Currency wars have been predicted for years. Outright monetary battles were last seen during the Great Depression of the 1930s, when governments competed to devalue their currencies to gain market advantage. But since the return to floating exchange rates in the 1970s, the risk of renewed competitive manipulation has hovered over the monetary system like a dark cloud.
The only question, it seemed, was: who would be the main culprit? Would it be the United States, pushing around exchange rates through the machinations of the Federal Reserve? Would it be Japan, hoping to reverse years of stagnation by engineering a depreciation of the yen? Or might it be the eurozone, seeking an escape from its problems?
Who would have guessed that, remarkably, it might turn out to be none other than Switzerland – perhaps the stodgiest monetary power on the face of the earth? The Swiss franc has long been regarded as one of the world’s most dependable currencies, prized by investors as a stable and secure haven for their wealth. Yet a few days ago, with one bold stroke, the Swiss National Bank succeeded in severely destabilizing financial markets around the world.
Franc becomes a haven
The act itself was deceptively simple. Since 2011, the Swiss franc had been firmly pegged to the euro at a cap of 1.20 francs. Prior to that it floated freely, and 1 euro equaled as much as 1.68 francs back in 2007 before the financial crisis increased its value as a haven.
To ensure the franc didn’t trade below the cap, the Swiss National Bank spent enormous sums selling francs and buying up euros and other currencies to keep the franc from increasing in value. In other words, when traders and investors were buying francs, driving up their value, the central bank was selling them in similar quantities to keep the currency stable.
Then, last Thursday, the peg was removed, allowing the franc to move freely. Henceforth, the Swiss National Bank would refrain from buying up euros, dollars or anything else to keep the franc from appreciating.
Repercussions, however, were anything but simple. Almost immediately, the franc soared by as much as 30% before settling down at around parity to the euro – that is 1 to 1 – causing massive dislocations for investors and financial institutions around the globe. Particularly hard hit were banks such as Germany’s Deutsche Bank and Britain’s Barclays PLC, both of which had invested heavily in securities directly tied to the Swiss exchange rate. Eastern Europeans, who had borrowed heavily in francs to take advantage of low interest rates, now suddenly faced more onerous debt-service burdens. Currency traders everywhere suffered losses. Ripples from the shock spread widely.
Nor were the Swiss themselves spared. The currency’s abrupt rise immediately translated into higher prices for Swiss output in world markets, damaging sales prospects. “Words fail me,” said the chief of the Swatch Group, one of the country’s biggest exporters. It “is a tsunami: for the export industry and for tourism, and finally for the entire country.” Swiss stocks fell like a stone.
An increasing burden
So why did Switzerland do it? The peg was originally intended to counter large-scale inflows of capital fleeing the crisis-ridden euro zone and other trouble spots. The National Bank pledged to provide all the francs needed to satisfy foreign demand. The currency would not be allowed to become more expensive.
Over time, however, cost of the peg became increasingly burdensome. Sales of newly created francs greatly expanded the bank’s balance sheet, threatening domestic inflation. Since 2011, the monetary base (commercial bank reserves held at the central bank plus the currency in circulation) has quintupled, and in recent months inflows had actually accelerated. Notably, much was coming from wealthy Russians eager to get rid of their incredible shrinking rubles.
The final straw appears to have been the prospect the European Central Bank launching a program of buying billions of euros worth of government bonds in an effort to lower interest rates and boost inflation, which could begin within days. The ECB’s program, known as quantitative easing, essentially amounts to printing new money, increasing how much is in circulation.
Evidently the Swiss authorities feared that much of this newly created eurozone cash would slosh across their borders, adding to inflationary pressures. Letting the exchange rate go seemed the safer option.
Longer-term consequences, though, could be grave. Most obviously, many in Switzerland will suffer from the currency’s rise – everyone from the makers of cuckoo clocks to the employees of ski resorts. Worse, the reputation of the Swiss National Bank could be damaged, perhaps irreparably.
In reality, the bank had little choice. The tide of incoming capital was swelling, and with asset returns at all-time lows, there was little room for further interest-rate reductions to curb foreign appetite for the franc. Switzerland was caught in the classic dilemma that theorists call the Unholy Trinity – the mutual incompatibility of monetary policy autonomy, currency stability and capital mobility. Unable to directly restrict financial inflows, the bank chose to sacrifice exchange-rate stability for the sake of restoring domestic monetary control. The decision was not unreasonable.
But the way the Swiss went about their decision has upset many. The bank acted entirely on its own, without any consultations with monetary authorities elsewhere. “I find it a bit surprising that [the Swiss] did not contact me,” said Christine Lagarde, managing director the International Monetary Fund, in a classic diplomatic understatement. In fact, many central bankers were incensed by Switzerland’s unexpected unilateralism. The bank had always been regarded as a prudent and reliable member of the central bank fraternity. Could the Swiss still be trusted?
More broadly, would anyone now trust any central bank? If the stodgy old Swiss could behave with such abandon, who might not be similarly tempted? Central bankers traditionally pride themselves on their sense of community, communicating often to share views and signal intentions. But now some might feel that they too have the right to act unilaterally in what they regard, rightly or wrongly, as their legitimate self-interest. If so, a currency war could indeed erupt, as long predicted.