The SNB Shock

Only if the SNB is confident that it has vanquished deflation and that the Swiss economy is strong enough to cope with a stronger currency is now the right time to abandon the ceiling. A column by Barry Eichengreen.

Barry Eichengreen
«By abandoning the ceiling rather than adjusting it, the central bank did the only reasonable thing.»

The Swiss National Bank’s shocking decision to remove the ceiling on the franc exchange rate raises three questions that need to be distinguished. First, was this the right time to lift the ceiling? Second, will the new policy succeed in stemming capital inflows? Third, if the time was right, was the policy implemented in the right way?

Start with the last question. Commentators were critical of the SNB for surprising the markets. Even Christine Lagarde of the IMF in an interview on CNBC showed unhappiness about not having been warned. That the Swiss stock market dropped by near 10 per cent is an indication that private investors, as well, do not like being surprised. Other central banks have invested heavily in «communications policy» – that is, in developing mechanisms for communicating their intentions to the markets. This, clearly, was not an approach the SNB chose to take.

In addition, the SNB has been criticized for not smoothly guiding the exchange rate upward. Some suggest that it could have raised the euro-franc ceiling by a few percentage points on Thursday and by a few additional percentage points in the days or weeks following, repeating the process as needed. By instead removing the cap and abdicating responsibility for the exchange rate, the SNB allowed the franc to soar by an astounding and – for Swiss exporters – devastating 17 per cent.

In my view, these criticisms are misplaced. The SNB had no alternative to either maintaining the 1.20 franc ceiling or abandoning it entirely. Had it raised the ceiling by a few percentage points, investors would have concluded that it was no longer committed to the peg. They would have anticipated further increases. More hot money would have flooded into the country. The problems of the SNB’s bloated balance sheet would have worsened rather than improving.

Remember Germany 1971

This argument is not hypothetical. In fact it is exactly what happened to Germany in the late 1960s and early 1970s. Investors then were looking forward to the end of the Bretton Woods System and to the possibility that U.S. President Nixon would depreciate the dollar, much as they are looking forward now to the likelihood that the ECB will embrace quantitative easing on January 22nd and depreciate the euro.

In the late 1960s, capital therefore flooded into Germany in the expectation that the deutschemark would strengthen. Concerned over its export competitiveness, Germany was reluctant to try to stem those inflows by allowing the mark to appreciate. Finally, it reluctantly did so, revaluing by 9.3 per cent in October 1969 in the kind of policy some have suggested the SNB should have emulated.

But this limited revaluation excited expectations of further revaluation. The flood of capital into Germany, rather than abating, intensified. In the last 40 minutes of trading on the key day, May 5, 1971, the Bundesbank was forced to buy nearly $1 billion of dollars, a gigantic sum at the time. Seeing its balance sheet exploding, the German government finally allowed the mark float.

Fortunately, Thomas Jordon & Co. understand this history. By abandoning the ceiling rather than adjusting it, the central bank did the only reasonable thing.

Might the SNB have done more to warn the IMF and foreign central banks, and thereby not caused such unhappiness on the part of Mme. Lagarde? Diplomatic niceties suggest yes, but it is not clear what more foreign central banks or the Fund could have done to prepare for the event. It is not likely that other countries would have adjusted their own exchange rate and monetary policies.

On a Monday might have been better than on a Thursday

There is also the danger that information communicated to Frankfurt or Washington gets leaked to the markets. Had investors gotten wind of the SNB’s intentions, a tsunami of capital would have flooded into Switzerland, wreaking further havoc with the SNB’s balance sheet. Traditionally, central banks have addressed this problem by communicating with their foreign counterparts over a weekend and implementing the new policy on Monday. If there is a mistake here, it is that the SNB moved on a Thursday.

So will the new policy stem hot money flows into Switzerland? The classic analysis of Rudiger Dornbusch, the famous German-American economist, suggests that it will. Dornbusch’s «overshooting model,» constructed shortly after the collapse of the Bretton Woods System, predicts that when there is an unexpected change in policy like the SNB’s the exchange rate will «overshoot.» In the short run it will appreciate even more than justified. This in turn will create expectations that it will depreciate subsequently, giving back some of the excess ground just gained.

In other words, if the franc is suddenly so strong that it can now be expected to depreciate, investors no longer be inclined to rush into it. The SNB will have succeeded in stemming capital inflows.

The final question, of whether the central bank was right to act now, is the most difficult. The answer turns on motives. If the SNB removed the cap because it was stung by political criticism, then its action is not defensible. If it was worried by the size of its balance sheet, such worries are not adequate justification for putting the Swiss economy at risk. That the ECB is poised to ease does nothing to change these fundamental facts. Only if the SNB is confident that it has vanquished deflation and that the Swiss economy is strong enough to withstand the headwinds from a stronger currency is now the right time to abandon the ceiling.

Is that what the SNB in fact thinks? It needs to tell us.