Swiss franc on a high: who wins, who loses

Prepare to pay more for Swiss watches. Or, to get richer if you have money in Swiss banks. The Swiss National Bank (SNB), the central bank of Switzerland, on 15 January surprised financial markets with its decision to no longer maintain the value of Swiss franc at 1.20 per euro, as it had done for a few years. The SNB also announced a rate cut of 50 basis points to (-)0.75% on deposit account balances.

When a central bank offers a negative interest rate, it is asking banks to pay to park money with the central bank (read more on http://goo.gl/If4Dkz).

The SNB’s decision took markets by storm; the Swiss franc went up about 40% against the euro in trade, though it ended the day with gains of about 20%. Since the Swiss economy is heavily dependent on trade, especially with the euro zone, the stock market cracked. Fear is that the currency appreciation will affect exporters as prices will become less competitive.

This was an extremely sharp move, and unusual for a developed market currency. The SNB decision to break the peg has implications for both financial markets and central banking. In the market, companies that have been borrowing in the Swiss currency but have revenues in a different currency will see debt go up significantly. In fact, anyone who has borrowed in Swiss francs is in for a difficult time, and the effect will be visible in different parts of the world.

On 16 January, Bloomberg reported that a New Zealand-based foreign exchange broker went out of business. Things are more volatile in some European countries such as Poland. As reported by Bloomberg, 46% of home loans in Poland are denominated in Swiss franc. There are also reports of some large hedge funds suffering huge losses.

It will not be surprising if similar news emerges from other parts of the world as Switzerland has a developed banking system and, arguably, it is easier to borrow in Swiss franc. “The implications of this historic policy turnaround extend well beyond a period of bumpy economic and financial adjustment for Switzerland itself. They risk destabilizing some other countries and decision making in the neighbouring euro zone will become even more complicated and contentious,” noted Mohamed El-Erian, chief economic adviser, Allianz, in his recent Financial Times column (See: Implications of the SNB decision extend far beyond Switzerland, 15 January).

Why the U-turn?

It is not entirely clear as to why the SNB did what it did, and experts are not ready to believe the official explanation. In its communication to announce the end of currency peg and cutting rates, the central bank said: “The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation.”

The bank also stated that the franc has depreciated significantly against the US dollar because of a weakening euro. But the official line is not finding many takers. “...on Thursday the Swiss suddenly gave up. We don’t know exactly why; nobody I know believes the official explanation, that it’s a response to a weakening euro,” noted Paul Krugman in his The New York Times column (see: Francs, Fear and Folly, 15 January).

The story actually began with the global financial crisis of the last decade. As the crisis intensified in Europe, also because of problems related to the euro zone, money started moving towards what’s known as safe havens and Switzerland was a major recipient. This money, coming in to seek safety from other parts of the world, resulted in appreciation of the Swiss currency, which hurt exporters. To check the appreciation, SNB came into the picture and started buying foreign currency. But it did not fully succeed in its attempt and the local currency kept rising. This pushed SNB to an extreme.

On 6 September 2011, it announced setting a floor for its currency. “The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development. SNB is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities,” SNB had declared.

The idea, perhaps, was to quell speculators as they tend to invest in countries with rising currencies to gain from the appreciation. To maintain the floor, all SNB needed to do was to keep creating the local currency to buy foreign currency. Also, it did not have to worry about excess money leading to inflation as prices were lower than desired. Normally, central bank intervention of buying foreign currency in large quantities leads to excess supply of domestic currency, which can result in higher inflation. But Switzerland had no such problem. The reported data showed inflation at -0.10% for November.

Reality check

However, things in the real world turned out to be more intricate than what SNB had anticipated. Normally, it is difficult to defend a falling currency as the central bank has limited foreign exchange reserve and the market is aware of this reality. But it turns out that shielding a rising currency is also difficult even when there is no threat of inflation. One of the reasons for this surprising action by the SNB could be that in its assessment, the cost of shielding the currency against the euro is becoming higher than the perceived benefits. It is possible that financial problems in Russia and elsewhere are leading to more flows into Switzerland, making the job difficult for the SNB.

Also, the possibility of the European Central Bank (ECB), which is said to be moving closer to an outright quantitative easing (QE), may have prompted the move. QE by the ECB would mean that the euro will weaken further and more money will flow to Swiss assets.

It is possible that with limitations to the extent to which it could have shielded its currency, the SNB decided to break the peg and give markets some time to adjust. But at a macro level, this has raised several questions for the world of central banking and its ability to maintain low volatility in the currency market and, by extension, maintain financial stability at a time when monetary policy path for bigger economies is getting divergent.

India impact

Experts are of the opinion that the direct effect of what has happened in Switzerland will be limited. “The exposure to Swiss franc in India’s total external debt is very low. There could be companies with debt in Swiss currency, but overall, it should not be a cause of worry,” said Madan Sabnavis, chief economist, CARE Ratings. Others agree.

“The quantum of exposure is limited and risk-aware companies would have hedged their positions,” said Deep Narayan Mukherjee, senior director (corporates), India Ratings and Research, but adding that there are concerns about the indirect effect. “Macro hedge funds tend to face huge losses due to such events, and subsequent liquidation of their assets if it spins out of control, may cause extreme volatility in currency and interest rate markets,” added Mukherjee.

India has not been affected this time because of its improved external situation. “As of now, India is not getting affected because of lower oil prices,” said Abhishek Goenka, founder and chief executive office, India Forex Advisors Pvt. Ltd, adding that the event goes on to show that the situation is not very comfortable in international currency markets.

Mint Money take

The move by SNB shows that it is becoming difficult even for central banks in the developed world to contain pressures in the currency market. The event may not have a direct effect on India as of now, but volatility in currency markets can lead to risk aversion in the global financial market, which may affect Indian markets later. It also indicates that global financial markets still have to deal with the after-effects of the financial crisis, and companies, along with policy makers, will have to move forward with caution and care.

And while Indians who have money in Swiss bank accounts can reap the benefits of a higher franc, a holiday to Switzerland has become more expensive. Your favourite Swiss chocolates and cheese, have become dearer too.