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Analysis

In defence of the Swiss National Bank

by David Marsh and William Baunton

Thu 12 Feb 2015

In defence of the Swiss National Bank Enlarge Chart loading Image

The Swiss National Bank’s peg of SFr1.20 to the euro, implemented in September 2011 to protect the currency from export-threatening appreciation, shuddered to an abrupt halt last month, causing financial market waves. The unexpected move exposed the SNB to considerable criticism, partly on the decidedly risible grounds that the central bank had given the markets no warning of the impending change.

In fact, the bank’s decision was correct, if not overdue. Thomas Jordan, the SNB president, deserves plaudits, not brickbats, for bringing to an end an exchange rate distortion that was exacerbating further large-scale economic imbalances in Europe.

Defending the peg, forcing the SNB to take in massive quantities of the European single currency, was a fight the SNB could not win. A balance sheet burdened by too many depreciating euros, at a time of general European uncertainty and impending quantitative easing by the European Central Bank, would have stretched the SNB too far.

The unpegging sparked a 20% one-day Swiss franc rise against the euro – an indication of what would happen if the German currency ever suffered its own demerger from the euro. Once again, repeating the circumstances which led to the peg, Switzerland is seen as a safe haven.

In the 2011 bid to protect Swiss exporters, the SNB bought swathes of euros with newly created francs. Its total assets swelled from 40% of GDP in 2011 to 85% of GDP in 2012, a level at which it has remained. Total assets were just 20% of GDP in 2008. By comparison, the Federal Reserve, Bank of England and ECB have balance sheets of around 25% of GDP. During the last few years of balance sheet expansion, none of their ratios exceeded 30% of GDP. The Bank of Japan’s balance sheet, following prolonged QE, stands at just over 50% of GDP.

In OMFIF’s 2014 ranking of Global Public Investors, the SNB ranks No.10 in the world – an astonishing position for an institution widely regarded as one of the most conservative central banks.

A 30% drop in the gold price impaired the value of the SNB’s reserves in 2013, causing the SNB to cancel its dividend for the year. For 2014, with the franc falling against the dollar and stable against the euro, the SNB expects to record a profit of SFr38bn, SFr34bn of which is due to foreign currency positions. SNB’s gold holdings recorded a gain of SFr4bn, resulting from gold rising 10% in Swiss franc terms.

By mid-January, the SNB had renewed cause for concern, leading to the currency decision on 15 January. The subsequent fall of the euro has hurt the SNB’s balance sheet. With substantial holdings of euros (46% of foreign currency investments) and dollars (29%), as well as yen (8%), pounds (7%) and Canadian dollars (4%), the sudden appreciation left the SNB with the need for substantial valuation write-downs.

If the peg had continued, the SNB would have maintained its buying spree. In the fourth quarter of 2014 it purchased over €20bn in euro-denominated assets, bringing the total to €197bn at year-end. Further buying would probably have brought the bank’s assets to more than 100% of GDP, clearly detrimental to financial stability.

Now, the SNB faces fresh problems. The franc’s appreciation coupled with low oil prices is intensifying deflationary pressures. Expectations of inflation were already zero before the peg abandonment. Economic growth will fall, with exporters harmed (around half of their exports go to the euro area) and business confidence hit. The stock market has dived and not recovered.

With a current account surplus of 13% of GDP and specialisation in high value-added manufacturing exports with moderate price sensitivity, Switzerland is in a good position to weather the shocks. Separation from the euro bloc was the best way of riding out the storm.