Switzerland ties itself to euro mast

http://blogs.reuters.com/james-saft/2011/09/08/switzerland-ties-itself-to-euro-mast/

Comment by Adamantine:

This is an excellent article which makes it understandable just what the nations of the world are doing to deal with the crisis in currencies.

Switzerland ties itself to euro mast
Sep 8, 2011 16:44 EDT

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ECB | euro zone | switzerland
James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. – It is clear we are living in a strange world when Switzerland, that most euro-skeptic of nations, has tied its fortunes to the success, in its current fragile form, of the euro zone common currency.

The Swiss National Bank on Tuesday shocked the markets when it announced it was imposing, unilaterally and with immediate effect, a cap on the value of its currency against the euro, seeking to shield its economic competitiveness from the massive flows seeking safe haven amid doubts over the euro zone.

This amounts to an extreme expression of confidence in the euro zone’s ability to sort itself out, because if it cannot this policy will fail expensively. It may even fail if the euro does not but if worries about it generate enough of a flow of cash that the SNB turns and flees.

“The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development,” the central bank said in a statement.

Saying it would “no longer tolerate” a value of its franc below 1.20 to the euro, the SNB said it “will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.”

That’s right, the Swiss will print unlimited amounts of their own currency, exchangeable for chocolate or whatever you please, and with that money will buy euros.

It thereby hopes to win respite for its exporters, though it is doing so by almost deliberately seeking to ruin its own reputation for sensible economic management, a bit like an unpopular but hard-working high schooler who, looking around him, decides that the way to improve his social life is to fail a few classes. “Safe haven? We’ll show them how safe we are,” you can almost hear the stolid burghers of the SNB say.

The thing is that Switzerland can print all the francs it likes, but after having forked them over it must do something with the euros it gets in return. Almost no matter what it does, it either creates euro zone disintegration risk for itself, or actually increases the risk of the euro zone disintegrating.

Let’s say it decides to take the money and buy Italian and Spanish government bonds. That certainly would be helpful for those countries, and also ease the job of keeping the euro zone together. Well and good, but even though the SNB managed to lose more than $40 billion intervening in currency markets last year, we might not be talking enough money to solve those countries’ issues. If one or another of those countries leaves the euro, or remain in the euro while the good credits leave, the value of the SNB’s reserves will take a massive hit.

VOLUNTEERING FOR FIRING SQUAD PRACTICE

And I ask you: if things take a turn for the worse in the euro zone and breakup risk rises what are you going to do? Perhaps, just perhaps, you’ll take some of your euros and trot along to the central bank which has offered you relatively safe Swiss francs in exchange at a fixed rate, and in unlimited amounts, no less. Talk about volunteering for firing squad practice.

Conversely, if the SNB invests its euros in German and French bonds, as some speculative reports have indicated, it will only drive interest rates in core Europe lower, increasing the troublesome gap between “safe” euro zone rates and riskier peripheral ones. That’s a risky move: most widenings between these bond yields in the past year have been interpreted as indicators of increasing breakup risk. If the Swiss buy German bonds, other investors may pile on by selling Italian ones. The SNB is making the job of the ECB that much harder.

To be fair, Switzerland faces two real risks, first that its industrial base melts as its currency strengthens, and second the risk of deflation. This currency intervention is really a form of quantitative easing, though one in which Switzerland has outsourced the decision making about how much to do to the market.

The policy has worked well so far. The euro has strengthened by almost 9 percent against the franc since the announcement. The test though is not how it works when the policy is new and a surprise, but how well it works when other surprises, ugly ones, come out of the euro zone.

Europe’s problems are a tremendously deflationary force, sending waves of falling prices out around the world. Switzerland has turned its share of that deflation into event risk, avoiding the full price now but potentially paying much more later.

Expect others to follow suit shortly and do what they can to weaken their currencies, starting perhaps with the Federal Reserve at its upcoming monetary policy meeting.

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