Switzerland's central bank EIU ViewsWire

Switzerland's central bank has dramatically intervened in an attempt to stem the appreciation of the Swiss franc, imposing a ceiling of Swfr1.20:€1. The move, which prompted a sharp fall in the franc on September 6th, is broadly in line with recent Economist Intelligence Unit analyses suggesting that more unconventional measures would be needed to offset upward pressure on the currency. However, there is a substantial chance that rising global risk aversion will sustain the franc's safe-haven appeal, making it harder to prevent appreciation. The new policy also exposes the Swiss National Bank (SNB) to potentially heavy losses on its foreign-exchange holdings.

SNB acts

The SNB, Switzerland's central bank, stunned markets on September 6th by announcing that it would enforce a minimum franc/euro exchange rate of Swfr1.20:€1, and that it was prepared to buy "unlimited quantities" of foreign currency in order to do so. The new policy comes in response to what the SNB described as the "massive overvaluation" of the franc, and follows the failure of previous measures to counter the franc's rise.

In 2010 the SNB intervened heavily in the currency markets, selling francs and buying foreign currency. But the franc still rose by about 19% against the euro for the year. In the second half of 2010, the franc appreciated substantially against the US dollar as well. This year the upward pressure has continued as the debt crisis in the euro zone and an increase in global risk aversion boosted safe-haven flows into the franc. In recent weeks the Swiss currency hit record highs against both the euro and the US dollar. On August 10th the franc neared parity against the euro, reaching Swfr1.03:€1. This was despite an early-August cut in interest rates, accompanied by the announcement that the SNB intended to keep rates as close to zero as possible. Measures to increase Swiss-franc liquidity in the domestic money market have also been ineffective in preventing currency appreciation.

The strength of the franc has created problems for Swiss exporters. It is also tantamount to monetary tightening, threatening domestic growth and contributing to fears of deflation. As a result of these factors, the SNB has been under increasing political pressure to take stronger action to weaken the franc. This has culminated in its extraordinary imposition of an exchange rate ceiling vis-à-vis the euro, which could be considered a step towards a currency peg.

Costs and benefits

Will the new measure work? And at what cost to the economy and/or the SNB? These are difficult questions to answer in more than speculative terms. The Swiss franc immediately fell sharply against the euro, from Swfr1.1:€1 to Swfr1.2:€1, on news of the SNB's move. However, currency intervention often results in no more than temporary exchange-rate movements, reflecting the very large global market forces that such measures attempt, like King Canute, to defy. The fact that the SNB acted unilaterally rather than in concert with other central banks could render its policy less effective. In the SNB's favour is the fact that preventing currency appreciation is arguably less difficult than defending a currency that is under downward pressure. The central bank can theoretically print unlimited amounts of money to buy foreign currency; and it does not have to worry about running out of foreign-exchange reserves, as these increase, rather than fall, the more policymakers intervene. (Indeed, one side-effect of the SNB's unsuccessful efforts thus far to curb franc appreciation has been the huge rise in such reserves, from around US$45bn in 2008 to US$233bn in June 2011, according to IMF data.)

The biggest concern over the policy's effectiveness is simply the fact that investors' preference for safe-haven assets such as the Swiss franc looks likely to persist. The global economy is weakening, and the debt crisis in the euro zone remains severe. Moreover, the scale of intervention that will be needed, day after day, is formidable.

There is also the risk that the SNB's purchases of foreign currency could hurt its finances. The central bank's intervention in 2010 saddled it with losses of some Swfr21bn (US$24bn at the current exchange rate), as the value of foreign holdings was undermined by the subsequent strengthening of the franc. Should the SNB's new policy succeed in holding down the value of the franc for a sustained period, this ought not to be a problem. Still, a repeat of the losses suffered last year would be politically unacceptable. This also suggests that the difficulties facing the export and tourism sectors as a result of currency appreciation have become so acute that political pressure to weaken the franc is overriding other concerns for now.

SNB intervention also has potential implications for liquidity, inflation and bond markets in the euro zone. Printing money to buy euros and dollars implies an expansion in the money supply, which—as with quantitative easing in the US—could risk increasing inflationary pressures in the future if liquidity is not promptly drained at the appropriate time. However, such risks are mitigated for the time being by the fact that Swiss inflation is very low. Consumer prices rose just 0.2% year on year in August, the slowest pace so far this year. Last but not least, some commentators have suggested that the SNB's purchases of euros could lead the bank to increase its holdings of government bonds from euro members. This could increase Swiss exposure to euro area risk or, assuming the SNB bought high-quality bonds such as those from Germany, indirectly add to market pressures on the weaker "periphery" countries.

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