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August 16th 2011:  7 reasons not to peg the Swiss franc to the Euro

 

The Swiss rumour mill has been working overtime over the past few days as further measures to tackle severe franc over-valuation are discussed.  The government will meet on August 17^th and also decide whether or not to hold a press conference. The question, of course, is what will be announced? There has been increased speculation over a peg against the Euro, but there are strong reasons for the Swiss authorities to reject this option.  The more likely outcome looks to be further intervention in money markets to push short-term interest rates even more negative, allied with direct measures to support industry and possible taxes on bank deposits. There is the possibility of a minimum Euro rate against the franc which would be defended by both Swiss National Bank and ECB.

If the franc is pegged to the Euro, then this will give extremely important clues as to the future direction of the Euro itself. It would give a strong hint as to which direction Germany is ultimately looking to take the currency and would increase speculation that Germany will look for a ‘hard Euro’.

There is no question that something needs to be done as the franc has appreciated by over 30% against the Euro over the past 12 months. Switzerland has long been accustomed to dealing with a strong currency, but it simply can’t adjust quickly enough to deal with the latest gains. Large swathes of the manufacturing sector are hopelessly uncompetitive at current exchange rates and the German industrial powerbase will look to take full advantage. The tourism infrastructure will also be extremely vulnerable if the situation cannot be reversed quickly.

Although action is necessary, there are still important reasons why a formal peg should be rejected.

1. Most importantly, Switzerland will not want to lose its sovereignty over monetary policy, especially as independence goes to the very heart of Swiss culture. Their resistance to the Euro and the EU itself illustrates the depth of feeling and determination to maintain control.

2. Similarly, The National Bank would find it extremely difficult to pursue any kind of independent monetary policy and any formal link to the Euro would also push Swiss interest rates higher, exactly what the central bank is looking to avoid.

3. A peg would probably prove unworkable, especially as Switzerland would be linked to a 17-country currency union. That is a very different prospect from the policy of linking with the Deutschemark in the 1970s.

4. There is very little sense in pegging to a currency which has such high uncertainty as the Euro.  As the Euro-zone continues to battle with sovereign-debt default risk, the Euro faces a highly uncertain future at best.  At an extreme level, the Euro may not exist in 6 months time which would make a currency peg worthless and embarrassing.

5. Once the franc was pegged against the Euro it would be very difficult to break the arrangement without triggering fresh destabilising capital flows.

6. It is possible that the Euro will become even more unstable as sovereign tensions intensify. In these circumstances, massive intervention could be required to maintain the link which would eventually destabilise the currency peg and the Swiss economy.

7. Switzerland needs to buy time not destabilise the whole economy. Markets do have powerful self-adjusting mechanisms and these will be a strong forces at work over the next few months to correct the situation. There will be a very strong incentive for Swiss companies to buy overseas manufacturers to diversify their power base and secure lower-cost manufacturing plants. These purchases will have a direct impact in weakening the franc over the next few months.

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