by Andreas Hoffmann and Gunther Schnabl
It came as a surprise to many: the Swiss National Bank announced an exchange rate target. Accordingly, the Swiss franc will be held above the level of 1.20 francs per euro. Switzerland gives up a part of its sovereignty, when the ECB makes bad press in buying trash-rated euro area government bonds to support unsustainable national budgets.
But, particularly in an environment of global excess liquidity originating in too-easy monetary policies in major advanced economies, small open economies have incentives to stabilize exchange rates. We see the following reasons for the Swiss peg:
First, the competitiveness of the Swiss export and tourism industry is at stake as the Swiss franc continued to appreciate because investors rushed into the franc as the last safe haven. Goods and services became too expensive, even for foreigners with high propensities to pay. Second, „one way bets” on appreciation of the Swiss franc are prevented as it is harder to make easy profits from franc appreciation as seen in the first half of 2011. If this is successful, third, the risk of a Swiss asset market bubble originating in excessive capital inflows is reduced. The Swiss interest rate will not be further pushed towards zero by sustained appreciation expectations (as in Japan). Instead, the interest rate is likely to rise slightly towards the euro area benchmark.
Fourth, the Swiss National Bank trades some of its independence against revaluation losses on its assets. If the large stocks of euros in terms of domestic currency devalued, this would necessitate a recapitalization of the SNB by the government. Then, the government (which aims to support the export sector to maintain growth) could ask for exchange rate stabilization and monetary expansion in return. Fifth, while the SNB was independent in monetary policy making up to now, also before the recent decision, the Swiss interest rate was highly correlated with the euro interest rate. Therefore, the loss in independence may not weight too much.
While the move towards a peg is sensible to contain short-term capital inflows and revaluation losses, Switzerland may turn out to be stuck between a rock and a hard plate as another risk prevails. Once the ECB opts for further rescue measures via monetary expansion, the monetary expansion will be directly transmitted to Switzerland. The resulting inflationary pressure would devalue the Swiss euro reserves in real terms. Switzerland would be involuntarily forced to take its share of the costs of the European monetary bailout measures.
Capital controls could be seen as an escape route by short-sighted authorities. In Switzerland they would bring about a problem beyond the misallocations and distortions they usually cause. They would erode Switzerland’s status as a strong room for international capital and therefore an important source of Swiss revenues. Therefore, Switzerland must hope for a timely turnaround in ECB policy which is – at the moment – very unlikely.