Can the Swiss peg the franc?

The Swiss National Bank stunned financial markets on Tuesday by setting a ceiling for the Swiss franc against the euro in an attempt to prevent the strength of its currency from pushing its economy into recession.  The central bank said it would set a minimum exchange rate of SFr1.20 against the euro.

Scott Sumner is happy, Matt Yglesias is happy, and I am not unhappy but I am nervous.  Keep in mind the Swiss tried such pegs before, in 1973 and 1978, and neither lasted.  At some point limiting the appreciation of the Swiss franc implied more domestic price inflation than they were willing to tolerate (seven percent, in one instance, twelve percent in another).  You can argue about whether they should be, or should have been, nervous about seven percent price inflation but the point is that they were and indeed they might be again.

Fast forward to 2011.  It’s the Swiss saying “we can create money more decisively and more quickly than the speculators can bet against us, and keep it up.”  If the flight to safety continues, the Swiss can reap seigniorage by creating money but also there may be spillover into price inflation.  You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel.  If you’re holding and trading euros, and the Swiss central bank keeps churning francs into your hand at a good rate, at some point you will consider buying a chalet in Schwyz.

If the speculators sense less than a perfectly credible commitment from the central bank, they will continue to bet on franc appreciation.  In other words, the Swiss are putting their central bank credibility on the line, at least in one direction.  And even if they stay credible, they may not much lower their real exchange rate over a somewhat longer run, so why should they be fully committed to credibility?

Stay tuned…

Comments

Maybe the Swiss plan to join the eurozone at some point in the future, as a fixed exchange rate is generally the first step?

Just fooling - though maybe the Swiss aren't.

The whole reason for the intervention is that Switzerland is facing deflationary pressures. If the money printing causes domestic inflation beyond what is desired, the Swiss can simply stop exchanging newly printed francs for euros, or even reverse direction in order to "unprint" francs. The real issue is whether they will lose on the reverse direction. That is, if the Swiss exchange 1.20 newly printed francs per euro now, but later receive only 1.10 francs when they sell the euros back, then Swiss taxpayers lose and speculators gain on the round-trip.

Now I'm tempted to put some of my pension money into Swissies.

Hold on: what will the Swissie be linked to when the Euro joins the choir immortal?

Or should that be "choir invisible"? Anyway, when it pines for the fjords.

FYI people commenting here - its a ceiling not a peg (or a floor depending on which way round you look at the exchange rate).

The Swiss National Bank believes that current monetary conditions need loosening, and that there is some sort of "asset price bubble" in the relative value of their currency - by committing to this ceiling they feel they can kill two birds with one stone.

Deflationary pressures would be welcomed by most in Switzerland. It has long had a giant price premium on imported goods that just cannot be justified.

Besides, if the SNB is worried about something, it's a real estate bubble, not deflation. The main reason why the interest rates are as low as they are is the exchange rate, not anti-deflation or even monetary stimulus (the economy simply does not need that, although obviously the current overvaluation hurts the export sector a lot).

Tyler, today I have been studying the SNB's new policy. I don't think explanations based on capital flight from the Eurozone to Switzerland or on the prospects of the Swiss economy are relevant. Many times in my life I have studied devaluations from the perspective of the bad guy (Argentina, Chile, and many other countries that had been printing currency to finance government expenditures). This time I have to do it from the perspective of the good guy (regardless of SNB's intentions). Bad guys have been printing currency at high rates per month (the ugly guys at high rates per day), good guys are supposed to let their supply of currency be demand determined. Bad guys create an excess supply of their currency (as hyperinflation experiences have shown), good guys have to meet an excess demand for their currency (as in normal times during the gold standard).

Since I didn't know anything about the SNB and the Swiss franc, first I looked at the possibility that the Swiss franc has been increasingly used as a means of payments in neighboring countries. Big surprise: the Swiss franc is legal tender in Campioni d'Italia, an enclave in the Swiss canton of Ticino but formally a municipality in the Province of Como, Lombardy, and more important the place where my mother's father was born 130 years ago! I also learnt that for a long time the Swiss franc has been a means of payments --albeit not a legal tender-- in Busingen, an exclave in Germany. I have yet to find evidence, however, that today the Swiss franc is much more used as a means of payments than before the 2008 crisis. Then, I looked at the possibility that the Swiss franc is expanding its role as a reserve currency --not as a unit of account but as a means of payments that central banks of advanced economies must hold to meet their commercial banks' demands. The IMF data on the currency composition of foreign exchange reserves (COFER) includes mainly liquid securities, in addition to currency, and are available with a lag of over three months, so I could not get anything from them.

Since I have not been able to identify a source of additional demand for Swiss-franc currency, I look at the exchange rate between the Swiss franc and the Euro; see (to get a lot of information from this page you have to the relevant periods)

http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-chf.en.html

and my conclusion is that the appreciation of the Swiss franc in the past three years has been slow but continuous, but not as large as we have seen in other cases involving currencies of advanced economies as well as of developing countries. Thus, in my view the appreciation of the Swiss franc (until yesterday) appears to be consistent with a sustained but low increase in the foreign demand for the Swiss-franc currency. On the supply side, since December 2007 SNB has increased currency in circulation just 10% in total, and all the increase took place in 2008.

Therefore, the new policy will allow SNB to increase its supply of currency just to meet the demand without putting pressure on the exchange rate. The SNB will earn some seignorage only if they buy liquid assets with the euros and other currencies that they receive in exchange for the newly printed Swiss-franc notes. As I said, good guys meet the increasing demand for currency.

Breaking news. We should study this report to know more about today's demand for reserve currencies:

http://af.reuters.com/article/libyaNews/idAFLDE7850BQ20110906

Just an FYI: Many eastern european mortgages are denominated in CHF. It's been a non-trivial means of payment outside of Switzerland in this area for a few years.

I'd argue that there is something new here - the recognition that Central Banks are not balance sheet constrained. There is nobody to force the SNB to stop selling CHF and Buying EUR and shutter their doors, no matter how large the "losses" are on the balance sheet.

I am not sure what "losses" mean to a central bank. Presumably, the SNB has the full faith and credit of Switzerland behind it.

Imagine for a second the CHF goes up to 1.40 and the SNB is stuck with very large losses. Imagine it buys back all of the CHF and sells a bunch of Euro. The SNB then has fewer CHF than it sold.

What happens then? Do some guys come in and board up the place?

Most likely, they wave a wand and create enough CHF to make themselves whole. This is the place that is widely accepted can create all the CHF it wants.

You make a good point that reducing the credibility of the SNB is something they actually want. What happens if the SNB succeeded in reducing their credibility? Well, the currency would devalue at least a bit! This is exactly what the SNB is trying to do.

I think the difference today is that its now widely recognized CB's can expand their balance sheet without solvency constraints. This was not accepted in the past, but the Chinese showed people its totally possible to just keep doing this.

This does not mean the balance sheet expansion won't or should not have consequences, but consequences are different than hard constraints.

As Swiss watching this from the other side of the world, this is interesting news. A similar thing had been tried already in 2010 but after mounting losses the SNB gave up on it. Inflation seems like a relatively minor issue (aside real estate, but there is at least some fundamental point in there), in fact, if anything, the strong CHF has deflationary effects as imports have become significantly cheaper (well should have, most of the benefit is being pocketed by trading companies but that will change over time, especially as customers shop abroad more and more).

So the main question is really whether the SNB is going to risk sitting on an ever expanding pile of Euros. Personally I say just invest the money in foreign real assets and so get the currency of the balance sheet.

|You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel.

I fail to see that risk considering that the CHF is way overvalued according to the PPP anyhow. The SNB move serves to move it closer (still not quite there though) to the PPP. This would be a definite risk in the case of countries trying to develop below PPP, but while you are overvalued I really doubt this.

Your first paragraph is a very good summary of what's going on in that country. For outsiders it is often surprising how a nation that is so very competitive internationally can be this anti-competitive internally, an economy with unbelievable monopolies or duopolies pocketing unbelievable prices from consumers. Now, finally, the Swiss seem to wake up and start shopping abroad in more significant numbers.

The swiss may not be able to peg their currency in real terms, but they can sure as hell peg it in nominal terms...which is all they've said they will do

As a resident and consumer the Swissie rate has been absolutely fantastic. We, and most of our neighbours buy most items in Germany which is 20 minutes drive away. Car parks in the centre of Konstanz are heaving with Swiss shoppers most days and as well as the exchange rate we then take off the VAT. Often we're seeing 40% savings on local prices.

As a business owner having to compete and price contracts in my clients' local currency it's not so good. At the moment I'm converting back only what I need (and shifting costs to other currencies).

I do think, however, that the SNBs action is going to end in tears. Also most folk I know here are feeling a strong personal benefit from the exchange rate - I am not convinced it's the big vote winner the politicians seem to think it is.

Thanks for sharing your CSI information. Do you know reports about the changes in trade and means of payments during the past 5 years along the Swiss borders with all Eurozone countries?

This is great news for precious metals!

If Switzerland does face 7% inflation then they should (and would) abandon the peg. The purpose of the peg is to prevent deflation (actually falling NGDP.) So the worrisome situation you describe would be a success, wouldn't it?

And yes, they most certainly should have been worried about either 7% or 12% inflation.

Yes, the market sets the real exchange rate, but what the Swiss are trying to do is make sure that the nominal rate is at a level such that when the market sets the real rate it does so through low inflation, rather than high inflation or outright deflation.

You're saying inflation as if it was a bad thing.

"at some point you will consider buying a chalet in Schwyz"

If only it were that easy. The Swiss have cracked down on foreigners buying property in Switzerland, and for the average person it's not even all that easy to open a Swiss bank account.

Huh?

The current threat is deflation because the price of that Chalet is already catastrophically high relative to the rest of the world, the price of a McDonalds is twice that across any of its borders and even more crazy, the price of Swiss made goods are cheaper across the border, where Swiss people are going to do their shopping. A rum and coke at the naff nightclub at the Kempinsky hotel in Geneva is $45 for goodness sake.
The 1 EUR= 1.2 CHF ceiling is still massively high and inflation wouldn't be a problem if it were pegged at 1.60 or the EUR to USD went to parity, which is not an immediate problem when the Fed are about to run the presses.
In short the Swiss Frank has been pegged for 2 years against gold - but gold isn't a country.

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