The fallout from the decision of the Swiss National Bank (“SNB”) to abandon a fixed value of the Swiss Franc (“CHF”) against the Euro may foreshadow the potential consequences of the end or failure of central bank activism. As Gloucester in Shakespeare’s King Lear states: “These late eclipses of the sun and moon portend no good to us “.
Turning Back the Flood…
In September 2011, the SNB set a ceiling of CHF1.20 to the Euro. This was a response to large inflows of capital seeking a safe haven in the aftermath of the global financial crisis and, especially, Euro-zone debt problems. The value of the CHF increased by around 20 percent relative to its major European trading partners, making Swiss exporters uncompetitive and damaging growth. The strong CHF also reduced domestic inflation, threatening to trigger deflation.
Under the policy, the SNB intervened buying Euros which were invested in European bonds. The purchases were funded by printing CHFs or creating CHF reserves.
The SNB actions have been costly. It has been forced to purchase large amounts of foreign currencies, sometimes at the rate of billions each day. In 2012, it spent nearly US$200 billion, against around US$15 billion the previous year.
These actions have resulted in the accumulation of record foreign currency reserves and the expansion of the SNB balance sheet. As at end of 2014, the SNB balance sheet was around US$500 billion, equivalent to around 80 percent of Swiss Gross Domestic Product (“GDP”). As a percentage of the size of its economy, the SNB’s balance sheet is about three times larger than those of the US Federal Reserve and the Bank of England. The size of the balance sheet and the currency mismatch has resulted in large changes in the SNB’s earnings.
The policy kept the CHF below the cap. The impact on the Swiss economy has been mixed. Switzerland has grown at a slightly faster rate than the Euro-zone. Inflation remains low, below the SNB’s 2 per cent target. Prices fell between 2011 and 2013.
Since 2011, Switzerland’s monetary base has quintupled to CHF 400 billion. Bank lending has increased to around 170 percent of GDP, a rise of 25 percent. In turn, this has resulted in sharp rises in property prices and rents.
The major argument offered in defence of the strategy was that it would have been worse without the intervention.
On 15 January 2015, the SNB abandoned its policy without warning, catching financial markets and analysts by surprise. The only sign of any impending policy shift was an article on 11 January 2015 in the NZZ newspaper (“Euro Mindestkurs – SNB-Doyen will neue Untergrenze“), which quoted an “influential thinker in monetary policy” Ernst Baltensperger who recommended termination of the ceiling because of the increasing risk to the SNB.
The SNB stated the decision was taken because the policy had accomplished its “mission”. It argued that the “exceptional and temporary” measure had been necessary as a result of the exceptional overvaluation of the CHF and market conditions, which had now abated. The SNB argued that the value of the currency was high but the overvaluation had deceased, citing the weakening of both the Euro and CHF against the US dollar. In reality, the SNB’s policy was increasingly unsustainable.
In its announcement, the SNB noted the divergent policies of major currency areas. It was a coded reference to the likelihood of European Central Bank (“ECB”) actions to weaken the Euro increasing the inflow of capital into CHF. Combined with inflows driven by problems in Russia, Greece and the Middle East, this would necessitate further intervention. Given the large and growing size of its balance sheet, the SNB’s ability to exit would become increasingly compromised. In addition, the currency mismatch would expose the SNB to rising risk of ever larger losses if the CHF appreciated. In effect, the SNB believed that conditions would make continuation of the currency floor increasingly difficult.
Economists argue that central bank losses and solvency are irrelevant as it can create reserves or print money to cover potential losses. However, this would require a commitment to expanding the money supply without constraint. Given financial stability concerns from rapid increases in asset prices, the SNB chose not to commit itself to such a course.
One factor may have been the SNB’s unusual ownership structure. The Swiss central bank is a quoted public company, owned 61 percent by Switzerland’s 26 cantons and public bodies and the remainder by around 3,000 retail investors. The third largest shareholder, behind Bern and Zurich, with a holding of 5 percent is a German investor Theo Siegert.
Losses threatened the SNB’s guaranteed 1.5 percent dividend yield, reasonable by Swiss standards. The risk to future payments has outraged shareholders, who like the cantons depend on the dividends for income. This may have influenced on the policy change.
Crash, Boom, Bang!
Following the announcement, the CHF rose by around 40 percent against the Euro and dollar, ending the day about 20 percent higher. It traded almost a 60 centimes range during the day.
The only parallel in major currencies was the performance of the Yen during the Asian crisis. In October 1998, after many months of uneven Yen depreciation, in one two-day period, the U.S. dollar dropped in value by 20 Yen. On 7 October, the Yen fell from about 134 to 120. On 8 October, the Yen traded in a remarkably large range between 111 and 123. The volatility was such that market-makers refused to quote Yen/Dollar prices for more than US$1 million.
Goldman Sachs Chief Financial Officer Harvey Schwartz described the CHF price move as a 20-standard-deviation event. It was eerily similar to his predecessor David Viniar’s description of events in August 2007: “We were seeing things that were 25-standard-deviation moves, several days in a row.” Given that this is equivalent to something every 100 or more billion years, it would be reasonable to assume that such an event was unexpected.
The rise resulted in immediate losses to holders of short positions and borrowers of CHF. The SNB suffered losses around US$50 to 60 billion, equating to 10 to 15 percent of GDP. The losses were cushioned, in part by over US$30 billion in gains in 2014 from the position, which might have influenced the timing of the policy change.
The effects were widespread, reflecting the use of CHF as a funding currency in carry trades because of its perceived stable value and low interest rates. Bank losses to date are around US$400 to 500 million. A number of hedge funds have also suffered losses, forcing some to close or restructure. A few currency brokers, who facilitate retail foreign exchange trading with leverage of between 10 and 100 times, were bankrupted by clients unable to cover shortfalls.
An unexpected casualty of the rise was Poland and Hungary, whose currencies and financial markets fell sharply. It is estimated that up to €30 billion worth of Polish mortgages and up to €10 billion of Hungarian mortgages are denominated in CHF or Euros. Home buyers took out CHF mortgages to benefit from lower interest rates. Borrowers now face higher repayments, with some mortgages valued at greater than the underlying property. Under a protection programme, the state will shield Hungarian households from losses under a pre-existing program. To the extent, the conversion is unhedged, this merely transfers the loss to the government.
More collateral damage may emerge over time.
If the CHF continues to strengthen and remains overvalued, then the real economy effects will be significant.
As a relatively open economy, a strong currency will affect Switzerland’s competitive position. Swiss exporters will be adversely affected, impacting revenues and investment decisions. Inbound tourism will be negatively affected. A stronger CHF, especially against the Euro, may reduce growth by between 0.5 and 1 percent.
This led to the over 8 percent fall in the Swiss stock market after the SNB abandoned its currency ceiling. The US$100 billion loss of market value may be exaggerated. Many Swiss firms import commodities which will be cheaper. In addition, many Swiss companies will be unaffected, having relocated manufacturing overseas because of high local costs.
A more serious problem will be externally-induced deflationary forces which will affect the economy through the stronger currency. It will accelerate falling prices, expected to reach as much as negative 2 to 3 percent. This will create problems for asset prices and the increased levels of debt.
The abandonment of the ceiling will have important ramifications outside Switzerland.
First, it opens a new front in the currency wars.
There will be pressure on other currencies. Following the Swiss decision, the Danish central bank cut interest rates to a record low, from minus 0.05 per cent to minus 0.25 per cent. It was designed to discourage capital inflows and speculation that Denmark would be forced to discontinue its peg to the Euro. It also increases speculation on the sustainability of the Euro itself.
It will drive competitive reductions in interest rates and currency devaluations as nations seek to preserve competitiveness and limit unstable capital movements. The SNB set an interest rate on sight deposit accounts of minus 0.75 percent, well below the minus 0.25 percent previously assumed to be the effective lower bound on interest rates. Other countries may be forced to follow, forcing global interest rates even lower. This may exacerbate asset price bubbles, increasing the risk of future financial system problems.
Second, it draws attention to the ability of central banks to intervene in and control market prices.
Given assurances from the SNB in late 2014 about the continuation of the ceiling, the change in policy reduces trust in central bank forward guidance generally. In the words of one online commentator: “SNB have effectively done for central banking what the Ferguson Police Department have done for community policing.”
Insofar as the SNB decision was dictated by concern about the risk of losses from continued expansion of its balance sheet, it highlights the limit to central bank actions. As noted above, the ownership structure of the SNB is unusual. However, even state owned central banks face constraints.
Central banks can operate without conventional capital, creating reserves and printing money. However, a large loss may affect its credibility and ability to perform its functions and implement policies. It may also affect market acceptance of the currency. This means that it would require recapitalisation by governments which would draw political attention to the issue. Conservative, orthodox economies, such as Germany, the Netherlands, Austria and Finland and the Netherlands, will see the actions of the SNB as reinforcing their fears of unconventional strategies as well as their potential costs and risks.
The relative stability of financial markets and recovery in financial assets since 2009 has been reliant on the actions of central banks. This includes forcing additional risk taking by artificially limiting availability of and reducing returns on low risk investments, such as cash or government bonds. As a result the premium for additional risk has fallen to inadequate levels. This has been predicated on central banks suppressing volatility and implicitly assuring markets that they will act to support prices if necessary by infusing additional liquidity.
Insofar as the SNB decision now casts doubt on the willingness and capacity of central banks to support markets. This may force a major re-pricing of assets, which are heavily reliant on extraordinary abundance of liquidity and central bank support. It will also reveal the deep-seated underlying economic problems, such as slowing growth, deflation, under employment, lack of real wage growth, lack of investment and inequality.
Third, it foreshadows potential volatility if and when central bank activism ends or disappointed markets cease to rely on it.
Markets are edging closer to a crucial moment. Ultra low interest rates and quantitative easing have been ineffective in restarting growth and inflation. Instead, they have created asset price bubbles and distorted markets. If current policies are discontinued having failed or central banks are forced to change policy because of increasing costs and risk, then major instability across financial markets may result. The events around the CHF may be a harbinger of sharply higher volatility to come.