9
$\begingroup$

There are many theories about why the Swiss National Bank (SNB) abandoned its currency peg a few days ago.

My question is more specific: why did they make the change so sudden? Why not reduce the peg to 1.19 (Francs needed to buy one Euro) one month, 1.18 the next month, and so on, until a reasonable balance is found, taking into account all of the factors that the bank would want to consider in targeting an exchange rate?

Disambiguation update: Some of the commentary/responses below maybe should be directed at the following related questions:

  1. Why did some call maintaining the peg "expensive"?
  2. Why did the SNB decide to end the currency peg?
$\endgroup$
4
$\begingroup$

Just to synthesize the other two answers together a bit and "join-the-dots".

Setting the Scene

Since 2011 SNB had decided that it wanted to prevent the CHF from strengthening past 1.2 CHF per EUR. In order to do this it had to do either or both of:

  • Discourage people from buying CHF. One way to try do this is to keep rates low.
  • Sell CHF by the bucket load.

Keeping rates low at the short end is easy enough - that's the base rate. But that was scuppered by the low EUR short rates. Keeping rates low at the long end is trickier, but can be done by not issuing too many bonds.

Selling CHF is fine, but that means buying other currencies. By the end of December the SNB had bought 85% of GDP worth of foreign currencies.

At this point the SNB decided that it did not want to keep expanding the balance sheet. Why it decided this is a different question (as the question points out). The question is how to end a cap once you hold a huge Euro position.

The Sudden Act

Once the SNB had decided it could not defend the cap, it had three ways it could act.

  • Stop supporting the cap, but not tell anyone
  • Tell people at the same time that it stops supporting the cap
  • Tell people before it stops supporting the cap (or as in your example, schedule a reducing cap).

The third case would have almost certainly bankrupted the SNB. If they had, as you suggest, let everyone know in advance what was going to happen, then everyone in the world would just arbitrage the situation into the ground. Everyone would just buy CHF from the SNB at the cheap rate while they support the cap, and sell as soon as the cap is dropped.

The first case is a little dishonest, and would almost certainly get found out (the worst kind of dishonesty!). As soon as they stopped supporting the cap, the FX rate would drift slowly down from 1.2. Once people realised that this was not "supposed to happen" and therefore the SNB must have stopped defending it, then it would probably snap anyway. There are two dubious plus sides to this approach I see though

  1. The SNB could have started offloading some of its 85% holdings before the market realised. This is called front running and market abuse, and would land a stock trader in jail, but for a central bank trading FX, it would not technically come under any legal challenge (at the moment...).
  2. The reputational damage to the SNB would be huge, which would go some way to undermine investment in the country, causing a weakening in the CHF!

As you can see this would be a rather dubious strategy, but I have often wondered if Thomas Jordan (chairman of SNB) could simply address the world with underpants on his head and his willy hanging out as a way to depress the CHF.

The strategy they opted for was the "ripping off a bandaid" style. The sudden shock is estimated to have cost the SNB about 13% of GDP due to all those foreign holdings. Since the SNB made a massive profit in 2014 (see: http://www.bloomberg.com/news/2015-01-09/snb-sees-2014-profit-of-38-billion-francs-resumes-dividend.html) it probably saw this as an opportunity to get out before things got any worse. Hold out longer and have 100+% GDP in foreign currency, and the bank might not have survived the jolt itself.

$\endgroup$
  • 1
    $\begingroup$ Can you elaborate on "The SNB didn't have unlimited supply of funds to fight this." It seems like all the difficult parts of answering this question are buried in this part of the answer. As the monetary authority of Switzerland they would seem to literally have an unlimited supply of Swiss francs to sell if they so desired. On the other hand, if they don't want to, why didn't they want to? And why did they decided they didn't want to so suddenly? $\endgroup$ – BKay Jan 19 '15 at 14:47
  • $\begingroup$ @BKay, regarding the "unlimited" issue, that's exactly what I'm wondering, and it's a new topic, so I might be posting separate questions shortly. $\endgroup$ – zkurtz Jan 19 '15 at 14:59
  • $\begingroup$ @BKay This related answer might help: economics.stackexchange.com/a/3071/119 $\endgroup$ – Corone Jan 19 '15 at 15:24
  • $\begingroup$ @BKay basically, although a central bank could in theory keep making more and more money expanding the size of its balance sheet (this is called quantitative easing...), eventually you would either destroy the bank or the currency. While the SNB were looking for a weakened CHF, they only want moderate weakness, not hyperinflation! In order to keep the cap they'd almost have to match pace with Eurozone QE, and the ECB is a lot bigger than the SNB $\endgroup$ – Corone Jan 19 '15 at 15:26
  • $\begingroup$ While monetization of government spending is known to be the notable cause of hyperinflation, this monetary expansion is sterilized so that seems unlikely here. After all, both sides of the SNB balance sheet are expanding here while in the monetization only the liabilities are expanding, so why would there be any risk of destroying the currency. $\endgroup$ – BKay Jan 19 '15 at 15:43
2
$\begingroup$

The main reason is that the next week the ECB will, with all the probabilities, expand again the money supply inside the EU area. This operation will devaluate the european currency forcing the SNB to carry on buying more euros to preserve the 1.20 exchange rate (take in consideration that they now hold something like 300 billions euro in their foreign currency reserve).

This operation was becoming costly and dangerous. The Swiss Francs introduced into the market as a result of the purchase of euros were going directly in the housing market as a matter of speculation creating in this way an high risk of a new real estate bubble. No one wants this, and no one wants to hold a very high and increasing quantity of a useless and almost dead currency in their reserves.

A risky move that will cause a drop in exports in the middle term and a worsening in the trade balance, but I'm confident in the SNB's move.

$\endgroup$
  • $\begingroup$ Very interesting points, but I'm missing how any of this specifically addresses the suddenness of the move. $\endgroup$ – zkurtz Jan 18 '15 at 21:36
  • $\begingroup$ Is there evidence from minutes or press releases for this position? Because if the currency peg was causing significant inflationary pressures it seems hard to see in the data. Swiss inflation hasn't be regularly positive in a couple of years. $\endgroup$ – BKay Jan 19 '15 at 11:45
  • $\begingroup$ @BKay Yeah, you are correct, but I think you are considering the CPI. According to UBS, the UBS property market index has seen a surge in the last months because of the expansive monetary policy: businessweek.com/news/2014-11-04/…. $\endgroup$ – ChicagoCubs Jan 19 '15 at 12:54
-2
$\begingroup$

An unpredictable player usually holds the advantage of being unpredictable when all other players are reasonably predictable. Most central banks are predictable. Now the move last week was as unpredictable as it can be precisely because it has been so sudden.

$\endgroup$
  • $\begingroup$ My other research is consistent with what you are saying; the goal of suddenness could be to maintain unpredictability. Then of course the question becomes why (in this particular operation) is unpredictability desirable? $\endgroup$ – zkurtz Jan 18 '15 at 21:38
  • $\begingroup$ Being unpredictable should help fend off excessive speculation and capital inflow. Nobody can really be sure that the SNB will not suddenly reinstate the peg. If you know the other player will shoot how hard would you fight? $\endgroup$ – RndmSymbl Jan 18 '15 at 21:48
  • $\begingroup$ It´s a little simpler than that. Anybody who knew the day the currency peg was coming off stood to make a fairly large fortune on currency speculation. $\endgroup$ – Lumi Jan 19 '15 at 1:53
  • 1
    $\begingroup$ @Lumi, yes, that's the Soros move. But I still need help connecting the dots between this observation and the observed bank policy. (a) How do the Swiss lose out when someone makes a fortune like that and (b) how is this any better/worse than the 'random' winners and losers that are sure to be created with a random jump in exchange rate? $\endgroup$ – zkurtz Jan 19 '15 at 2:39
  • $\begingroup$ Its exactly the opposite: Since central started being predictable (commitment era), they managed much more (through their newly gained credibility) to control interest rates and inflation. Being unpredictable (in general) is something that central banks tried not to be. The question remains why they wanted to be unpredictable in this very special case, where I agree with @Corone's answer. $\endgroup$ – FooBar Jan 19 '15 at 13:05

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.