As I highlighted in my previous post, the honeymoon period for the SNB in its enforcement of the 1.20 floor on the EURCHF exchange rate is well and truly over. In May, the SNB needed to intervene to the tune of CHF 66 bn to defend the floor. There’s even speculation that the SNB may be forced to implement capital controls or negative interest rates on offshore deposits in the event of a disorderly Greek exit from the Eurozone.
Increasingly, the SNB is caught between a rock and a hard place. Either it can continue to defend the peg and accumulate increasing amounts of foreign exchange reserves on which it faces the prospect of correspondingly increasing losses. Or it can abandon the peg, allow the CHF to appreciate 20-25% and risk deflation and a collapse in exports and GDP. It is not difficult to see why the SNB is being forced to defend the peg – the EUR in the current environment is a risky asset and the CHF is a safe asset. By committing to sell a safe asset at a below-market price, the SNB is subsidising the price of safety. It is no wonder then that this offer finds so many takers when there is a flight to safety.
Some argue that the continued deflation in the Swiss economy allows the SNB to maintain its peg but this argument ignores the fact that it is the continued deflation that also maintains the safe status of the Swiss Franc. Deflation provides the impetus for the safe-haven flows due to which the required intervention by the SNB and the SNB’s risk exposure are that much greater in magnitude. Therefore, if the SNB is eventually forced to abandon the floor, the earlier the better. A prolonged period of deflation punctuated by occasional flights to safety will compel the SNB to accumulate an unsustainable level of foreign exchange reserves to defend the floor. By the same logic, the SNB would obviously prefer that the Eurozone not implode but if it does implode, then it would rather that the Euro implodes sooner rather than later.
So what does the SNB need to do? It needs to engineer an outcome where the market price of the EURCHF moves up and the CHF devalues by itself. The only sustainable way to achieve this is to provide a significant dose of inflation to the Swiss economy and it needs to do so in a manner that does not provide an even larger subsidy to those running away from risk. For example, raising the EURCHF floor by itself only increases the temptation to buy the Franc and at best provides a one-time dose of inflation. The SNB could decide to buy CHF private sector assets but the safe-haven inflows and relatively strong performance of the Swiss economy mean that asset markets, especially housing, are already frothy.
The more sustainable and equitable solution is to simply make the safe asset unsafe by generating the requisite inflation for which money-financed helicopter drops are the best solution. Money-financed fiscal transfers will create inflation, deter the safe-haven inflow and shore up the balance sheet of the Swiss household sector. The robustness of this solution in creating sustainable inflation will not come as a shock to any emerging market central banker or finance minister. The crucial difference between this plan and that implemented by banana republics around the world is that instead of printing money and funnelling it to corrupt government officials we will distribute the money to the masses.