Swexit - When will Switzerland exit the euro?

Since September 2011, the Swiss National Bank has held a floor of 1.20 francs per euro. This floor has in practice been a peg, as the pressure has been in only one direction, downward (that is, in the direction of CHF appreciation).

Image via FT Alphaville

As funds fled the euro crisis last summer and fall, the Swissie appreciated, putting in jeopardy the competitiveness of Swiss exporters.  The SNB first intervened, first in an ad hoc way and then as a formal policy commitment. As long as the pressure is toward appreciation, this policy cannot run out of ammunition: the SNB can always meet the demand for francs against euros by creating new franc-denominated reserves to purchase euro-denominated assets. Before it runs out of ammunition, though, the policy could run up against other constraints, about which more below.

By fixing the exchange rate, Switzerland was joining the euro, albeit in a limited way. A unified payment system is what knits together a monetary union. Within the eurozone proper, this role is played by TARGET2. A euro deposit in Athens is guaranteed to extinguish a euro of debt in Berlin, and that guarantee is backed by the operation of TARGET2. The national central banks allow claims among themselves to clear payment flows for the system as a whole.

To hold fixed the exchange rate between the CHF-denominated Swiss banking system and the EUR-denominated eurozone, the SNB is in effect creating on its own balance sheet a payment system for the Swiss banking system, carrying correspondent balances for exchange against EUR for all its member banks. To achieve this, the SNB gives up the initiative in managing its balance sheet—it meets all demand for Swissies at 1.20 per euro. Here it is in balance sheets:

The SNB expands its balance sheet to prevent CHF appreciation.

When you look at it this way, you can see the other side of the transaction too: the SNB is facilitating the world's portfolio reallocation out of EUR and into CHF. Even fixed at 1.20 francs per euro, funds have been fleeing the euro area as the crisis heats up again. The SNB's policy means that any net flow results not in price adjustment, but in fluctuations in the size of its own balance sheet. This permits expansion of CHF-denominated claims for the entire Swiss system. Now we see that this expansion is not fast enough to prevent all price adjustment: via Zerohedge, the yield on 2-year Swiss government debt has now gone negative.

By fixing the exchange rate, Switzerland has, in a way, unilaterally joined the euro. As a haven destination, Switzerland faces problems not unlike Germany's. Just as the Bundesbank's claims on TARGET2 swell, so too are the SNB's euro-denominated assets:

From a speech by Hervé Hannoun of the BIS

This entails some credit risk—if a peripheral country exits the euro, either central bank could take losses.  Switzerland has some choice about what EUR assets it buys, where TARGET2 requires Germany to accept claims on other eurozone national central banks (though after Jens Weidmann complained, maybe BuBa is getting collateral for its TARGET2 assets?).

What if the SNB releases the peg? (Swexit is an unfortunate term, but it seems like the right one.) If the SNB abandons the peg, the Swissie will appreciate rapidly against the euro.  Even leaving aside the consequences for the Swiss trade account, this will mean an immediate loss on the central bank's asset portfolio. The SNB faces no liquidity constraint in CHF, so this is not immediately catastrophic, but prudent central bankers will want to avoid insolvency all the same.

There is also the risk of speculative attacks. We cannot yet see the SNB's balance sheet as of May 31, but as conditions in e.g. Spain have worsened, it is likely that it has grown again after being mostly stable since the peg was introduced. If policy is credible, no one will risk loss by testing it, but as soon as doubts enter, the SNB will quickly have to absorb large speculative flows to defend the peg. Again, the SNB has the ammunition to do so, but it would be an uncomfortable situation.

I won't hazard a forecast yet as to when the policy will come to an end. But Switzerland has put itself in an interesting and challenging position in the wider eurozone crisis, and Swexit will definitely come, sooner or later.

Comments

0

Valuable insight that is often lost in the supposed "success" of the policy to date. My only departure from this view is that the SNB cannot become insolvent since it can always create reserves. The SNB however, like other central banks, will not want to lose money on its euro assets because monetary policy then effectively becomes fiscal policy. Blurring this line risks their highly valued independence.

0

Woj, I would say that the SNB cannot become illiquid because it can always create reserves. If it were "insolvent", i.e. if it had negative equity, it could not rectify that by creating new money. Expansion would mean creating CHF reserves and using them to purchase assets. If it paid market price for them, this would mean an equal expansion on both sides of its balance sheet, leaving the negative equity unchanged.

Perhaps more to the point, though, is that because the SNB cannot be liquidity constrained in CHF, solvency doesn't matter too much. The main problem with insolvency is that, for commercial banks, it leads to illiquidity.

0

Thanks for this post Daniel,
To add to the discussion in previous comments, not to say that it might happen to the SNB, but there is a known case of an insolvent central bank, in Iceland. When other central bankers do not trust your central bank, illiquidity and insolvency are quite close to each other. Of course in that case all was reverse, depreciation of the currency and money flowing out of the country.

0

"When you look at it this way, you can see the other side of the transaction too: the SNB is facilitating the world's portfolio reallocation out of EUR and into CHF. Even fixed at 1.20 francs per euro, funds have been fleeing the euro area as the crisis heats up again. The SNB's policy means that any net flow results not in price adjustment, but in fluctuations in the size of its own balance sheet"

In the balance of payments language, one can say that "Reserve Assets" is the accommodating item.

0

Your incorporation of the TARGET comparison is inspired.

The Greek bank depositor who moves his Euro deposit to a German bank is engaging in a “contingent foreign exchange” transaction. The German Euro is contingently a strong “foreign” currency compared to the Greek Euro, the latter which could convert and devalue in the event of a Euro system break up.

Similarly, the Greek depositor who moves from Euros into the Swiss franc is engaging in a foreign exchange transaction whose value is currently pegged but contingently a floating foreign exchange risk.

In the example of the Greek/German Euro flow, the Bundesbank holds a TARGET surplus balance that is contingently a “foreign currency”, since its value could be changed by credit risk losses associated with possible conversion and devaluation of currency in those nations with offsetting TARGET liability positions.

The Swiss central bank holds Euro claims that are roughly analogous to Bundesbank target balances, and issues Swiss franc bank reserves that are analogous to Bundesbank issued Euro bank reserves.

There does seem to be an important difference relative to the contingent credit risk on the Euro claims held by the two central banks. The Bundesbank is effectively locked into a TARGET determined credit risk basket according to the ECB capital and loss sharing formula. E.g. the Bundesbank can’t choose to hold Euro claims in the form of French credit risk exclusively, since it is constrained by the consolidated credit risk structure of TARGET.

Presumably, the Swiss central bank does have a choice in selecting the composition of its Euro credit risk. So the Swiss central bank contingent foreign exchange risk exposure might be long “core Euro”, short Swiss Franc, whereas the Bundesbank contingent foreign exchange risk exposure is long “consolidated Euro”, short German Euro.

Or, is the Swiss central bank also holding Euro balances with the ECB?

0

Excellent - a fundamental point about central bank balance sheets that most get wrong.

0

Is this any different than the actions of the People's Bank of China? If so how?

0

Sorry I've been slow to respond—busy weekend.

One thing that has to be hammered home about TARGET2 balances, and other monetary concerns as well, is that this stuff is as old as the hills. TARGET2 is a system of correspondent balances, which is completely basic feature of banking. Rather than clear every transaction, we let some balance accumulate and settle the account when necessary. The trouble, of course, is that TARGET2 is not being settled, so that the payment system is being asked to carry a large accumulated flow.

I'm using the same logic to understand the SNB peg. It's the same to a point, since the correspondent balance is being used to absorb the net flow. But the arrangement is different, with TARGET2 being part of a formal multilateral currency union and Switzerland pursuing its policy unilaterally.

From the SNB balance sheet release, it looks like the EUR assets are euro-denominated securities.

0

"The trouble, of course, is that TARGET2 is not being settled"

I must be missing something. Why is that trouble? I thought the whole point was that these flows need not be settled, in order to guarantee fungibility of the Euro.

Doesn't it make more sense to treat the NCBs as components of a federated single entity?

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