07 September 2011 No 109.

Christian Ott Juan Carlos Rodado

EUR/CHF Peg : Temporary relaxation, but considerable long-term risks

After the announcement of the Swiss National Bank to peg the Swiss Franc to the Euro at a minimum rate of 1.20 EUR/CHF, the Franc has immediately depreciated by almost 9%. However, the Peg does only work if markets are convinced that it holds permanently. Against the background of the already failed intervention policy of the SNB in the previous year, at a level of uncertainty which was considerably lower compared to nowadays, this is hard to believe. On the contrary, the long-term risks accompanied by such a decision are immense. The loss of control over the domestic liquidity brings a substantial risk of inflation and fuels the housing price bubble. Moreover, the already high losses made by the SNB due to the great amounts of Euro reserves will increase further. In this report, we explain the chances and risks of the SNB decision. Furthermore, we show the impacts on the markets as well as the impact on Eastern Europe countries that are highly indebted in Swiss Franc. 1-Background of the SNB decision Switzerland as a small and open economy with 50% exports to euro zone countries has started to suffer considerably from the strong EUR/CHF exchange rate. The latest data shows that exporters can no longer keep their market shares due to the reduction of profit margins. This strategy has worked for a long time, however with the negative consequences of imminent job cuts. Furthermore, consumer prices increased only by 0.5% YoY in the first half of the year. Observing the mounting risk of deflation and the threatening of the economic activity, the SNB has seen itself forced to react. Keeping in mind the failed intervention policy in 2010, where the SNB bought great amounts of Euro and couldnt defend a target of around 1.40 EUR/CHF, other measures have been applied at first. Starting at August 3, the SNB lowered the Libor target from already 0.25% to 0% and narrowed the target range. At the same time, banks sight deposits had been increased to CHF 80 bn in order to increase the supply of liquidity. Since the reaction of the exchange rate was rather weak, the SNB has announced to increase banks sight deposits further to CHF 200 bn. After a temporary relaxation, the Franc appreciated again to 1.11 EUR/CHF on Monday. At this point, the SNB decided to adopt drastic measures and intervene again on the FX market in pegging the Franc to the Euro at a minimum target of 1.20 EUR/CHF. 2-Implications: Chances versus risks The success of this operation is above all dependent on the credibility of the SNB. In their statement they announced to be prepared to buy foreign currency in unlimited quantities. Technically this is no big deal, since the protection of a lower bound is always possible due to the opportunity of printing money for the purchases of reserves, whereas the protection of an upper bound is limited by the amount of reserves owned by the national bank. Furthermore, a target of 1.20 EUR/CHF is still strongly overvalued based on the Purchasing Power Parity (PPP), which limits the risks to a certain extent. On the contrary, in fixing an exchange rate target the SNB has to give up its control over the domestic liquidity. Thus, meeting the exchange rate target permanently involves a considerable risk of inflation. In the short term this is even helpful to fight deflation, but in the long term it could become a serious problem. Furthermore, the existing housing price bubble would already require a restrictive monetary policy. Finally, the already high book-losses made by the SNB could increase sharply. All these factors depend on the size of necessary reserve purchases of the SNB and thus on the degree of risk aversion. Certainly, defending a strongly overvalued target is easier than defending a target suggested by the PPP. Moreover, the SNB has the possibility to sterilize the money supply to some extent

in order to fight inflation in the long run. However, the uncertainty has considerably risen within the last year. Another round of risk aversion could force the SNB to massive actions.

80 70 60

Chart 2 Share of FX loans (% of total loans) Loans in FX Loans In CHF

3-Impact on the markets After the announcement of the decision, the Franc has immediately depreciated by almost 9% and has leveled out at around 1.20 EUR/CHF (see Chart 1). Thus, the SNBs goal has been met for the first time. However, markets will prove the credibility of the SNB in the future.
Chart 1 Sw iss Franc versus Euro and US Dollar

50 40 30 20 10
Sources : ONB, Natixis

0 Romania Eurozone Croatia Poland Hungary

130 125 120 115 110
Rise = appreciatio n o f the CHF

1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90 0.80 0.70

1.60 1.50 1.40 1.30 1.20 1.10 1.00 0.90

EUR/CHF
Sources : Datast ream

0.80 0.70 0.60

USD/CHF

0.60 10 11

The Swiss Market Index (SMI), whose weight of banks does only account for roughly 11%, has also reacted very positively and gained 4.36% compared to the previous day. 4-Impact on Eastern Europe countries: mortgage pain in Hungary and Poland The

This insane configuration exposes borrowers to an exchange rate risk and lenders to massive defaults in case of currency crisis. While todays intervention has alleviated the pressure on households (Chart 3), we believe that the currency loans will remain on the spotlight for several years especially in Hungary and Poland. The stock of CHF mortgages account for respectively 16% and 10% of their GDP and despite some actions (ban on new FX loans in Hungary, temporarily fixed exchange rate for debt repayments in Hungary, stricter conditions for FX loans in Poland), the problem will not be solved unless there is a long run significant appreciation of the PLN and the HUF. Given the current market distress this will not be plausible in the short term. We recall that since 2008 the CHF has appreciated of 60% against the PLN, 50% against the HUF, 40% against the HRK and 37% against the EUR.
130 125 Chart 3 CHF vs.. (base 100=1/1/2011)
EUR HUF P LN HRK

The strong appreciation of the CHF has considerably hit the solvency of the private sector in Hungary and Poland and to a lesser extent Austria and Croatia (Chart 2). Since the mid-2000s, foreign currency loans became popular especially among households in Eastern Europe, while Austrians have been borrowing in CHF since 1990s 1 . Loans in CHF account for 61% of mortgage debt in Hungary, 54% in Poland and 40% in Croatia. The rapid increase in CHF denominated debt is in line with Switzerland's lower interest rates compared to local rates. Moreover, the appreciation of CEE currencies between 2003 and 2007 encouraged the demand for foreign currency loans as repayment conditions improved.

120 115 110 105 100 95 90

Austria

105 100 95 90
Sources : Bloomberg

85 Jan-11

85 Mar-11 May-11 Jul-11 Sep-11

Due to strong economic ties with Switzerland and lower interest rates in CHF.
No 109 - 07 September 2011 I 2

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