Thursday, January 29, 2015

Was Switzerland Right in Removing Its Currency Peg?

Switzerland was at it again with shocking the world, this time with removing itself from its fixed exchange rate. Prior to January 2015, the Swiss central bank pegged its franc to the euro at a rate of €1:1.2 CHF. Once the Swiss government resumed being a floating exchange-rate regime, the CHF appreciated to €1:1CHF. Not only did this move mess with various hedge funds, but the Swiss stock market dropped about sixteen percent the following day. What was the Swiss government thinking?

It might seem like the Swiss government's thinking has about many holes in it as Swiss cheese, but let's take a look at the basic of exchange rate regimes. In a floating rate regime, which is what Switzerland returned to this month, is when the value of the currency is allowed to fluctuate based on the foreign currencies market. Essentially, the supply and demand for a given currency relative to other currencies is what determines its worth in the foreign currencies market. A fixed exchange rate, on the other hand, is when a currency is fixed or pegged to the value of another currency, a basket of goods and/or currencies, or a good (e.g., gold). There are gradations of a fixed exchange-rate regime (e.g., managed floating), but any regime that is not floating means that the government attempts to control the exchange rate.

Governments who use fixed exchange-rate regimes typically are either trying to prevent major inflation or are trying to make sure its exports remain competitive in the international market because using a fixed exchange rate, like Switzerland did, keeps exports relatively low. A central bank doesn't want its currency greatly appreciating because it means that its goods would become more expensive relative to foreign goods, which is one of the primary allures of a fixed exchange rate. Also, Switzerland thought that its currency was overvalued, which was one of the impetuses behind the regime change.

One of the catches with a fixed exchange rate is that in order for it to work, the government has to successfully maintain the peg. This means buying and/or selling either domestic currency or foreign currencies to succeed. In the case of Switzerland, it meant that the Swiss central bank had to print a whole lot of francs and exchange them for euros so it can have a nice stash of foreign reserves. In theory, the central bank can print more and more money, but that just leads to devaluation and ridiculous levels of inflation in the long-run. Plus, floating exchange rates adjust the balance of trade. A world with floating exchange-rate regimes means a world in economic equilibrium. To implement a fixed exchange rate is a form of price control on of the most macro levels humanly possible. And we already know how I feel about price controls on a more micro level.

The Swiss economy will have some short-term pain, not because they relinquished the fixed exchange rate, but because Switzerland thought it was necessary in the first place. It will take some time for its currency and markets to adjust, but once they do, they will be in better shape not having their currency pegged to the euro, thereby having its monetary fate tied to the failures of the euro zone.

It is speculated that the Swiss government timed the regime change to preempt the European Union's call for quantitative easing. Could the Swiss have handled it better in terms of making the change more gradually? Yes. A sudden shift caused a short-term shock to the system. Although it could have be better managed, on the whole, Switzerland did not want to become a casualty in the Euro Zone's idiocy, and I can hardly blame the Swiss. Switzerland didn't need to peg its currency in the first place, because there are derivatives, securities, and other financial instruments that can better hedge against the risks of competing in the international market. However, since Switzerland committed this folly, it's now undoing a monetary wrong. Any exchange rate regime comes with its advantages and disadvantages (e.g., for a developing country, fixed exchange rates might help produce economic stability in the short-run), but feeling that you need to peg your currency to a bigger country's currency shows a sense of economic immaturity on your end (or possibly succumbing to ignorant, fear-mongering politics) because floating exchange rates allow for better economic growth. I'm glad Switzerland grew up and underwent a reform that will continue its overall reputation as an economically free nation.

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