The Swiss “Paradox”: The Case Against Currency Wars

Conventional wisdom has it that a relatively weaker currency will stimulate exports and years of monetary interventions have been based on this very premise. In this article, we examine whether this rule might indeed be an oversimplified solution to a deeply complex problem and an unsound “panacea”, with potentially dangerous side-effects. We look at one of the most notable exceptions to this rule, the case of Switzerland, which casts doubt over the prudence and the net effect of central bank policies around the world to manipulate and control their currencies.

Exchange rate fundamentals

A currency reflects its purchasing power relative to other currencies and while exchange rate movements are not the sole indicator of the performance of an economy, they are certainly an important one. These movements reflect the level of supply and demand of a given currency, as well as inflation, and other economic factors. It is often the case that central banks step in to keep the exchange rate of their local currencies under control and contain it within their targeted range. Sometimes, aggressive interventions escalate to full-fledged currency wars, driven by the commonly held assumption that a weaker currency will lead to increased exports. Economist Raúl Prebisch pointed out this correlation back in 1964, arguing that a weak currency, and therefore relatively lower export prices, would translate into a higher demand for the exported products and services.

Although this assumption is theoretically plausible, in practice, the causal relation between the two is not absolute, nor does it always retain its predictive power or replicability – the fundamental distinctive properties of a generalizable theory, as opposed to a hypothesis, based on isolated cases or anecdotal narratives. To illustrate this point, we look at the conspicuous counterexample of Switzerland and in particular, at how the structural features of the Swiss economy played an instrumental role in pushing export performance, despite the strengthening of the Swiss franc.

The franc – an independent currency

For centuries, Switzerland has established itself as a safe haven for investors. It enjoys political stability as a result of a transparent and solid democratic system based on the principle of subsidiarity, while its productivity and economic prowess go hand in hand with financial and monetary governance that is autonomous from the European Union. Accordingly, investors are confident in Switzerland’s hedging capacity that can protect their wealth in times of uncertainty and turbulence in the economy or volatility in the markets. We saw clear evidence of this after the 2008 financial crisis, when this confidence in the Swiss economy translated into a sharp increase in capital inflows. This, in turn, inevitably led to an appreciation of the Swiss franc (CHF). In the four years between 2007 and 2011, the CHF appreciated from 1.61 against the Euro to parity price (1 EUR = 1 CHF) in August 2011, prompting the Swiss National Bank (SNB), the country’s central bank, to resort to pegging the currency to the Euro at a rate of 1.20, to prevent further appreciation and protect the country’s economic interests.

The SNB had to use large amounts of its reserves to maintain the artificial exchange rate, and by the end of  2014, its foreign reserves reached about USD504 billion, according to SNB’s balance sheet. The SNB maintained the cap until it announced its removal on 15 January 2015, which, predictably, rattled the markets. The press dubbed this move the “Frankenshock”, and it lived up to its name, as it quickly led to a massive spike of the Swiss franc. The appreciation lasted throughout 2015, but Swiss exports held strong: they only declined by a meager -2.5% in constant prices. The Swiss case negated the assumption of the inverse relationship between currency appreciation and exports – in other words: you don’t need a weak currency to have a strong economy.

capping_swiss_franc

To understand this “Swiss paradox”, the effect of those exchange rate fluctuations should be considered in context and alongside other factors:

  • Autonomous economic governance: By disengaging from the European Central Bank’s policy direction, Switzerland sent a message that is has the ability to act independently to protect its currency: If the SNB had not removed the cap, it would have risked devaluation of the franc, and an “uncontrollable expansion” of its balance sheet, particularly exacerbated by the ECB’s decision to launch QE.
  • Robust industry: Switzerland’s industries are mostly technology-intensive and the country’s leading sectors, chemicals and pharmaceuticals, followed by machinery, electronics and the watch industry, also score very high globally. The chart below shows the increasing performance of pharmaceuticals and watches in the monthly export index, particularly since May 2009. This creates a rather sophisticated basket of exports which helped Switzerland top the global competitiveness index for six years in a row from 2010 to 2015. These are structural, country-specific factors that cushion the impact of the exchange rate on exports.

Pharmaceuticals and watches help push up Swiss exports

pharmaceuticals

Source: Bloomberg

Conclusion

Conventional economic and monetary wisdom operates under the assumption that an appreciating currency will lead to a decline in exports and a depreciating currency will improve exports performance, but there are exceptions to this rule – and Switzerland makes a strong counter argument. In fact, as economists Alfred Marshall and Abba Lerner have pointed out in their “Marshall–Lerner condition”, a depreciating currency will only lead to rising exports if the sum of the elasticity of exports and imports is greater than one. As the Swiss case illustrates, the effect of changes in exchange rate can come second to the effects of changes in global demand for the exported goods – clearly indicating that there are more variables to be considered.

Switzerland is a classic case where the structural strength of the economy enabled the country to attain and maintain a strong presence in international markets, despite currency fluctuations. Its advanced production systems and sophisticated exports enabled it to remain on the top of global growth trends, even with a currency which habitually appreciates during global turmoil, due to the country’s status as a reliable safe haven for investors.

Like many “laws” of economics, the causal relationship between exchange rate and exports has its own caveats and it does not hold true all the time or in all cases. It can therefore be dangerous for policy makers to generalize this rule and overlook case-by-case nuances and special conditions. This oversimplification has led countries to engage in misguided “currency wars”, based on the wrong assumptions.

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