Switzerland is considered a stable, conservative country that is beautiful, but sometimes a bit boring. The preference of its policy makers and the public for safety, order and predictability has made the country a haven in many respects, not least as an economic bolt hole where investors and savers can go to safeguard their savings and their investments. The swiss franc is one of the world’s reserve currencies.
Switzerland was anything but boring or predictable last week, when the Swiss National Bank (SNB, the country’s central bank) abandoned its efforts to cap the rise in the value of the franc, and let the currency adjust to market levels. That decision prompted an immediate 20 percent rise in the value of the franc, a historic adjustment for any reserve currency, and triggered turmoil in international markets. The surprise move will have important repercussions for Switzerland, Europe and the global economy. None of them are especially good.
The SNB decided to try to stop the franc’s appreciation in September 2011 as the euro zone experienced one of its periodic economic crises, pledging to print money to buy “unlimited quantities” of foreign currency. The announced target was a value of 1.20 francs to the euro, a level that would allow Swiss companies to remain competitive with their European counterparts. Unfortunately, the global economy has not strengthened since that time, and as a result, by keeping its word the SNB has acquired vast quantities of foreign currencies — by one estimate, an amount equal to 75 percent of GDP — that continue to lose value, exposing the bank to potentially huge losses.
The decision to abandon the currency market intervention released three and half years of built-up pressure and the franc increased in value by 20 percent, rising to parity with the European currency — one franc being worth one euro — and reaching $1.15 against the dollar.
Swiss companies howled. Larger companies that can move production elsewhere should be able to avoid the impact of skyrocketing franc. Small- and medium-size companies, which account for 20 percent of Swiss exports and employ 2.3 million of the country’s 8 million people, will be hammered. Switzerland’s most famous industry, watchmaking, will be especially hard hit as legislation passed in 2013 requires 60 percent of the value of products to be manufactured in the country to carry the label “Swiss made.” One analyst reckons the SNB decision increased the cost of Swiss products by 10 to 40 percent. The Swiss Textiles industry group called the franc’s appreciation “an existential threat.” For a railroad company that exports most of its products, the SNB decision was “shock therapy.”
The rising value of the franc will offer consumers some relief, as prices of imported goods will decrease. But the danger for Switzerland, like many if not most developed economies, is now of deflation. Prices fell 0.3 percent from the previous year in December. Unfortunately, while stable prices are good, falling prices over an extended period of time are dangerous, as Japan knows well. Deflation is a downward spiral and can trap economies. The spread of deflation throughout developing economies now looks like a danger as real as the 2008-9 global economic crisis. With its decision to stop defending the franc, the SNB appears to have given up the fight.
The decision also badly hurt traders and financial institutions who bet against the franc. Several banks were reported to have taken hundreds of millions of dollars in losses and two brokerage firms that trade currencies announced large losses that will force them to close; others are under pressure.
Finally, the move has profound implications for the international financial system. First, the snap decision badly dents the credibility and reputation of the SNB. Central bankers are conservative, predictable people who do not do the surprising — or at least, not without a better sense of the ramifications of their actions. The consensus view is that last week’s decision did not take into account the potential downsides. (The increase in negative interest rates on certain bank holdings was intended to dampen enthusiasm for acquiring francs, but that did not work.)
There is also a fear that the move will make markets more skeptical that any central banker has the stomach for long-term unconventional strategies, which is exactly what is required if the world is entering a period of sustained deflationary pressures — an unprecedented situation.
The biggest question now is how the European Central Bank will respond. Europe is facing the very real danger of a deflationary spiral, yet the bank seems more focused on inflation, the traditional German concern. Because of high deficits, European governments are not ready to — and many cannot — increase budgets to stimulate demand and counter deflationary pressure. That means it is up to the ECB to devise ways to pump money into the euro economy and some form of quantitative easing, perhaps a bond buying program, looks increasingly likely at the ECB’s Jan. 22 meeting. That could trigger a further fall in the euro, however, which is good for European businesses, but tough on its competitors. Switzerland’s troubles are not over.