Sunday, January 25, 2015

25/1/15: Swiss Out, Danes In: Pegs and Euro Mess

My comment from earlier this week on SNB and Denmark's Nationalbank pegs decisions (Expresso, January 24, 2015 page 09):

There are two truths about currency pegs.

The first one is that no Central Bank is an island. In other words, all pegs are temporary in their duration and costly in their nature, while held.

The second one is that exiting a peg with underlying conditions similar to those when the peg was set in the first place can never be a smooth and risk-free decision. Disruptive nature of such an exit is only highlighted by the necessity of the peg in the first place.

Swiss CHF to Euro peg is emblematic of the above two facts. The peg, de facto maintained from the summer 2011 (but officially launched on September 6, 2011) at the height of the euro area crisis, was designed to remove pressures on the Swiss Franc arising from the rapid acceleration of capital inflows from the euro area to Switzerland. The resulting inflows pushed values of CHF well beyond the sustainable bounds, threatening to derail the Swiss economy, heavily dependent (especially in 2011) on exports.

The cost of the SNB peg to the Swiss economy was manageable, but accelerating in recent months. As part of the peg, SNB printed CHF to purchase surplus euros. Bought euros were accumulated on the SNB balance sheet. recent devaluation of the euro against the US dollar, and expected future devalutations of the euro (on foot of upcoming ECB QE measures) pushes down the real value of these forex reserves accumulated by the SNB. Exiting the peg simply realigned these values to actual currency fundamentals and crystallised the loss in one go, de facto partially sterilising the inflows.

Chart below illustrates accumulation of Forex reserves by SNB from the peg introduction on September 6, 2011.

The disruption caused by the SNB exiting the peg has been significant. Some 46 percent of all Polish mortgages have been issued in CHF. Hundreds of thousands of loans in other Eastern European countries were tied to CHF as well. The cost of funding these loans rose by between 15 and 20 percent overnight, causing some panicked reactions from some Eastern European Central Banks. Beyond this, home-felt impact of SNB move has been less pronounced in the short run. However. in the longer term, stronger Swiss Franc is going to put severe pressure on Swiss exports and will likely result in deterioration in the overall balance of payments. Swiss economy is still heavily reliant on Forex valuations to support its global trade. Current world trade conditions - with the likes of Baltic Dry Index at 753,000 close to crisis period lows, and IMF projections for ever lower rates of global trade growth in 2015-2016 - all signalling serious pressures on Swiss exporters.

Denmark's decision to introduce a Krone/Euro peg this week is likely to fare about as well as that of the Swiss decision in 2011. Just as the Swiss, Danish regulators also set negative deposit rates to further reduce pressure on Krone from Euro inflows. However, the pressure on the Krone is rising not due to the crisis-related capital flight (as was the case with Switzerland in 2011-2013), but due to currency hedging in anticipation of the ECB quantitative easing move expected to be announced this week.

Danish peg is critically different from the SNB previous attempt to peg CHF. The reason for this is that Krone has a long-term link to the Euro and in effect current peg is simply a form of repricing this link. And, unlike CHF (which accounts for roughly 5.2 percent of global currency trading volumes), Krone is a relative minnow in the forex markets (its share of the global currency trade is only 0.8 percent).

The two factors make Krone peg more credible and less costly to defend over the medium term. But none of these factors help to alleviate the problem of currency valuations for Danish exporters, who will see their markets for exports more contested now that the Krone is appreciating against the Euro.

The reserves dynamics preceding the Denmark's peg introduction and the SNB peg announcement in September 2011 are similar: both currencies have sustained heavy 'buy' pressures and both pressures were driven by the crises in the euro area. SNB introduced the peg at relatively benign levels of forex reserves accumulation back in 2011 which, at the time, were nonetheless consistent with crisis-period peak levels. Denmark's Nationalbank's peg introduction also takes place close to crisis period peak of reserves accumulation and the question to be asked is: how much pain on DKK can Denmark take in this environment. 

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