(note: this is an unedited version of my Sunday Business Post column from last week).
Currency trading is not for the faint hearted even at the best of times. At the end of this week, most currency traders are probably a year closer to their first heart attack. Switzerland’s Central Bank removed its currency ceiling against the euro it instituted during the euro crisis and cut its base interest rate to -0.75% in order to avoid deflation. Now not only is the currency going wild on the markets, actually leaving money on deposit with the central bank will cost you money. Negative real interest rates are going to be a feature of central banking for the foreseeable future. It’s a weird time to be a central banker, and a frankly scary time to buy and sell currencies.
We know what interest rates are. But what’s a currency ceiling? A currency ceiling is a device used by central banks to stop inflows of capital from abroad. Think about it like this. We all know the exchange rate is the price of some foreign currency expressed in terms of a home currency. We know the more people want a certain currency the higher the foreign exchange rate will be for this currency. A currency appreciates when it can buy more of a currency. When the eurozone exchange rate between euros and the Swiss France falls, the price of one euro goes down in Swiss Franc terms and the euro experiences an appreciation.
There are three main reasons private citizens demand foreign exchange in the first place: for purchases and sales of imports and exports, for portfolio diversification, and for outright speculation. The euro crisis of 2010 and 2011 terrified investors. The breakup of the currency was a real possibility. Investors sought safe havens to protect their wealth. The Swiss Franc was one of those havens. So investors bought Swiss Francs by the lorryload. The currency appreciated against everything, and its competitiveness got hammered.
If you are the national central bank of a small open economy you have to act when scared investors pile into your currency, driving up the price of everything, including your export industries and in particular your tourism markets. Remember that Switzerland was (and is) already one of the most expensive countries in the world, so the impact of all of this hot money would have been disastrous for it in 2010 and 2011.
To stop all this hot money wrecking your economy, what you do is to tell the markets you will use your power as the lender of last resort and the issuer of currency to issue infinite amounts of the currency if necessary to maintain the currency at a particular level. That policy ended dramatically on Thursday, leaving business leaders speechless and the world’s currency traders scrambling to unwind positions they had taken based on the perceived stability of the Swiss Franc.
As you can see from the chart, which shows the price of Swiss Francs and US Dollars relative to euros, that stability just is not there anymore. The Franc is now appreciating again as some investors buy it up, but once the market calms down and people adjust back to the reality of a normal floating currency again, there will be real effects in the economies of Europe and, of course, the reaction of the market to QE as it arrives.
The real economy gets whacked when large currency movements take place. Everything the Swiss sell is now much more expensive, so the move is likely to hurt the Swiss economy and its trading partners quite a lot. If you are going to Davos for the world economic forum next week, bring your cheque book, it is not going to be cheap. Lots of households in Eastern Europe, and particularly in Poland, have loans and particularly mortgages denominated in Swiss Francs. When the currency you borrowed in surges against your home currency, the effective cost of your debt skyrockets, receding your disposable income massively. For the average Swiss person, the stuff they import just got cheaper. The move will also change how other markets for equities and other assets position themselves for the advent of quantitative easing by the ECB. European bonds, for example have been rising as people get out of Swiss stocks and into bonds. The yield on Swiss sovereign 10 year debt turned negative for the first time as well.
When (and not if) the European Central Bank begins quantitative easing, one effect of this large scale asset purchase scheme will be to drive the euro as a currency down against other currencies. If it had held onto the currency ceiling policy the Swiss central bank would have had to print billions and buy up European bonds in order to sustain the ceiling. In effect, the Swiss would be doing QE for the Eurozone. That just isn’t worth it. The Swiss are banking (literally) on a resurgent eurozone economy to help its economy grow via the usual spillover effects. Quite honestly, that’s what everyone is hoping.
I think the Swiss decision was the wrong one. Central banks need credibility to do their jobs. The Swiss National Bank promised in 2011 to pursue the currency ceiling with ‘the utmost determination”. Abandoning the ceiling with no warning because it was likely to get expensive hardly counts as displaying ‘the utmost determination’. And so, in future, the utterances of the central bank will be treated with much more circumspection by the markets. Another reason the decision was the wrong one is the strange position of the central bank’s balance sheet in the overall economy. It just doesn’t matter what it looks like when you can print money have someone hold it because they think it is worth something. And for that you need credibility, which the Swiss have just squandered.