Thursday, 21 June 2018

SNB — central bank or hedge fund?

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Switzerland is rapidly turning into a large hedge fund with a small country attached. Switzerland on Tuesday revealed its foreign exchange reserves now total SFr365bn (US$374bn), a rise of 50% in just three months and taking it to a dizzying 62% of Swiss annual output.

James Saft, Reuters Columnist

A small Alpine country with a big banking industry is now the world’s sixth-largest reserves holder, behind only much larger or resource-rich countries like China, Japan, Russia and Saudi Arabia.

The reason: the Swiss National Bank’s strategy of imposing a cap on the value of the franc against the euro, a policy which obliges it to buy euros in unlimited amounts when the exchange rate hits its line in the sand of SFr1.20 to the euro.

That’s right: if anyone, anywhere, wants to exit their position in the troubled euro, no matter how large, the SNB will buy at a guaranteed price and hand over in exchange francs.

Little wonder Switzerland is experiencing a property price boom. That’s essentially a global macro hedge fund strategy, though no hedge fund manager would be foolish enough to publish and commit to it.

The SNB believes that this policy defends the ability of Swiss companies to compete internationally and also helps to limit the deflationary impact of a strongly rising currency.

So it does, but Switzerland has done this only at the price of taking on an enormous amount of risk, and in essence painting a big bull’s-eye on itself.

To be sure, the SNB made a bit more than US$8bn on its holdings in the second quarter, due in part to movements in the price of gold and capital market holdings. Not quite hedge fund hurdle territory, but better than losing.

And of course the SNB has something no hedge fund has – a printing press which allows it to satisfy any obligations with freshly created money. That means no redemption calls from pesky investors, though they may well get howls of outrage at some point from taxpayers and the politicians who represent them.

Diversification, there’s the rub

At issue is not the SNB’s ability to fund – it can – or the near-term benefits, but rather what happens if things go terribly badly in the eurozone. The worse things get, the heavier the flows of euros in Swiss coffers will be, and the more disastrous, and pointless, the losses if ever the currency union comes asunder. At that point, or sometime in the run-up, the SNB will blink, as everyone understands they will, and choose to crystallise their losses rather than add to them.

Why on earth allow everyone in Spain, and all of the dubious euros in offshore havens to simply sell their dross for Swiss francs? The peg, being static, won’t loosen, it will break like a dam if it breaks at all, but not before saddling the Swiss with a disproportionate share of the euro pain.

The SNB was relatively inactive in diversifying its reserves, somewhat to the market’s surprise. The euro share of reserves went up to 60% from 51% three months before, implying that the central bank had only been doing a small amount of selling euros for other currencies.

“This outcome could lead investors to question the sustainability of the peg,” Todd Elmer, currency strategist at Citigroup wrote in a note to clients.

“The SNB has been unable to diversify a large portion of its EUR holdings, so investors may see greater risk of severe capital losses (and potential desperation selling) down the road. Thus investors may be less inclined to believe that the SNB can maintain its present course in the face of mounting pressure”

To be sure, the euro does not have to fall apart and the peg may never be seriously challenged. If so it will have gained a meaningful benefit to its economy, and may even bag a reasonable return on its money.

But by taking euro risk on, Switzerland is making itself hostage to eurozone policy, and subjecting itself to a huge and destabilising loss. Switzerland has no control over the German electorate, or Italian bank depositors, but has chosen to make itself even more at their mercy. This is exactly the bad trade that banks and economies were making for years before the onset of the crisis – a small gain now against an unlikely but catastrophic loss sometime in the future.

Policy makers err in thinking they can control markets, when what they are really trying to do is control events, a task beyond the ability of mortals.

The price of hubris is not inevitable but it is high.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at

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