When a currency ceiling’s broken

 
Chris Papadopoullos
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The Swiss policy U-turn spooked markets – Chris Papadopoullos explains the change

WHAT is an exchange rate cap? Foreign currencies can be bought or sold and have a price just like any other good such as a loaf of bread or a newspaper.

The exchange rate can be thought of as the price of one currency in terms of another.

An exchange rate cap is where the price of a foreign currency is limited in one direction. In Switzerland, there was cap on the price of euros in terms of francs. The Swiss National Bank – the central bank – said it would it not allow the euro to become cheaper than 1.2 francs. To keep the price of the euro above the floor it would buy euros and other currencies using newly created francs to devalue the franc.

Why did Switzerland have a cap?

Switzerland is often seen as a safe haven for investors.

In 2007, a euro cost over 1.6 francs. By September 2011 the franc had strengthened – its value had risen – and a euro cost just one franc. Such a sharp strengthening over just a few years can create havoc for exporters who sell goods and services in euros but pay wages in francs.

A strengthening franc is likely to reduce revenue relative to costs. In more general terms, volatile exchange rates make financial planning harder for firms who operate in more than one currency.

Why has it removed the cap?

The SNB has bought vast quantities of foreign currencies in order to keep the franc weaker than it would be otherwise. Jameel Ahmad, a currency analyst at Forextime believes the decision to scrap the cap probably has something to do with expected Eurozone monetary policy.

“With the pressure on the European Central Bank to provide further stimulus to reinvigorate the EU economy and combat dangerously low inflation levels intensifying in recent weeks and further devaluing the euro, perhaps the Swiss decided it was just going to become too expensive to continue its commitment to the 1.20 floor,” he said.

What are the consequences of removing the cap?

A rapidly strengthening currency is bad news for exporters, whose products become more expensive to sell in foreign currency terms.

The harm to manufacturers can be seen by the 11 per cent drop in Swatch’s share price.

The SNB also cited deflation fears – a strong currency makes imported goods cheaper. Firms that export financial services also took a hit.

Shares in investment banks Credit Suisse and Julius Baer both dived yesterday. A strong franc is also bad for people who earn in one currency but pay their debts in francs.

“If the Swiss franc stays at these levels it will have implications for Eastern European emerging markets such as Poland and Hungary,” Gaurav Saroliya, a strategist at Lombard Street Research, told City A.M.

Hungary and Poland have sizeable stocks of franc-denominated mortgages, Saroliya explains. This means workers need more of their wages to pay their debts. In Hungary, many of these mortgages are liabilities of the government who allowed citizens to swap franc mortgages for florint ones.

But it is not all bad news. Swiss citizens will find imports cheaper. They will also find it is cheaper to go on holidays abroad.

Firms exporting to Switzerland also benefit given that the prices of their exports to Switzerland are now cheaper in terms of francs.