The Swiss National Bank left investors stunned by a sudden change in monetary policy last week, just ahead of an ECB decision on QE. What does this mean for investors in the Eurozone and is a small currency war on the horizon?
The Swiss National Bank (SNB) took markets and investors by surprise last Thursday (January 15) when it decided to remove its cap on the franc at 1.20 euros and lowering its interest rate to negative 0.75 percent, immediately sending the Swiss Market Index (SMI) plunging by 14 percent as the franc shot up in value more than 30 percent against other major currencies.
The SNB first put the cap in place at the height of the European financial crisis in 2011 to keep the franc from appreciating in value. As fears of a Greek exit and breakup of the Eurozone loomed, investors sold off euros and flocked to the Swiss franc, seen as a safe haven amidst uncertainty. The SNB created the ceiling at the time to keep a competitive exchange rate, which has been vital to protecting major Swiss export and tourism markets.
With no prior warning, the SNB’s snap decision came as a shock to markets – just the day before it had promised to keep the cap in place.
SNB Chief, Thomas Jordan, justified the move saying that maintaining the minimum exchange rate for the Swiss franc against the euro was “no longer justified,” given the recent divergence among major currencies and that Swiss manufacturers had been given enough time since 2011 to adjust.
Yet, it is little surprise that the SNB’s decision came the day after the European Court of Justice made its preliminary ruling on the ECB’s controversial Outright Monetary Transaction (OMT) program, essentially giving the bank the anticipated green light to move forward with a European QE program.
Since its 2011 decision the SNB has already had to buy up large quantities of euros every month to maintain the currency ceiling, causing its foreign exchange reserves and balance sheet to expand to over 85 percent of Swiss GDP.
With QE almost certain to come in the following weeks, flooding the market with billions of euros (further devaluing the euro), the SNB would find it increasingly difficult to buy up more euros to maintain its ceiling, potentially causing the SNB to “lose control of its own monetary policy in the long-term.”
Swiss markets hit hard
A decision to break from its ceiling may provide the SNB with more flexibility in the long run, but Swiss industry will continue to suffer short-term losses. Hardest hit by the move are the export and tourist industries the ceiling was designed to protect in the first place.
The franc has appreciated almost 20 percent against other major currencies and is currently on par with the euro. With 85 to 90 percent of Swiss company sales coming from abroad, Swiss firms will essentially be forced to swallow the difference. The SMI is down 12 percent.
Swiss resorts have already lost many holiday travellers put off by higher prices and Union Bank of Switzerland (UBS) has changed its economic growth forecast from 1.8 to 0.5 percent for the year.
Reverberations felt throughout the Eurozone
Despite the short-term adjustment pain in Switzerland, much of the impact emulating from the currency move will be felt elsewhere in the Eurozone and around the world.
Currency traders unprepared for the sudden shift have gone bankrupt and large banks Barclays and Deutsche Bank have suffered heavy hits, with Citigroup reporting close to 150 million in losses. Both the European and Asian stock markets have fallen in the immediate aftermath.
Eastern and Central European (CEE) banks are also vulnerable from the sudden appreciation of the Swiss franc. After the Cold War, many CEE countries took advantage of the relative stability and low interest environment surrounding the currency, issuing mortgage loans denominated in francs.
This has posed significant risk to banks when the franc appreciates as it did during the 2011 financial crisis, making loans harder to repay and increasing household delinquency. Countries like Hungary and Poland have taken steps to reduce this risk since 2011, reducing the amount of loans issued in foreign currency and converting a large portion of loans into local currency.
However, franc-denominated mortgages continue to pose a risk in the Czech Republic, Serbia, Croatia, and Romania, and still make up an estimated 3 to 5 percent of Hungarian GDP and 7.7 percent of Polish GDP. With franc appreciation, households in these countries could struggle to repay loans, placing banks higher risk of default and further weakening state economies as household purchasing power diminishes.
In Poland, with upcoming presidential and parliamentary elections, this may also prove to be a larger political issue as pressure mounts on governments to provide some form of relief.
More uncertainty to come: small currency war ahead?
As markets adjust to the SNB’s actions, Thomas Jordan has said that currency and stock prices “should begin stabilize in the coming months”. However, monetary politics in the Eurozone will not be over anytime soon as the ECB and state leaders continue to make crucial decisions affecting the economic future of the region. Markets will most certainly react again this month after the next ECB meeting this week, when QE is expected to be announced and more details are given surrounding its exact structure.
With QE looming, investors should also pay close attention to central bank moves of other currencies closely tied to the euro. On Monday, following the SNB, the Danish National Bank lowered its interest rate from negative 0.05 to negative 0.2 percent in a pre-emptive attempt to weaken the krone’s attractiveness to investors. Currency analysts have said that the bank could act again after the ECB’s meeting. In place since 1982, the National Bank has said that it will continue to keep the krone’s peg to the euro.
However, given the abrupt change in policy by the SNB, a revision by the National Bank is not entirely out of the question. After setting its interest rate to zero just this October, speculation has also surrounded a possible move by the Swedish Central Bank to move its interest rate into the negatives.
If anything, the current situation in Switzerland has revealed the increasing globalization of financial markets and investors should continue to monitor their foreign exchange risks, especially as the SNB’s actions reverberate throughout different markets and as US and European monetary policies continue to diverge this year.