The Swiss National Bank shocked the financial world overnight by scrapping its cap on the franc, which pegged the currency at a minimum rate of 1.20 francs per euro. Market participants were sent scrambling, with the franc appreciating by 30 per cent within five minutes of the announcement.
At its peak throughout the day, the franc appreciated almost 40 per cent before moderating somewhat and ending the day just 18 per cent higher. The Swiss sharemarket responded by falling 8.7 per cent by the close of trade.
The SNB tried to mitigate the fallout by also lowering interest rates but that failed to gain much traction.
That the announcement came as a shock is an understatement. Consider this statement from SNB chairman Thomas Jordan in December after the bank’s monetary policy meeting.
Noting that the Swiss franc is still high, Jordan said: “We will therefore continue enforce the minimum exchange rate with the utmost determination. If necessary, we are prepared to buy foreign currency in unlimited quantities for this purpose.”
Just two days ago, Jordan told Swiss broadcaster RTS that “We’re convinced that the cap on the franc must remain the pillar of our monetary policy”.
The cap has existed as a cornerstone of Swiss monetary policy since September 2011. Concerned about the implications of a stronger franc on the broader economy -- market participants had begun to treat the Swiss as a safe haven during the sovereign debt crisis -- the SNB implemented controls to ensure that the currency did not rise above 1.20 francs per euro.
The SNB’s credibility was enhanced by its single-minded pursuit of that target. Since implementation, the Swiss currency had not exceeded that cap. However, with deflationary pressures plaguing the global economy and the European Central Bank set to pursue further quantitative easing, maintaining the cap would prove increasingly difficult.
Those factors have been in play for some time and certainly haven’t changed in the past couple of days. Sometimes policies remain sustainable until the very moment they aren’t, giving market watchers no forewarning that something is amiss.
It is also unclear why the bank decided to simply exit the currency market rather than pursue a more managed transition by increasing the cap incrementally until it was no longer required. A managed transition would have ensured a more orderly exit and certainly less financial market turbulence.
The economic implications of the SNB’s shock decision are staggering. Obviously there are winners and losers on the market side: some traders will go home today either elated or visibly ill.
However, the other effects on the Swiss economy will take a little longer to materialise. The biggest loser looks to be the Swiss export sector, with the eurozone accounting for around 40 per cent of total Swiss exports.
“Today’s SNB action is a tsunami for the export industry and for tourism, and finally for the entire country,” said Nick Hayek, chief executive of Swatch.
The response from the market underlies the challenge ahead for the Swiss economy. The reality is that the entire Swiss economy will be affected, with feedback loops flowing from the trade-exposed sector towards the non-tradables sector.
Currencies appreciate by this magnitude all the time without significant complications, but the transition usually takes years, not minutes. In normal circumstances, businesses have some opportunity to lower their costs or shift their production to account for a stronger currency.
Some Swiss businesses started the day on a competitive footing and finished the day wondering how they will survive. Jobs will be lost -- thousands of them -- although the composition of the Swiss economy will shift towards consumption as households take advantage of cheaper foreign goods coming out of Europe.
Firms which primarily import goods and services or inputs into their supply chain will be the big winners. Households who manage to keep their jobs will also do quite well out of a stronger currency.
But once we account for the total impact on domestic demand, including income flows from abroad and employment growth, it appears as though the Swiss economy is set for a pretty tough year.
The SNB is hopeful that the market turbulence is just temporary; it believed that the Swiss franc was overvalued prior to their announcement. If it is right, then markets will correct themselves over the next few weeks and months, there will collateral damage among market participants but otherwise the economy will be fine. However, if it is wrong, the Swiss economy may be crippled, dragged lower by deflation and with limited monetary tools at their disposal.
The whole situation highlights the challenges ahead for central banks in both advanced and emerging economies. Years of extraordinary monetary policy has supported the global recovery but also created significant and unfortunate spillovers.
Unfortunately, every country cannot have a low currency and the Swiss economy appears set to become collateral damage in the ECB’s pursuit of growth.