Painted into a Corner

On January 15th, the Swiss National Bank (SNB) stopped defending its currency peg of Swiss franc (CHF) 1.20 to the euro (EUR).  It also imposed a -0.75% overnight rate and moved its target for 3 month libor to -1.25% to -0.25% from -0.75% to +0.25%. Within minutes of the announcement, the CHF rose 41% at the extreme.  It closed that day up 23%.

The short answer as to why they unpegged is that it was becoming too costly, that the SNB was unwilling to pile up more reserves in the face of potential QE from the ECB and that the franc’s fall against the US dollar, among others, left it less overvalued than it had been. The SNB had good intentions when it pegged the EURCHF to the 1.20 level, but they painted themselves into a corner with the peg. There was no easy way out and it is probably best that they pulled the plug now rather than letting their reserves continue to climb.

There is another story that is just as interesting, the lack of risk management that has led to large losses and bankruptcies across the world’s financial sector as a result of the franc’s free float. That story is for another time.

EURCHF 09-15

When the financial crisis erupted the CHF had been depreciating against the EUR for about 6 years.  It had fallen roughly 14%, a negligible amount over that time frame. CHF reversed that depreciation from late 2007 to the end of 2009; safe haven currencies like it did well during the global financial crisis. Then the fun began.  Swissie rallied over 35% between the end of 2009 and late summer 2011 when the SNB pegged it.

Why did they peg it?  Capital began flowing into Switzerland from the inception of the Eurozone crisis in late 2009. That is the first spike in the chart of Swiss FX reserves. The flow was relentless. It was the result of panic. It had nothing to do with Swiss fundamentals. The unwanted appreciation emanating from the flows made Swiss exports uncompetitive.  The SNB intervened. The CHF continued to appreciate and the SNB lost money due to the intervention. This aroused the ire of the cantons (Swiss states). The cantons get 2/3s of the SNB’s profit and the Swiss Federal government gets the balance.

The exporters may have been happy but, the cantons were not amused.  Flows spiked again in 2011. They intervened massively and pegged the CHF versus the EUR. That maintained a cheaper exchange rate while postponing losses until another day. Post peg, reserve accumulation slowed for a time.

The euro crisis re-erupted in 2012 and progressed to the point where the markets believed the EUR was on the verge of breaking up. That is the last large spike in the reserve chart. Markets calmed down in July 2012 when Mario Draghi of the ECB stated: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. Reserve flows moderated from that time on.


Both before and after pegging CHF, the SNB intervened in the FX markets, buying EUR while selling CHF.  Before the peg, the SNB lost money on its growing reserves as the EUR depreciated.  It tried to mitigate the damage by diversifying.  The SNB increased its holdings of British pounds, USD and other currencies as it intervened.  We know this because the SNB is kind enough to disclose the composition of its reserves, belying the country’s reputation for secrecy. See the table below. Part of the movement was undoubtedly due to valuation changes as the EUR underperformed, but I suspect that some of it was purposefully done.

SNB reserve pcts

Another, not so minor, detail is that FX reserves had soared from 8% of GDP in 2008 to 74% of GDP as of June 2014 and, given the 8% growth in reserves from June to December 2014, the ratio is probably above 80% today.  China, famous for holding almost $4 trillion in FX reserves, is a piker compared to the Swiss in GDP terms.  It holds less than 40% of its GDP in reserves.

CH reserves2GDP

The Swiss have a problem. It’s a mark to market problem that probably runs through the SNB’s balance sheet, not its income statement at least not in the short run. It is, however, a time bomb. Luckily, central banks are not marked to market and, thus, can ride out a big balance sheet hit indefinitely.  However, there is a difference between can and should.  The SNB has decided that it should draw that line.

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