Swiss National Bank, Swiss Franc and financial shocks

by George Hatjoullis

Today the SNB surprised (shocked) the currency market by abruptly dropping the floor on eurchf. This was set at 1.20 while I was still working. In the wake of the eurozone crisis and the earlier banking crisis, the SNB was experiencing an unprecedented demand for CHF deposits. The result was a relentless climb of CHF. The disinflationary pressure within the Swiss economy was enormous. The SNB floor was designed to stop this relentless appreciation. A lot has happened since then and not the least a dramatic appreciation of USD vis-à-vis EUR. The result has been to depreciate CHF vis-à-vis USD. This, according to the SNB, is the reason for the abrupt dropping of the 1.20 eurchf floor. However, the timing is interesting.

Next week the ECB will hold its next policy meeting and there is wide expectation of some news on ECB QE. Yesterday the European Court of Justice cleared the last hurdle to such action (if indeed it was ever a hurdle). The timing of the SNB action cannot simply be a coincidence surely? A more cynical man than myself might conclude that the SNB (always well-informed) now expect ECB QE at the earliest opportunity. This is next Thursday. He might also conclude that the ECB QE will be large and effective and will depreciate EUR further. This would explain the unseemly haste with which the SNB dropped the link to EUR. If I were still working this is what I would be suggesting.

The abrupt move caused quite a flurry in equity markets this morning. This sort of response is common but might puzzle the average person. The SNB move has caused severe damage to anyone short CHF or, what amounts to the same thing, having CHF debt with no corresponding CHF asset. Those having made the loans and long CHF are correspondingly better off. Swings and roundabouts you might conclude. In fact such shocks are invariably negative. The short party may now be unable to repay and this also hurts the long party. Everyone is a loser. Furthermore, no one knows with any certainty what the distribution or size of these shorts/debts might be. Every counterparty is suddenly looked at with jaundiced eyes. Caution prevails, or risk aversion, if you prefer. Quite often losses require some action to cover liabilities and agents sell what they can, often totally unrelated assets. Unexpected price shocks are always initially negative in a leveraged system. There have been many such shocks in recent months, notably Ruble and Oil prices. The cumulative effect of such shocks can cause serious problems in an over leveraged system. The effectiveness of the financial reforms since 2008 and the massive deleveraging that has accompanied these reforms is now being seriously tested.

The residual problem is debt and deflation. There is still a lot of debt in the financial system despite the deleveraging. Despite the best efforts of all but the ECB, which is about to have a go, deflation has not been avoided. The real burden of this residual debt is thus being increased by falling prices. The deleveraging has stopped in real terms. One important reason the authorities fear deflation is because it will slow the process of eroding the real burden of debt, public and private. If nominal default is excluded (e.g. for sovereigns) then this could lead to a period of demand stagnation that will stop nascent GDP growth in its tracks. The only exit from this deflation trap would then be monetary financing. But policy makers will not consider this yet! It is a very unpromising outlook. People that have cash or near cash assets and an income will do well. Any one else is in dire straits.