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Central banks and exchange rates
How should we interpret the recent decision by the Swiss National Bank to abandon the floor of 1.20 Swiss francs to the euro that it had enforced since 2011? The decision caught the market by surprise and triggered a sharp adjustment in the exchange rate. Financial history is dotted with central bank attempts to peg exchange rates that have ended in failure. Under which conditions can a central bank maintain the value of its currency at a given level? There is an important distinction between a policy that seeks to keep the currency weak and one that aims to keep the currency strong.
Keeping the currency weak
The Swiss National Bank's interventions since 2011 sought to maintain a CHF/EUR floor of 1.20. This type of intervention seeks to prevent the national currency from becoming too expensive and to enable the export sector to remain competitive on the world market. The SNB therefore intervened regularly in the currency market by selling Swiss francs and buying foreign currency. Indeed selling one's own currency tends to push its market price down, in other words to lower its value in terms of foreign currency. Over the months, the SNB thus accumulated substantial foreign currency reserves (see chart). In December, these totalled CHF 495 billion, which represents around 80% of Swiss GDP. Again with the aim to prevent currency appreciation, the central bank cut its deposit rate to -0.75%.
Sources: Macrobond, BGL BNP Paribas
It is important to remember that the market cannot force a central bank to abandon this type of intervention. This is because the central bank controls its own currency: it can always “print” more money in order to buy foreign currency. This is the fundamental difference between this type of intervention and the second type, described below. This explains in part why the market was surprised by the SNB's announcement on 15 January that it was abandoning the floor, and why there was such a sharp adjustment in the exchange rate following the announcement (see chart). On the chart, a lower exchange rate means a more expensive Swiss franc (you need fewer Swiss francs to buy euros).
Why did Switzerland's central bank decide to abandon the currency peg? Part of the answer may have been the expectation that the European Central Bank would start its Quantitative Easing programme and that this would increase the upward pressure on the Swiss franc in the months ahead. Maintaining the floor under those conditions would therefore require larger and larger interventions and entail bigger and bigger foreign currency reserves. This could have raised questions about the central bank's capital. The SNB has capital of around CHF 75 billion. A 15% loss on reserves of CHF 500 billion (roughly the adjustment observed since the floor was abandoned) would wipe out the central bank's capital. But a central bank does not face the same constraints as a commercial bank. In particular, a central bank can operate with negative capital, as the SNB in fact did in the 1970s. The fundamental reason for this is that a central bank can always print money to reimburse its creditors. However, if conducted on a large enough scale, this policy carries the risk of poorly controlled inflation.
After the move of 15 January, the Swiss franc appreciated sharply, with considerable implications for the Swiss economy and its export sector in particular. The exchange rate with the euro initially stabilised around parity before rising again to around 1.05. Against this backdrop, the recent release of the size of the foreign currency reserves held by the SNB is revealing. Expressed in Swiss francs, reserves increased from CHF 495 billion at the end of December 2014 to 498 billion at the end of January 2015. In light of the sharp appreciation of the Swiss franc over the same period, the value in Swiss francs of these foreign currency reserves should have fallen sharply in the absence of further interventions by the central bank. Given that their value has actually risen slightly, this would seem to imply that the Swiss central bank sold approximately CHF 60 billion to buy foreign currencies during the month of January.
Maintaining a strong currency
In other circumstances, a central bank may try to prevent its currency from depreciating too sharply. This situation is usually associated with capital flight during a crisis, such as during the Asian crisis of 1997. In this case, the central bank's interventions go in the opposite direction: selling foreign currency and buying the national currency on the market in order to shore up its value. The scale of these operations is limited by the amount of foreign currency reserves held by the central bank. Once these reserves have been used up, the bank will no longer be able to intervene. Unlike in the situation described above, the market can force the central bank to abandon intervention in this case. Russia has been facing this type of issues for several months now (see chart). The central bank's reserves have diminished and the rouble has depreciated.
Sources: Macrobond, BGL BNP Paribas
Several questions remain unanswered with regard to Switzerland. Will the SNB continue intervention despite abandoning the floor? Will it cut the deposit rate even further? Recently, the market has also turned its attention to Denmark and, to a lesser extent, Sweden. Denmark's central bank has cut key interest rates four times in recent weeks. They are now at the same level as Switzerland's. It has also been intervening in the currency market, and its foreign currency reserves increased by more than EUR 14 billion in January to around 30% of GDP, which is still well below the levels reached in Switzerland.
BGL BNP Paribas
Published in the Luxemburger Wort (in French) on 12 February 2015.