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Swiss Franc Policy Conundrum solved

On January 15, Thomas Jordan, president of the Swiss National Bank, announced that the Bank was abandoning its policy of placing a ceiling (which the SNB called a floor), writes Professor John Ryan, under the Swiss franc at €1.20 per Swiss franc (CHF) which was introduced in September 2011 to manage the country’s exchange rate at a lower limit of 1.20 CHF/Euro.

There was so much capital flight to Switzerland in anticipation of the quantitative easing in the Eurozone that the Swiss central bank was unable to stem the tide. There are three reasons why it was simply going to cost too much to continue to defend the 1.20 CHF/Euro currency floor.

First, the monetary base has exploded from CHF 80bn to almost CHF 400bn since mid-2011. Second, it has set off a property boom were apartment prices have risen almost 60pc since early 2007 and bank lending has jumped from a historic average of 145pc of GDP to a new peak of nearly 170pc. Third, the SNB’s balance sheet has ballooned to 85pc of GDP.

At one point it was buying half the entire sovereign bond issuance of the Eurozone while money is pouring into Switzerland from Russia, and Greek tensions return to the Eurozone. Switzerland before the financial crisis had run large and rising current account surpluses and kept a stable exchange rate against the Euro without the need for any intervention, proving that these surpluses constituted market equilibrium.

However, with the outbreak of the financial crisis speculators started to consider the Swiss Franc a safe haven, driving the currency to a level at which the Swiss export sector could not compete any longer. The SNB intervened heavily and then fixed the exchange rate against the Euro. Swiss politicians were attentive to the profitability of the SNB because Switzerland’s 26 cantons are its main shareholders. For the smaller cantons in particular, the SNB dividends have been an important source of funds.

Figures released by the SNB show that its Euro holdings have ballooned as the bank battled haven demand from investors and struggled to maintain a floor of CHF 1.20 against the Euro. The cost of defending the Swiss Franc limit had become overpowering. Switzerland had a considerable financial incentive for maintaining its exchange rate policy. The SNB knew that it would face major losses on its foreign assets if it abandoned its target for the Swiss Franc.

Yet the global economy is in a fragile state with the re-emergence of the Eurozone crisis and on-going Russia-Ukraine conflict.  Consequently the SNB found it increasingly difficult to maintain its fixed exchange rate with the Swiss Franc gradually gaining strength. The Swiss economy is far from immune to the risk posed by another exchange rate shock. Swiss real estate inflation has turned into a bubble which would normally cause a central bank to raise interest rates. The threat of inflation increases, as does the upward pressure on the Swiss Franc.

For the Swiss, half its exports go to the Eurozone and they are about to become ferociously expensive. Other sectors, such as the tourist industry, will find that skiers in the winter and walkers in the summer will migrate to cheaper Alpine destinations in the Eurozone. The SNB finally understood that its policy was unsustainable, with international reserves approaching 100 percent of GDP and the prospect of further accumulations as the ECB contemplates adopting a belated policy of quantitative easing.

It changed its policy, it bit the bullet, and it offered no free rides.  The SNB deserves praise for not telegraphing its intentions to the market. It is not a central bank’s responsibility to save market participants from the consequences of their mistaken assumptions.

Professor John Ryan is Research Associate at the Von Hügel Institute of St Edmund’s College, University of Cambridge

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