The Swiss have made it abundantly clear that they will defend the 1.20 floor against the euro no matter what:
But keeping the Swiss franc structurally undervalued against the euro is becoming costlier than ever.
The act of having to put its money where its mouth is — via that permanent 1.20 bid — has not only reduced Switzerland to “currency manipulator” status, but also into one of the biggest acquirers of euro-denominated assets in the world.
And nobody wants coffers full of euros-denominated assets at this point.
No wonder the Swiss are busy coming up with alternative plans … some of which, we might add, are remarkably Chinese in flavour.
Just as China is becoming more flexible with it capital controls and RMB trading band (a symptom of the country having the very opposite issue of Switzerland, a capital outflow problem) Switzerland is thinking about instituting capital controls and negative interest rates.
George Saravelos at Deutsche Bank has a good round up of the options available to Switzerland on Thursday.
First off, while it’s clear that the EUR/CHF floor is under pressure for the first time since inception, there’s no chance it will go any time soon.
As he notes:
First, the SNB has unlimited firepower to defend the floor, only constrained by its willingness to expand its balance sheet. There’s plenty of scope to increase this compared to other central banks (chart). Second, the costs of letting the floor go are too large. The CHF would appreciate by 20-25% over the scope of a few days, hitting the economy with a large deflationary shock at a time when the global macro picture is deteriorating. Markets should not be asking whether the SNB will let the floor go, but what alternative steps the SNB can take to reduce capital inflows if they accelerate.
So what are the three main alternatives to solving Switzerland’s current problem (the forced accumulation of unwanted euro-denominated assets)?
One of the most talked about options is introducing negative rates. And to a degree the market is already enforcing this policy. Swiss yields are negative up until four years out:
But there are ways to make those rates official. As Saravelos explains:
(1) Negative rates. This would involve the SNB charging banks for holding sight balances at the central bank currently more than 200bn Sfr. The Riksbank lowered its deposit rate to -0.25% in 2009, so this has been done before. However, the Swedish banking system was not faced with a structural overhang of liquidity, so negative rates had a minimal impact. In contrast, negative returns on sight balances in Switzerland would see an immediate re-pricing of the Swiss rates structure, serving as a material disincentive to capital inflows as well as discouraging hedging activity (Sfr buying) by corporates. The policy would also have damaging side-effects though. It would hurt domestic bank profitability, while also encouraging additional credit origination in an economy where the central bank is worried about excessive lending and a housing bubble.
A strange manoeuvre for a banking-based economy indeed.
So perhaps capital controls might prove more attractive to officials?
(2) Residency-based capital controls. These would be similar to those introduced in the 1970s. The government could levy a tax on all Swiss franc deposits or assets held by foreigners, or even prohibit outright purchases. This selective approach would prevent the building of domestic imbalances. The disadvantage is that it may encourage a shift in the composition of portfolio inflows (for instance to derivatives-based flows, similar to the Brazil experience with the IOF tax), as well as creating two-tiered onshore/offshore market and damaging Switzerland’s position as an open global financial centre.
(3) Other capital controls. These are used in EM. The most popular is the imposition of unremunerated reserve requirements against foreign currency positions, to disincentivize FX accumulation. The SNB could ask banks to hold excess reserves against short EUR or USD positions, increasing the cost of carry. The financial already has surplus liquidity and Swiss franc accumulation is not driven by carry trade flows though. We see limited benefits to such an approach
So, not that wonderful either.
Given all of the above Saravelos concludes the SNB might be best off letting its balance sheet expand, and diversifying out of its euro-denominated as quickly as possible. In which case we might expect to see substantial selling – SNB induced – of EUR vs USD, JPY, GBP, CAD and other liquid EM FX:
Though too much diversification into the dollar, and we’ll see Tim Geithner starting to call Switzerland a currency manipulator soon enough.
The Swiss boson – FT Alphaville
The SNB as victim of a decentralised market structure – FT Alphaville
Floored, but not unfloored – FT Alphaville