While the scale of Switzerland’s forex intervention on Tuesday caught many people off guard, what’s also caused a bit of bother is seemingly the interpretation of the move.
A key observation, for example, has been that Switzerland tried this before — and failed. The mark-to-market losses on the euro reserves it accumulated were seen as far from justifiable. Thus, de facto, many have judged the move equally unsustainable this time too.
But that was then. This is now.
As Rabobank pointed out on Tuesday:
While SNB share holders were dissatisfied last year with the losses that resulted from intervention it could be that the Swiss authorities now view the losses from intervention as a cost worth bearing if it affords exporters and the wider economy protection from excessive currency strength.
What’s more, it’s arguable that it was the fear of the inflationary consequences of a monetary base expansion associated with FX intervention that were viewed as most undesirable back then. As Barclays has pointed out, there’s a much lower risk of that now:
By contrast now, central banks around the world are on hold or loosening and with a renewed risk of Swiss deflation (CPI printed at 0.2%y/y today, cons 0.3%), loose policy is not an obstacle.
Thus, by all definitions, the ‘unlimited’ nature of the SNB’s move is now genuinely that. Unlimited — at least until inflation becomes an issue again. A point expressed well by Societe Generale’s Sebastien Galy:
Now, it already has the political support to move ahead as well as a clear economic imperative so that the SNB’s move is credible. The CPI yoy inflation dropped more than expected. This is even as the well publicized price cuts by retailers such as Migros, Coop and Manor are yet to show up in the data.
To understand the real limits of the SNB’s intervention commitment, one really has to look to the mechanics.
What the SNB has in effect done is announced a major QE-style easing — but rather than buying government bonds it’s buying euros in the foreign exchange market instead. The mechanics, nevertheless, are similar. In order to buy the euros, the SNB will be expanding its balance sheet to accomodate the purchases. That is, creating fresh new Swiss franc credits, that will fall on the liability side of its balance sheet. The limit thus lies only in its own appetite for balance sheet expansion.
And as China has proved, in some cases, that appetite can remain limitless. (Though China at least does attempt to sterilise its operations, something the SNB won’t be doing.)
What the SNB will definitely be doing is accumulating major euro reserves on the asset side of its balance sheet.
So what will it do with all those euros?
Yet again there are some differing opinions.
RBC Capital has noted that traditionally, the SNB will have been inclined to buy AAA euro-denominated debt:
What does the SNB buy? At end-Q2, reserves were held 55% in EUR, 25% in USD, 10% in JPY, 4% in CAD, 3% in GBP and 3% in other. Of that, the majority was in AAA bonds.
But as we now know, there’s not enough of that around.
Nevertheless, Simon Derrick at Bank of New York Mellon has alerted us to this story in Dow Jones which suggests top quality German and French debt might be just the thing for the SNB:
FRANKFURT (Dow Jones)–The Swiss National Bank has begun buying government debt directly on the market as part of ongoing efforts to bring the country’s soaring currency in check, German newspaper Frankfurter Allgemeine Zeitung reports Saturday, citing banking sources in Frankfurt. The Swiss National Bank will also only acquire German and French bonds, which it deems the most secure and liquid within the currency block, when buying euro-zone debt, the FAZ further reports, based on source information. The Swiss National Bank has recently said it is only intervening in the currency markets through swap operations, through which it temporarily acquires euros and dollars in exchange for Swiss francs, thus boosting the overall supply of francs in the market.
Of course, the SNB will no doubt be alert to the vicious circle that a move into bunds and French bonds could create. A limited amount of supply means any large additional flows would have an immediate widening impact on periphery spreads — something that could be misconstrued as a fundamental deterioriation in the Eurozone position, only fueling further inflows into Swiss francs instead.
Hence RBC notes:
We do not want to make suggestions on what the SNB should buy but if it really wants to support EUR/CHF, buying Italian and Spanish debt might not be such a bad idea.
There are other consequences too. Piling into euro debt heightens Switzerland’s own exposure to the eurozone, while simultaneously creating a weirdly symbiotic relationship akin to China’s dependence on US Treasuries, and the US government’s related dependence on China buying its Treasuries.
As HSBC’s David Bloom notes, one thing is certain, it won’t be easy for the Swiss to diversify that exposure into anything else:
The question now is, if the Swiss have now created stability for themselves who have they created instability for? Is it the Eurozone? If the private sector continues to unload periphery eurozone bonds and buy CHF, the Swiss authorities are now committed to use the central bank’s balance sheet to sell CHF and in turn buy EUR. They are most likely to buy core Eurozone debt.
This keeps the EUR bid but would also have the distorting impact of widening the spread between the core Eurozone bonds and the periphery. This may be interpreted by the market as a sign of distress. It is possible that this further undermines relations between the core and the periphery. This is a risky policy for the Swiss: just at a time when the Eurozone’s future is most uncertain, it would leave the CHF massively exposed to the Eurozone’s fortunes. The market will now be carefully monitoring their reserve position to see how big their euro holdings become. The Swiss cannot then sell these EUR to buy USD as this would be intervening in USD-CHF.
So what to do?
Eventually — especially if things don’t turn around soon — there will be only three nuclear options left for Swiss to consider.
One, aligning Swiss interests to those of the eurozone completely — i.e. by actually joining the eurozone. (Unlikely.)
Two, by changing accounting metrics so as to avoid mark-to-market loss focus on euro-denominated reserves.
Three, by taking euro-reserve management responsibility off-balance sheet completely via the creation a sovereign-wealth-fund.
The two latter points, for example, were noted by Deutsche Bank’s George Saravelos:
Second, the SNB could alter the accounting treatment on its balance sheet and avoid marking-to-market its foreign currency reserves. There are precedents for this. The US Federal Reserve does not mark its gold holdings to market, for instance.
Alternatively, the SNB could move reserves off-balance sheet, similar to the Norges Bank petroleum fund, and establish a sovereign wealth fund.
To us, the idea of a Swiss sovereign wealth fund resonates well.
Related links:
The Swiss National Bank is pegging it - FT Alphaville
Carried away in Switzerland - FT Alphaville
SNB euroquake, the analyst reaction – part one - FT Alphaville
SNB euroquake, the analysts react – part two – FT Alphaville