This dramatic action is likely to result in three big changes in the foreign exchange markets. First, the Swiss franc will begin to lose its haven status. Since the credit crunch began in 2007, Switzerland’s authorities have cut interest rates to zero, undertaken large-scale spot market interventions and massively increased liquidity in the Swiss banking system in order to check the strength of the franc. But the eurozone debt crisis has caused demand for Switzerland’s currency to continue appreciating to levels regarded as ‘absurd’ by the central bank.
By committing itself now to maintaining a ceiling for the franc’s value against the euro, the SNB seeks to stop its currency behaving as a one-way bet. Moreover, by insisting that it stands ready to ‘buy unlimited amounts of foreign currency’ the central bank has signalled that it is prepared to print money indefinitely and accept inflation as the price for keeping Swiss industries competitive while warding off the risk of deflation.
This was the course the SNB undertook in the late 1970s when it also faced huge, haven-seeking inflows. From 1978 to 1981, the franc was effectively pegged against the old German Deutschmark, and the currency was only allowed to freely float again when inflation had reached high single-digits, making it unattractive to risk-averse investors.
Of course Switzerland’s authorities risk being overwhelmed by large capital inflows that cause inflation to rise more rapidly than expected and bubbles to form in domestic asset markets. This was the painful experience of the UK economy in the late 1980s when chancellor Nigel Lawson decided to “shadow” the pound against the Deutschmark. By instructing the Bank of England to sell sterling whenever it reached three marks, the UK Treasury put a cap on the pound from early 1987 to early 1988. But this caused inflation to increase sharply and Britain’s property markets to experience a boom and bust. As a result the UK Treasury was forced to allow the pound to appreciate again from the spring of 1988.
The same may happen to Switzerland during 2011 and 2012 now. But until the SNB abandons its new exchange rate target, the combination of zero currency appreciation, the prospect of rising inflation and the risk of domestic asset bubbles in the Swiss economy over the next few quarters will diminish the appeal of the franc now.
Second, SNB foreign currency reserves will increase even more, having already risen more than five fold to over $200bn when the central bank intervened from March 2009 to May 2010. As a result its reserve diversification policies will be closely scrutinised. Admirably, the SNB publishes the composition of its foreign currency holdings. In recent years it has begun shifting its foreign reserves away from traditional reserve currencies such as the dollar, euro and pound to commodity currencies such as the Canadian dollar. Its decision to intervene again now and thus build up more foreign currency assets is likely to support these new reserve currencies on the margin.
Third, the US dollar increasingly looks set for a broader-based rally as risk-averse investors run out of other havens to turn to. Already the Bank of Japan has sold a record amount of yen in one day last month to stop the rise of the yen. The SNB’s actions similarly are supporting the greenback against the franc. At the same time central banks with room to cut interest rates are doing so, Brazil’s being the most notable recently. As the market has already marked down the dollar on the view that the Federal Reserve will engage in further easing, the prospect that other central banks will also loosen monetary policy either through foreign exchange actions like the SNB or interest rate cuts will force investors to mark up the greenback again.
The SNB’s decision to target the franc against the euro should not be taken lightly. If successful, it will give Swiss policymakers much needed breathing space on the currency. But if the authorities cannot maintain their new experimental exchange rate policy, they may need to consider more, unpalatable measures such as capital controls. That would mark another step back to the 1970s, a move that was simply inconceivable before the credit crunch began four years ago.
Mansoor Mohi-uddin is managing director of foreign exchange strategy at UBS
Source: http://www.ft.com/intl/cms/s/0/e954354e-d93c-11e0-884e-00144feabdc0.html#axzz1YO8jKXD1
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