30 January 2020

In its recently released report on foreign exchange markets, the US Treasury added Switzerland to its watchlist of currency manipulators. To be sure, the Swiss franc does meet some of the criteria. Indeed, Switzerland’s current account surplus is a staggering 10% of GDP, and its bilateral trade surplus with the USA has ballooned to $26 billion last year from near balance as recently as 2013.

However, is the Swiss National Bank (SNB) engaged in FX intervention with the objective of gaining an unfair trade advantage via an undervalued exchange rate, as the US Treasury’s moniker suggests? And, is a cheap Swiss franc (CHF) the cause of Switzerland’s out-sized external surplus?

More accurately, the SNB’s aggressive currency intervention in recent years has been part of a two-pronged effort — along with negative interest rates — to prevent an appreciating CHF from contributing further to already powerful deflationary risks in the economy. Has the SNB succeeded in its battle against deflation? With the SNB’s tool kit now fully deployed, will the Swiss government deploy expansive fiscal policies to stimulate economic growth? What would be the impact on the Swiss franc?

Is the Swiss Franc Undervalued?

Investors often view the CHF as a safe haven. And, to be sure, the sharp rise in the Switzerland’s foreign currency reserves (Chart above) reflects the SNB’s aggressive attempt to curb the currency’s appreciation in the wake of the Global Financial and Euro Crises. It is worth noting, however, that the scale of these interventions appears to have abated during the past year or two.

However, is Switzerland enjoying the competitive benefit of an undervalued currency, as is the habit of FX manipulators? Quite the contrary! The Chart above illustrates the CHF is up to 10% overvalued following its appreciation in the wake of the two international crises. Fortunately, Switzerland’s high level of productivity helps offset the impact of a strong currency. Indeed, the folllowing Chart illustrates that Switzerland is roughly 10% more efficient than its G7 partners, and the advantage is even greater compared to the Eurozone nations (although less of an edge relative to France and Germany). High productivity allows Switzerland to cope with an overvalued exchange rate, and enjoy amongst the highest living standards in Europe.

Three D’s: Deflation, Demographics, and Demand

If the CHF is not undervalued, what’s producing Switzerland’s persistently large current account surplus? As always, the answer lies in underlying macro-trends. In particular, Switzerland’s external imbalance reflects the nation’s elevated, and sharply rising national savings rate (Chart above), which dampens both overall spending and imports.

Several powerful structural shifts are responsible for the increase in thrift. First of all, like all advanced economies, Switzerland is confronting the demographic challenge of an aging population. However, the Chart above projects the impact will be even more pronounced in the beautiful Alpine nation than in the rest of the OECD. In response, the frugal Swiss citizens are building a nest egg by increasing precautionary savings — despite negative interes rates. The government, likewise, has been running budget surpluses in anticipation of higher health care and pension spending.

At the same time, like other advanced economies, Swiss labour productivity growth has slowed dramatically following the GFC. Indeed, despite outpacing its European competitors for decades (resulting in the higher efficiency level illustrated earlier), the Chart above highlights Switzerland’s productivity deceleration is more pronounced than in other Eurozone partners.

The unwelcome combination of an aging population (reducing future labour supply) and slower productivity improvements has contributed to weak demand growth, deflation risks, and the current account surplus. In addition, unless addressed, this mix will reduced Switzerland’s long-term GDP growth potential towards a mere 1% annually.

These structural changes pose significant policy challenges. In order to expand labour supply, Switzerland must boost female participation in the work force. Incentives must also be given to extend the working careers of the current labour force. For example, greater investment in life-long learning and training will help older workers boost productivity, and to adapt to evolving requirements of the labour market. Pension reforms (in addition to those aready enacted) should require that people extend their careers, and aim to reduce the need to aggressively build precautionary savings.

Continued high levels of immigration will likely be necessary to offset local demographic patterns. The Chart above illustrates Switzerland already leads the way on this front And, the following Chart indicates the bulk of new jobs have been filled by foreign nationals in recent years.

Reversing flagging productivity growth will be a challenge for both Switzerland and other advanced nations. Despite the large number of jobs recently filled by foreign citizens, the majority of high-skilled positions are still taken by Swiss nationals (next Chart). Even though Switzerland enjoys an excellent education system, the advantages must be more broadly shared, especially within the immigrant community.

Fighting Deflation: SNB Needs Help!

The Chart above illustrates that the SNB’s two-track approach to fighting deflation — combining monetary stimulus (negative rates and QE) and FX intervention — has led to an even greater expansion in its balance sheet than at other central banks.

Has the SNB succeeded in warding off deflation? The Chart above illustrates that CPI inflation dipped into negative territory as recently as Oct/Nov 2019, before turning positive again in December. Likewise, the economy slowed to less that 1% last year. Despite the ultra-stimulative monetary stance, domestic spending remains fragile. Consumer spending advanced only 0.9% through Q3 2019. Meanwhile, business investment declined 0.2% during the first 9 months of last year, as the tradewar et al took a toll (next Chart). This is especially discouraging as the nation seeks remedies for its productivity slowdown. And, while the most recent evidence suggests the economy is stabilising, there is little reason to anticipate GDP growth much above 1% in 2020.

As the SNB’s options are pretty much exhausted, additional stimulus efforts will need to come from other sources. Indeed, the booming housing market — an unintended consequence of the negative interest rates — further limits the SNB’s room to maneuver (next Chart).

As in much of Europe, it is now time for more expansive Swiss fiscal policies to play a greater role in stimulating the economy. Recent conservative budgetary programs have led to a low and declining debt ratio, and provides considerable scope for action (next chart). Indeed, at current interest rates, Switzerland could stimulate fiscal policy by a massive 3% of GDP simply to prevent a further decline in the debt ratio.

Unfortunately, I do not expect this to happen. To be sure, stimulative fiscal plans have a valuable role to play in the fight against deflation. It is not clear, however, whether it would prevent a further CHF appreciation, especially if it allowed the SNB to eventually begin the long process of normalising monetary conditions.

Strategic Conclusions

• Although I believe deflationary risks have abated and the Swiss economy has stabilised, there’s little reason to expect GDP growth much above 1% in 2020.
• Despite ample fiscal space, I expect Swiss budgetary plans to remain cautious. Consequently, the SNB will continue to be responsibile for boosting growth. Ultra-accommodative monetary conditions will prevail in 2020, and perhaps throughout next year as well. Any future normalisation of Switzerland’s monetary stance will lag adjustments by the ECB.
• Of course, defining Switzerland as a currency manipulator is absurb, and will have no impact on the CHF’s valuation.
• Switzerland’s current account surplus will remain large. US political risks, Chinese virus concerns, and a possible correction in global markets (one is overdue) will enhance the CHF’s safe haven value in 2020.
• These factors suggest that EUR/CHF may appreciate further towards parity in the near term. However, renewed appreciation of the overvalued CHF poses additional deflation risks, which the SNB will intervene to avoid. I am optimistic that Switzerland will successfully address its key structural issues over the long term. However, ongoing economic weakness — combined with the SNB lagging the ECB’s eventual normalisation of interest-rates — inevitably will lead to CHF weakness towards EUR/CHF 1.20 during the next 12-18 months.