Last week, the Swiss National Bank announced it would no longer enforce the price floor that held the CHF price of a euro to 1.2 or less. In the minutes following the announcement, markets panicked and the pundits lost their bearings. The move was described as a historical mistake that would impose large costs on the Swiss economy.
The decision is debatable, but in my view the policy conclusion is more finely balanced than these initial reactions suggest. The key questions are:
- Whether the SNB should have abandoned its one-sided peg to the euro;
- Whether this was the right time to do it;
- Whether the central bank should have prepared the markets;
- Whether superior alternatives existed; and
- Whether the accompanying measures were adequate.
My answers are simple. The peg was always meant as a temporary measure that had to be lifted one day; the timing might have been wrong; the move inevitably had to come as a surprise to markets; that the alternatives were not obviously better; and that the accompanying measures are puzzling.
Should the peg be abandoned?
When it adopted the peg in September 2011, the SNB presented it as a temporary move. The franc had become massively overvalued as it was seen as a haven when fire was raging in the Eurozone and we faced the prospect of several years of QE in the US and the UK. As a small open economy, Switzerland could not live with such an overvaluation. As a financially integrated country, it was caught in an impossible situation purely because of what was happening elsewhere, see Lamla and Sturm (2012).
Yet, for good or bad reasons, Switzerland wants to retain full policy autonomy. Since September 2011, the franc has moved in a narrow margin 1.20-1.25, often very close to the floor. Predictably, the one-sided peg has operated as a rigid peg. For much of this period, such was the credibility of its officially unlimited commitment that the SNB did not have to intervene on the foreign-exchange market. All it had to do was keep Swiss interest rates aligned on the ECB’s. The SNB was waiting for the right time to recover policy autonomy.
The right time? Role of the dollar euro rate
Since the onset of the financial crisis, the exchange rate between the US dollar and the euro has been surprisingly stable, given the shocks and the relative policy differences. It seems that we have now entered a period of differentiation during which the dollar is expected to appreciate sizeably relative to the euro. This will make the position of third currencies ‘uncomfortable’ to say the least. About half of Swiss trade is with the EU, which makes the franc-euro exchange rate a strategic matter for its economy. But what about the other half? Clearly, the US dollar must matter. In addition, financial flows between the US and Eurozone may well follow circuitous routes, including through the Swiss franc. The euro peg will no long have the overall stabilising effect that greatly benefitted Switzerland over the last three years.
Retaining the one-sided peg could have meant a likely effective depreciation of the franc. Pegging to the dollar, instead, could have led to an effective appreciation. Assuming that the franc was about right – in fact it was still somewhat overvalued – a reasonable objective would be to keep the franc in-between, hence suggestions to shift to a basket peg (more on this below). An alternative was to just let it float and thus recover monetary policy autonomy. One can discuss the policy choice, but certainly dubbing it an own goal is not warranted.1
While the predicted swing of the dollar-euro exchange rate, including a likely overshooting, means that the one-sided peg was reaching the end of its usefulness, an alternative timing was attractive.
- For the past three years, inflation has been negative in Switzerland (without much of a fuss) and growth has been positive but unimpressive.
- Following the euro into depreciation for a while would have helped bringing inflation into positive territory and supporting the ongoing recovery.
The cost would have been possible large-scale foreign-exchange-market interventions, but there was no economic limit to such action. Nor is the accompanying expansion of the central-bank balance sheet inflationary since the newly created francs are not circulating within the country. The SNB could and should have waited.
A big surprise: The best way to exit
Until the last day, the SNB kept repeating that the exchange-rate floor represented the alpha and the omega of its policy. The decision to abandon it therefore came as a complete surprise, which led to panicky reactions in financial markets. Clearly, many investors suffered large losses. Unsurprisingly, their reaction was angry. But did the SNB have any choice? Surely, pre-announcing the end of the one-sided peg would have triggered a momentous speculation, forcing the central bank to absorb a huge amount of reserves on which it would have suffered losses at the time of carrying out its decision. Keeping exchange-rate regime-change decisions secret is perfectly justified standard practice.
The common view on the markets is that the SNB has suffered a large loss of credibility. However, imagine that it would have hinted at its move. Abandoning the one-sided peg after massive speculation would have been interpreted as a capitulation to market forces. That would have been a serious credibility loss.
Once the dust settles, the markets will come to recognise that the SNB did it right. Central banks are powerful because they can take important decisions, not when they are seen to bow to market pressure. Remember the taper tantrum that followed President Bernanke’s gentle reminder that QE was not for ever. This pre-announcement was also seen as a loss of credibility. It seems that central banks can never win when their actions cause investor losses.
The SNB faced a policy dilemma; it would have had to act some point. A number of alternatives were possible.
- One of them was to adopt a basket peg to steer the franc in between an appreciating dollar and a depreciating euro.
This was suggested by Ernst Baltensberger in the Swiss media. The benefit would the assurance that the franc would not overshoot. The cost would have been a continuing loss of policy autonomy and a seemingly technocratic arrangement. A real trade-off with no superior solution.
- Another alternative would have been to bring the policy interest rate deeper into negative territory.
How far down? No one knows, but the SNB would have been obliged to explore this uncharted territory. As economists, we would have loved to observe this experiment but it is understandable that the SNB was not willing to play guinea pig with the Swiss economy. In addition, negative interest rates act as a tax on the banking system. Given the importance of the financial sector for the Swiss economy, it seems reasonable for the SNB not to bind itself.
Little has been made so far of the accompanying measures.
- The SNB lowered the deposit rate from -0.1% to -0.75% and established a trading range of -1.25 to -0.25% for its policy rate (the three-month LIBOR).
This is a bold move. The intention is clearly to reduce speculation that could lead to a strong overvaluation. This may be seen as a wise pre-emptive move against market overreaction. On the other side, it is a commitment that the central bank may find hard to uphold if the implicit tax on banks leads to financial instability.
What would the SNB do if some banks start failing? Raising the interest rate could trigger capital inflows and force the SNB to intervene on the foreign-exchange market, precisely what it wanted to avoid. More generally, is it wise to tax banks when the problem is excessive capital inflows? There exist other instruments like a tax on inflows. They are all broadly part of the capital control toolkit. Capital controls are seen as financial repression, but so are negative interest rates. At least, capital controls are more likely to be second best than taxes on banks.
The decision to end the one-sided peg cannot be described as a mistake. As most decisions, it balances various considerations. In the end, the dominating reason is the one that is untold. The SNB is bound to carry out an independent monetary policy, which means a flexible exchange rate. It is also under pressure for the size of its foreign-exchange reserves. In addition, its profits represent a non-negligible resource for the cantons. It is suffering losses on its euro-denominated assets and probably did not want to accumulate more of them. As noted by Brunnermeier and James (2015), political considerations must have loomed large.
Brunnermeier, Markus and Harold James, “Making Sense of the Swiss Shock”, 17 January 2015, Project Syndicate.
Michael J Lamla and Jan-Egbert Sturm, “Swiss National Bank under Attack”, VoxEU, 9 November 2012.
1 Citibank, “Did the SNB score an own goal? Francly, yes”, Global Economic Views, Citi Research, 15 January 2015.