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. 

12/09/2011: CHF and the "soon-to-be-busted" peg

Some weeks ago I have addressed one of the core reasons why the CHF/Euro peg, announced last week by the SNB will not hold for longer than 1-2 months. Here are the previous links to:

1. Small Open Economy argument (link)
   
2. Small Open Economy as safe haven argument (link)

Since then, in last weekend comment to the Sunday Times, I outlined another core reason for the peg to fail - the SNB has been brandishing the war chest of some USD 230 billion of FX funds that it says will be delivered into the battle field to support CHF, should pressures on CHF/Euro cross continue to mount. Now, that number above is roughly 1/2 of the Swiss 2010 end-of-year M1 money supply.

• Imagine the scale of intervention and the resulting interest rates hikes that will be required to extinguish inflationary pressures arising from this?Up by 50-100%?
• Now imagine what will happen with CHF cross with the euro if the interest rates in Switzerland were to, say, rise by 50-100%? Correct - demand for CHF will go through the roof, undoing any CHF/euro supports erected before.
• And alongside this, imagine what the 50-100% increase in interest rates do to capital investment and corporate balancesheets in Switzerland? Again correct - corporates, spared by SNB peg from being destroyed by the exchange rate appreciation will now face the very same FX pressures as before, plus higher cost of capital

And now, folks, for the third weighty reason why SNB will be forced to abandon its peg. Medium-term promise of a devalued CHF coupled with zero interest rates (0-0.25% on 3mo Libor target against Euribor 1.56% comp) implies a huge incentive for carry trades origination in very short term run, while in the medium-term, expected long-term revaluation of the CHF creates an incentive to make carry trades very short-lived. Both are not so much the forces to drive demand up, but the forces to destabilize fundamentals-determined medium-term FX rates.

Good luck betting that CHF peg holds, my friends...

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.

04/08/2011: Safe Haven within a small open economy

Some interesting news flow on the Swiss Franc side today with the Swiss National Bank announcing that it will intervene in the markets across not just one instrument, but three, simultaneously. CHF had seen dramatic appreciation against the Euro and the USD in recent months (see charts below), with current valuations of CHF, according to SNB: "threatening the development of the economy and increasing the downside risks to price stability in Switzerland."

In line with this, SNB announced that it will (1) move target 3-mo Libor rates closer to the range of between 0% and 0.25%, down from the current range of 0% to 0.75%, (2) will "very significantly increase" the supply of CHF, and (3) will hike required deposits for Swiss banks from CHF30 billion to CHF80 billion.

Funny thing, folks, shortly after the announcement, CHF fell against the Euro by 1.8% to CHF1.1061/Euro, and against the dollar +1.4% to CHF0.7761/USD. Yet, with the latest rumors from the US - about QE3 - the USD promptly fell back against the CHF to 0.7701/USD and erased most of the euro gains to CHF1.1054/Euro.

The problem, of course, is that for all the firepower deployed, SNB has little power to shift the prevalent investor sentiment that, at the time of expected QE3 and continued uncertainty about the Euro area sovereigns, CHF - alongside other small currencies - represents, in the minds of investors, a safe haven. This, of course, is the dilemma of the Swiss franc - a safe haven within an small and open economy: too well-run to join the basket cases across its borders, too small to defend...

And so to end with some good background on what's going on with CHF recently - read this.