The Swiss National Bank has been the most aggressive central bank in a developed economy when it comes to seeking to stop its safe haven status from driving excessive currency appreciation, but many other such institutions are using other, more varied techniques.

For central bankers there is such a thing as too much money. In many countries, capital inflows have powered economic growth, but have also caused a currency appreciation headache. In response, policy-makers have intervened to weaken their currencies, sparking concern over the huge foreign exchange (FX) reserves now languishing on national balance sheets.

Little more than a year ago, the Swiss National Bank (SNB) announced it would buy as many euros as necessary to prevent its currency appreciating beyond SFr1.20 against the euro, after unprecedented safe haven flows out of Europe pushed it to near parity against the eurozone currency.

As a result, Swiss FX reserves have ballooned, hitting a record SFr41bn at the end of August 2012, or 71% of national output. The accumulation has raised questions over what the SNB will do with the currencies it has bought, and led to unease over the potential impact of a deterioration in the euro (in which 60% of its reserves are now held).

“The Swiss were faced with enormous inflows and with the currency near parity with the euro they faced a severe threat to exports,” says Steven Saywell, head of FX strategy for Europe at BNP Paribas. “They made the entirely reasonable decision to draw a line in the sand, but there is a danger they will incur FX losses, and alongside that comes huge political risk.”

Success at a price

In 2010, the SNB posted a record SFr27bn loss on its holdings of euros, leading to calls for then central bank chief Philipp Hildebrand to resign. However, in the first half of this year the publicly owned SNB posted a gain of more than SFr5bn on its FX position, deflecting further criticism.

Alongside selling the franc, the Swiss central bank has flooded the money markets with liquidity, effectively driving rates down and encouraging investors to seek returns elsewhere. The longer-term danger in that policy is that any faster-than-expected upturn in economic growth could lead to a spike in inflation.

The actions of the Swiss central bank have been admirably successful, with investors reluctant to bet against its ability to print limitless amounts of francs, and in recent weeks there has been some talk in the markets that the SNB may raise its ceiling on the franc to as high as SFr1.25, amid continuing concern over economic growth. Interestingly, there was no official confirmation from Switzerland that a rise in the ceiling was being considered, but such is the sensitivity of the currency markets that a rumour, if credible, is often as powerful as the real thing.

In a world where uncertainty is grist to the policy-maker’s mill, Swiss central bank president Thomas Jordan said in late August that the ceiling was “not for eternity” and described SNB policy as “an extreme measure for an extreme situation”. A couple of days later, however, he said the bank would continue to defend the SFr1.20 level “with the utmost determination”.

The SNB has previously demonstrated its ability to stay the term, analysts at UBS observe, when in the 1970s it held the franc peg to the German mark for three years. Derivatives markets illustrate that the Swiss policy has been effective. Short positions on franc futures have outnumbered long positions by as much as eight times over the past six months, according to US Commodity Futures Trading Commission data, suggesting investors are taking the SNB medicine.

Worth emulating

Not many years ago, the overt currency manipulation seen in Switzerland would have prompted howls of indignation from rival economies, focused on the unfair competitive advantage it generates. However, the extreme economic problems in the eurozone have mitigated those complaints, and instigated what may be a new recognition of the acceptability, if not merits, of currency intervention.

Japan, which has over recent years routinely intervened to attempt to stem a rise in the yen against the dollar, is a case in point. The yen has appreciated by more than 30% against the dollar over the past four years, as risk aversion prevented the export of the country’s chronic current account surplus, while inflows were fuelled by liquidity provision and low interest rates elsewhere.

The US Treasury has made no secret of its opposition to the Japanese government’s attempts to contain the yen, but the criticism has been muted. The US “did not support" two large-scale interventions in August and October last year, the US Treasury said in a semi-annual report on FX released in late December 2011. 

In June 2012, a senior official with the International Monetary Fund (IMF) said that the yen was moderately overvalued, and that intervention was an option, a move widely interpreted as a partial mandate of Japan’s action. The change in tone perhaps reflected the fact that US-based currency indignation is no longer focused on Japan, but rather its larger neighbour China.

Unlike Switzerland, Japan has not drawn a metaphorical line in the sand, or hard limit for currency appreciation. Rather, it has made known its discomfort with the yen’s inexorable rise, and its intention to combat the trend. The policy has been somewhat successful, and the yen has remained stable at about Y80 to the dollar since late 2010.

“The Japanese government has done a good job in stemming the yen’s rise, but with the economy’s structural problems, the currency should be a lot weaker,” says Marc Ostwald, a strategist at Monument Securities in London.

In the process of defending its currency against appreciation, Japan has accumulated FX reserves of about $1300bn, placing it second in the world only to China, whose gargantuan reserves top $3200bn. Globally, total FX reserves reached $10,050bn in July, according to IMF figures. That compares to about $6500bn before the financial crisis and just $2400bn in 2002. In 1990, the figure was $500bn.

A long history

The rise in FX reserves is partly a reflection of central bank preoccupation (in particular in emerging markets) with currency strength, fuelled by rising exports, hot money inflows, and demand from investors seeking safe havens, or carry trade speculation. However, while the scale is unprecedented, central bank intervention itself is nothing new. 

In the 1960s, under the Bretton Woods system of fixed exchange rates, intervention was used to help maintain rates between prescribed margins, and was considered an essential component of the central banker’s tool kit. With the collapse of Bretton Woods in the early 1970s, and the move to managed floating exchange rates, the rate of intervention actually increased, as was noted by the US Federal Reserve economist Hali J Edison, in her 1993 paper The effectiveness of central-bank intervention: a survey of the literature after 1982.

The wider point is that if China let the yuan float freely then many other emerging markets would also be able to do so. That is because a primary reason for many countries keeping their currencies weak is fear over losing competitiveness against China

Marc Ostwald

“In late October and early November of 1978, for example, the central banks of Japan, Germany, Switzerland and the US intervened together to support the dollar,” Ms Edison wrote. “The Federal Reserve alone sold more than $2bn-worth of foreign currencies, a substantial amount at that time.”

In the early 1980s, US policy-makers questioned the effectiveness and cost of intervention and it went out of fashion for a few years. Outside the US, uninhibited intervention proceeded apace and European central banks habitually used it to keep their exchange rates within the bands prescribed by the exchange rate mechanism of the European Monetary System. The UK Treasury notoriously came unstuck in a battle with speculators including George Soros over the value of the pound.

“The hedge funds won with a knockout punch,” says Mr Saywell at BNP Paribas. “It shows how difficult it can be to protect your currency against speculators.”

It is easier to prevent appreciation than depreciation – FX reserves can run out if the central bank has to sell too much, but there is no limit for a central bank on buying foreign currencies. Even so, the Swiss authorities have struggled, buying $60bn in a month in 2010 in a failed effort to weaken the franc, and a further $55bn the following year, with little discernible effect. It was only when the SNB bought $90bn in a month and announced a public ceiling that the speculators met their match, and even then the central bank has been forced to accumulate vast amounts of FX reserves to meet its objectives

As in the Swiss case, the difficulty of achieving success has historically not been an impediment to trying, and in a Bank for International Settlements survey of 22 central banks at the turn of the millennium, some 21 respondents said they had intervened in their currencies over the previous decade (the Reserve Bank of New Zealand being the honourable exception).

Alternative methods

Given the dangers of direct intervention, and attendant build-up in FX reserves, some central banks have attempted to finesse currency depreciation, with Sweden’s Riksbank being a recent example. Rather than taking on the speculators, in September it cut its key interest rate by 25 basis points to 1.25%, citing the appreciation of the krona as the reason for the move.

Despite some controversy in Sweden over the effectiveness of monetary policy in currency intervention, Riksbank officials argued that the krona’s 20% rise against the euro over the past three years and the resulting impact on exports was enough to offset potential inflationary pressures.

“A strong currency is welcome because it contains inflationary pressures, but primarily the central bank does not like to see strong appreciation,” says Georgette Boele, head FX strategy at ABN Amro in Amsterdam. “The recent rise in the krona has contributed to the decision to cut interest rates, though gains in productivity also played a role.”

High-yield appeal

While the sovereign debt crisis in Europe has affected smaller European economies regarded as safe havens, they are playing catch-up in a game that has long occupied central banks with higher yielding currencies, from Australia to Thailand, India and Brazil. Emerging market FX reserves have grown six-fold over the past decade, according to the IMF, and it has become a truism that a weak currency and large reserves is the right combination to protect against the type of financial crisis seen in Asia and Russia in 1997 and 1998.

For many countries, the policy has gone far beyond the simple purchasing of dollars to unconventional measures to stem flows of hot money. Among these have been the introduction of withholding taxes on fixed-income securities in Brazil and the cutting of interest rates in Turkey, despite inflationary pressures and a large current account deficit.

Chief among protagonists in the currency game is, of course, China, which has built its export might, and drawn much criticism from the US, on the back of unwillingness to let the Chinese yuan float freely against the dollar. Amid talk of 'currency wars', China has gradually widened the band in which it allows the yuan to trade, but the issue remains a bone of contention with the US.

“The wider point is that if China let the yuan float freely then many other emerging markets would also be able to do so,” says Mr Ostwald.  “That is because a primary reason for many countries keeping their currencies weak is fear over losing competitiveness against China.”

With the yuan, alongside other emerging market currencies, depreciating 'naturally' in recent months, amid slowing global economic growth, the heat has come out of the debate over competitive devaluation. However, concern remains over levels of global FX reserves, with the IMF and others questioning the need for such huge stores of 'rainy day' cash.

“A key problem with buying FX is that you increase money supply and make monetary policy inefficient,” says Thierry Apoteker, chief economist at economic consultancy TAC. “Another issue is low returns on reserves, which is why we are seeing some countries using part of their reserves to invest in higher-yielding assets through sovereign wealth funds.”


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