When Strength Creates Weakness. Imagine a country with a mere 8 million people, whose popular claim to fame is watchmaking and an army knife, landing on the headlines of the financial newspapers around the world! Yes, it’s true. Last week, this quiet and unassuming little country of yodelers, with a GDP of only .43% of the rest of the world, wreaked havoc on the balance sheets of big banks around the globe.
The explanation lies in the outsized strength of the Swiss currency compared to its largest trading partner, the European Union. You see, Swiss exports had been suffering during the world-wide recession that commenced in 2008, since the euro had been worth a fraction of the franc. To the haute couture, this meant that when a Frenchman wanted to purchase a custom-made suit from Ermenegildo Zegna, which is tailored in Switzerland, he didn’t want to have to pay with too many euros.
The Solution. Exporting is a big deal to the Swiss, as it represent over 72% of the country’s GDP. The strength of its franc was creating weakness in its exporting-dependent economy. So, according to Bloomberg Businessweek:
…in the summer of 2011, the Swiss National Bank announced a cap on the exchange rate between the euro and the franc. The euro wouldn’t be allowed to weaken below 1.20 against the franc. The bank maintained the cap by printing francs on a regular basis to buy euros in the market to ensure that the currencies wouldn’t breach that line. The cap held without a hiccup for more than three years. Their action was described as putting a cap on the value of the franc. A franc would never be worth more than 0.83 euros. But it was also putting a floor under the value of the euro, that one would never sell for fewer than 1.2 francs. It was a policy of keeping the Swiss currency “weaker” than it would be if the Swiss central bank did not intervene. [Source: Edward Lotterman: Real World Economics: “Swiss took least bad option on their franc”]
But now, all that’s over. On Thursday morning, January 15, 2015, the Swiss National Bank (“SNB”),” which conducts Switzerland’s monetary policy as an independent central bank, pulled the plug on the cap, and let the franc float. The result, according to Bloomberg.com here:
The Swiss franc jumped as much as 41 percent against the euro, while climbing more than 15 percent against all of the more than 150 currencies tracked by Bloomberg after the SNB’s surprise announcement….
Ouch! That sounds a bit like the SNB just threw the country’s entire export-dependent economy under the bus – not to mention its major trading partners. Tiny little Switzerland was poking its finger in the eye of its major trading partner, the EU, with a population of 500 million. What’s up? The answer lies, in part, with the shaky economies of the European Union [excluding Germany]. As expected, on January 22, the EU embraced Quantitative Easing, the same policy the Federal Reserve had in place in the U.S. from 2008 until October 2014. Since QE entails flooding the financial markets with currency, in this case, euros, with the 1.20 cap, it would mean Switzerland would be purchasing an increasingly weak currency with its increasingly strong one. The economic consequences at home were not looking good. The weakening euro coupled with the need for the Swiss to print more and more francs to maintain the 1.20 cap was leading to asset bubbles in Switzerland. The SNB was going to have to make a decision between two unpleasant alternatives, i.e. protect the stability of its own currency, or tie its economy to the weakness of the EU. Blowback. An excellent discussion of the almost immediate blowback is found in the following quote from John Browne in a triblive.com article entitled on January 24, titled “Swiss unleash currency turmoil”:
Trusting that the Swiss bank would never allow the franc to strengthen against a plummeting euro, investors and speculators placed trades that were buying the appreciating dollar while selling short the euro-pegged franc. Within seven minutes of the Swiss peg abandonment announcement, the franc rose 34 percent against the dollar. So abrupt was the movement that market stop-orders went unfilled. Investors with just $10,000 exposed lost about $345,000. Financial institutions with millions invested, such as Everest Capital’s $850 million Global Hedge Fund, were vaporized. Markets were taken by surprise.
According to blogs.wsj.com, here:
(SNB) faces two immediate problems: its credibility and the potential for major losses on its balance sheet. The reversal may make it harder in the future for Swiss policymakers to persuade investors that its declared intentions are its real intentions. In addition, because the SNB holds a big chunk of its balance sheet in assets denominated in foreign currencies that will have fallen in franc terms, it faces large losses on those holdings.
The Economist wrote [“Why the Swiss unpegged the franc”]:
The big question now is how much the removal of the cap will hurt the Swiss economy. The stockmarket fell because Swiss companies will now find it more difficult to sell their wares to European customers (high-rolling Europeans are already complaining about the price of this year’s skiing holidays). UBS, a bank, downgraded its forecast for Swiss growth in 2015 from 1.8% to 0.5%. Switzerland will probably remain in deflation. But the SNB should not be lambasted for removing the cap. Rather, it should be criticised for adopting it in the first place. When central banks try to manipulate exchange rates, it almost always ends in tears. [Emphasis added.]
Conclusion. The take-away is that in the world of international trade, a strong currency is not always an asset. For the Swiss, with an export-dependent economy but strong currency, it was faced with a choice of evils. What appears to have happened was that in 2011 it created the 1.20 exchange cap in the belief that the EU would pull out of the world-wide recession along with the U.S. in due time. That did not happen, and the Swiss could wait no longer. The EU, with its disparate demographics, internal politics, and histories, have, so far, proven unable to collectively right their ship. After waiting four years to commence Quantitative Easing, they are, in my opinion, a “day late and a Euro short.” In other words, the EU is woefully behind the curve in instituting QE now. We know that QE in the U.S. did not bring immediate relief to the country. Whether it was actually effective at all, is subject to some debate; despite flooding the markets with money, and keeping interest rates artificially low, manufacturing, housing, and employment improved only at a snail’s pace. Whether the countries of the EU will have the collective patience and political will to bide their time – before the Union collapses – remains to be seen. ~PCQ
