Switzerland’s cap on its currency, which it removed on January 15th, was unsustainable, protectionist and exposed the central bank to catastrophic losses, according to many commentators. Not so, argues Simon Cox of BNY Mellon Investment Management.
ON THURSDAY January 15th Switzerland’s central bank, the Swiss National Bank (SNB), removed the cap on its currency, which it had imposed over three years ago and reaffirmed only three days before its repeal. The doffing of the cap surprised and upset the foreign-exchange markets, hobbling several currency brokers, including Alpari (which happens to sponsor the London football team I support). Many commentators nonetheless welcomed the cap’s removal, arguing that the policy was either unsustainable, protectionist or risky, exposing the SNB to grievous losses. I find these criticisms of the cap unconvincing—and not just because I am a West Ham United fan. Let me address each of them in turn.
Misconception 1: The cap on the Swiss franc was unsustainable
Exchange-rate pegs often fail. To prop up its currency, a central bank might have to buy large amounts of its own money in exchange for dollars or euros. Eventually, it will exhaust its hard-currency reserves forcing it to abandon its peg.
The first thing to understand about the Swiss drama is that it is the exact opposite of this more familiar case. The Swiss central bank was trying to keep its currency down not prop it up. To achieve this goal, the SNB had promised to sell as many Swiss francs as necessary (in exchange for “unlimited quantities” of foreign currency). The promise was credible, because a central bank can print its own currency without limit. It cannot run out of its own money to sell. The cap was, therefore, sustainable if the SNB had wished to sustain it.
If a central bank overworks the printing press, its money will eventually lose value, of course. Inflation and depreciation set a limit on the power of central banks. But the Swiss had imposed the cap precisely because they wanted to raise domestic inflation from dangerously low levels (consumer prices fell by 0.3% in the year to December 2014, according to the Federal Statistics Office). Persisting with the currency cap might have pushed up prices. But that is no objection to the policy; on the contrary, it was the objective of it.
Misconception 2: The Swiss central bank needed to worry about big losses on its euro holdings
The second misconception is less basic. Every economist knows that a central bank cannot run out of its own currency. But many believe the Swiss cap was unsustainable for a different reason.
If the SNB had stuck with its cap, buying as many euros as people were willing to sell at its set price of 1.20 Swiss francs, its holdings of the single currency would have swollen in size. By the end of September 2014, it already held over €174 billion, according to its balance sheet. With the single currency weakening in anticipation of further monetary easing by the European Central Bank, this hoard was likely to grow to epic proportions.
Perhaps because I live in Hong Kong, where the monetary authority’s foreign assets amount to over 120% of the economy’s annual output, big central-bank balance sheets don’t scare me. But others worry. They point out that if the franc were ever permitted to rise against the single currency, the Swiss central bank would suffer an enormous loss on its euro assets. Euro holdings worth, say, 240 billion francs at the capped exchange rate would be worth 40 billion less in the Swiss currency if it rose by 20%.
If the loss were big enough, the central bank’s assets (which include its euro holdings) might end up being worth less than its liabilities (which are overwhelmingly in its home currency). The central bank, known until last week for its quiet conservatism, would be technically insolvent.
That would be a little awkward. It would not be easy to explain the central bank’s predicament to its shareholders, who include the Swiss cantons, or to unsympathetic political parties, such as the Swiss People’s Party—which has already sponsored an unsuccessful referendum to force the SNB to hold at least a fifth of its assets in gold.
But although insolvency is humbling for a central bank, it is far from crippling. “Central banks may operate perfectly well without capital as conventionally defined,” pointed out Peter Stella in a working paper published by the International Monetary Fund back in 1997. Central banks cannot go bust in the way that a commercial bank can. They can always pay their bills, because they print the money they owe.
Their debts are also peculiar. The SNB’s liabilities are chiefly Swiss francs. For the most part, as its balance sheet shows, they take the form of simple banknotes or the deposits that commercial banks hold at the central bank.
The franc, like all fiat money, is not backed by anything tangible. People accept it as payment because they are confident other people (including the tax authorities) will accept it. Try to redeem a banknote at the central bank and all you will get is a newer banknote. That is all that a central bank’s liabilities promise: I owe you an IOU.
These debts are also uniquely easy to service. Banknotes pay zero interest. Deposits at the SNB now yield even less than that: depositors pay the central bank, not the other way around.
Central banks do not, then, have to worry much about satisfying their creditors. Nor are they judged by the returns they earn for shareholders. They are judged by their ability to keep inflation in check and the financial system stable. Their balance sheet—the size and mix of their assets and liabilities—is important insofar as it serves that mission. It is a macroeconomic tool, not a statement of financial success or failure.
The SNB itself understands this. After it reported big losses on its foreign-exchange holdings in 2010 and early 2011, it faced doubts about its financial strength. Some people speculated that it might eventually suffer from negative net worth (also known as “negative equity”). In a 2011 speech, Thomas Jordan, who now heads the institution, answered these concerns directly.
“Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?…
he short answer to all these questions is ‘No’.”
If the SNB ever became insolvent, it would not be the first central bank to suffer such an indignity. The Czech central bank and the Bank of Chile, among others, functioned perfectly well for years with liabilities that exceeded their assets.
Some economists argue that negative net worth is damaging for other reasons. It undermines a central bank’s “institutional credibility”, even if it doesn’t impair its day-to-day viability. These economists worry that a broke central bank might compromise its independence by going cap in hand to the government, asking to be recapitalised. Or it might print currency willy nilly to cover its losses and earn its way out of its financial hole. Either response would damage its standing as the guardian of the nation’s money.
But these worries hardly apply to the SNB. It has suffered losses (now and in the past) because its currency has strengthened, a reflection of the confidence foreigners place in it. If anything, “institutional credibility” is a cause of its balance-sheet problem not a potential casualty of it. Right now, the Swiss National Bank’s ability to prevent inflation is not in doubt. What is in doubt is its ability to create it.
Besides, a central bank’s financial strength is not ultimately the source of its operational independence. If a society is not, on balance, committed to price stability, the central bank will struggle to achieve it, no matter how strong its balance sheet. By the same token, if inflation is sufficiently unpopular, the state will give its central bank the leeway it needs to prevent it. That remains the case even if the central bank needs recapitalising once in a while.
Misconception 3: The cap was protectionist
When the SNB imposed the cap back in September 2011, the Swiss franc was strengthening fast, bid up by “refugee-capital” seeking a safe haven from the eurozone’s troubles. The strong franc made Switzerland’s upscale goods even pricier abroad, damaging its exporters’ competitiveness.
The cap put a stop to that. It thus drew criticism from economists worried about the impact on Switzerland’s trading partners. Ted Truman of the Peterson Institute for International Economics has described the cap as “openly protectionist”. According to other commentators, the cap contributed to the “currency wars”, in which countries try to seize market share from each other by weakening their exchange rates. By removing the cap, Switzerland was acting like a “good world citizen”, according to Dean Baker of the Center for Economic Policy Research, giving an “economic boost” to other countries that will enjoy healthier trade balances as a result.
When the SNB introduced the cap, it was indeed concerned about the “massive overvaluation” of the Swiss franc. Safe-haven flows were driving up the currency, displacing its manufacturers, just as oil or gas earnings can hollow out a country’s industrial base. The Swiss cap was helpful in preventing Dutch disease.
But the central bank’s main motivation for imposing the cap was not protectionism. It was trying instead to avert the risk of deflation. In keeping the currency down, it was trying to drive prices up. This ambition to raise prices is at odds with the notion that it was seeking to protect Swiss exporters. Because in raising inflation, the SNB would have reduced Switzerland’s competitiveness (all else equal) not sharpened it. If an exporter’s local prices and wages go up, it becomes less competitive abroad, even if the exchange rate remains the same.
Currencies, it is fair to point out, move much faster than goods prices or wages. So although inflation would have eroded the competitiveness of Swiss exporters eventually, it would have taken time. Currency appreciation, on the other hand, worked with brutal speed.
In seeking gradual inflation rather than abrupt currency appreciation, the SNB was therefore helping the country’s exporters. But in doing so, it was not defying fundamental market forces. It was instead choosing to expose exporters to one set of market forces rather than another: the sluggish forces of the goods market, rather than the bone-shaking forces of the foreign-exchange market. Neither market is perfect. The goods market is bogged down by inertia, transaction costs and long-term contracts that inhibit price flexibility. The currency markets, on the other hand, are swayed by bouts of speculation and skittishness. Neither does an unimpeachable job of setting an economy’s terms of exchange with the rest of the world.
In practice, there is an easy way to tell the difference between the SNB’s policy and that of the “currency warriors”, mercantilist central banks that suppress their exchange rates for competitive gain. Like the SNB, the currency warriors buy dollars or euros to keep their currencies cheap. In so doing, they create additional local money, just as the SNB did. But unlike the SNB, they “sterilise” their interventions, withdrawing this extra money from circulation (either by selling other assets or raising reserve requirements on banks). This prevents prices from rising, thus preserving the competitive advantage their cheap currency provides.
The SNB was not waging this kind of warfare. In printing francs it was keeping its currency down but not its prices. If its policy had hurt its trading partners, they were free to retaliate by printing more money themselves. This tit-for-tat monetary easing would not have resulted in a zero-sum scramble for a fixed amount of global demand. It would instead have helped to increase world demand, in a process of mutually-assured reflation.
The Swiss policy was not, then, protectionist in intent, nor was it unsustainble. It exposed the Swiss National Bank to a loss of face, but not to a financial loss of any great economic consequence. I believe currency pegs remain a legitimate monetary choice—as long as central banks allow prices to adjust accordingly—if not always a wise one. I also think the removal of the Swiss cap was unnecessarily disruptive. The SNB must now find a new way to fend off deflation. And West Ham must find a new sponsor for its kit.
Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.
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