Where Europe’s smart money hides

Published in Business Spectator (Melbourne), 3 June 2010

When financial uncertainty is on the rise, the Australian dollar is usually among the first currencies to feel the pain. Its status as a proxy for risk has been confirmed in the euro crisis, although the government helped to amplify the Aussie dollar’s slump by waging war against the mining industry.

Just as there are some currencies that suffer in uncertain times, there are other currencies that thrive on uncertainty. In crises, safe havens are in high demand. Being such a refuge for nervous investors comes with a heavy price tag for the local economy, though. It is somewhat ironic that safe havens have to take on a great deal of risk.

Which of these three central banks holds the greatest currency reserves: the US Federal Reserve, the European Central Bank (ECB) or the Swiss National Bank? It may sound unbelievable, but the central bank of tiny Switzerland (population 7.6 million) has indeed greater reserves than either the Fed or the ECB. There are currently more than 150bn Swiss Francs ($154.77 billion) of foreign currency reserves on the books of the Swiss National Bank (SNB), two thirds of which are denominated in euros.

The enormous Swiss currency reserves are a direct result of the euro crisis as the SNB is fighting an uphill battle to stabilise the Swiss Franc against the weakening euro. Switzerland’s central bank soaks up euros and sells off francs on a massive scale. Every month the crisis lasts it only increases foreign currency holdings of the SNB.

As European savers are becoming more and more concerned about their savings, many are looking for alternative investments. Gold is one of them, and there are media reports of people queuing in the streets to buy gold bars and coins. Another option that is mentioned less often is the rush into everything Swiss.

Switzerland enjoys an image of utmost respectability to the point that it almost looks dull. In troubled times, this is precisely the kind of place where worried savers would like to know their hard-earned money. They probably imagine Switzerland as a gigantic bank vault, protected by high mountains and bankers who are ready to defend their savings with the all-so practical Swiss pocket knives if necessary.

Reality in Switzerland does not always resemble the picture postcard image of watches, chocolate and cuckoo clocks. However, there are indeed good reasons to trust investments in Switzerland, not least the fine reputation of the SNB.

In the past, the SNB has been more careful in its monetary policy than most other central banks. “The SNB has valued Swiss price stability more highly than short-term economic growth. In other words, the SNB printed less money than the others”, says Claus Vogt, head of research at Quirin Bank. “This makes the Swiss Franc a currency safe haven.”

There is a downside to this image of stability, though. As euros are flooding into Switzerland, the Swiss Franc tends to appreciate against the European common currency. This is poisonous for the Swiss economy which heavily depends on the eurozone for about 60 per cent of its exports. To make matters worse, European imports get cheaper, which poses a deflation risk for Switzerland.

To confront both these developments, the SNB has gone to extraordinary lengths to protect the economy from the euro’s weakness. From the beginning of the financial crisis until today, Switzerland’s central bankers have been taking an enormous amount of euros onto their books. In April alone, the SNB bought almost €30bn.

For the SNB, this is a big gamble. It must hope that the euro recovers rather sooner than later, otherwise it will have to write down its currency holdings. An even bigger worry for the SNB are the price effects of its efforts to stabilise the exchange rate. In the long run, the increased supply of Swiss Francs could well lead to inflation risks for Switzerland. It is quite ironic that the flight from inflation in Europe could actually lead to inflation in the supposed safe haven of Switzerland.

At the SNB headquarters, they are only too well aware of these problems. Thomas Jordan, vice-president of the SNB, recently gave a speech which highlighted the dilemma for Swiss monetary policy makers. He and his colleagues are simultaneously frightened of inflation and deflation, and there are indeed good reasons to fear both scenarios.

A continuing euro crisis would have a deflating effect for Switzerland, whereas lower interest rates and higher reserve currency holdings would eventually lead to the opposite. Jordan did not have a satisfactory answer to this dilemma, except to underline the SNB’s commitment to price stability.

As it looks unlikely that the euro crisis will be resolved quickly, the SNB is slowly realising that it is fighting a war against the appreciation of its currency that it cannot win. How else could you interpret the passage of Jordan’s speech in which he states that a strong currency may also have a few positive effects for the economy? A strong Swiss Franc, he said, could help keep interest rates low and maintain pressure on exporters to improve their productivity. This is undoubtedly true, but it is precisely to avoid such pressures that his bank had previously spent billions in stabilisation efforts.

As we are watching the troubles of the unenviable Swiss central bankers from afar, perhaps it is a good opportunity to remind us how lucky we are with our risk-sensitive dollar. It may not be flattering to have a currency that is associated with risk in international markets. But it adds a buffer and a safety valve to the Australian economy.

Thus when the world economy wobbles, the falling Australian dollar provides some relief to our exporters. This may be worth more than any government stimulus programme could ever achieve.

At least we don’t have to worry that investors could soon come to regard Australia as a safe haven. Given the government’s ill-conceived mining tax there is no reason why they should change their minds.

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