Lessons from and for the franc

Switzerland is not the first country to discover the problem of large central bank assets, but is likely to be the first country where the problem will be dealt with. A column by Charles Wyplosz.

Charles Wyplosz
«Entrusting another institution with managing central bank assets – a sovereign wealth fund – would shift the responsibility away from the central bank, creating a sort of scapegoat. »

On 15 January the Swiss National Bank stunned the world when it abandoned the 1.20 € floor for its exchange rate. Of course, the decision came as a total surprise. It had to. You cannot pre-announce an exchange rate decision, because doing so would immediately trigger massive speculative action. Great losses were recorded and angry losers vented their frustration, but that is the rule of the game. The bigger loser probably was the SNB itself, which could not do anything to prevent the losses that it knew would follow its decision. That too is the rule of the game. The real surprise was the decision itself : why and why then ?

When it announced the floor in September 2011, the SNB presented it as a temporary measure. It was only a matter of time until the measure would be revoked. Like many other central banks, the SNB was engaged in what is now called non-standard monetary policies, adopted to deal with a historical crisis. These policies have served us rather well. The financial crisis of 2008 was as deep as that of 1929 and yet it has not been followed by a Great Depression. The only exception, maybe, is the Eurozone, but that is another story. The problem with all non-standard policies is that they must eventually come to an end. This requires an exit strategy, which itself has to be non-standard. This means that it is bound to create a surprise. Remember the speech of then-Fed Governor Ben Bernanke in June 2013 when he merely reminded markets that QE was not forever. The panicky market reaction, known as the taper tantrum, was a first signal that exit is fraught with difficulties. On 15 January, the SNB embarked on its own exit, with the same panicky reaction. Then as before, the central bank was blamed for destabilizing the financial markets. But no one has explained how to avoid that.

There is a big difference between the Fed and the SNB approaches. With his speech, Ben Bernanke was trying to develop a strategy. He was not giving any date but he was laying out the criteria for exit. In the event, the criteria were not well crafted and they have evolved since then. By the way, almost two years later, the Fed has not yet embarked on exit. But the markets understand its logic and remain calm. In contrast, the SNB has never articulated its exit strategy. Rightly or wrongly the markets did not expect it to happen now, hence the big surprise. And now that it has happened, we still wonder what led the SNB to act at this moment of time.

In principle, the floor was unassailable

From its statements, we understand that the SNB was worried by the impending announcement from the ECB that it would start doing QE (several years after other central banks, which may explain the continuing stagnation of the Eurozone). Indeed, since it appeared obvious that the ECB would make its move in January, capital has started to flow into Swiss francs and the SNB has had no choice but to accumulate sizeable amounts of foreign exchange reserves. The prospect of an acceleration of inflows and of potential enormous foreign exchange market interventions seems to be what worried the SNB. Exit from the floor was a way of escaping the need to mechanically absorb foreign exchange rate reserves. The impending ECB decision determined the timing.

If that story is correct, it raises as many questions as it answers. In principle, the floor was unassailable. The SNB only had to produce whatever quantity of francs the market wanted to acquire, which it can do with no limit. This is what made the floor so successful and credible from the start. The large inflows of early January probably were not really an attack against the floor. They rather represented efforts by investors to escape euro-denominated assets in anticipation of troubled economic and political times in the Eurozone, given the controversies that surrounded the adoption of QE by the ECB. Proof is that the euro depreciated vis à vis the dollar during this period. Until 15 January, even though there started to be discussions in the Swiss media about its fate, the floor was credible. The market reaction is evidence to that effect.

The counterpart of franc creation was the accumulation of foreign exchange reserves. While the level of reserves can be too low, and thus force central banks to give up defending their exchange rate against a depreciation, there is no known principle that reserves can be too high, and thus force a central bank to give up fighting an appreciation. This is why the SNB action is so interesting: it brings a new argument in an old debate.

The SNB feared losses

Why then did the SNB fear accumulating foreign exchange reserves? There may be political reasons specific to Switzerland, as the November referendum shows. But the SNB is independent precisely to fend off political pressure – which the proponents of the referendum deeply resent, of course – and the referendum outcome strengthened its independence. The more plausible explanation is that the SNB feared losses. The more euros it accumulated, the bigger the potential losses on the day when the floor is abandoned. This is indeed correct, but it brings up new questions.

In principle, the aim of a central bank is to achieve price stability, which in Switzerland means an inflation rate between 0% and 2%, an objective that the SNB is struggling to achieve. As a by-product of its monopoly to create currency, a central bank usually makes profits, which it passes on to its shareholders. So far, though, these profits were not seen as a monetary policy objective. The decision of 15 January is challenging this conventional wisdom. The new argument is that the central bank is also in charge of part of people’s wealth and that it ought to manage it in the best possible way.

In fact, the SNB always stated this aim and, indeed, actively managed its portfolio. Yet, it was not believed that this aspect would prevail over monetary policy decisions, which it did. Indeed, the unavoidable effect of the franc appreciation is that it will push inflation further into negative territory. At a time when oil prices are falling, this will take the SNB further away from its monetary policy objective. Clearly, a well worked out exit strategy would have helped clarify this question

What is required is clarity of thought and a solid democratic debate

Thus one lesson from the exit is that central bank profits (and losses) matter a lot. Canton finance ministers well know that, of course. We must now explicitly recognize a conflict of interest between monetary policy independence and the interests of central bank shareholders. This has to be the next debate, because the situation is unhealthy. It has already created tremendous turmoil. If the franc remains too strong for too long, it will hurt parts of the Swiss industry. Not only will a recession reduce tax collection, but also it will create explicit or implicit unemployment, affecting the lives of many citizens.

The solution must be to clarify the objectives of the SNB without reducing its monetary policy independence that has served the country so well (and that an increasing number of countries have adopted worldwide). If managing the people’s wealth is recognized as a major objective, at par with the price stability objective, the SNB must be given guidelines on how to deal with conflictual situations, as was the case in early January. Entrusting another institution with managing central bank assets – a sovereign wealth fund – would shift the responsibility away from the central bank, creating a sort of scapegoat. But it will not fully solve the situation because, in the end, it is monetary policy actions that determine the evolution of the size of the fund.

These are important questions that require clear answers. Switzerland is surely not the first country to discover the problem of large central bank assets, one thinks of China, of course. It is likely to be the first country where the problem will be dealt with and the chosen solutions stand to matter for many other countries. What is required is clarity of thought and a solid democratic debate. Maybe, this is why the SNB did not detail an exit strategy: the debate could be divisive.