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Implications of the SNB decision extend far beyond Switzerland

OWoN: The Swiss Blinked first and fast and grabbed for the Diaper rack.

Switzerland will live to regret this. It just lost its Cherry as the Safe Haven of Banking and London will take it all.

Bad move, it will cripple Swiss Exports now. Strong Franc, try selling overseas now. Welcome to reality.

Implications of the SNB decision extend far beyond Switzerland

Central banks are struggling to quell market volatility, writes Mohamed El-Erian

Financial Times
By Mohamed El-Erian
15 January 2015

You need only look at the immediate reaction of the foreign exchange markets to the Swiss National Bank’s announcement on Thursday that it was dismantling its one-sided currency peg against the euro to get a sense of the momentous and surprising nature of the decision.

The Swiss franc initially surged some 40 per cent higher against the euro before partially retracing, while Swiss stocks immediately fell by 10 per cent before partially recovering.

The implications of this historic policy turnround extend well beyond a period of bumpy economic and financial adjustment for Switzerland itself. They risk destabilising some other countries and decision-making in the neighbouring eurozone will become even more complicated and contentious.

Confirming the historical lesson that large currency moves tend to break things, they also highlight the extent to which central banks, operating in a world of growing economic and policy divergence, are struggling to maintain the paradigm of low market volatility that is central to their efforts to generate higher economic growth.

In implementing its SFr1.20 floor against the euro three years ago, the SNB aimed to protect Switzerland from excessive volatility occasioned by the eurozone’s debt crisis. The approach served the country well as the European Central Bank took steps to overcome the crisis.

But the ECB’s successful crisis management phase did not hand off to a comprehensive European policy response that produced growth; and with other policy-making entities failing to step up fully to their responsibilities, it has again fallen to the ECB to lead the policy response — and to do so in the context of large and growing divergence between the eurozone and the US when it comes to both economic performance and policy prospects.

In order to preserve the SFr1.20 floor in what is now a period of secular depreciation of the euro against the US dollar, and having already cut interest rates to negative levels, the SNB was forced to step up its foreign exchange intervention. In the process, it has taken its already large balance sheet to unprecedented levels relative to the size of its national economy.

And with the ECB about to do even more next week to loosen monetary policy and, therefore, further weaken the euro, the SNB was looking at the risk of even greater distortion to Switzerland’s economy as a result of a renewed surge in capital inflows.

Following the abrupt removal of the currency peg, Switzerland is now looking at a period of bumpy economic and financial adjustment. Being a relatively “open economy”, in which trade and tourism play an important role, Swiss companies face a considerable competitiveness challenge ahead. The country will also have to deal with issues of currency mismatches, as well as having to battle larger, externally-induced deflationary forces.

But the implications extend far beyond Switzerland. Countries with Swiss franc denominated liabilities, such as Hungary, now have to deal with a major adverse valuation shock.

More importantly in terms of global systemic effects, politicians in the core economies within the eurozone — including Germany, Austria, Finland and the Netherlands — will see the SNB’s move as a reaffirmation of the dangers of substituting financial engineering for real economic reform. As such, they will be less willing to accommodate the hyperactivism of the ECB. And while this is unlikely to stop the ECB from doing more, it may increase the legal, reputational and unity risks it takes in doing so.

Then there are the consequences for a global economy which, in the absence of a comprehensive policy response in the advanced world, has ended up overly reliant on central bank interventions. Given that their tools cannot reach directly and sufficiently at what holds back growth and jobs, these central banks have been forced to use the partial channel of financial asset prices to influence real economic outcomes.

To this end, central banks have sought to repress market volatility as a means of encouraging risk taking that would then boost asset prices and thus encourage greater household consumption (via the wealth effect) and corporate investment (via animal spirits).

The SNB’s decision is further evidence that central banks are finding it harder to implement a policy of volatility repression that already was being challenged by the growing divergence in policy prospects between the eurozone and the US.

All of which leads to a simple but important conclusion that is relevant both to Switzerland and many other economies. The post-2008 period of excessive reliance on central bank policies needs to give way to a more comprehensive policy response that deals with the fundamental shortcomings in supply responsiveness, demand and debt overhangs. The longer that is postponed, the greater the risk of abrupt policy moves that accentuate the related probabilities of policy mistakes and market accidents.

The writer is chief economic adviser to Allianz and author of ‘When Markets Collide’


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