Swiss Franc: More Weakness as SNB Lags ECB

4 February 2018

In the wake of the Global Financial Crisis followed by Europe’s Sovereign Debt Crisis, the Swiss franc (CHF) appreciated sharply (see top Chart), reflecting its traditional role as a safe haven. Confronting considerable deflationary risks the Swiss National Bank (SNB) abandoned its policy aimed at setting a floor for the exchange rate versus the Euro at EURCHF 1.20.  In its place the SNB established a two-pronged strategy to reduce CHF’s attractiveness: cutting interest rates dramatically to -0.75% (and establishing a band providing flexibility to reduce rates further if needed) and pledging to intervene in FX markets to offset capital inflows if necessary. The new policy stance just celebrated its third anniversary.  Is it achieving its goals? Will unintended consequences, especially in the housing market, lead the SNB to change direction?  What are the implications for interest rates, FX, and equities during the next 12 to 18 months?

Policy Working, But Goals Not Yet Secured

Ultimately, the SNB’s goal is to ensure that deflationary risks have abated, and the economy can sustain its economic recovery.  Considerable progress has been made , but risks still remain.  As a small, open economy, for instance, Switzerland has benefited from the recent acceleration in the global economy, as recent manufacturing PMI data highlight (Chart).  However, despite the improved performance in the second half of last year, Swiss economic performance still lags that of the European Union.  For example, while Swiss Q3 GDP advanced 1.2% (admittedly Q4 will be higher), EU output gained 2.7% in H2 2017.

Swiss manufacturing PMI approaches peak levels of previous cycles.

Furthermore, despite the recent improved performance, considerable slack remains in the Swiss economy.  As a result, while deflation has ended, CPI inflation at 0.7% remains well below the SNB’s 2% objective.  Furthermore, price gains also lag the EU, where CPI is running at 1.7% (core is lower at 1.2%).

The Chart at the top of the blog illustrate the Swiss franc is still 10-15% overvalued compared to the level still prevailing before the crises starting in 2008. Indeed, the real exchange rate is only now approaching the 2015 level existing prior to abandoning the policy perceived to be contributing to deflation.  Swiss international reserves data highlight the difficulty of the task the SNB confronts. Prior to the surge in safe have inflows prior to the international crises, Swiss reserves remained stable, despite experiencing large current account surpluses (4% of GDP annually).  Currently, despite offering the most negative interest rates in the world,  reserves continue to surge (Brexit perhaps?).  In 2017, for example, international reserves advanced $100 bn, well in excess of the current account surplus of $70bn.  Continued FX intervention has swollen the SNB’s balance sheet, which is now larger than those in the G3 nations implementing quantitative easing!

How to Prevent Unwanted Swiss Franc Appreciation?

As we have seen, life is complicated at the SNB.  Despite ultra-low interest rates, capital inflows continue, reserves are rising, and the central bank’s balance sheet continues to expand.  It is easy to understand CHF’s attractiveness as a  safe haven.  Per capita GDP is the third highest in the OECD, income inequality is amongst the lowest in the area, confidence in government policy is higher than in any other major nation, the World Economic Forum ranks Switzerland as the 2nd most competitive nation, unemployment stands at only 3% — you get the point.  In addition, Switzerland’s net international investment position stands at over 100% of GDP — the second highest in Europe (after oil-rich Norway) and twice as high as Germany’s.

In addition to capital inflows, however, Switzerland out-sized current account surplus — over 10% of GDP in recent years — contributes to the buildup in international reserves, upward pressure on the CHF, and the undesirable expansion in the SNB’s balance sheet.  The persistence of a large external surplus combined with an overvalued exchange rate indicates that Switzerland saves too much and spends and invests too little.  The current account will only decline after addressing these structural issues.

What are the options?  First of all, the government could expand fiscal policy to boost domestic spending.  Switzerland has the flexibility to do so, as the public sector budget is near balance and debt levels are comparatively low.  However, strict , conservative guidelines, which enjoy huge public popularity, restrict action on this front.  In addition, the Chart illustrates that Swiss infrastructure is amongst the world’s best already.

As the government is not the cause of Switzerland’s excessive level of thrift, the issue lies in the private sector.  One option would be to encourage businesses to invest more.  To be sure, Switzerland’s R&D spending is high, innovation scores high marks in international surveys, and business investment as a percent of GDP is about average compared to other nations. However, the following Chart illustrates that while Swiss productivity is well above the OECD average, labour efficiency lags that in key competitors, e.g. the USA and Germany.  Even more importantly, the next Chart illustrates that Swiss productivity growth has slowed sharply during the past two decades.  And, while this is a world-wide issue, Switzerland’s performance lately ranks amongst the worst.  Renewed focus on capital spending could both help efficiency and play a role in curbing the current account surplus.

The following  Chart looks at nations with large current account surpluses, and identifies the source of the excess savings.  Without doubt, Switzerland’s external surplus reflects excessive thrift in Swiss households. Unfortunately, this is unlikely to change near term.  As is true elsewhere, the Swiss population is aging.  Inherent fiscal conservatism is leading to additional belt-tightening.  The government is taking measures to strengthen the nation’s pension system.  This would help, but will take time to alter household spending patterns.  Improved productivity (perhaps from business investment) could lead to higher wages and spending.  Likewise, deregulation, especially in service sectors where prices are high compared to other countries, could boost real incomes and household outlays. Swiss households should enjoy the fruits of their labours, but are reluctant to do so.

Monetary Policy Will Continue to Carry the Burden

With the government and household  spending remaining cautious, the current account will remain bloated, and monetary will continue to play the central role in limiting unwanted CHF appreciation. There continues to be much discussion about the unintended consequences of ultra-low interest rates, especially the exposure of banks and households to rising property prices.  The following Charts illustrate the rapid growth in bank lending, predominantly to the property sector (lending elsewhere remains tepid).  Recent government measures to cool the property markets do seem to have curtail price rises lately.  This will buy the SNB some time to maintain negative interest rate policies.  However, should a full-blown property market bubble emerge, the SNB may need to react earlier than planned.

Market Implications
  • Monetary policy will continue to play the lead role in preventing unwanted CHF appreciation. The ECB is expected to remain on hold until the first half of 2019.  With Swiss inflation and GDP growth trailing Euroland’s trends, SNB policy will lag ECB decisions.  Also, after initially widening following Switzerland’s 2015 rate cut, the next Chart shows that the Swiss-Euro interest rate differential has narrowed significantly, as the ECB cut rates in recent years .   If the SNB began normalising monetary policy prematurely, this could risk a renewed deflationary currency appreciation.  Swiss rates will remain on hold until H2 2019 or even into 2020.

  • With Swiss GDP, inflation and monetary policy trailing that in the rest of Europe, the overvalued CHF will weaken towards 1.25 to 1.30 versus the Euro.
  • Economic and profit recovery, easy monetary conditions and a weak FX will lead to a 5% to 10% gain in the SMI equity market index — outperforming bonds and cash, but underperforming the broader European indices.