Opinion



By Markus Brunnermeier and Harold James


Making sense of the Swiss shock




Posted on January 22, 2015


SINCE THE European sovereign-debt crisis erupted in 2009, everyone has wondered what would happen if a country left the euro zone. At first, the debate focused on crisis countries -- Greece, or maybe Portugal, Spain or Italy. Then there was a rather hypothetical discussion of what would happen if strong surplus countries -- say, Finland or Germany -- left.

  
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A shop in Zurich offering a 20% discount “due to the sudden rise in the Swiss franc against the euro, and to allow us time to adjust our prices.” (Reuters)
Through it all, a consensus emerged that an exit by one country could -- like the collapse of Lehman Brothers in 2008 -- trigger a wider meltdown. Now, in Switzerland, we have a demonstration of just some of the risks that might emerge were a surplus country to leave the euro zone.

In September 2011, Switzerland pegged its currency to the euro to set a ceiling to the Swiss franc’s rapid appreciation in the wake of the global financial crisis that erupted in 2008. The country thus became a temporary adjunct member of the European monetary union. But, on Jan. 15, the Swiss National Bank (SNB) suddenly and surprisingly abandoned the peg.

Obviously, exiting a real currency union is far more complex and legally fraught than ending a temporary exchange-rate arrangement; the effects of such a move would be greatly magnified. Nonetheless, the Swiss move reveals at least some of the uncertainties that a full-fledged exit could create.

The SNB was not forced to act by a speculative run. No financial crisis forced its hand, and, in theory, the SNB’s directorate could have held the exchange rate and bought foreign assets indefinitely. But domestic criticism of the SNB’s large buildup of exchange-rate reserves (euro assets) was mounting.

In particular, Swiss conservatives disliked the risk to which the SNB was exposed. Fearing that euro zone government bonds were unsafe, they agitated to require the SNB to acquire gold reserves instead, even forcing a referendum on the matter. Though the initiative to require a fixed share of gold reserves failed, the prospect of large-scale quantitative easing by the European Central Bank, together with the euro’s recent slide against the dollar, intensified the political pressure to abandon the peg.

Whereas economists have modeled financial attacks well, there has been little study of just when political pressure becomes unbearable and a central bank gives in. The SNB, for example, had proclaimed loyalty to the peg just days before ending it. As a result, markets will now hesitate to believe central banks’ statements about future policy, and forward guidance (a major post-crisis instrument) will be much more difficult.

There is historical precedent for the victory of political pressure, and for the recent Swiss action. In the late 1960s, the Bundesbank had to buy dollar assets in order to stop the Deutsche mark from rising, and to preserve the integrity of its fixed exchange rate. The discussion in Germany focused on the risks to the Bundesbank’s balance sheet, as well as on the inflationary pressures that came from the currency peg. Some German conservatives at the time would have liked to buy gold, but the Bundesbank had promised the Fed that it would not put the dollar under downward pressure by selling its reserves for gold.

In 1969, Germany unilaterally revalued the Deutsche mark. But that was not enough to stop inflows of foreign currency, and the Bundesbank was obliged to continue to intervene. It continued to reduce its interest rate, but the inflows persisted. In May 1971, the German government -- against the wishes of the Bundesbank -- abandoned the dollar peg altogether and floated the currency.

Politics had prevailed over central-bank commitments. Within three months, the fallout destroyed the entire international monetary system, and US President Richard Nixon took the dollar off the gold standard. The credibility of the entire system of central bank commitments had collapsed, and international monetary policy became extremely unstable. The Deutsche mark appreciated, and life became very hard for German exporters.

Today, the global ramifications of a major central bank’s actions are much more pronounced than in 1971. When the Bundesbank acted unilaterally, German banks were not very international. But now finance is global, implying large balance-sheet exposures to currency swings.

Big Swiss banks fund themselves in Swiss francs, because so many people everywhere want the security of franc assets. They then acquire assets worldwide, in other currencies. When the exchange rate changes abruptly, the banks face large losses -- a large-scale version of naive Hungarian homeowners’ strategy of borrowing in Swiss francs to finance their mortgages.

Though the SNB had given many warnings that the euro peg was not permanent, and though it had imposed a higher capital ratio on banks, the uncoupling from the euro came as a huge shock. Swiss bank shares fell faster than the general Swiss index.

The risks created by the SNB’s decision -- as transmitted through the financial system -- have a fat tail. The negative effects for the Swiss economy -- through the decreased competitiveness of its export industries (including tourism and medicine) -- may already be showing that abandoning the euro peg was not a good idea.

But the consequences will not be limited to Switzerland. After years of wondering whether the exit of a small, fiscally weak country like Greece could undermine the euro, policy makers will have to deal with an even bigger shock stemming from the exit of a small, fiscally strong country that is not even a member of the European Union.

Markus Brunnermeier is professor of Economics and director of the Bendheim Center for Finance at Princeton University. Harold James is professor of History and International Affairs at Princeton.

PROJECT SYNDICATE

4 IMPACTS


ECONOMIC UNCERTAINTY

The Swiss currency ambush compounds global economic uncertainty at a time when oil prices have more than halved to below $50 per barrel, copper prices have fallen to a five-year low and Russia’s ruble has lost some 55% of its value against the dollar since June due to the energy price shock and Western sanctions over Ukraine.

With major central banks all trying to steady markets by providing long-range guidance on monetary policy, it also raised questions about the SNB’s credibility.

SNB Chairman Thomas Jordan said last week the currency cap was “absolutely central” to maintaining the right monetary conditions. His deputy said on Monday the minimum exchange rate “must remain the cornerstone of our monetary policy.”

COSTLIER TOURISM

The cost of a holiday in Switzerland, already one of Europe’s most expensive ski destinations, just went through the roof in the middle of the busy winter sport season.

The global business and political elite, who gather for the annual World Economic Forum in the Alpine resort of Davos next week, will find the cost of hotels and entertainment sharply higher in dollars, euros or yen. They can afford it, but other visitors may cancel or curtail their trips, and foreign companies may reduce their presence.

Even before the franc’s surge, four Swiss cities -- Zurich, Geneva, Basel and Bern -- were among the 10 most expensive places in the world for expatriates to live and work, according to the 2014 Employment Conditions Abroad survey.

SAFE HAVEN NO MORE

Switzerland’s cherished reputation as a safe haven for foreign wealth may also take a hit from the currency turmoil. Holders of accounts in Swiss francs have made a massive paper gain that some may be tempted to cash in fast.

But coming on top of Swiss moves reluctantly to cooperate more with tax authorities in the United States, the European Union and other jurisdictions, the decision may have consequences for rich Russians and others who sought to park their money in seemingly stable Alpine vaults.

INDUSTRY LOSSES

Trademark Swiss exports that target the upper end of the world’s consumer markets, from watches to chocolate and cheese, just became significantly more expensive, and imports from the surrounding European Union substantially cheaper.

Swiss bank UBS estimated the direct cost to exporters will be equivalent to 0.7% of gross domestic product.

But the Swiss economy faces the shock from a position of strength. Unemployment was 3.4% in December -- among Europe’s lowest -- and the government last month forecast economic growth of 2.1% this year and 2.4% in 2016, after an estimated 1.8% in 2014. However, the blue-chip SMI share index fell by more than 8.6%, wiping $100 billion off the value of Swiss stocks, with watch manufacturer Swatch, luxury goods firm Richemont and cement-maker Holcim down 10 to 16% in the carnage.

Swatch Chief Executive Nick Hayek called the decision “a tsunami” for the Swiss economy. Businesses with most of their costs at home will be most exposed.

REUTERS