Switzerland Sets Currency Ceiling as the Swiss Franc Becomes a Victim of its Own Success

The Swiss National Bank (SNB) on September 6 said it would set a minimum exchange rate of 1.20 Swiss francs (CHF) per euro (EUR) and committed to sell unlimited amounts of Swiss francs to control how much the franc can gain.

This measure is a last-resort response to contain the recent strong appreciation of the Swiss franc due to a huge influx of safe-haven-seeking capital into the currency. The Swiss economy's recovery has been robust, as Swiss consumption remained resilient while the country benefited from the post-crisis acceleration in global trade. Growth has outperformed neighboring Germany, France and the whole euro area. Economic resilience, high current account surplus, low debt-to-GDP ratio and zero fiscal deficits – all explain the attraction of the Swiss franc as safe-haven currency amid the current euro zone debt worries and mounting global uncertainty.

In recent months, the SNB has grown increasingly desperate to stem the massive appreciation of Swiss franc. The strong appreciation of currency is posing downside risk to the Swiss economy. Export suffers as a strong Swiss franc increases the prices of exports while falling import prices put pressure on deflation.

The decision to peg the Swiss franc to the euro came after several failed attempts to curb Swiss franc appreciation in recent weeks. In August 2011, to reduce the attractiveness of Swiss assets, the SNB lowered interest rates to become negative at one point. The SNB also injected liquidity into the banking system by expanding banks' sight deposit from an average of CHF 5 billion in the pre-crisis years to CHF 200 billion on August 17. However, the SNB had been reluctant to intervene directly in the foreign exchange market, given its intervention experiences between March 2009 and June 2010, which resulted in heavy mark-to-market losses. But in face of continued Swiss franc appreciation, SNB Chairman Philipp Hildebrand acknowledged that the bank "sets foot on a challenging journey" by pledging to buy euros in "unlimited quantities" to maintain the peg, despite the potential of "very high" foreign exchange losses. "At the same time, doing nothing would almost certainly inflict tremendous long-term damage on the economy."

Will SNB Succeed? In the short run, yes; in the long run, success may be doubtful. The Swiss franc plunged nearly 10 percent against the euro on the day of the announcement. The exchange rate jumped from a low of 1.1016 to close at 1.2060. More importantly, the significant fall in implied volatility suggested that the market thinks the peg is likely to hold under such strong statement of intent. Since there is zero inflation in Switzerland, the SNB could potentially print as many Swiss francs as it wishes, and sell them on an unlimited basis to counter the surge in demand from capital inflows. With such resolve, the SNB may have instilled fear in investors who try to seek shelter in the Swiss franc away from the euro zone's sovereign debt crisis. It is conceivable that that exchange rate will stay above 1.20 in the near term.

Longer term success will not come easily. Despite the euro's steep gain against the Swiss franc last week, the single currency fell against the U.S. dollar (USD). Broad euro weaknesses intensified after the European Central Bank (ECB) signaled last Thursday a pause in its interest-rate-tightening cycle that began just five months ago. ECB's Jean-Claude Trichet stressed the "exceptionally high" uncertainty surrounding the outlook at the moment, opening the way for a prolonged period of steady rates. This gives the ECB time to see how the debt crisis unfolds and to re-assess the situation on a month-to-month basis. An intensification of the euro zone crisis is a reasonable prospect, given that the market remains concerned that the next tranche of bailout funds for Greece may be delayed and the funding risk of European banks has intensified. Calls for a Greek exit from the European Economic and Monetary Union have flared up again in Germany, where many are also longing for the "good-old days" of the Deutsche mark and the Bundesbank.

As the outlook of these events worsens, there could be a stepped-up demand for Swiss francs despite the pledge by the SNB to intervene. Under a scenario where the euro comes under severe pressure, or in the unlikely event, ceases to exist, it would become a very expensive strategy for the SNB to defend. Buying unlimited amounts of euros runs the risk of losing a lot of money if in the extreme worst-case scenario the euro melts down.

On top of that, once the dust settles, the market will be quick to test the SNB's resolve and speculate about the eventual break of the peg. The SNB will need very deep pockets and determination to fend off the safe-haven-seeking capital from all over the world.

Will the peg stabilize the market? Not really. Switzerland's economy is too small to have a meaningful impact on the key problems facing global asset markets: the euro debt crisis and weakening global growth. The SNB decision reflects a world where policy options have become significantly constrained. Fiscal policy is hamstrung by large debt levels and monetary policy, in many countries, by effectively zero interest rates and the futile outcomes of previous quantitative easing. Loose monetary conditions have limited investment opportunities in the U.S. and Europe. The SNB's decision may limit them further.

The SNB floor for the euro and Swiss franc peg is in part designed to ensure that the Swiss franc is not treated as a safe-haven currency going forward. What it does is reduce the number of safe-haven assets and force investors to be drawn to the traditional safe-havens: U.S. dollars (USD), Japan yen (JPY) and gold. The market has been quick to look for other currencies that might appreciate against the euro during bouts of risk aversion. Candidates include the Norwegian krone (NOK) and the Swedish krona (SEK). For those two currencies to take on a safe-haven role would be a major role reversal because they have been considered "high beta" versions of euro for years. Both appear too vulnerable to global risk and growth to seem truly attractive as safe-haven currencies.

What is the most attractive trade in the short run? Buy gold. There is so much event risk in the next few weeks coming from Europe that safe havens are likely to continue to perform well. The U.S. dollar still struggles with growth and deficit issues while the Japan yen's attractiveness is limited by the possibility of Bank of Japan intervention. The Swiss franc and gold have been the star performers this year. The Swiss franc is likely to lose some of its safe-haven appeal at the moment as markets have to assume the floor will hold. Gold seems to be the last one standing. 


The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.