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The SNB chose deflation over financial instability

The essential

On January 15, the Swiss National Bank (SNB) abandoned its 3 ½-year-old 1.20 floor on the EUR/CHF exchange rate in one go, marking a paradigmatic change of policy to address the influence of the Eurozone at home. We explain here the rationale for the move and its consequences.

Switzerland will experience a new phase of deflation and recession. The SNB’s move is helping the ECB as it had a significant impact on the trade-weighted euro and will discourage capital flights associated with a possible increase in political risk in Europe in 2015.

 

 

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The SNB’s announcement was largely unexpected. On January 15, the Swiss National Bank (SNB) abandoned its 3 ½-year-old 1.20 floor on the EUR/CHF exchange rate in one go, marking a paradigmatic change of policy to address the influence of the Eurozone at home. After the announcement of the measure, the EUR/CHF significantly overshot to 0.85 (a 30% adjustment) before returning to parity (a 20% or so correction), a sign of the suddenness of the Swiss central bank’s move and lack of anticipation by the foreign-exchange markets. Such a large correction can only signal that the SNB’s passive absorption of ECB liquidity from private operators at times of tensions had to stop.

The SNB was increasingly cornered by the one-way bet it was offering. The rationale for the move is that, over the almost four years of FX interventions by the SNB to buy large amounts of EUR, the SNB’s balance sheet was threatening to become over-inflated, having increased by close to 30 percentage points of GDP to around 80% of GDP, far more than the size of the Bank of Japan’s balance sheet (around 60% of GDP). In 2013 and during the first half of 2014, The SNB did not have to buy euros to maintain the EUR/CHF exchange rate above 1.20. But, since the ECB stepped up its strategy in June 2014, there has been a strong downward pressure on the euro and the SNB had to buy euros again. Further downward pressure on this exchange rate would have meant that the SNB would have to expand its balance sheet in exaggerated proportions (100% of GDP? 150% of GDP?), putting the country’s domestic financial stability at risk. 

The CHF’s overvaluation had diminished over the last few years. The SNB argued in its statement that the overvaluation of the Swiss Franc had diminished over time. Indeed, the trade surplus continued to widen quickly over recent years. With downward pressure on the EUR (because of the deflation threat and because of the strengthening of ECB’s easing policies) and upward pressure on the CHF (very high current account surplus, conversion of Hungarian mortgages denominated in CHF), the overvaluation of the Swiss Franc vis-à-vis the euro has significantly decreased. Maintaining the EUR/CHF above 1.20 would have required massive purchases of EUR – further ballooning the SNB’s balance sheet – and, consequently, even larger FX losses in the future for the SNB.

Very negative rates to discourage capital flights that may arise because of the European political risks. The SNB’s move can only be understood if analysed in combination with the introduction of highly negative rates as the SNB wants to discourage capital inflows, which would threaten financial stability at home. The SNB lowered the deposit rate to -0.75% and the target range for the 3-month Libor to between -1.25% and -0.25%. The market is now pricing in that money market rates will remain exceptionally negative for a long period. The very negative rates can be considered as a substitute for currency controls. This has not prevented the CHF from appreciating strongly versus the euro but will be a key factor in the future. Political risk will probably increase in 2015 in Europe: the approval rating of populist parties is now very high and there will be elections in Finland, France, Spain, the UK, Portugal, etc. The hostility towards traditional elites is high and the negotiations between the new Greek government and European authorities will be hard: political uncertainty could trigger massive capital flights to Switzerland. The introduction of very negative rates by the SNB will help the ECB as it will help reduce the outflow of QE liquidity and keep it in the Eurozone. Indeed, exporting capital from the Eurozone to Switzerland has become 20% more expensive and should discourage some Greek investors from doing so (at least to some extent). Some Swiss banks already announced that they would charge their clients negative rates on cash balances over a given amount. Less liquidity will be tempted to leave the Eurozone for Switzerland just when the ECB is launching its QE: the SNB is indeed (intentionally or not) doing the ECB a big and very timely favour.

What will be the impact on the Swiss economy? Undoubtedly, Switzerland will experience a phase of deeper deflation and also recession. In its latest Quarterly Bulletin, the SNB itself explained that “a further appreciation of the Swiss franc would have a major impact on salary and price structures, and would push inflation well into negative territory. Companies in Switzerland would be forced to cut costs drastically again to remain competitive – a scenario that would severely impair price stability”. After the CHF’s massive appreciation vs. the EUR in 2011, imported inflation became largely negative and history will certainly repeat itself in 2015. The SNB will probably not remain inactive with such a gloomy inflation outlook (the drop in oil prices will also continue to weigh on inflation figures). Lastly, it also seems that the manufacturing sector has been sacrificed: in Switzerland, manufacturing employment remains depressed (still below 2008 levels) while services employment is very dynamic and this will be reinforced by the SNB’s announcement.

The SNB’s move is helping the ECB. Intentional or not, the appreciation of the CHF versus the EUR entailed a further weakening of the trade-weighted euro as the Swiss Franc represents more than 6% of the main currency basket monitored by the ECB. It should be reiterated that the EUR depreciated mainly versus the USD and the GBP in 2014, but that it appreciated versus several European currencies (NOK, SEK, HUF, PLN, CZK), while depreciating only slightly vs. the CHF. A further decline in the trade-weighted EUR is a welcome development for the ECB.

The CHF becomes the favourite carry-trade currency once again. As the entire CHF curve moved downward and as Swiss rates will remain negative for a long period, the currency is now offering a source of low- and even negative-cost funding. It has also reinforced the interest of using the CHF for carry trades with other currencies. Coordinated or not, the SNB’s decision is also helping the ECB a great deal because the euro was in fact threatening to end up cornered into the role of the next carry-trade currency.

The USD will remain a safe haven currency. The fact that the CHF is no longer constrained by the SNB’s currency floor will allow it to take back its role of traditional safe haven but it became massively overvalued with its recent appreciation, which makes it unattractive. The US dollar will remain one of the main safe haven currencies. The expected increase in political risk in Europe in 2015 is likely to put some downward short-term pressure on the EUR/USD exchange rate. On top of that, any disappointing news coming from China would also trigger a USD appreciation. With a sequel certain to take place in Spain (if not Portugal) when the general elections come around, the EUR is likely to further dip below USD 1.10 before returning to 1.10.

The impact on the other European countries

Polish households will suffer from CHF appreciation. Many Polish households borrowed in CHF during the 2000s. The sharp appreciation of the Swiss Franc has raised the amount (taken in zlotys) that they will reimburse. The Hungarian authorities addressed this issue at the end of 2014. The Polish government will now have to work on this to alleviate the households’ debt burden.

The SNB move makes the Riksbank’s life harder. By abandoning the EUR/CHF floor just few days after SNB officials publicly stated that the currency floor was a crucial tool in its fight versus deflation, the SNB lost credibility and has discredited this tool. As Sweden has been experiencing deflation and an excessively strong currency for some time, a currency floor may have been an efficient solution for the Swedish central bank but for now, it is less than certain that the markets would appreciate the introduction of this type of policy.

The Danish central bank is also under pressure. The Danish krone (DKK) is pegged to the euro since the creation of the latter (to the Deutsche mark previously). Like the EUR/CHF exchange rate, there are strong downward pressures on the EUR/DKK, because of the ECB policy but also because of the safety associated to the Danish securities (with a very low public debt, Denmark is one of the last countries rated AAA for all the agencies). In order to discourage capital inflows, the Danish central bank has decided to lower its deposit rate to -0.75%.

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Cross Asset of February 2015 in English

Cross Asset de Février 2015 en Français

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2015-02-5-03

 

2015-02-5-04

 

2015-02-5-05
DOISY Nicolas , Strategy and Economic Research at Amundi
DRUT Bastien , Senior Strategist at CPR AM
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The SNB chose deflation over financial instability
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