With the benefit of hindsight, it seems clear that many critics simply underestimated the political will in Europe to keep the euro together – writes Professor John Ryan
In September 2011 the Swiss National Bank introduced measures to manage the country’s exchange rate at a lower limit of 1.20 Swiss franc-euro. This commitment to weakening the Swiss franc will most likely be maintained at any cost. Switzerland before the financial crisis had run large and rising current-account surpluses; and kept a stable exchange rate against the euro without the need for any intervention – proving that these surpluses constituted market equilibrium.
However, with the outbreak of the financial crisis, speculators started to consider the Swiss franc a safe haven driving the currency to a level at which the Swiss export sector could not compete any longer. The SNB intervened heavily and then fixed the exchange rate against the euro. Swiss politicians are attentive to the profitability of the SNB because Switzerland’s 26 cantons are its main shareholders. For the smaller cantons in particular, the SNB dividends have been an important source of funds. Figures released by the bank show that its euro holdings have ballooned as the bank battled haven demand from investors and struggled to maintain a floor of 1.20 Swiss francs against the Euro.
The cost of defending the Swiss franc limit is becoming apparent. The SNB’s policy of weakening the Swiss franc means that it is accumulating euros so rapidly it is unable to offload them fast enough. And SNB foreign currency reserves stand at around $530bn – making it the fifth largest holder of foreign reserves behind China, Japan, Saudi Arabia and the eurozone.
The eurozone has low growth rates, chronic unemployment and public debt problems. The banks are in far from rude health and there are difficult political battles ahead. From a German standpoint, the single currency has a number of attractions. It prevents, for example, Germany’s principal trading partners from making their products more competitive against German ones by devaluing their currencies against the deutschmark like they were able to do in the time before the introduction of the euro.
From the outset, the euro was a controversial construct. It was known at its inception that the eurozone had design flaws including a lack of fiscal union and no mechanisms to deal with asymmetric shocks or diverging competitiveness. A number of those concerns materialised and investors have become increasingly skeptical about the sustainability of the eurozone in its current form. However, political factors trumped economic concerns: a united Europe, and thereby the single currency was at root a political project.
The single currency bloc confounded its many critics. Over the last few years, an increasingly confident position emerged advocating that the end to the euro was near. Among the critics were some of the world’s leading economists, investors and journalists; many of them based in the United States and the United Kingdom. They have had to revise their confident projections of imminent single currency demise.
With the benefit of hindsight, it seems clear that many critics simply underestimated the political will in Europe to keep the euro together. Nevertheless, various ‘euro disaster stories’ continue to be published at a stable rate by same critics who hope that they are eventually proven right. Switzerland has a considerable financial incentive for maintaining its current exchange rate policy. The SNB would face major losses now on its foreign assets if it abandoned its target for the Swiss franc. Yet the global economy is in a fragile state with the possible reemergence of the eurozone crisis. The US, UK and Japan continue with their quantitative easing programmes – putting pressure on Switzerland. Consequently the SNB could find it increasingly difficult to maintain its current exchange rate with the Swiss franc gradually gaining strength.
The Swiss economy is far from not immune to the risk posed by another exchange rate shock. Swiss real estate inflation is beginning to creep up, which would normally cause a central bank to raise interest rates. The threat of inflation increases, as does the upward pressure on the Swiss franc. If the SNB were faced with restricting inflation while having to defend the Swiss franc-euro exchange rate, it would leave the bank in a difficult policy conundrum and might ultimately force it to consider a controlled appreciation of the Swiss franc.
Professor John Ryan is research associate at the Von Hugel Institute of St Edmund’s College, at Cambridge University, in the United Kingdom