central bank or hedge fund?: James Saft

August 2, 2012

By James Saft

Aug 2(Reuters) – Switzerland is rapidly turning into a large
hedge fund with a small country attached.

Switzerland on Tuesday revealed its foreign exchange
reserves now total 365 billion francs ($374 billion), a rise of
50 percent in just three months and taking it to a dizzying 62
percent of Swiss annual output. 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 1.20 francs 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 manage 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 $8 billion 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.


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 euro zone. 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 crystallize 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 percent from 51 percent 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

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 euro zone policy, and subjecting itself to a huge and
destabilizing 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.

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