John Taylor of hedge fund FX Concepts takes on the recent Swiss intervention, and discusses some of the massive risks the Swiss National Bank has now opened itself up to.
Last week, when the Swiss National Bank announced that they would support the euro against the
Swiss franc at the 1.2000 level for the foreseeable future, they took a bold and risky step. By buying all currencies offered, presumably the vast majority will be euros, the Swiss have lost control of their
money supply. This is the ultimate in quantitative easing. The Eurozone has a population of over 325 million while the Swiss have under 8 million. The Swiss can easily be swamped and capsized by a large flow into their banking system, as only a few percent of the European M-3 would more than double the balance sheets of all Swiss banking institutions, and primary among those would be the Swiss National Bank which would be forced to absorb all the offered currencies, adding them to its reserves. Don’t think that this flood of money will be deterred by anti-tax avoidance restrictions because this money will be ‘white’ money, with all taxes paid, and will be almost entirely conservative, non-hedge fund money that is looking to protect itself against a euro collapse. The primary movers will probably be Swiss and European corporations that will park their excess cash in the franc rather than in the euro, which pays a fraction of a percent more. Speculative money will go elsewhere, like Norway or Canada, as there is absolutely no quick profit to be made owning the Swiss against the euro because the two are pegged together.
Looking ahead, our more positive view sees the Eurozone racked by crises on an erratic time schedule as the various countries have continuing problems with the restrictions applied by the troika of the IMF, EU, and ECB. Those sporadic crises could force the SNB to support the euro multiple times in the next two years, continuously adding to Swiss currency reserves. A more negative view would argue that the euro will begin its collapse and money will flood into Switzerland, forcing the Swiss to give up their peg.
The Swiss National Bank is at an increasing level of risk as their currency reserves grow in size relative to the domestic economy. Already the Swiss have lost over 5% of the GDP when marking their reserves to market. If the euro continues to decline against the Swiss, the number would quickly
become problematic. However, if the peg holds, this loss will not occur as the Swiss franc will decline
equally with the euro. Because of this, the Swiss can get away with this risky peg. If the Swiss keep all of their reserves in euros, they will never lose anything against the euro – nor gain anything either.
The Swiss will still be at risk for the amount of their reserves that they leave denominated in dollars, or
pounds, or yen. Because of this need to protect itself, it is clear that the SNB should move all of its
reserves towards the euro. If the SNB chooses to do this, their only risk is a nasty blow-up of the euro
which would make some parts of it worth much less than others. For instance, if the Swiss invested in
Greek government paper and Athens were to be forced to leave the euro, the SNB would lose much of
its capital. This being the case one can be assured that the SNB will not be investing in Greece.
Drawing this point to its logical conclusion, the Swiss should invest only in German government paper,
or that of the Netherlands, Austria, or Finland, as it is clear that they will be among the strongest parts
of the euro if a break-up or internal division were to occur. By lashing themselves to the side of the
German boat, the Swiss can assure themselves that they will not flounder in these stormy seas. The same positive outlook can not be drawn for the euro-central banks. Although they are not loaded with government paper from dicey countries, their banking systems are and they must rescue them. Even the Bundesbank has to worry about the euro-paper held by its banks, and the German government must stand behind the whole structure – the final bill will fall on the German taxpayer. Iceland and Ireland are examples of what could go wrong. The European central banks are at increasing risk.