Don’t fight the Swiss National Bank
On 6 September, the Swiss National Bank (SNB) set a maximum value for the franc at EUR/CHF 1.20. After about two months, we can say that this exceptional operation has been successful.
The Swiss franc has remained above 1.20 without experiencing any evident speculative attack.
Moreover, early SNB criticism has waned because this operation has not led to (i) massive interventions in the currency market and (ii) it allowed the SNB to turn its first half cumulative loss into a profit in the third quarter.
Against the euro, the Swiss franc has remained above 1.20 since 6 September
The central bank’s success proves its ability and improves its credibility. However, the fixing of a maximum value was not sufficient to prevent the Swiss economy to slow at a worrisome quick pace and for deflationary pressures to build. This deterioration reinforces the SNB’s determination to act against a strong franc as mentioned in its September 6th statement: “If the economic outlook and deflationary risk so require, the SNB will take further measures”. In the last couple of weeks, the board of governors repeated at several occasions that the SNB stands ready to act if necessary.
Latest economic data signal that the Swiss economy has reached a tipping point. On the economic outlook, the future looks rather bleak when one looks at the KOF leading indicator (see chart hereunder) falling towards recessionary levels.
Deflationary risk is materialising as both consumer price inflation (-0.1% y/y) and core inflation (-0.5% y/y) negative figures suggest. Additionally, Swiss newspaper headlines echo the impact of the strong franc on the labour market. Large players of the pharmaceutical and the equipment industries are reducing their staff and delocalising their production. Among the reasons invoked, the expensive Swiss franc is regularly mentioned. And among the two requirements for the SNB to take further measures, the deflationary risk is by far the most important as central banks’ monetary policies do not work properly in such an environment. Moreover, deflationary pressures result directly from of the Swiss franc’s overvaluation.
On the other hand, the economic outlook is obviously darkened by the excessive value of the franc, but the weak global demand – which the SNB cannot do anything about – also explains much of it.
We think that the Swiss franc could weaken in the coming months, either by itself, or helped by the SNB. Indeed, economic fundamentals unanimously speak in favour of a weakening. It is only the unresolved eurozone crisis that prevents the currency to adjust properly. If the pace at which the economy is decelerating remains as it is and deflationary pressures continue to grow, the SNB should set a new maximum value before year-end or a the latest in Q1 2012.
No one knows with accuracy what the fair value of the franc is and the SNB is not saying anything specific about this, except that at the current level the franc remains overvalued. According to our estimates based on the purchasing power parity theory, equilibrium values are around EUR/CHF 1.37 and USD/CHF 1.14.
According to these figures, a new maximum value of EUR/CHF 1.30 is the most likely in our view because a) The franc will be still broadly perceived as overvalued, making the SNB intervention sustainable and profitable; b) it would reduce deflationary pressures (while not avoiding a recession) and c) it would refrain foreign governments to talk about unfair competitive devaluation.