"Kee" Points with Jim Kee, Ph.D.

Without a doubt, the big event last week was the Swiss National Bank’s (SNB) surprise decision to allow the Swiss franc to appreciate (float) against the euro, to which it had previously been pegged. Big events this week will be tomorrow’s release of China’s 4th quarter GDP numbers (>7% expected), and a big European Central Bank (ECB) meeting on Thursday. The ECB is widely expected to announce a debt purchase program at that time.

 

A little background, fixed or flexible? Advocates of flexible exchange rates argue that they allow full discretion on the part of a country’s central bank to pursue monetary policy as it sees fit, with the freely floating exchange rate adjusting to any consequent excess or deficient supply of currency relative to other currencies. Advocates of fixed exchange rates, on the other hand, argue that this full discretion is destabilizing, and that the exchange rate gyrations make it difficult for individuals and businesses to plan and transact on a global basis. They favor a true fixed exchange rate regime, which replaces the monetary authority of a central bank with that of a “currency board.” The board holds a foreign currency as reserve, and issues its own currency for each unit of foreign currency it holds. The country’s currency is in effect “backed” by the currency (or currencies, or gold) to which it is fixed, and there is no more central bank pursuing discretionary monetary policy. Milton Friedman was the best known advocate of floating exchange rates, while Robert Mundell is the best known advocate of fixed exchange rates. Both were awarded Nobel Prizes in economics. Economists have never agreed upon which system is best, and the arguments take on the nuances of things like the size of the country, its openness to foreign trade, the structure of its banking system, etc.

 

The Swiss peg: Many countries try to achieve the best of both worlds by adopting some form of exchange rate “peg,” wherein the discretion of a central bank is maintained, but the bank buys and sells a foreign currency in order to peg or hold its currency’s value at some pre-determined rate. That is what Switzerland was doing. During the global financial crisis money from around the world flowed into safe-haven currencies like the dollar and the Swiss franc. The franc appreciated, which made Swiss goods more expensive on global markets. For example, if you were a US, or Japanese, or a Chinese buyer of Swiss goods, you needed Swiss francs to buy those goods. You would exchange (well, your bank would exchange) your currency for francs, and the stronger the franc, the less francs you got, and the more dollars or yen or yuen it would take to buy Swiss goods. Since Switzerland is a very export-oriented economy, it decided in 2011 to “peg” its exchange rate to the euro, not letting the franc rise above 1 euro per 1.2 francs. If it did start to appreciate the SNB would buy euros and sell francs. But with the euro plunging on international markets during the second half of the year, and a likely quantitative easing (really credit easing) program to be announced soon by the European Central Bank (printing even more euros to buy public and private debt), a huge increase in euros was certain. This was all making Switzerland’s currency peg to the euro untenable.

 

Pegged exchange rates, the worst of all worlds? The key problem with “pegged” rates versus truly (legislatively) fixed rates is that the peg can be changed at the whim of authorities. This creates currency speculation, which can be very destabilizing. That is what happened during the Asian currency crisis in the late 1990s, which involved a slew of speculative attacks against pegged currencies (the central banks in those countries were pursuing monetary policies that were at odds with their exchange rate pegs, but that is another story). So in a surprise announcement on Thursday the Swiss dropped their peg to the euro and allowed the franc to float. It immediately rose 28 percent relative to the euro. In my view – and it is just a hunch – the reason the Swiss didn’t adopt a gradualist approach and allow their currency to appreciate incrementally is that they didn’t want to create a long, destabilizing period of endless currency speculation regarding further changes, so they decided to bite the bullet and remove the peg all at once.

 

The Swiss move in and of it itself wouldn’t be too much of a surprise for world markets to handle, but when thrown into the mix of other global uncertainties, it certainly didn’t help. Those uncertainties include (1) unknown fallout from the collapse in oil prices with Brent flirting with $50/barrel on London’s ICE Futures exchange, (2) ECB meeting on Thursday (stocks there are up in anticipation of QE), Greek elections on Sunday, and a full European electoral calendar for 2015 (UK, Spain, possibly Italy and Portugal, with regional elections in France and Germany - WSJ). The European Union won’t break up, but opposition parties are significant enough for a year’s worth of headline risk, and (3) China cracking down on brokers’ use of margin loans (borrowing to buy) for stocks. Chinese stocks were down almost 8% with those actions, but they were up over 50% last year (hence the Chinese authorities’ concerns of excessive speculation).