By Elsa Felgar
Famous for being a top travel destination, Switzerland attracts visitors from all around the world for its nature, skiing, food and shopping. But this might change this year due to the Swiss National Bank (SNB) unpegging its currency from the Euro. A problem for the SNB from the very beginning, pegging the Swiss franc to the Euro was done in Switzerland’s best interest from a Swiss perspective. But with rising complaints from Swiss industries and politicians, and the European Central Bank (ECB), at the time, planning to increase the value of the Euro though a process of quantitative easing, it was time for the Swiss to cut the currency cap.
The SNB Backstory
To understand the SNB and the reasons to pegging and then unpegging their currency, we must delve back to the happenings of 2011. Greece and Ireland had already asked the European Union (EU) and the International Monetary Fund (IMF) for bailouts and the eurozone crisis was still very much underway. Portugal, Italy and Spain soon followed and at the end of 2011, and soon the instability of Europe became unsettling for politicians and investors alike. Switzerland, however, remained a safe investment route and it was not long before foreign investors put their money into Swiss banks. The value of the Swiss franc increased, and exports became more expensive and less competitive. As the Swiss franc’s value rose, it became overvalued and the SNB decided to peg its currency to the Euro at a rate of 1.2 Swiss francs. This meant that the SNB had to artificially increase the amount of Swiss francs to main its currency cap. Since then, the SNB has done exactly that.
With a lower value of the Swiss franc relative to the Euro, Europeans could easily buy more Swiss goods and vacation in Switzerland, particularly at well-known ski resorts. This also allowed for Swiss exports to remain relatively low against the Euro. Thus, the cap was used as a mechanism to control for the increase in franc value.
Unpegging the Swiss Franc
After three years, this mentality slowly began to change as politicians pressured the SNB to lift its peg, and as European politicians did not see an increase in the economic recovery from the European debt crisis. Christine Lagarde, IMF director general, mentioned that the slow progress was dangerous because Europe and Japan would experience long-term low growth and low inflation. As a result, this constant deflation needed the intervention of the European Central Bank (ECB). The solution was the implementation of quantitative easing.
The purpose is to increase the money supply of the euro to artificially influence economic growth. If the currency cap were to still be in place, the SNB would have to print more Swiss francs to match the value of the Euro. Because this would no longer serve a proper purpose of maintaining the cap, the SNB decided that it should disable it.
The Reason for Quantitative Easing
Before we can continue talking about the effects from the Swiss franc currency increase, we need to understand the connection between the SNB and ECB. The main process of quantitative easing is that the ECB buys government bonds, increasing the demand for bonds and in return increasing their value . Although a major risk is that inflation will increase and the currency value will decrease, currently Europe is struggling with deflation so any pull to get inflationary measures enacted is welcomed.
An important point of quantitative easing is that the ECB cannot be afraid to commit to the program. Only when prices start to increase can they say they have effectively used quantitative easing, but before a rise in prices can happen, they first have to fall. Economists predict that they fall to match the value of the dollar before there can begin increasing again. The goal is to enact the program through September 2016, but some those who have studied the effects of quantitative easing are skeptical. These specialists believe that the ECB will need a longer period of time to see any change in growth rates, or that maybe it is too late to implement quantitative easing at all. The European mindset has been so focused on consumers saving money, banks not lending, and investors not investing, that it will take more than the economists in the ECB to make things right. It will need to come from the European citizens themselves. In summary, because with the Swiss franc pegged to the Euro, the SNB is required to follow the decisions made by the ECB. With an already large pool of foreign currency in the SNB, they would have to risk economic disparities. Because those disparities would echo not only in Switzerland but also throughout Europe, the SNB’s decision foresaw what would have been an even more strenuous financial situation if they had continued with the currency cap.
Where is the Swiss Franc Today?
After three years of increasing foreign currency stock and monitoring the value of the Swiss franc, the SNB made a drastic and surprising decision this past January. The day after, the value of the franc rose by at least 20 percent. A rise of 2 percent is incredible, but 20 seems unimaginable. This automatically increased the price of all Swiss goods. If a French family wanted to spend their winter holiday skiing in Switzerland, their hotel room just became 20 percent more expensive. As a result of Swiss exports becoming more expensive, imports will become cheaper in relation. But this will only increase deflationary pressure. Banks, manufacturers, and the tourist industry have all felt the impacts of the SNB’s decision. For example, as exports become more expensive, it becomes harder for Swiss watch manufacturers to sell their goods to Asia. The same type of problem can be seen in the north where trade with Germany has also been impacted.
This major shock to the rest of the world was a reminder that central banks can still make sudden changes like the one made by the SNB. We live in a world where decisions are made after long deliberation. For example, the ECB is now being criticized for its lack of action. They could have used quantitative easing sooner, but instead tried softer methods. It is also a surprise that the SNB would give up the currency cap that they fought so hardly to keep. This change lets the world know that our international financial world is constantly changing and that we should not become too comfortable with our current systems. The actions of the SNB have taken many by surprise. With a strong U.S. dollar and quantitative easing aimed towards Europe, there was no other choice than to show the world that Switzerland was ready to make the switch.