The Swiss central bank’s announcement last week that it was scrapping the franc’s peg to the euro came as a shock to the investment community.
The peg, introduced in September 2011 in the form of a cap to prevent the franc from strengthening to an exchange rate lower than 1.2 to the euro, made Switzerland an adjunct member of the European monetary union and helped reduce exchange rate volatility in the wake of the 2008 financial tsunami.
At the European Central Bank’s meeting Thursday, it is believed that eurozone members, including Germany, will agree on a European version of quantitative easing to print more banknotes to buy bonds as deflation looms large over the continent.
One immediate outcome is that the euro’s exchange rate, which has already dropped to nine-year lows, will plummet further.
Once the cap was lifted, the freewheeling Swiss franc initially jumped 40 percent against the euro, and it is now at par against the common currency.
Switzerland’s pillar industries, including the tourism and export sectors, will be among those hit hardest.
Some currency speculators who had boldly sold the franc short suffered a crippling blow: news reports say within the past week several big investors and funds in Britain, Australia and New Zealand found themselves in grave trouble.
Central bankers are all aware that their comments and actions easily stir up ripples in the markets, so they typically display extra caution and deliberation before a major policy shift.
But now the Swiss central bank has set a precedent (one of its vice-governors reiterated just days prior to the announcement that he had “faith in the peg”), and that could signal a change in the traditional style of central banks.
Other governments may make similar surprise moves, and this new normal means markets may become more volatile.
The Swiss government is somewhat justified in its surprising reversal: to maintain the peg and the cap on the franc’s appreciation would mean the country would have to keep selling down its foreign currency reserves in return for the embattled euro, which faces dim prospects given the European Central Bank’s intention to print more money.
So it was sensible to take precautions before more euros flood the market.
The European Union’s economic fundamentals have yet to show any sign of recovery, and accumulation of more assets priced in euros won’t be a good idea.
This article appeared in the Hong Kong Economic Journal on Jan. 20.
Translation by Frank Chen
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