss franc. As Tyler Cowen and others have written, last Thursday’s action was akin to a Swiss decision to ‘leave’ the eurozone.

So now that the initial shock is over, the franc is trading at essentially parity with the euro — that amounts to a 20% appreciation, which makes Swiss exports 20% more expensive, which makes mortgages 20% costlier to Polish homeowners. The SNB last week simultaneously lowered the interest rate on deposits from negative 0.25 to negative 0.75 — increasing the costs of holding Swiss currency, indicating that it believed (probably accurately) that investors will continue to view the Swiss franc as a safe haven, especially if the ECB program is much bigger than expected.

For many reasons, the ECB’s decision on an asset-purchase program accelerated the SNB’s moment of truth (whether or not you believe that central bankers in Geneva and Frankfurt have been coordinating information). As Raoul Ruparel writes at Forbes, inaction was as much of a choice for the Swiss, too:

[The ECB’s decision] would likely see a huge influx of liquidity into the Swiss system as investors search for quality assets (in short supply now). This would have involved the SNB purchasing hundreds of billions more in euros and expanding its already huge balance sheet beyond the 74% of GDP it is now (around CHF 500bn). While this may have been technically possible the SNB balked at the proposition. If the SNB had not dropped its [currency] floor it would have become even more intertwined with ECB policy which is likely to become increasingly divergent with the desires of the SNB (as well as the US). As such, it saw an opportunity to get out before it becomes just another ship caught on the wave of ECB QE.

If it turns out that the ECB’s quantitative easing program is much, much bigger than expected, the effects that Ruparel describes above will be amplified.

Another crucial piece of the puzzle is the way that the SNB is structured — it has private shareholders and is majority-owned by each of Switzerland’s 25 sub-national cantons. That makes it increasingly accountable for the wide holdings it has amassed over the past three years in its attempt to maintain price stability. As its balance sheet approaches 100% of Swiss GDP (or even higher, much like Hong Kong’s central banking authority), the SNB would have come under increasing pressure to change course, especially following a failed referendum last year that would have required the SNB to hold 20% of its assets in gold.

Either way, the SNB’s decision will look a lot different on the other side of the ECB’s action tomorrow.

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