Can Markets Attack a Strong Currency? The Case of Switzerland
The Swiss franc has traditionally been a “safe haven” currency: a currency investors buy when they fear instability in the global economy. When a simmering global financial crisis intensified in September 2008 (as we discuss in later chapters), the usual pattern repeated itself. Investors (many of whom were Swiss and owned substantial assets abroad) rushed to put their money into Switzerland. As you can see in Figure 18-6, the Swiss franc price of euros fell sharply (a Swiss franc appreciation), while the reserves of the central bank, the Swiss National Bank (SNB), rose sharply. (Reserves are measured on the figure’s right-hand vertical axis.) Reserves rose because the SNB was intervening in the foreign exchange market, buying euros with francs so as to slow the franc’s appreciation.
The SNB cut interest rates quickly, both to stimulate economic activity and to discourage appreciation. By November 2008, Swiss short-term interest rates were essentially at zero (where they remained). The Swiss franc’s exchange rate briefly stabilized at levels slightly over CHF 1.5 per euro.
But renewed pressure came when the euro zone entered its own financial crisis late in 2009 (as we discuss in Chapter 21). The Swiss franc appreciated dramatically against the euro and reserves ballooned as a result of further foreign exchange purchases. Switzerland began to suffer from deflation and unemployment as import prices fell and as export industries (such as the watch industry) found themselves priced out of world markets. In August 2011, the currency reached CHF 1.12 per euro.
At that point, the SNB took radical action: in September 2011, it pledged to defend a minimal euro price of CHF 1.2 per euro. It would allow the Swiss franc to depreciate up from that floor, but not to appreciate below it. To accomplish this, the SNB had to buy all the euros the market wished to sell it at a rate of CHF 1.2 per euro.
Figure 18-6 shows that Switzerland’s international reserves subsequently rose even more rapidly. As money flooded in from speculators betting that the currency floor would not hold, SNB foreign currency reserves reached a level equal to about three-quarters of a year’s national output! When a weak currency is under attack, the defending central bank, which is selling reserves, may run out. But is there any limit to its ability to hold down a strong currency by buying reserves with its own money, which it has the power to print without limit? The main potential brake is that by buying reserves and allowing the money supply to increase, the central bank sparks excessive inflation. But this did not happen. In part because of the neighboring euro zone’s dismal economic growth, Switzerland remained in deflation long after it stepped in to limit the Swiss franc’s appreciation.