By Alex De Pfyffer
On January 15, the Swiss National Bank (SNB) shocked international markets by abandoning the 3-year-old exchange rate floor of 1.20 Swiss Franc (CHF) per Euro (EUR). Put simply, this means that the SNB stopped spending billions of Swiss Francs to buy euro-denominated bonds. By creating demand for Euros, the Swiss central bank artificially kept the CHF undervalued.
Efforts by the SNB to weaken its own currency stem from its desire to keep Swiss exports competitive vis a vis the European Union, Switzerland's largest trading partner. However, renewed worries about the Eurozone and the prospect of a large quantitative easing (QE) program by the European Central Bank (ECB) led the SNB to a point where it became unsustainable to continue its large-scale purchases. The result was a sudden and massive appreciation of the CHF which now stands at a 1:1 parity with the Euro (an almost 30 percent appreciation in a single day).
One argument for abandoning the floor was the ever-increasing size of euro-denominated assets required to maintain the floor (EUR174bn in the third quarter of 2014, up from EUR89bn in mid-2011). The SNB balance sheet to GDP ratio reached ~80 percent, compared to a ratio in the 20s in other developed economies (England, EU, US). The riskiness of a ballooning balance sheet for the central bank could no longer be ignored and was undoubtedly a key driver of the decision.
Surprise and Central Bank Credibility
Market participants did not expect the SNB's move. Wild gyrations in equity and foreign exchange markets indicate the extent to which this caught markets off-footed. The move increased volatility in a time of delicate market situations and underscored the outsized effects that Central Bank decisions now play in the markets. The SNB's approach, to surprise the markets, is hotly contested both among policy makers and investors.
In an interview he gave to the Swiss press, the SNB's chief, Mr. Jordan, argued that a surprise effect is important because it keeps speculators at bay. This isn't necessarily true. There's a lot of merit to giving hints to the markets about upcoming policy shifts, as most major central banks tend to. Doing so ensures a smoother price action and minimizes the likelihood of market shocks such as the one felt this week. Just three days before the SNB's announcement, its vice-chairman issued a statement calling the 1.20 floor a "cornerstone of our monetary policy". Unfortunately, the abruptness of the SNB's change of heart is likely to have damaged its credibility with international financial markets.
What's at stake?
The Swiss economy is another clear loser from this policy shift given that exports represent about 50 percent of its GDP (of which 45 percent is to the Eurozone). These exports come primarily from the industries of pharma, watchmaking & specialty machinery. Those that have most to lose are the companies with operations in Switzerland that make most of their revenue in EUR or/and USD. Their cost base has gone up 20-30 percent overnight, severely and negatively impacting profitability.
Contrarians argue that Swiss exports are inelastic and that fears of a recession (or deflation) in 2015 are overblown. Short-term, demand for luxury goods such as watches or for medical goods are unlikely to be in free-fall. After all, a Swiss watch remains a Swiss watch and pharmaceutical patents are protected. However, it is only a matter of time before competitors find a way to exploit the cost differential or before the companies themselves rationalize their cost base by setting up production elsewhere.
Some observers point to the silver lining that is the increased purchasing power of the Swiss consumer. Surely, the Swiss can now travel a few extra kilometers to shop on the other since of the border and get more for their money. But in the longer run, the Swiss consumer is unlikely to be celebrating. A downturn in tourism and exports will lead to higher unemployment and fewer fiscal revenues for the government -- not a happy cycle to be caught in.
Is it safer to be wrong in a pack than to be right alone?
Perhaps the biggest loser in all of this is the model for prudent monetary and fiscal policies that over the years has turned Switzerland into one of the world's most resilient economies. The Swiss will pay the price for applying economic policies such as maintaining a balanced budget, enforcing labor force flexibility and having a lean public administration, when its neighbors are running recurring deficits and using QE in order to restart their stalled economies. This begs the question of how long Switzerland can continue to adhere to strict economic policies when its trading partners are on another path. Sometimes it may better to be wrong with everyone else than to be right alone.
This post first appeared on www.opedspace.com