13/08/2011: The Swiss Franc dilemma

If you are wondering why Swiss Central Bankers are growing increasingly alarmed at the precipitous rise of the Swiss Franc, consider the following charts based on the real effective exchange rate (REER).

Take first a look at the historical relationship between the Swiss REER and the peer rates:
According to chart above, which is based on the data from the Bank for International Settlements and takes us through June 2011, Euro area REER stood at 106.49 in June 2011, up from 101.53 in January and from 100.83 in June 2010. Euro area REER index was at 105.96 in January 2010. In contrast, Swiss REER stood at 122.60 in June 2011, up from 115.36 in January 2011, 106.80 in June 2010 and 104.9 in January 2010. That means since January 2010, Swiss REER index rose 16.87% while Euro index rose just 0.5%.
Using historical (1965-present) time trends, Swiss REER should be at 109.95 in June 2011 against the actual 122.60 level - an over-valuation on trend of 11.51%. At the same time, Euro REER should be at 99.95 against 106.49 actually posted in June 2011 - an overvaluation of 6.54% on long-term trend. Again, the problem is in the Swiss side of the court.

Taking a shorter horizon look: from 2000-present - Swiss REER should be currently around 104.12 - implying an overvaluation of 17.75%, while the Euro should be at 112.32, implying Euro undervaluation of 5.19%. Hence, Swiss problem is even greater over more recent period of time. In reality, trends since 2000 clearly show that Swiss franc should be competitive vis-a-vis the Euro. And of course, it's strength means it is not.

Next, consider the gap between the euro and the other REERs for the countries in direct competition with Switzerland for trade and investment. Charts below summarize historical trends:
In some periods in the past, countries above acted as 'safe havens' for Euro area tribulations. Let's take a look at where these countries stand today compared to Euro REER:

• Australia's REER is now at a premium of 23.15% on the Euro, down from January 2011 premium of 26.12%. Australia did not act as a safety zone vis-a-vis the Euro in the 1990-2006, but started acting as a safe haven since 2006 and currently leads the pack of safe havens in terms of absolute premium on the Euro REER.
  
• Canada REER stands at 10.41% premium on the Euro REER and this premium has declined from 15.31 in January 2011, but is up on January 2010 premium of 0.36%. Canada acted as strong safe haven against the Euro in the recession of the early 1990s, low range safe haven in the slowdown of 2001-2002 and a decent safe haven against Euro performance in 2006-2008. It is now the 4th strongest safe haven for the Euro since June 2011 and amongst top four safe havens since 2010.
• Hong Kong is a historically strong safe haven for the Euro, but is currently at a discount on the Euro REER of 17.63% - the discount that has been growing in size since June 2010 when it stood at 3.27%, although the change is marginal on the discount of 15.96% back in January 2010. Hence, Hong Kong is not a safe haven for the Euro at this point in time.
• Japan is a weak safe haven for the Euro REER today with a premium of 3.64%, down from a stronger premia in January 2011 (+10.86%), June 2010 (9.81%), but up on the discount of 5.87% in January 2010.
• Korea's REER index is currently at 17.00% discount on Euro's index and the discount is consistently high since January 2010 when it stood at 21.23%. Korea acted as a strong safe haven for the Euro in all periods since mid 1990, although it was relatively weak in the early 1990s recession.
• New Zealand currently has REER at a 5.59% discount on the Euro REER index, but the discount was much weaker at 1.69% in January 2011 and is now down from the high discount of 13.55% in January 2010. New Zealand is not a safe haven for the Euro historically since 1965.
• Norway, despite being a perceived as a safe have for nominal bilateral exchange rate is not a safe haven for the Euro in terms of REER. It's discount on Euro REER of 4.85% in January 2010 moved to a premium of 3.90% in June 2010 which remained at a premium of 3.33% in January 2011. Currently, it is back at a discount, albeit shallow, of 1.23%. Norway did act as a safe haven,even a strong safe haven, in the past episodes of Euro area instability, so the current departure from this pattern can be temporary.
• Singapore is now at 19.43% premium on the Euro REER index and this premium is consistent since June 2010 when it stood at 21.15%, although January 2010 reading for the premium was just 4.45%. Singapore is now the second strongest safe haven for the Euro area REER movements after Australia.
• Switzerland is now one of the top 4 strongest safe havens for the Euro with the premium of 15.13% on Euro REER. More importantly, it is the second best safe haven over the period of 1990-present after Singapore and the same is true for the broader range of periods, from the 1980s through today.
• Both the UK (discount of 22.86% today, and 25.45% in January 2010) and the US (discount of 16.51% today and 14.83% in January 2010) fail to act as safe havens for the Euro REER in the current crisis, although in previous periods between 1965 and 2007 they did act as safe havens against the Euro REER.

Chart summarizing current safe havens vis-a-vis Euro REER index:
Lastly, equally important is the factor of risk / volatility. As the two charts below clearly show, Switzerland is not only one of the strongest 4 safe havens in the world when it comes to hedging REER risk on the Euro area, it is also one of the historically less volatile (since 1990s - second in quality only to Singapore and least volatile since 1965). In fact, since about 1982 on it is less volatile than Euro area as a whole.
This, therefore, is the dilemma faced by the Swiss Central Bank today: debase the currency in terms of its value (less controversial, though still hard to attain for a small open economy - see a post on this here), plus debase the stability of the CHF (an even harder and more painful thing to achieve), or continue experiencing deteriorating competitiveness on exports side.