UNIVERSITY OF FRIBOURG FACULTY OF ECONOMICS AND SOCIAL SCIENCES DEPARTMENT OF ECONOMICS FRIBOURG (SWITZERLAND)

Swiss monetary policy and its implications on the economy in the aftermath of the global crisis
Master Thesis

Author: Georgi Nachev Supervisor: Prof. Dr Sergio Rossi, Ph.D.

Fribourg, May 2013

Contents
Abstract .......................................................................................................................... 6 Introduction ................................................................................................................... 7 1. The main factors of the global crisis and their impact on Switzerland .... 9
1.1. The US financial crisis ............................................................................................................. 9 1.2. Europes sovereign debt crisis ............................................................................................ 12 1.3. Swiss economic performance during the crises ............................................................ 16 1.3.1. Swiss foreign trade in times of volatile exchange rates ..................................... 16 1.3.2. The Swiss balance of payments ................................................................................. 17 1.3.3. Swiss GDP ........................................................................................................................ 20 1.3.4. Unemployment rates ...................................................................................................... 22 1.3.5. Property market ............................................................................................................... 23 1.4. Factors for the appreciation of the Swiss franc ............................................................. 24 1.5. Issues concerning the exchange rate floor on the Swiss franc ................................. 32

2. The risks for price and financial stability in Switzerland .......................... 34

2.1. Risks for price stability in Switzerland ............................................................................ 35 2.1.1. The price stability framework .................................................................................... 35 2.1.2. Monetary policy instruments ...................................................................................... 36 2.1.3. Proactive monetary measures and their effects on price stability .................. 38 2.1.4. The future of price stability in Switzerland ........................................................... 40 2.2. Risks for financial stability .................................................................................................. 51 2.2.1. Monetary policy effects on financial stability in Switzerland ......................... 52 2.2.2. Systemic risk for the whole Swiss economy ......................................................... 54 2.2.3. Domestic risks for Swiss financial stability .......................................................... 55 2.2.4. Policy instruments to mitigate medium-term risks ............................................. 59 2.2.5. External risks for financial stability in Switzerland ............................................ 61

3. Swiss National Banks independence .............................................................. 68

3.1. The proper recognition of central bank independence ................................................ 69 3.2. The measurement of central bank independence .......................................................... 71 3.3. Monetary policy independence according to Mundells impossible trinity .... 81 3.4. The efficacy of SNBs independence and its implications ........................................ 85

3.4.1. Price level .......................................................................................................................... 85 3.4.2. Production ......................................................................................................................... 87 3.4.3. Trade balance and exports ........................................................................................... 89 3.4.4. Tourism industry ............................................................................................................. 93 3.5. Foreign reserves purchases in a price stability framework ........................................ 95

Conclusion .................................................................................................................... 98 References ................................................................................................................. 100

List of figures
Figure 1. Bond yields of various countries, 2007-13 ......................................... 13 Figure 2. Sight deposits in Switzerland and EUR/CHF exchange rate, 2007-12............................................................................................... 15 Figure 3. Swiss current accounts, net, 2002-11 ................................................. 19 Figure 4. Annual Swiss GDP growth contributions, 2002-12 ........................... 21 Figure 5. Unemployment rate in Switzerland, the United States and the euro area, 2002-2012 .................................................................................. 22 Figure 6. Swiss property price indices, real, 1970-2012 ................................... 23 Figure 7. Evolution of EUR/CHF and USD/CHF exchange rates, 2007-13 ..... 25 Figure 8. Evolution of the Swiss franc in terms of risk appetite, 2010-11 ........ 26 Figure 9. Real interest rates in Switzerland, the euro area, United States, and United Kingdom, 1995-2012 .............................................................. 28 Figure 10. Lending by commercial banks, 2002-11 ............................................ 29 Figure 11 . Swiss franc divergence to fair value, 2000-12 ................................... 30 Figure 12. Balance of payments, reserve assets of SNB, and EUR/CHF exchange rate, 2007-12....................................................................................... 31 Figure 13. Swiss Libor target range, 2004-12 ..................................................... 38 Figure 14 The SNB inflation forecast of September 2011 and of December 2011 with Libor at 0.00 per cent ................................................................. 40 Figure 15. 10-year Swiss government bond yields and term premiums, 19982011 .................................................................................................... 42 Figure 16. Fed balance sheet expansions, June 2008 - June 2011, assets side in millions of dollars............................................................................... 46 Figure 17. Swiss National Bank balance sheet expansions, September 2007 March 2013, assets side in billions of Swiss francs ........................... 46 Figure 18. US CPI and Swiss CPI, 1999-2013 .................................................... 47 Figure 19. Federal funds rate and Swiss 3-month Libor, 1999-2013 .................. 48 Figure 20. Capacity utilization in the United States, 2007-12 ............................. 49 Figure 21. Capacity utilization in Switzerland, 2008-12 ..................................... 49 Figure 22. Pro-cyclical behaviour and systemic risk ........................................... 54

Figure 23. Home prices relative to household income in Switzerland, 1980-2012........................................................................................... 57 Figure 24. Mortgage volume relative to income in Switzerland, 1980-2012 ...... 57 Figure 25. Goals and instruments under the range of micro-, macro- prudential and monetary policy approaches ........................................................ 59 Figure 26. Export-weighted real exchange rate of the Swiss franc, 1990-2013 .. 61 Figure 27. Stock indexes, July 2007 - April 2013 ............................................... 63 Figure 28. National government debt-to-GDP ratios, various countries, 2007-12............................................................................................... 64 Figure 29. Sovereign CDS premia, in basis points per annum, for 5 years CDS, as of April 2013 ...................................................................................... 65 Figure 30. Eurozone and Swiss interbank markets dynamics, 3-month LIBOR, January 2010 May 2013 .................................................................. 83 Figure 31. Swiss inflation by origin, 2001-12 ..................................................... 86 Figure 32. Sight deposits, CPI, and Swiss franc exchange rate, 2007-12 ........... 87 Figure 33 Swiss Purchasing Managers Index and annual GDP growth rate, 1995-2013........................................................................................... 88 Figure 34. CHF/EUR exchange rate and Swiss trade balance, 2000-12 ............. 89 Figure 35. Swiss exports and trade balance towards Europe, 2010-13 ............... 92 Figure 36. Swiss tourism from EU15 guests, overnight stays in 1000s, 2010-13............................................................................................... 93 Figure 37. Money supply, foreign currency investments, and CPI in Switzerland, 2007-13............................................................................................... 96

Abstract
This masters thesis examines the monetary policy of the Swiss National Bank and its implications for the Swiss economy after both the US credit crisis and the European sovereign debt crisis. The aim is to show what are the economic sectors most severely affected by the global crisis and what are the costs and benefits of the actions carried out by the monetary authority in Switzerland. The purpose is to point out the credibility of the independently taken measures of the Swiss National Bank in regard to price, financial, and economic stability in Switzerland. This work provides various analyses of many economic indicators and their dynamics in the aftermath of the crises: an analysis of the factors that led to the appreciation of the Swiss franc; another analysis of the risks associated with price stability and regarding domestic and external risks for financial stability in Switzerland; two analyses of the independence and efficacy of the Swiss National Bank monetary policy regarding its economic effects on the Swiss trade balance, production, exports and tourism industries. Lastly, the thesis analyzes monetary policy credibility as regards its ability to ensure price stability. The thesis provides a near-term guidance of the future path of development of the price level in Switzerland and therefore to predict the first upward correction in Swiss policy rates of interest. In addition, it provides several recommendations in order for the Swiss central bank to have political and economic independence. In light of this work, it can be concluded that the independent monetary policy of the Swiss National Bank has always been credible and accurately supporting the development of the Swiss economy, either via its hampering effect on the deflationary pressures originating from the global crises or by providing certainty and indirect support for economic activity in Switzerland.

Introduction
During the global crisis, money market conditions in Switzerland have reached their effective bound. As of the end of 2012, the real interest rate of 0 percent, along with the significant amount of foreign currency reserve of 432 billion Swiss francs (equal to 75 percent of Swiss GDP), constitute an exceptional monetary situation, deserving thorough examination for its implication on the whole Swiss economy. This work analyzes the factors that led to the current situation where the mortgage loan, real estate, and bond markets in Switzerland have been gaining momentum. Therefore, it is not to be unexpected that perhaps corrections of some of these markets might occur, if the global and domestic money market conditions change. In order to assess the fragility of the Swiss economy, it is important to understand the unique performance of the Swiss economy over the recent years and then to measure the effects on price level stability, economy performance, and financial stability. This masters thesis is divided into three chapters. The first chapter focuses on the impact the global crisis has had on the Swiss economy. Many fundamental indicators show the Swiss uniqueness, especially as the exchange rate of the Swiss franc appreciated by 33 percent against the euro in the course of the crisis, while the unemployment rate in Switzerland raised to 4 percent in 2009. The second chapter provides different analyses regarding the fragility of the Swiss financial system and the systemic risk originating from its macroeconomic importance. As currently there are no risks in Switzerland regarding a real estate bubble, no inflationary pressures and no risk exposure of Swiss banks towards the peripheral European countries, the chapter argues that the Swiss financial system is currently on a sound footing. To further analyze agents expectations regarding changes in Swiss monetary policy stance and downward price corrections, the decomposition analysis of the 10-year Swiss government bond, along with the retrospective comparison of the Swiss and US fundamentals over time, provide identical forecasts of a price level threshold breach as early as in 2015. On the basis of such results and given the assumption of no premature factors influencing

the money market, the SNB is expected to raise its police rate of interest as early as near the end of 2014. The third chapter examines the independence of the Swiss National Bank and its credibility to maintain stable prices in an exceptional framework of a highly accommodative monetary policy over the past 5 years. The analysis based on Swiss legislation supports the view of an extremely high degree of political and economic SNBs independence. Likewise, the effects of the foreign currency purchase programme over the years have been proved to come along with no compromise on price stability and therefore suggest high degree of monetary policy credibility. Lastly, the thesis examines the economic effects of the stable Swiss franc exchange rate against the euro. The results differ, depending on the economic sector and its price sensitivity towards the exchange rate of the Swiss franc. Besides, our analysis reveals either positive or no effects, as the correlation between the Swiss franc exchange rate and the fundamental economic factors is not always significant to prove any kind of relationship.

Chapter 1 1. The main factors of the global crisis and their impact on Switzerland
This chapter focuses on Swiss economic performance in light of the US financial crisis and the European sovereign debt crisis. The impacts of both crises on the Swiss economy have been fairly diverging from extremely severe to positive. The chapter structure follows a chronological order, starting with a summary of the scope as well as the fundamental nature of US and European crises, and drawing the relationships of these crises with the Swiss economy. We will then focus on Swiss economic performance, by analyzing the statistical data about a variety of Swiss economic indicators. This chapter focuses particularly on Swiss monetary policy, which during the relevant timeframe has played a tremendously important role for the Swiss economy. The last section of this chapter explains the reasons for the historically strong Swiss franc and its positive and negative effects on the Swiss economy. By doing this, it introduces the analysis carried out in the second chapter about the issues stemming from the recent expansionary monetary policy in Switzerland.

1.1.

The US financial crisis

Considered as the worst financial crisis in the United States since the Great Depression in the 1930s, the US financial crisis that erupted in 2007 gave rise to many catastrophes, such as downturns in the world stock markets, bankruptcies of large financial institutions, bailouts of too-big-to-fail banks, and strict austerity measures. It started in 2007 in an unregulated and huge derivative market, based upon a low interest rate environment with an expanding bubble in the housing market and flourishing financial innovation, based on the practice of securitization and originate-to-sell models that led to weak lending standards and a connection between borrowers and lenders (Prager, 2012). 9

In this regard, Bernanke et al. (2011) argue that issues such as distribution of mortgage loans, loose lending standards, poor risk management, conflict of interests in government sponsored enterprises, and faulted regulations were the primary source for the US housing boom and the following burst. In addition, the authors point out another factor called the global saving glut. It is the increased capital inflows to the United States from countries exporters of commodities with trade surpluses as well as from Asian emerging markets. The capital inflows from emerging Asia and Middle Eastern exporters, along with portfolio investors from Europe, exercised an upward pressure on the price of US treasuries notes and pushed down long-term interest and mortgage rates. The resulting low interest rates came with considerate lending in the housing market, which has thus been pushing up property prices (Bernanke, 2005). US housing prices peaked in early 2006 and since there was no fear of an increase in the federal funds interest rates, these prices kept on rising. In 2006-7, however, owing to an increased foreclosure rate as regards US homeowners, housing prices started to decline. On the whole, the crisis was coming. In August 2008 the risk of bursting housing bubble materialized and gave rise to several crises on the real estate, credit, and foreign bank markets. The unfolding of this financial crisis can be attributed to the bankruptcy of Lehman Brothers, previously one of the four largest investment banks in the United States, which had enormous exposure to sub-prime mortgage loans. On September 15, 2008 Lehman Brothers filed for Chapter 11 (Bankruptcy protection) and that is how the credit crunch started. Buik (2011) describes that day as unforgettable, with markets getting worried, with no deposit business going on, and with no bank picking up a penny piece. Crowe et al. (2011) examine the macroeconomic costs of a bursting property bubble and find historical evidence that these costs are exceptionally severe. Further, when the bubble is financed through credit and when leveraged financial institutions are directly involved, as this was plain in 2007, the consequences are even more damaging. In 2007, the US Federal Reserve took actions to mitigate the developing issues in the financial sector, after the subprime mortgage crisis shook the markets. The US Federal Reserve Board released a statement on August 10 claiming that it was

10

prepared to act in response to the downturn and had increased liquidity. In an unscheduled meeting on 17th of August the Fed decreased the spread between the Discount Rate and the Federal Funds Rate from 100 to 50 basis points. This move signaled that thrust and confidence between financial institutions was wiped off, banks cannot borrow from each other, and have to go to the Fed as the lender of last resort. The Federal Open Market Committee cut its target for the federal funds rate three times to help mitigate the adverse effects from disruptions in financial markets. Numerous further reductions followed in 2008, in response to the January stock downturn, tightening credit conditions, the deepening of the housing contraction as well as some softening in labour markets. In addition to its liquidity providing facilities, the FOMC provided buyouts of JPMorgan Chase & Co. and the Bear Stearns Companies Inc., and on 16th of December started Quantitative Easing One, which in essence involves an expansion of the Fed balance sheet of up to 600 billion dollars in agency mortgage-backed securities (MBS) and agency debt. In 2009, the Fed expanded that programme by an additional 750 billion dollars in purchases of agency MBS and agency debt and 300 billion dollars in purchases of Treasury securities. The consequences of the crisis would have been much more severe if the Federal Reserve would have not intervened. As Buik (2011) puts it in an interview about the US financial crisis, without the world central banks, thrust me, we will be all pouring around the fields, pulling out the old wheat to eat, because that was the end of the world. Central banks really never had the credit they deserve. The relations between the United States and Switzerland are close and strong. According to the Swiss balance of payments, the United States is the largest foreign investor in Switzerland, and the largest single destination of Swiss foreign investment. The consequences of the financial crisis are illustrated in the Swiss balance of payments, which is examined later in this chapter. In addition, according to UBS (2012) the United States is the second-largest importer of Swiss goods with a 10.1 per cent share. The consequences of the crisis on the Swiss trade balance are examined later and one can conclude that the US financial crisis did not have much of an impact on Swiss trade, owing to the inelastic demand for

11

Swiss products. In fact, Swiss exporters were even able to raise prices for their products (Swiss Federal Customs Administration, 2012). However, the US financial crisis gave rise not only to the world economic recession in 2008, but also to Europes sovereign debt crisis that erupted in 2010.

1.2.

Europes sovereign debt crisis

At the end of 2005, in its Financial Stability Review, the European Central Bank (2005) raised its first concerns about growing financial imbalances at the global and euro-area level, with rising insolvency risk in spite of improving shockabsorbing abilities of banks. Since the onset of the US financial crisis in 2007, the spread of the government bonds of all European countries relative to the German Bund has been widening. According to De Santis (2012), there are three factors, namely, aggregate regional risk, country specific risk, and contagion effect from Greece, which contributed to the financing issues in the euro area and the widening spread between German bunds and the interest rate on sovereign bonds of government facing deficits in their public budgets. The European sovereign debt crisis officially begun in April 2010, as Greece officially requested a financial support to fill in the gaps in its fiscal budget. From 2008 to 2011, triple AAA governments experienced a decline in their costs of borrowing (Figure 1). Figure 1 also shows the evolution of long-term interest rates by illustrating the development in 10-year government bonds yields in Switzerland, the United States and AAA-rated European countries. Importantly, owing to lower inflation rates, the yields in Switzerland have been clearly apart, while inflation rates in the United States and Europe have been positive and generally close to the stated objective of monetary authorities. Overall, it bears emphasizing the correlated movements in these yields even in a case of different economic circumstances and monetary policy objectives. These movements justify that monetary policymakers in advanced economies have responded in a similar manner to the major economic developments in their countries.

12

Figure 1. Bond yields of various countries, 2007-13

Source: Authors elaboration with data from US Federal Reserve, Swiss National Bank, Eurostat. By contrast, many euro-area countries with excessive fiscal deficits, conceived as unsustainable in the Maastricht sense, experienced difficulties to finance their public sectors debt, since concerned investors asked for an extra premium for the extra risk they had to take. The principles for government finance were laid down in 1992 in the Maastricht Treaty. They include the rule that sovereign debt levels should not exceed 60 per cent of the countrys Gross Domestic Product (GDP) and annual government deficit be less than 3 per cent of the preceding year GDP. As a consequence of many violations of these rules, interest rates for peripheral countries skyrocketed and governments had to impose austerity measures that led their economies into recession. As a result, the issues of serving government debt became more severe, owing to the fact that unemployment rates surged followed by a decrease in consumption and income hoarding. The recession made the European Central Bank to launch two programmes, one in December 2011 called Longer-term refinancing operations for providing cheap liquidity to banks, the other in August 2012 called Outright monetary transactions in order to provide

13

financial support to sovereign debtors. The need of liquidity came from the fact that banks assets have lost value. In addition, national government tax revenues plunged, owing to reduced economic activities. The move also came along with a surge in sovereign debt costs. The growing imbalances in public budgets made governments insolvent to cover their current short-term liabilities and ended their access to financial markets at affordable costs. On 28 November 2010, Ireland, the European Commission, and the International Monetary Fund agreed on arranging a 85 billion euros rescue deal. On 7th of April 2011, Portugal demanded a 78 billion euros bailout package to stabilize its public finances and sustain access to the financial market. During 2012, after Spains 10-year government bonds yield reached 7 per cent, the country was allowed to participate into a financial support programme (European Central Bank, 2013). Haidar (2012) examines the European sovereign debt crisis. According to him, the crisis originates mainly from three major reasons. One of them is the fiscal intervention measures, which improve the future outlook of the countries but on the other hand burden their sovereign debt service, including bailouts that have to be paid back in the future and thus pose a burden on future government budgets. The second reason lies in the decrease of government revenues owing to a sharp devaluation of financial assets and real estate. The third channel also comes from the emerging economic recession and relates to a reduction of aggregate demand and the consequent drop in fiscal revenues. In addition, new governmental expenditures such as unemployment benefits were incurred owing to the severe economic situation. In 2011, the situation for the euro area had changed completely. The main reason was the launch in 2010 of the second round of Quantitative Easing in the United States, in order to monetize the US government debt and to stimulate the US economy by increasing the available funds in the financial system (Mishkin, 2006). As a result, the positions in the euro-area balance of payment improved, followed by an inflow of portfolio investments that flew back into that area. As Figure 2 shows, the euro was appreciating against the Swiss franc during the first months of 2011. The upward move of the euro was counteracted by the Swiss

14

National Bank, which began selling foreign currency reserves it had built before. At the end of 2011 the euro along with market sentiment went down, followed by capital outflows from Spain, Greece, Italy, Portugal, and Ireland of 300 billion euros, according to ING data. In January 2011 the current account of the euro area recorded a surplus of 4.5 billion euros. However, the single European currency depreciated greatly owing to the outflow in the financial account of 53 billion euros (European Central Bank, 2012). Figure 2 uses monthly averages data and shows the steep August 2011 move of the Swiss franc against the euro. The Swiss franc appreciated greatly against the euro in the months preceding August, however on 11 August 2011 the Swiss franc hit the level of 1.04161 for one euro, according to data of the archive of the Swiss Federal Customs Administration. The situation was posing a thread for economic performance and deflationary risk in Switzerland, so the Swiss National Bank took decisive actions and in September 2011 declared that it will enforce a minimum exchange rate of 1.20 Swiss francs for one euro. The commitment was backed up by the Swiss National Bank readiness to purchase foreign currencies in unlimited quantities (Hildebrand, 2011). Figure 2. Sight deposits in Switzerland and EUR/CHF exchange rate, 2007-12

Source: authors elaboration based on data by the Swiss National Bank.

15

1.3.

Swiss economic performance during the crises

The purpose of this section is to familiarize the reader with the performance of the Swiss economy in the timeframe of the US financial crisis and the European sovereign debt crisis. First of all, the section explains the relationship between Swiss foreign trade and the fluctuating Swiss franc. Next, it analyzes the Swiss balance of payments and the consequences of the global financial crisis on it. Then, the section focuses on Swiss GDP by explaining its structure and contrasting developments during the global crisis. The macroeconomic analysis of the Swiss economy then focuses on the changes in Swiss unemployment rates and in the Swiss property market. Finally, the section gives credit to Swiss fiscal and monetary policies for their proactive actions within the scope of their mandates, with the former being a great contributor for the safe haven image of Switzerland and the latter being a protector for adverse developments in the Swiss economy.

1.3.1.

Swiss foreign trade in times of volatile exchange rates

Starkes Wachstum mit hohen Preisen (Strong growth with high prices) was the official title for the third quarter of 2012 of the Swiss foreign trade report (Swiss Federal Customs Administration, 2012). The Swiss Federal Customs Administration stated that during the third quarter of 2012, both exports and imports increased, owing to higher prices. Especially strong was the rise in export prices in both US dollar and euro terms, with the Swiss chemical and pharm industry and the watch industry being the two major industries able to raise prices of their products. The reasons why these sales remain resilient to the strong Swiss franc are to be found in their price insensitiveness. As Lamla et al. (2011) argue, demand for pharmaceuticals, chemicals, clocks, and food is insensitive to the volatility of the Swiss franc. The world-known image of Switzerland, whose products have acquired the title Swissness, along with the highly innovative, research and knowledge based economy, are factors for the success of Swiss exports in spite of an appreciating Swiss franc. On the contrary, the machinery and electronics industry and the metallurgical industry experienced a decline in 16

their exports of 6.7 and 7.6 per cent in the third quarter of 2012 and of 8.3 and 10.1 per cent for the period January-September 2012. These two industries, which are members of the Swissmem organization, advocated the minimum exchange rate and even asked for a higher floor for the EUR/CHF rate. The reason for their export drop is that the demand for machinery, electronics and metallurgical product is highly elastic. As a result, any upbeat changes in prices, which come from appreciation of the Swiss franc, results in downbeat changes in demand for these products. Most of their sales are recorded in countries such as France and Germany, something that make sales figures vulnerable to the fluctuations of the Swiss franc.

1.3.2.

The Swiss balance of payments

The openness of the Swiss economy made Switzerland vulnerable to the financial shock generated by the 2008 US crisis. As the world faced a plunge in income and disinvestment from financial activities, so did Switzerland as well. There are two main reasons for this. The first reason is the size of the Swiss banking sector, which, according to the OECD Structural Analysis Database, was 13.5 percent of the Swiss GDP at its pick in 2007. This number is way greater than in any other developed country. The second reason is the international orientation of the Swiss financial industry. In 2011, according to the Swiss Bankers Association, the Swiss financial sector made around half of its profits from foreign activities, which contributed with 15.1 billion Swiss francs to the GDP of the country. In general, Switzerland has been more resilient and less affected by the recent crisis. Nevertheless, at the onset of the US real estate crisis in the second half of 2007, the current account surplus and the investment income from foreign Swiss subsidiaries recorded a decrease of 3 billion Swiss francs. Indeed, the negative consequences were a bit more severe for the capital account, which plunged from 88 billion Swiss francs in 2006 to 51.9 billion Swiss francs in 2007. The outflow came from reduced direct and portfolio investment abroad. The fall can be entitled to big losses incurred by Swiss banks. The two big banks (UBS and Credit Suisse) had great exposure to the US prime mortgages and derivative markets. After the

17

burst of the crisis, they had to experience expenditures greater than their revenues. Moreover, the Swiss capital account was influenced by a decrease in expenditure on acquisitions by the manufacturing industry (Swiss National Bank, 2008). The declining trend of the Swiss current account surplus continued in 2008. The banks losses in particular were to blame for the plunge in income receipts from abroad. Moreover, the current account surplus went down from 52 to 13 billion Swiss francs, which was the lowest level since the beginning of the 1980s. In addition and in line with the current account, the Swiss financial account also experienced same negative developments. Owing to the crisis in 2008, Swiss banks had reduced their claims and liabilities towards banks abroad and the resulting inflow was offset by an outflow of 35 billion Swiss francs, including the swaps that the Swiss National Bank had to contract to provide with liquidity other central banks. In total, net direct investments abroad dropped 35 per cent from 73 to 48 billion Swiss francs, which was mainly due to the large disinvestments in Switzerland by investors from the European Union and large withdrawals by Swiss investors in the United States. On the other hand, huge outflows of funds were recorded as portfolio investment in debt securities. This can be seen as a sign of a worsening world economic situation, at times when Swiss investors started to look for safe investments. The foreign investors also increased their holdings of portfolio investments in Switzerland, but the main inflow was in equity securities. Indeed, investors consider the Swiss equity market as a safe haven, where the majority of funds fly into in a time of world turnover. In total the outflow in the portfolio investment was higher than the inflow, and the net portfolio outflow position increased to 37.7 billion Swiss francs, from 23.3 billion in 2007 (Swiss National Bank, 2009). As Figure 3 shows, the Swiss current account recorded a surplus of 63.8 billion Swiss francs in 2009. During that year, exports of goods plunged on a monthly basis from nearly 18 billion Swiss francs in the middle of 2008 to around 14.5 billion Swiss francs one year later. Along with exports, imports also fell by 13 per cent in 2009. The reason for the falling exports was the falling world demand, owing to the waning world economic activity. In contrast to 2008, in 2009 net investment income was extremely high having a surplus of 32 billion

18

Swiss francs, attributable to a rise in foreign direct investment income. This rise can be explained by an increase in the direct investments income receipts, which reflected the improved situation in the financial industry and the increase of profit making activities of foreign Swiss banks. It can also be explained by a significant decrease in foreign investments expenses. In 2009, the current account surplus skyrocketed to 64 billion Swiss francs. For Switzerland, the fact that the surplus reached its pre-crisis level of 12 per cent of GDP can be seen as signifying the successful recovery from the crisis in 2007. Figure 3. Swiss current accounts, net, 2002-11

Source: Swiss National Bank, Swiss Balance of Payments 2011. In the Swiss financial account, there was a considerate cutback of the foreign direct investment abroad, a trend of disinvestment in new business activities. The trend from 2008 continued in 2009 and the direct investment abroad went in half. As regards foreign direct investments in Switzerland, there was a gradual increase of 100 percent throughout the year, but all in all the net outflow of FDI went from 43.7 to 2.6 billion Swiss francs. The surplus in the current account was not offset by a deficit (sufficient outflows) in the financial account, which at the end of the year was 26.6 billion Swiss francs, far less than the current account surplus. In 2009, the Swiss National Bank reduced its swap and repo transactions, as another sign of a lessening tension in the financial markets portfolio investments (Swiss National Bank, 2010). In addition, during the European sovereign debt crisis of 2010, Switzerland has

19

accommodated inflows bigger than the outflows in its capital account that justify this countrys image of a safe haven (Swiss National Bank, 2011). In addition, the crisis has shown a tide interdependent relationship between the Swiss economy and the performance of the global economy. Having analyzed the developments in the Swiss balance of payment, the growth in Swiss GDP and its components in the recent crisis period, namely from 2007 to 2011, we can notice that Switzerland is more dependent on foreign investment and less dependent on foreign trade, with the US financial crisis having severe negative impacts and the European sovereign debt crisis having a positive impact on the Swiss economy.

1.3.3.

Swiss GDP

Since the first quarter of 2006 for 11 quarters in a row, Swiss GDP was increasing with a pace of 6 per cent on year-to-year basis as shown in Figure 4. In the fourth quarter of 2008, the US crisis had it major impact when the Swiss GDP growth dropped significantly to 1.8 per cent. Accordingly, the correction was mainly due to negative developments in the Swiss exports sector and fixed investments, as both experienced a sharp and substantial fall of respectably 3.3 and 5.4 percent. Oppositely, private consumption at that time stood stable, with households increasing their spending at an average annual rate of around 1 per cent. In the aftermath of the US financial crisis, the Swiss GDP experienced alike some volatile dynamics, as according to our calculation, the nominal Swiss GDP fell by 2.44 per cent during 2009. The average growth for the four quarter of 2009 is the arithmetic average of the four quarter values, namely -1.5, -4.1, -3.5, and 0.4 per cent. The significant drop in Swiss GDP for the second quarter of 2009 can be attributable to a decrease of domestic demand of 3.1 per cent and to 1 per cent decline in the balance of trade. The one percent decline in the balance of trade is due to falling exports and imports of accordingly 15.4 and 16.4 percent (State Secretariat for Economic Affairs, 2012). The fall in domestic demand in particular consisted in declining overall investments that plunged by 15.9 per cent annually. In this regard, the investments that took the biggest hit were fixed investments, which fell by 15.9 per cent during the second quarter of 2009 and

20

equipment and software investments, which dropped significantly by 20.8 per cent. However, investment in construction experienced a lift of 4.3 per cent. Although the negative development for the Swiss GDP was present throughout 2009, since the first quarter of 2010, the growth rate of Swiss GDP has always been positive. This can be considered as a sign of recovery from the US financial crisis and resilience against the European sovereign debt crisis (State Secretariat for Economic Affairs, 2012). The reason for the positive Swiss GDP growth in a time of European crisis can be found in the composition of the Swiss GDP. Private and government consumption is the biggest sector accounting for 66.8 percent of the GDP. Both sectors remain unaffected from the two crises. Importantly, investments and foreign trade consist of 22.1 and 11.1 percent shares as according to (State Secretariat for Economic Affairs, 2012). Although both declined as a result of the US crisis, only net exports fell during the European crisis. Figure 4. Annual Swiss GDP growth contributions, 2002-12

Source: UBS (2013b, p. 4). In conclusion, the Swiss economy dependents on both foreign trade and investments and a financial crisis can have a significant slow down on the 21

economy. Investments are crucial for Switzerland and any future financial crises may affect the country. Owning to the fact that the European sovereign debt crisis is still lacking the necessary reform in 2013, any growing financial excesses can impose systematic risk for the whole Swiss economy. However, the European debt crisis has its positive implications, in term of bringing significant amounts of capital inflows in the Swiss economy.

1.3.4.

Unemployment rates

The global financial crisis has been weighing heavily on the world economy since 2007. In most advanced countries, the recovery has been weak with economies struggling to regain the job losses. In 2008, as Figure 5 shows, the unemployment rate in Switzerland increased modestly by 1.8 percentage points, in comparison to the United States, which experienced a 5-percentage surge, and the euro area, which faced a 3-percentage increase of the unemployment rate Figure 5. Unemployment rate in Switzerland, the United States and the euro area, 2002-2012

Source: UBS, Swiss Chartset 2013.

22

1.3.5.

Property market

Switzerland is a widely known place for international investments and a global financial center with a large international orientation. This international orientation of the financial industry also involves a highly diversified Swiss economy that is less dependent on its domestic economy. In the past there are examples showing that this has contributed to the resilience of the country in crisis situations. One such example is the performance of the economy during the Swiss real estate crisis of the 1990s. By that time in the economy there were imbalances that were addressed by profitable international business activities, which helped and stabilized the suffering banking sector (Jordan, 2012a). The Swiss economy has gone through the recent crises as no other county. For example, during the US credit crisis, housing markets all over the world crashed. However, the prices of properties in Switzerland held their level and compared to the United States and European Union did not experience any downward pressure. As illustrated by Figure 6, the property price index has been going up since the end of the Swiss property crisis of the early 1990s. Figure 6. Swiss property price indices, real, 1970-2012

Source: UBS, Swiss Chartset 2012.

23

1.4.

Factors for the appreciation of the Swiss franc

In its quarterly assessment of September 3, 2011 the Swiss National Bank argued that the strong Swiss franc poses a significant thread on the Swiss economy. However, the Swiss economy is not only interdependent with the European one, but also with the US economy. The question that arises is why the Swiss National Bank did not implement a minimum exchange rate against the US dollar as well. According to the State Secretariat, the United States is the second larger exporter for Switzerland, with income from US direct and portfolio investments having a great share in the current account of Switzerland. Therefore an increase in the Swiss franc would mean lower profit from companies having their businesses in the United States. The Swiss exchange rates dynamics against same of the major currencies are shown in Figure 7. Importantly, the euro depreciated 31 per cent, compared to the 30 per cent devaluation of the US dollar between the end of January 2008 and the end of August 2011. Although the magnitude of appreciation of the Swiss franc was alike in relation to both currencies, the direction changed at the end of 2012. Accordingly, the Swiss franc sustained its momentum against the US dollar, whereas the euro discontinued its declining trend and currently moderating at 1.23, above the floor of 1.20. One plausible explanation for the discrepancy in currency dynamics is the decision taken by the European Central Bank on 6th of September 2012 to execute its outright monetary transactions in the secondary bond markets of the euro area, therefore eliminating the tail risk stemming from a euro-area breakdown.

24

Figure 7.

Evolution of EUR/CHF and USD/CHF exchange rates, 2007-13

Source: authors elaboration based on Swiss National Bank data. Figure 7 also shows that in the first half of 2007, when the world economy was growing rapidly, the euro was appreciating against the Swiss franc more than the US dollar against the Swiss franc. It is likely that the euro is perceived as the risky currency, which in good time appreciates relatively more, as opposed to the US dollar and the Swiss franc that are seen as a safe haven currency. At the time of writing (May 2013), the United States was lacking a stable and sustainable fiscal policy, as they delegate the reasonability for low unemployment rates and sustainable economic growth rates to another policy instrument such as monetary policy, which de jure should only stand for price stability (Zurbrgg, 2012). As a result, the dynamics in the USD/CHF and EUR/CHF exchange rates were in accord from 2007 to 2011, as both, the US dollar and the Euro lost near 25 percent of their relative values to the Swiss franc. In terms of risk aversion the factors that influenced the exchange rate of the Swiss franc are best reflected in Figure 8, which shows the dynamics in the EUR/CHF exchange rate since 2010.

25

Figure 8.

Evolution of the Swiss franc in terms of risk appetite, 2010-11

Source: Credit Suisse Economic Research (2012). In 2010, the Swiss franc experienced its first significant increase, as investors became risk averse owing to the Greek crisis that erupted at the end of 2009. Then, the fear of double dip recession from September 2010, correlates with another push of the Swiss franc, which reached a low of 1.30 for one Euro. The following Irish crisis from the end of 2010 resulted in further appreciating of the Swiss franc to record high levels of 1.25 for one euro. In 2011, as the Greece crisis gained momentum and panic took over the investors, the Euro dropped to 1.04 against the Swiss franc, as the demand for safe Swiss investments increased. There are several reasons that led to the significant appreciation of the Swiss franc. One of the reasons for the high demand for Swiss francs is the countrys fiscal soundness. Fiscal conditions in Switzerland have always been healthier and much safer that in many other European countries. From the fiscal policy point of view, the Swiss Confederation has never lost its triple-A credit rating. In addition, the public debt brake that was first applied to the federal budget of 2003 is represented as a simple government instrument for managing federal expenditure. The purpose of the debt brake is to prevent longstanding and accumulating budget deficits and thereby keep the debt level within some limits, reasonably justified by the current economic situation. The rule has contributed to have a stable and longterm oriented fiscal policy. This fiscal rule aims to establish a balanced budget

26

with fiscal surpluses when the economy is booming, so that they can be used to offset any deficits in downturn scenarios (Federal Department of Finance, 2012). Owing to the ceiling imposed to government expenditures and the fiscal buffer in a time of crisis, the debt brake is seen as an important prerequisite not only for an independent fiscal policy but also for an independent monetary policy. By having balanced and sound federal budgets, the Swiss National Bank can preserve its independence and resist monetizing any government debt. The fiscal conditions in Switzerland led to a significant decrease in the borrowing needs for the Swiss government. All that gave rise to an increase in the price of Swiss Confederation bonds. Figure 1 shows the recent developments in the bond market, which in the period from the onset of the US credit crisis in late 2007 until the winter of 2012 was dominated by investors having low expectations about future economic growth. In this regard, prices of government bonds of safe haven and triple-A rated countries increased, owing to high demand that pushed the bonds prices up along with dragging down the bonds yields. Another factor that contributed to the appreciation of the Swiss franc is the high real interest rates, encompassing the low level of inflation expectations in Switzerland. As Figure 9 shows in international comparison, Switzerland has been the country with the highest real interest rates. These rates are calculated from the 3-month Swiss Libor rate that then get adjusted for the rate of inflation.

27

Figure 9.

Real interest rates in Switzerland, the euro area, United States, and United Kingdom, 1995-2012

Source: UBS, Swiss Chartset 2012. Moreover, there is a significant discrepancy between real interest rates in the euro area and Switzerland. Notably, the real interest rate in the euro area is running negative and compared to the real interest rate in Switzerland, which moderates near zero levels, favours significant movements of capital into the Swiss economy. The main contributor for negative euro-area interest rates is the higher inflation rate. As a result of these factors, Switzerland has experienced an inflow of capital from European investors who want to protect their wealth from losing value. Another reason for the appreciation of the Swiss franc was the high demand from foreigners in the Swiss housing market. According to property housing indices, housing prices in Switzerland have increased during the crisis. This has made the country an attractive destination for foreign investors who want to invest in the Swiss housing market. In addition, the resilient Swiss property market made those investors who had already invested in Switzerland not willing to reallocate their investments abroad. In addition, the recent expansionary monetary policy of the Swiss National Bank and its lower rates of interest also contributed as another factor for the

28

strong value of the Swiss franc. Figure 10 shows the lending activities of foreign commercial banks, which are represented in the figure as foreign liabilities for the SNB. Figure 10. Lending by commercial banks, 2002-11

Source: Swiss National Bank (2012c). Noticeably, they sky rocked in 2009, as some Eastern European countries had to raise their interest rates to curb inflation, which made banks finance their activities from the low rates Swiss interbank market. The increase in the amount of loans given to foreign banks elicited a high demand for Swiss franc denominated mortgage loans. This initially pressured the value of the Swiss franc down as such loans are usually immediately converted into euros. However, when such loans have to be repaid, foreign banks exercised an upward pressure on Swiss franc exchange rates. The political stability in Switzerland has been another source of strength for the Swiss franc. The soundness and transparency of the Swiss political affairs lead to inflow of foreign capital by basically removing any political and economic barrier for international investors. There are other economic indicators that justify the argument that Switzerland has become an attractive destination for investors during the recent crisis. Some of them are the global economic downturn, higher real GDP growth in Switzerland, lower Swiss unemployment rates, and a positive growth differential between

29

Switzerland and the euro area. According to UBS (2013b) and the statistical data from their Swiss Chartset report, the positive differential for Switzerland in GDP growth ranges from 0.5 per cent in 2006 and 2011 to 2.5 percent in 2009. In 2012, the gap was estimated to be 1.5 percentage points. However, the trend appears to be declining with a somehow shrinking GDP growth differential between Switzerland and the euro area. The UBS projection is justified by the expected positive developments in euro-area GDP. Having reached its par value with the euro in the third quarter of 2011 (Figure 11), owning to several prime factors such as a deteriorating world economy and decreased risk appetite, the Swiss National Bank decided to introduce an exchange rate floor. That move was justified by the value of the Swiss franc prior to 2010. As Figure 11 illustrates, the Swiss franc was undervalued prior to the European sovereign debt crisis. The discrepancy between the market value of the Swiss franc with its fair value began to go in the opposite direction with the onset of the credit crisis and safe haven demand. The crisis led to the massive overvaluation of the Swiss franc, something that Jordan (2012b) argues would cause a major damage to the Swiss economy. Figure 11 . Swiss franc divergence to fair value, 2000-12

Source: Credit Suisse Economic Research (2012). Figure 12 plots net positions in the Swiss current and financial accounts, together with the Swiss National Bank foreign reserves position. According to the balanceof-payments approach, since 2008, the value of the Swiss franc and the capitals

30

inflows in the country have always been correlated, with Swiss balance surplus pushing up the value of the Swiss franc. Figure 12. Balance of payments, reserve assets of SNB, and EUR/CHF exchange rate, 2007-12

Source: authors elaboration based on Swiss National Bank data. However, since 2007, there have been imbalances in the balance of payment that constitute greater inflows than outflows in either accounts. In order to address the issues stemming from an appreciating Swiss franc, the Swiss National Bank accrued large piles of foreign currency reserves from the fourth quarter of 2009 to the second quarter of 2010. As Figure 12 shows, this move was a balancing act in regard to the overall surplus in the Swiss balance of payments. Now, there are basically two main reasons for the overall surplus in the Swiss balance of payments. First, it is the result of repatriation of profits in Swiss francs and disinvesting activities from Swiss investors. Secondly, it is the result of its resilience to crises. Figure 12 shows a discrepancy between the balanced Swiss balance of payments accounts and the still appreciating Swiss franc. The Swiss franc appreciated in the second quarter of 2010, even though the reserve assets in the

31

Swiss National Bank increased to more than 110 billion Swiss francs. According to the asset allocation strategy of the Swiss National Bank, any purchases of foreign reserves represent a purchase of foreign currency and outright investment normally in triple-A securities, such as government bonds. This is reflected as an outflow in the financial account, since the foreign currency is flowing out of the countries and any subsequent income receipts is reflected as inflow in the current account. The asset allocation of foreign investments has been around 55 per cent in euro denominated assets, so that it is important to notice that only 55 per cent of reserve assets are in euros. Therefore, one can conclude that a 100 percentage increase in the reserve assets would lead to 55 per cent increase in the value of the euro and 55 per cent decrease in the value of the Swiss franc.

1.5.

Issues concerning the exchange rate floor on the Swiss franc

There are numerous issues one can find in the recent expansionary monetary policy of the Swiss National Bank. The mostly debated issues originate from the implementation of a minimum exchange rate floor on the Swiss franc. That decision comes inevitably with a substantial expansion in the balance sheet of the Swiss National Bank and several correlated risks. First of all, any risks of inflationary pressures, relating to the growing foreign currency reserves, would force the Swiss National Bank to flip its policy stance back to contractionary. Next, in regard to the SNBs investments, any brake in the policy stance would lead to great losses originating from the Banks investments in foreign assets. At the time of writing (May 2013), the Swiss National Bank holds around 485 billion Swiss francs in assets, which are equivalent to more than half the Swiss GDP (around 600 billion Swiss francs). Therefore, these positions could bring losses of several percentage points of the countrys GDP if the euro crisis worsens. That would push the EUR/CHF exchange rate further down resulting in Swiss National Banks costs owing to exchange rate losses on its investment position.

32

In addition, any inconsistency in the monetary policy stance would result in a loss of credibility for the Swiss National Bank. Financial and banking instability is also a thread that has been emerging since the onset of the recent expansionary monetary policy, owing to the imbalances that have been building up in both real estate and credit markets in Switzerland. The adverse consequences for the Swiss economy could be severe, if one considers the last real-estate crisis in Switzerland. Therefore, the Swiss National Bank (2013a) as of February 2013 requested to the Federal Council an activation of the Countercyclical Capital Buffer (CCB). Another issue that will not be examined here is the international acceptance of the Swiss currency devaluation. The risk of currency war is rising since the recent maneuvers of the Bank of Japan and the following international reactions. Hence, the stance of the Swiss National Bank as regards the exchange rate of the Swiss franc should not be perceived as a way to gain some international competitive advantage but as a way to address deflationary developments, owing to a massive overvaluation of the Swiss franc.

33

Chapter 2 2. The risks for price and financial stability in Switzerland

This chapter focuses on price and financial stability, because both are part of the objectives of the Swiss National Bank. It explains in its second part why ensuring financial stability comes along with price stability as an additional task, which is indirectly part of the SNB mandate. First, the chapter defines the time frame of the recent monetary policy and the progress made towards financial stability in a framework of price stability. Further, it analyzes the Swiss National Bank monetary instruments and more particular the purchases of foreign exchange reserves during a period of price stability that started in November 2009 and lasted until September 2011. Lastly, given the assumption of no risk and cost originating from the recent monetary programme of September 2011, it constructs a hypothetical projection for the path of development of the main interest rate in Switzerland. Our model considers the most recent US economic projection and the guidance embedded in it for the forward development of the federal funds rate, which, as explained in the chapter, experiences similar volatile movement as does the 3-month Libor on Swiss francs. The chapter also addresses the financial stability situation in Switzerland, which currently shows signs of partly bearing consequences stemming from the recent SNB market interventions. Moreover, it analyzes these side effects and risk, and focuses importantly on the stability and soundness of the Swiss banking system. The conclusion of this chapter shows that it is not possible to precisely ascertain the origin of build-up of imbalances in the mortgage credit and real estate markets.

34

2.1.
2.1.1.

Risks for price stability in Switzerland

The price stability framework

The recent expansionary monetary policy of the SNB as analyzed in this work started on December 17, 2007, when the SNB agreed with the US Federal Reserve to provide Swiss banks with US dollar liquidity. The SNB monetary policy strategy consists of three elements. First, the SNB defines price stability by an annual rise of less than 2 per cent in the consumer price index. Secondly, it bases its monetary policy decisions on a medium-term inflation forecast. Thirdly, it sets a target range for the three-month Libor on Swiss francs deposits. In addition, the SNB uses a conditional inflation forecast that takes into account two distinct interest rate projections to forecast the inflation rate to justify its policy. Should there be a discrepancy between the measured rate of inflation and the conditional inflation forecast, the SNB will have to decide to either use expansionary or contractionary monetary policy. In March 2009, Swiss National Bank (2009, p. 9) published an inflation forecast that illustrates the expansionary nature of recent accommodative Swiss monetary policy in the context of sustained deflationary pressures. The forecast also plots an interest rate projection made in December 2008 with 0.50 per cent Libor and a new projection made in March 2009 with 0.25 per cent Libor. It bears emphasizing that the Swiss National Bank took into account a Libor interest rate cut of 25 basis points that took place in March 2009. Although the March 2009 target range is lower in value than the December 2008 target range, the forecasted inflation rate in March 2009 is counter-intuitively lower than the one forecasted in the December projection. In the context of a global economic downturn, monetary policy is likely not able on its own to fully offset major economic slowdowns, such as those that raised at that time from significant consumption and demand restrains and from sharply falling stock and house prices. Since the onset of the financial crisis in 2008, the downside risks for the Swiss price stability materialised in 2009 and 2012, as illustrated by Figure 13. All policy decisions are taken according to the SNB mandate, as set out in the Swiss

35

Constitution and in the National Bank Act. In this regard, as the Swiss National Bank states it, any mechanical acts, such as those in response to inflation forecast differentials, will be ignored, owing to the facts that inflation cannot be measured accurately and it is not always congruently affecting the economic outlook of the country. In addition, the Swiss National Bank should take into consideration the general development of the Swiss economy and banking system. Therefore, one can conclude that the deflationary developments from March 2009 to October 2009 did not pose a significant thread for the overall health of the Swiss economy, even though statistical data from July 2009 shows that the consumer price index went down by 1.2 per cent in the middle of 2009. 2.1.2. Monetary policy instruments

The Swiss National Bank, as mentioned earlier, should guarantee price stability. It does not set inflation targets, however, as not every price movement is definitely inflationary and inflation rates cannot be measured precisely. However, the Swiss National Bank sets a target range for the three-month Swiss franc Libor, which is the average rate of interest at which banks and other financial institutions lend to each other on the interbank and financial markets. The loans taken at the Libor are unsecured and uncollateralized. In order to achieve its monetary policy, the Swiss National Bank uses a 1 percentage point corridor within which it aims to keep the Libor. The Bank has several tools that it can use to influence the development of the Libor, such as SARON, that is, the Swiss Average Rate Overnight. The SARON is the interest rate at which the Swiss National Bank is willing to provide liquidity against collateral on the interbank repo market. The way it works is that the National Bank buys different securities from commercial banks and credits their sight deposits accounts at the Swiss National Bank. At the same time, the counterparty is obliged to repurchase the securities at a later date and to pay the SARON interest rate. In addition to providing liquidity, by setting a SARON rate it exercises a downwards pressure on or provides a ceiling for the Libor towards the chosen target range, by providing banks with the opportunity to lend outside of the market. Currently, the Swiss National Bank has set a target range of 0.00 to

36

0.25 percent for the Libor, with SARON equal to -0.01 per cent and actual Libor at 0.02 per cent. The other tool in the hands of the Swiss National Bank is the deposit interest rate. This is the interest rate banks earn for depositing their funds in their accounts at the Swiss National Bank. By steering this rate the Bank sets a floor for the Libor, by simply discouraging banks to lend to each other at a lower rate (Swiss National Bank, 2004). When the Libor is in the target range and the Swiss National Bank should take further expansionary actions, it can use another policy instrument to influencing the Libor and to provide liquidity. In this respect, the Bank employs two main tools. The first are open market operations in which the Bank takes the initiative and conducts repurchase agreements to provide liquidity or issues its own bills to absorb market liquidity. The second main instrument is the standing facilities, through which the Swiss National Bank acts as a short-term liquidity provider. Currently, the special rate of interest on the liquidity-shortage facility is 0.5 per cent. By being such a provider of emergency liquidity, the Swiss National Bank prevents market bottlenecks in a case when there are unexpected needs of liquidity that cannot be obtained quickly enough on the interbank market (Swiss National Bank, 2004). In addition, the Swiss National Bank has access to other instruments such as foreign exchange swaps. That instrument is usually contracted with other central banks to provide liquidity when and where needed. Moreover, the Bank can purchase or sell foreign currency receivables or derivatives on receivables to deliver or withdraw liquidity. Likewise, the Swiss National Bank may purchase or sell Swiss franc-denominated securities (Swiss National Bank, 2004). The Swiss National Bank target range of the interbank rate of interest has greatly evolved over time. The Swiss National Bank in the period from 2004 to the end of 2008 conducted a restrictive monetary policy. As it can be seen in Figure 13 the upper limit of the target range reached 3.25 per cent and the lower limit 2.25 per cent in September 2007, from the former being 2.25 per cent and the latter 1.25 per cent in January 2000. During a period of 8 years, the Swiss National Bank conducted a restrictive monetary policy, owing to a booming world economy. However, with the already coming along US financial crisis in the end

37

of 2007, the Swiss National Bank brought a change in its policy by switching gears from restrictive to expansionary monetary policy. Figure 13. Swiss Libor target range, 2004-12

Source: Swiss National Bank. The need of liquidity led to a sharp decrease in the target rate, with the first decrease by 25 basis points in October 2008. One month later the target rate was decreased further 50 basis points. However, the corridor of 3 to 2 percent was not a sufficient measure to address the crisis: in November 2008, the Swiss National Bank pushed it further down twice, 50 basis points each time. There was a further decrease of another 50 basis points in December 2008 that was setting the tone of recent expansionary monetary policy. The special interest rate on bottleneck financing facilities went also in line with the Libor target range and experianced a bunch of downward cuts. From 3.84 per cent in 2007, it was reduced to 2.02 per cent in 2008 and to 0.054 per cent in 2009 (Swiss National Bank, 2013e).

2.1.3.

Proactive monetary measures and their effects on price stability

The SNB as the Swiss institution to guard for price stability is fully aware of its actions and the following consequences originating from them. It justifies them in

38

its annual reports and states the factors influencing any possible movements in the price level, as well as any further implication of them for the Swiss economy. In that regard, the recent monetary policy was justified by major world events such as the euro-area crisis, the high price of oil, and the strong appreciation of the Swiss franc. The SNB considered that these events pose a downside risk for the Swiss economy and its price stability. Therefore, it has been advocating for an implementation of a long-term expansionary monetary policy, characterised by lowering the Swiss Libor target range and providing the markets with Swiss franc liquidity. In September 2011, the SNB decided to put a floor for the exchange rate of the Swiss franc against the euro. The underlying motive as illustrated in Figure 14 was addressing the forecasted deflationary development, which according to the projection of September 2011 would hit 1 per cent for imported goods at the end of 2011. Swiss National Bank (2011, p. 14) argues that the impact of a strong Swiss franc would adversely affect profit margins of internationally exposed Swiss businesses. In addition, the adverse effects of an overvalued Swiss franc were not at that time reflected in the statistical data about production and capacity utilization in Switzerland. Further, as Swiss National Bank (2011, p. 14) shows, the Swiss monetary institution expected economic growth that would not be enough to reach a normal capacity utilisation levels. In sum, Figure 14 shows that in 2012 the minimum exchange rate introduced in September 2011 limited the deflationary developments that had arisen as a result of the strong appreciation of the Swiss franc. It bears emphasizing the proactive nature of the September 2011 decision, which related, according to Hildebrand (2011), to the deflationary developments not present in September 2011, but already forecasted as Figure 14 shows. Importantly, the author argues that those deflationary pressures in Switzerland will be carrying the unbearable risk of long-term economic headwinds. The Swiss National Bank (2011, pp. 14, 28) partly connects the September 2011 decision to losing some competitive advantages of Swiss companies, which at that time were suffering from a severe fall in margins, owing to Swiss franc overvaluation. Importantly, out of a survey of 164 companies, the author concludes that the Swiss construction sector remains resilient and unaffected, in contrast to the responses by 96 companies including

39

the Swiss manufacturing and service industry, which experienced significantly negative effects from the Swiss franc appreciation Figure 14 The SNB inflation forecast of September 2011 and of December 2011 with Libor at 0.00 per cent

Source: Swiss National Bank (2011).

2.1.4.

The future of price stability in Switzerland

Having a more clear and transparent vision about the nominal short-term interest rates over time improves agents expectations. Indeed, less uncertainty provides a meaningful support to economic growth and job creation, with the 3-month Swiss Libor projection being relevant for long-run infrastructural or real estate projects. In this regard, an exceptional and prolonged period of low rates of interest might imply a decrease in the lifetime average rate of interest on mortgage loans. On the other hand, unexpected interest rate volatility could lead to capital losses of those agents holding fixed-income instruments, including banking institutions. Such a development may leave the financial system vulnerable to declining asset values that force investors to deleverage their portfolios and to sell assets, driving asset prices ever further down. This section provides a two-way examination that may be useful for understanding the likely path of how interest rates might evolve in future. The

40

question of additional information about the expected monetary policy stance and more particular about the path of development of the Swiss Libor is relevant for both financial stability and monetary policy efficacy in Switzerland. By providing greater clarity, the SNB may enhance transparency and accountability, and make its monetary policy more effective by reducing the risk of agents misperceptions of SNB intentions. Such misinterpretations could lead to increased interest rate volatility and outcomes that would adversely affect financial stability. Therefore, transparency about the likely path of interest rates can mitigate those risks stemming from unexpected interest rate movements. In addition, monetary policy clarity facilitates the decision making process of both households and businesses by reducing uncertainty about the future. In order to provide an answer to the question of how are the short-term interest rates likely to evolve over the coming years, it is worth running two different projections, one by decomposing the 10-year Swiss government bond and another by conducting a historical comparison of Swiss and US monetary policy over the past three decades. 2.1.4.1. Decomposition analysis To start off building up a speculative forecast for the likely path of Swiss interest rates, it is useful to decompose the 10-year Swiss government bond yields into three components. The first component of long-term bond yields is the expected rate of inflation, measured by the consumer price index. As part of the SNB longer-run objective, the projected number for the longer-term objective of two per cent inflation can be taken as certain for the purpose of our examination. The second component is the expected short-term real interest rate over the 10-year term of the life of the bond. In spite of the fact that the Swiss monetary authority does not directly influence the short-term real interest rate, it manages the nominal rate of interest, which over the short to medium term translates into control of the real short-term interest rates. The fact that the current 10-year Swiss government bond yield as of April 2013 of 0.6 per cent incorporates very low real

41

interest rates over the next 10 years suggests that agents project slow growth and low real returns of investment. The last component is the term premium or interest rate risk. It encompasses the extra return investors demand to obtain from holding long-term bonds as opposed to holding and rolling over a sequence of short-term securities. Within this framework, results for the risk premium embedded in the 10-year Swiss government bond yields were produced by Hellerstein (2011), who examined Swiss government bonds and reckoned periods of time with negative risk premium contribution for the 10-year Swiss government bond yield. The left part of Figure 15 shows that since 1998 the investors in the Swiss long-term bond market have demanded negative term premium, in periods that usually follow a severe economic and financial crisis. For example, the Russian default and the LTCM bailout in the fall of 1998, as well as the onset of the European sovereign debt crisis in 2010, both gave rise to negative term premium. The main reason for that is that investors expectations regarding Swiss monetary policy actions manifest in projecting highly accommodative monetary conditions that are likely to sustain for some time the economic situation. During periods of financial turmoil, the interest rate risk decline, owing to a safe-haven demand for longer-term government bonds. Figure 15. 10-year Swiss government bond yields and term premiums, 1998-2011

Source: Hellerstein (2011, p. 17). Importantly, the right panel of Figure 15 shows that the US credit crisis of 2008 has triggered a downward movement in Swiss bond yields. The structural problem

42

in the euro area then appears to significantly have elevated the safe-haven demand on the bond market, pushing down bond yields and implying a lower, or even a negative, term premium. However, the gap between yields and term premium rates has always been closely around two per cent. Given the fact that bond yields equal the sum of the real short-term interest rate, the rate of inflation and term premium, all over the lifetime of the security, the difference between the bond yield and term premium estimated by Hellerstein (2011) manifests in a 2 per cent rate gap that incorporates the expected very low real interest rate and the expected maximum inflation of 2 per cent. Given the fact that in the longer-run inflation expectations anticipate 2 per cent CPI inflation, one can reckon that currently the long-run real interest rate over the next 10 years incorporates a 0 per cent real short-term interest rate. Given the assumption of a sustained 2 per cent gap between the bond yield and term premium, along with the situation in the bond market as illustrated in Figure 15, which since 2010 has evolved in lower long-term interest rates, one can claim a currently present negative term premium for the Swiss government bond yield of -1.4 per cent. This negative number manifests in the compensation that bondholders are likely to provide for the probability of risk of capital gains that may originate from a sustained period of no interest rate changes. In addition, the negative contribution of the term premium can be attributed to expectations of persistent slow economic growth, which also requires an accommodative monetary policy. In order to sustain price stability, the SNB will exercise upward pressure on the short-term interest rate when the rate of inflation hits the 2 per cent threshold level. According to the Swiss National Bank (2013c, p. 18) and its conditional inflation forecast assuming a 0 per cent short-term interest rate, inflation will remain subdued around 0.9 per cent at least until the end of 2015. Such low expected inflation rates will not trigger a change in short-term interest rates over the next three years. However, over the longer-run real short-term interest rates can be expected to remain near the zero level, as a gradual increase in the nominal short-term interest rate will be translating in controlling inflationary pressures. Any upward corrections in the real interest rate are primarily influenced by non-

43

monetary factors, such as the expected return of capital investments, which in turn is closely related to the underlying strength of the economy. Such movements have to be preceded by increasing term premium and long-term interest rates. An increase in the long-term interest rates illustrated in an upward move in the yields of the long-term government bond is likely to move the term premium upwards, suggesting that monetary policy will experience a change in its stance from accommodative towards restrictive. In conclusion, as long-term interest rates are the sum of expected inflation rates, expected real short-term interest rates, and a term premium, a change in the nominal short-term interest rate should be expected when CPI inflation runs around the 2 per cent threshold. Such a change should be preceded by an increase in the term premium in the term structure of longer-term Swiss government bonds. Moreover, the current economic situation and the development in the bond market expect real interest rates to remain low, reflecting the weakness of the recovery in advanced economies, along with low real rate of long term investments return. The risk of longer-term interest rate hike, along with the risk of inflationary developments near the 2 per cent moderate level, impose a risk for the financial industry, which might encounter capital losses owing to expected nominal shortterm interest rate raise. As a result, transparency as regards changes in interest rates will help improve the market expectation of investors and help them sustain their role in the economy as credit providers. 2.1.4.2. Retrospective analysis In order to establish another link regarding the possible future developments in the monetary policy stance of the Swiss National Bank, let us focus on external factors and more specifically on those most important for a hypothetical projection
about the possible future changes in Swiss nominal short-term interest rates.

Importantly, this section justifies the idea of using US monetary policy guidance as a benchmark for future changes in the Swiss monetary policy stance. The use of such a benchmark can increase the transparency of Swiss monetary policy,

44

improve on the creating process of expectations by economic agents and provide a future path for financial stability. The Swiss National Bank takes into consideration the development in the world economy every time it issues its quarterly bulletin and provides argumentation for any change in its policy stance. Indeed, the Governing board of the Swiss National Bank conducts and publishes firstly assessments of the global economic environment of countries such as the United States, the euro area, Japan and emerging countries. Therefore, and owing to the fact that the Swiss economy outreaches internationally and is one of the greatest export countries with highest export to GDP percentage ratios, the decision making process of Swiss monetary policy is correlated with the world economic perspectives. Taking all this into account, one can conclude that every move by the SNB is analyzed and tailored according to the surrounding economic situation. Importantly, there is a concern that changes in the US monetary policy stance would affect price stability in Switzerland, as UBS (2011) pointed out. The author states that Swiss monetary policy would be influenced and depends on changes in the Fed policy stance. Particularly, in case of full capacity utilization and surging inflation in the United States, there is a contagious effect from the US economy to the rest of the world. As a result, the Swiss National Bank would have to react by also getting back to contractionary policy and raise interest rates. In order to justify the argument of a hypothetical guideline for the policy path of the SNB, a thorough consideration and comparison of both the Swiss and the US central banks decisions and decision-influencing factors, like balance sheet expansions, inflation indexes, main reference policy interest rates, and capacity utilization should be carried out. The examination of the interconnectedness between Swiss and US monetary policies can be done considering the recent expansions of the relevant central banks balance sheets. Figures 16 and 17 represent the balance sheet expansion of the Federal Reserve and the Swiss National Bank from June 2008 to June 2011. Similarly, the aggressive expansion in both balance sheets comes with the risk of underpricing the assets bought during that period and eventual losses on some

45

of the asset classes. Further, there are similar consequences in expansions in both US and Swiss francs monetary aggregates. Figure 16. Fed balance sheet expansions, June 2008 - June 2011, assets side in millions of dollars

Source: Federal Reserve Bank of Cleveland. Figure 17. Swiss National Bank balance sheet expansions, September 2007 - March 2013, assets side in billions of Swiss francs

Source: UBS (2013a).

46

Secondly, we have to examine the similarities regarding the developments in the US and Swiss consumer price indexes. Figure 18 plots both inflation indexes for a period of 13 years, starting in 1999. Since 1999, both indexes have been experiencing comparable volatility as regards their overall relative change. Before 2008, inflation rates in both countries remained high. However, since the onset of the credit crisis in 2008, inflation rates failed to moderate and even plunged in the middle of 2008 in Switzerland and the United States likewise. Nevertheless, the overall development in a framework of restrained economic growth after the crisis seems to reflect similar Swiss and US inflationary developments. However, the Swiss rate of inflation has been characterized by slightly modest moderation, compared to the inflation rate in the United States, as it was the case at the end of 2009 and since then. In general, both indexes were in accord, justifying the interdependence between the Swiss and the US monetary aggregates. Figure 18. US CPI and Swiss CPI, 1999-2013

Source: Authors elaboration with data from the Swiss National Bank and the US Federal Reserve. Figure 19 illustrates the evolution of the main reference interest rates in the United States and Switzerland, namely the Federal funds rate and Swiss 3-month

47

Libor. Both interest rates follow the same pattern since 1999, although the magnitude of changes in the Swiss 3-month Libor has been running lightly below the one of the US Federal funds rate. Notice the conservative nature of Swiss monetary policy in terms of rate hikes, since this would increase the relative value of the Swiss franc and therefore impact on the Swiss exports sector negatively. In addition, since 2009, as Figure 19 shows, both the US and the Swiss monetary policies have been characterized with record low reference interest rates. Both central banks justify their decision on fostering market liquidity by the need to spur economic growth and to mitigate downside risks to economic activity. Given the fact that global investors seek higher returns, any interest rate differentials associated with differences in the Swiss and the US monetary policies may promote cross-border capital flows, despite the fact that there are more dominant reasons behind capital flows such as risk sentiment and economic growth expectations. In sum, national monetary policies are likely to adjust likewise to interest rate differentials. Therefore, one may claim that any reasonable and sustainable pace of GDP, inflation, and employment growth in the United States that according to the Fed will trigger an increase in the target of the federal fund rate will probably result in a rise in short-term interest rates in Switzerland. Figure 19. Federal funds rate and Swiss 3-month Libor, 1999-2013

Source: Authors elaboration with data from the Swiss National Bank and the US Federal Reserve.

48

The monetary policies authorities of the two countries consider capacity utilization in their decision making process, as is always indicated in the Swiss National Bank quarterly bulletins and the Federal Open Market Committee (FOMC) statements. In general, higher capacity utilization corresponds to increasing interest rates. Figures 20 and Figure 21 show the growth path of US and Swiss capacity utilization, whose development, if shown to experience the same dynamics, could be a sign for the interconnectedness of the two monetary policies. Figure 20. Capacity utilization in the United States, 2007-12

Sources: tradingeconomics.com and United States Federal Reserve Research. Figure 21. Capacity utilization in Switzerland, 2008-12

Sources: tradingeconomics.com and KOF.

49

Importantly, as observed in both the US and the Swiss figures, the utilization developments were correlated during most of the time. Between 2008 and 2012 the developments in both countries followed a similar volatile path, namely a huge drop in capacity utilization in 2009 and a gradual recovery since then. However, since the middle of 2011, the capacity unitisation index diverged to the one in the US and began to decline. In conclusion, both the Swiss and the US economies share similar paths of capacity utilization before the summer of 2011 and therefore shared similar capacity utilization drivers, such as consumer and government spending, net export, and investments. However, the recent uncorrelated dynamics of the indexes prove oppositely the presents of different capacity utilization drives. Owing to the importance of the way in which the main policy rates of interest in the United States evolve and in order to extract hypothetical guidance for the possible future changes in the Swiss monetary policy stance, it is worth conducting an assessment of the most recent US economic projection and the relevant benchmarks and thresholds. The Federal Open Market Committee (2012a) explains the approach that its members follow in conducting their individual assessments of the appropriate US monetary policy. Importantly, three economic variables such as changes in real GDP, unemployment rates, and personal consumption expenditures (PCE) inflation are taken in consideration while assessing US economic projections. Currently, the Federal Open Market Committee (2012b) anticipates quantitative criteria in regard to the forward path of development of the Federal funds rate such as 6.5 per cent unemployment rate benchmark, a significant improvement in the economic outlook, and 2.5 per cent moderate inflation over a period of between 1 and 2 years. The author also states that a threshold breach will not trigger a policy stance change, as these benchmarks are meant to assure economic agents that monetary policy will continue its expansionary stance even in case of improvements in the overall economic situation and in the labour market. According to the Federal Open Market Committee (2013), 14 out of 19 FOMC participants expected in March 2013 that the Federal fund rate of interest would experience the first increase as early as in 2015. Their assessments show a

50

significant improvement in the US outlook and unemployment threshold breach in 2015. Moreover, the FOMC anticipates inflation rates to continue to be well anchored in the objective of the FOMC of less than 2 per cent. In light of all findings and bearing significant importance for the transparency of Swiss monetary policy as regarding interest rate change expectations, an initial increase in the main Swiss reference interest rates is likely to be expected at the same time as in the United States. However, the forecast is based under the assumption of manageable monetary policy risks and costs. Such conditions would keep the short-term interest rate in Switzerland unchanged. However, in regard to monetary policy risks, the most significant one is the risk of growing excesses in the Swiss mortgage credit and housing markets. The consequential costs of it constitute for a significant assumption in our hypothetical benchmark model. Because of that, it is of great worth to examine out assumption and assess the associated with the recent monetary policy risks for Swiss economy. Shall such risks materialize, the SNB would be forced to act accordingly and set the reference interest rate.

2.2.

Risks for financial stability

This section begins with exploring the question of how has the recent monetary policy that started in September 2011 affected Swiss financial stability. Next, it examines the importance of systemic risk for the Swiss financial system. Then, the section focuses on domestic risks originating in the recent build-up of excesses on the mortgage credit and real estate markets and examines the efficacy of the relevant instruments policymakers in Switzerland have at their disposal to address the financial stability issue. Lastly, the section looks at the European debt crisis, the exposure of the two big Swiss banks towards the peripheral countries and the necessity of additional capitalization.

51

2.2.1.

Monetary policy effects on financial stability in Switzerland

This section tries to justify the premise that the recent highly accommodative monetary policy has its implication in an inflating bubble somewhere in the Swiss economy, and therefore endangered the stability of the Swiss financial system. In order to justify this premise, a brief analysis of statistical data concerning monetary aggregates, CPI and credit levels to the Swiss private sector will be necessary. The analysis considers the monetary aggregate M1 since as a general rule it represents financial assets, such as currency in circulation, sight deposits, and deposits in transaction accounts that can be used as means of payment. On the other hand, M2 and M3 are considered irrelevant, since they contain assets such as saving and time deposits that are used as a store of value. The recent Swiss accommodative monetary policy, which the section refers to, has started in the fall of 2008, when the SNB lowered its target range for the short-term interest rate. Consequently, the short-term Swiss Libor went significantly down near its effective lower bound. Since then, the policy rate has been kept close to zero. In addition, on the 6th of September 2011, the SNB introduced a minimum exchange rate for the euro against the Swiss franc. That decision, according to Hildebrand (2011), has been aiming at a significant and sustained devaluation of the Swiss franc by employing the instrument of open market operations that include purchase of financial assets (such as government bond and shares) denominated in foreign currency. According to data from the Swiss National Bank (2013e), the result of this policy has been an increase in the M1 volume from 464,279 million Swiss francs as of August 2011 to 538,075 million Swiss francs as of February 2013. This represents a 16 per cent increase in M1 for the relevant period and an average annual increase rate of 10.5 per cent. Notably, according to the Swiss National Bank (2013d) and IMF special dissemination standard data, there has been a raise in the credit volume to the Swiss private sector from 929,538 billion Swiss francs as of August 2008 to 994,297 billion Swiss francs at the end of February 2013. The increase for the relevant period accounts for 7 per cent or almost 5 per cent on an annual basis.

52

Moreover, for the same time frame, no inflation has been present, as Figure 18 shows. In addition, data from the Federal Statistical Office (2013) shows that the Swiss CPI stood at 99.7 in August 2011 and slightly decreased to 98.9 in February 2013. Such dynamics correspond to 0.5 annual deflation rates for the relevant time period. As regards real GDP growth rates, data from the State Secretariat for Economic Affairs (2012) employing the expenditure show a gradual increase in real GDP, which as of the end of August 2011 amounted to 136,036 billion Swiss francs and then increased to 137,692 billion Swiss francs as of the end of 2012. The average annual growth rate of 1.1 per cent is much lower than the growth rate of private sector credit, which increased at 5 per cent on annual basis. The dynamics of GDP and credit market developments raise concerns of a build-up of imbalances in the Swiss economy and more particularly in the credit market. Owing to the increase in leverage across the Swiss economy, these developments bear conducting an examination of their origin as well as a cost and benefit analysis for the overall Swiss economy. It also bears emphasizing that both, the annual increase in the money supply of 10.5 per cent, along with a 5 per cent rate of growth in credit lines to private households, have been significantly overshooting the 1.1 per cent pace of increase in the GDP. In sum, the dynamics of the credit-to-GDP ratio gained momentum in 2009 and sustained it throughout the course of the next years. In 2013, the credit volume constituted 170 percent of the Swiss GDP. Such dynamics represent for the build-up of excesses, in a prolonged period of low interest rates. The relation between the two can be precisely ascertained to the nature of how low interest rates manifest in changes in the real economy. Obviously, low interest rates reduce the cost of serving the debt and therefore lead to an increase in its affordability for households. As a result, the credit volume to the Swiss private sector has been rising since 2009. Moreover, low interest rates translate into higher real estate prices and higher notional wealth, owing to the fact that higher credit lines finance additional demand on real estate and product markets. Importantly, Swiss real estate prices and more particularly the prices of owner-occupied apartments, single-family

53

houses and rental prices have been sharply rising since 2009. This, on the other hand, combined with moderate pace of GDP growth over the last several years has been resulting in a gradual build-up of excesses in the domestic mortgage credit and housing markets. Such situations of elevated residential prices and dynamic credit growth constitute an advanced indicator of financial instability.

2.2.2.

Systemic risk for the whole Swiss economy

Danthine (2012) supports a series of proactive measures against imbalances. He considers that systemic risk could originate in a credit crunch, which would result in additional and unassigned costs for the Swiss financial and economic system. Danthine (2012) differentiates between structural and cyclical systemic risks. Figure 22 illustrates the cyclical aspect of systemic risk, which could arise from the procyclicality of financial agents behaviour when they tend to underprice risk in times of crisis and overprice it in a booming economy. In other words, investors are always willing to invest in a housing bubble even though they are aware that the market they get in is inflated and unjustified by its fundamentals.. Figure 22. Pro-cyclical behaviour and systemic risk

Source: Danthine (2012). As Figure 22 shows, in case of outside shock in the capital market, the actions that every agent will take would be similar. In this regard, a mortgage market bubble that bursts would make all the agents get rid of any risky assets they have on their

54

balance sheets. The sell-off would push asset prices even further down, making collateral prices fall. The final outcome would result in a costly financial crisis, where banks get insolvent or even bankrupt. In other words, any procyclical forms of behaviour of agents would make the initial downwards movement even greater, because of the contagious nature of such psychology. Moreover, a phase of deleveraging of credit usage would follow, along with enormous costs for the whole economy The structural aspect of systemic risk for the Swiss banking industry comes from its composition of highly leveraged and interconnected agents with limited liability ownership. Danthine (2012) argues that a greatly leveraged banking industry induces higher insolvency risks for financial agents. The limited liability stimulates agents to take more risk, since managers and shareholders do not fully bear the risks of insolvency and bankruptcy. In short, all agents are incentivized to leverage their balance sheets up to the level where a credit crunch effect will spread among all market agents. The interconnectedness of agents means that any adverse effects in the banking industry will contaminate other financial institutions together with the whole economy. Danthine (2012) justifies the SNB position claiming that the cost of the US credit crisis amounted to 90 per cent of world GDP in 2009.

2.2.3.

Domestic risks for Swiss financial stability

Roggo and Rossi (2011) argue that in 2010 there was no real-estate bubble in Switzerland, whose implications for the whole domestic economy would pose a systematic risk, as shown by the Swiss real-estate crisis in the late 1980s. Their study concludes that the magnitude of economic imbalances is lower than in the real estate crisis from the late 1980s and early 1990s. Their analysis of the Swiss real estate market in 2010 compares current and past performances of the annual Swiss housing price index, which from 1988 to 1990 revealed a 21.96 per cent increase, along with the three-month Swiss Libor, which the authors simulate owing to lack of Libor data before 1989. To do that, the authors assume that Swiss monetary policy in that period was similar to the one after 1989. However, in

55

2011, 2012 and 2013, monetary policy actions such as further corrections in the target range of the main reference interest rate have not been possible, owing to the existing exchange-rate floor. In this regard, both the Swiss franc exchange rate and the commitment by the Swiss National Bank to maintain that minimum rate rule out the possibility of an interest rate intervention such as an increase in policy rates of interest, which on one hand will subdue financial imbalances but at the same time will contradict the overall accommodative policy stance of the SNB and more particular its September 2011 exchange-rate commitment. UBS (2013) obtains similar results to Roggo and Rossis (2011) work. Importantly, UBS (2013) argues in its bubble report for the fourth quarter of 2012 that there is currently no Swiss real estate bubble, despite the very accommodative monetary policy framework. However, according to UBS (2013) there exists an elevating risk of credit and real estate market imbalances. The UBS real-bubble index comprises of six sub-indexes and is at 1.11 for the fourth quarter of 2012. This figure corresponds to a bearable level of risk for the Swiss economy. More precisely, UBS (2013) argues that an unjustified growing investors appetite in the Swiss real estate market at a time of subdued GDP growth poses a risk for a future bubble. Figure 23 illustrates the use of mortgage credit for the purpose of purchasing a home. According to the UBS Home prices relative to household income subindex, there is a discrepancy reflected in the almost 6 time higher home price to household income. Moreover, one can infer that there is an excess of real estate demand, financed with new debt and resulting in elevated home prices. In regard to the mortgage volume-to-income ratio, Figure 24 illustrates a substantial differential between the growth rates in mortgage credit volume and income for a period of 30 years. These dynamics cannot be construed as an ongoing upwards trend, since there have been obviously mixed periods of upward and downward short-term trends.

56

Figure 23.

Home prices relative to household income in Switzerland, 1980-2012

Source: UBS (2013).

Figure 24.

Mortgage volume relative to income in Switzerland, 1980-2012

Source: UBS (2013). Notably, the figure shows that the growth pace of mortgage credit volume has been on a rise in regard to the growth pace of the overall income since 2008. This explains the leveraging up process in the Swiss economy. That process was preceded by a phase of deleveraging that came in the aftermath of the US credit crisis at which the mortgage-credit-to-income ratio declined and bottomed out at

57

the beginning of 2008. It bears emphasizing that the SNB began employing a highly accommodative policy in 2008 in regard to lowering the target range of the 3-month Swiss Libor. The role of the Libor for the leveraging up of the credit market can be explained by the effect of the prolong period of low interest rates, which as Figure 13 shows, has been present for Switzerland ever since the end of 2008. Such low rates are relevant to some extent to reducing the cost of mortgage credits by decreasing the average lifetime rate of serving the credit, which becomes a more affordable financing mean. Further, Danthine (2013) states other explanations for the build-up of excesses on the Swiss mortgage credit market such as improved availability of credit, optimistic expectation of the development in the domestic economy, and changes in the public attitude towards indebtedness. In sum, both Figure 23 and Figure 24 show the inflationary developments in the Swiss real estate market and excessive lending in the mortgage market. Such twin dynamics anticipate a financial stability risk for the Swiss banking sector. Should there be a fall in home prices, undercapitalized banks would face the issue of devaluation on assets, which in turn could make the bank insolvent. Therefore, damping the excessive price level imbalances is a goal that should be achieved, to exclude the risk of financial instability. UBS (2013) suggests that in order to deal with the emerging credit risk a reversal in the SNB monetary policy stance should occur, and more specifically an interest rate hike. The Swiss National Bank (2012b) also made a thorough assessment of possible costs and risks of a revived euro area crisis and concluded likewise that although there is a small direct exposure of Swiss banks to peripheral euro-area countries, there is a considerable risk of losses related to the banks loss-absorbing capital. In conclusion, economic imbalances are considered by the SNB as posing excessive risks for the development of the Swiss economy, owing to the contagious nature of risks. The building-up of excesses on the Swiss mortgage credit and real estate markets makes the Swiss banking industry vulnerable to interest rate hikes, coming either externally or internally, or to probable lower economic growth. In addition, surging unemployment is likely to constrain borrowers abilities to service their mortgage loans.

58

2.2.4.

Policy instruments to mitigate medium-term risks

Figure 25 summarizes all those instruments that Swiss policymakers currently possess to subdue the build-up of excesses in the Swiss economy. There are three types of instruments that can address the issue from micro, macro and monetary perspectives. Some of the instruments have been already employed by the Swiss regulators who in June 2012 took into account the issues of moral hazard coming from the public sectors support for the banking industry along with inaccurate incentives for lending institutions and revised the self-regulation rules for mortgage financing and imposed stricter capital requirements for mortgage loans. Figure 25. Goals and instruments under the range of micro-, macroprudential and monetary policy approaches

Source: Danthine (2012). In order to sustain the resilience and oversee the stability of the Swiss financial system, the SNB works in cooperation with the Swiss financial market supervisory authority and the Swiss Federal Council in imposing both micro prudential and macro prudential measures. As a key macro prudential instrument, the countercyclical capital buffer (CCB) obliges financial institutions to build up and increase their capital of up to 2.5 per cent. It has two goals. The first goal is to build a buffer of capital that, in case of an adverse scenario, would absorb banks losses and therefore prevent insolvency problems. The second use of the CCB is to restrict credit growth by increasing the cost of lending for banks. The CCB is 59

an instrument that dampens the strong growth in credit volumes and increases the resilience of financial institutions. Simultaneously, it does not get in the way of any of the SNB monetary objectives (Swiss National Bank, 2013b). The CCB is a supplementary instrument that does not constitute a trade-off in its essence between monetary policy goals such as price stability and banking soundness. The decision, taken in 2012 by the Swiss Federal Council, to activate the CCB in 2013 will permanently increase the risk-weighting for loans with loan to value ratio of more than 80 per cent and requires a 100 per cent risk weighting for any new mortgage loan unallied with banks self-regulation guidelines. The decision announced on the 13th of February 2013 obliges banking institutions to raise 1 per cent of additional capital by September 2013 and relates to direct and indirect mortgage loans collateralized by Swiss real estate assets. Indeed, a precise assessment of the efficacy and the exact date of activation of the CCB in the previous Swiss crisis are difficult. However, the Swiss National Bank (2013b) considers that such activation would have started earlier than the onset of the 1980s crisis and by increasing the cost of providing credit, the CCB would have subdued the imbalances in the Swiss credit and real estate markets of the late 1980s. Moreover, the CCB would have reached maximum capital buffer one year before the highest level of mortgage and real estate imbalances. By doing this, banks additional capital would have been 2.5 per cent higher, helping them improve their resilience to the foreseeable crisis losses. In addition, it is probable that the market imbalances would not have been at that high level, owing to the more expensive cost of capital. As regards the current build-up of excesses on the mortgage credit and real estate markets, the SNB has considered and taken into account the short-term interest rate as another instrument to address the issue. However, current foreign exchange market conditions and the SNB commitment to maintain a minimum exchange rate of the Swiss franc prevent the use of interest rates as an available tool to ensure financial stability in Switzerland. As the exchange rate of the Swiss franc in 2013 is overvalued (Figure 26), any increase of the SNBs policy rates of interest in an attempt to address financial imbalances will also exercise upwards pressure on Swiss franc exchange rates, therefore being in contrast to current

60

monetary policy. An increase of policy interest rates will create the so-called carry trade condition where investors, for example, get cheaper loans from US banks, convert the US dollars into Swiss francs, and invest them on the Swiss market. The process will even further intensify the demand for Swiss francs and hence appreciate its exchange rate further. Because of that and the current situation in Switzerland, any further increase of the exchange rates of the Swiss franc is intolerable by the SNB. In short, the level of interest rates that will ensure financial stability has to differ considerably from the interest rates needed by current SNB monetary policy. Because of that, an increase of policy rates of interest in Switzerland is currently unavailable to guarantee financial stability. Figure 26. Export-weighted real exchange rate of the Swiss franc, 1990-2013

Source: Danthine (2012).

2.2.5.

External risks for financial stability in Switzerland

The financial conditions for the Swiss banking sector depend not only on domestic factors such as the build-up of real estate and credit markets imbalances but also on external factors such as those originating from the lack of confidence in the European banking sector. This section examines the current situation in the sovereign debt crisis and more particularly it focuses on the peripheral countries of Europe, whose contagious structural problems pose risks of spillover effects to central European countries. It bears emphasizing the increase of market and credit 61

risks in the euro area by looking at the dynamics of several important indicators such as the level of short- and long-term interest rates, the volatile stock markets corrections, the significant credit default swap premia of a number of European government bonds, and sovereign debt to GDP ratio. Then, the section turns to the annual reports of UBS and Credit Suisse for 2012 in order to analyze their creditworthiness and resilience as regards a hypothetical price level correction and significant deterioration in the euro area crisis. The analysis presented in this section concludes on the insignificant risk exposure, UBS and Credit Suisse have towards the peripheral euro-area countries. Therefore, shall the Euro crisis bursts there would be no direct risk exposure for the Swiss financial system. First, global market risk has increased since the onset of the US credit crisis, as the global equity market experienced several significant corrections. As Figure 27 shows, there have been several price corrections in the major national stock indexes of advanced economies. The right scale of the figure shows the relative performance of the indexes, taking the top July levels of 2007 as basics. Importantly, Figure 27 shows significant volatility that implies high levels of market risk for those banking institutions that have large trading and investment positions and hedges in equity markets. Such volatility comes along with a significant decline in market participants net revenues and profitability. In this regard, long positions could be adversely affected by downturns in stock markets and, conversely, short positions could expose banks to significant losses should there be an upturn in the relevant market. Figure 27 shows that from July 2007 until March 2009 stock markets plunged. Some of them, such as those in Greece and Italy, experienced a drop of around 50 per cent of their initial market value. Notably, there are some differences in the magnitude of losses among countries, despite the fact that the general directions of the corrections were the same. It also bears emphasizing the ever since steady upwards movement of equity markets in the United States, Germany and in the United Kingdom. There were two notable price corrections that applied to all equity markets. The first downward movement appeared in the middle of 2010 and the second one in the middle of 2011. In spite of the fact that these developments were correlated, the dynamic of DAX, S&P 500 and FTSE 100 has

62

been clearly a case apart and over performing the others. Although current levels of the indexes are not adjusted for inflation and GDP growth, one may claim that they have recovered from the crisis. Further, notably the S&P 500 is currently moderating near a 5 percent positive growth. In addition, the major Greek stock index (Athex Large Cap) has lost near 90 per cent of its market value as of April 2013, showing that Greece has been the mostly adversely affected country by the crisis. Importantly, for the examination of risk exposure of Swiss banks towards the peripheral European countries, the Spanish IBEX 35 has fallen down near 50 per cent and is currently further away from pre-crisis levels. Likewise, the Italian FTSE MIB has failed to recover and is currently running near 60 per cent below its July 2007 level. Figure 27. Stock indexes, July 2007 - April 2013

Source: Yahoo! Finance. Overall, equity indexes of Greece, Italy, Spain, and France seem to be below their levels of July 2007. In addition, the equity markets in those countries have lost a significant part of their initial value, which as the risk appetite changed was directed towards assets perceived as safe, such as government bonds of safe haven countries constitutes in volatile capital movements that run the risk of future price corrections, increasing the financial system fragility. Secondly, owing to the nature of the relationship between the European banking system and European sovereigns, it bears emphasizing the dynamics in the developments in the government deficit to GDP and debt to GDP ratios. Such developments are relevant since European banks are the major source of funding 63

for national governments and therefore fiscally weak national governments could draw down on the financial system. Figure 28 shows the gradual increase in the debt to GDP ratio for the national governments of the economically stronger European countries. As the ongoing trend suggests, there is a build-up of leverage in the public finance system, which (owing to the interdependence with the banking system) increases its fragility to price level corrections. In addition, the unsustainable high level of government debt reflects the lack of progress as regards structural reforms in these countries. Figure 28. National government debt-to-GDP ratios, various countries, 2007-12

Source: Authors elaboration with data from Eurostat. Thirdly, there has been an overall increase in the credit risk of default in euro area periphery. Importantly, such developments have weighted on the quality of banks balance sheets, in particular on those having significant exposure to the peripheral countries. Credit Default Swaps (CDS), as invented by JP Morgan are derivative instruments insuring the buyer against the probability of sovereign governments default on their debt. Importantly, high CDS spreads imply high premium that a buyer should pay to an insurance company against losses stemming from a credit event. The premium depends on the expected default risk of the respective

64

countries to meet their financial obligations and therefore is an accurate measure of credit risk. A spread of 200 basis points equals to near 3 per cent annual chance of sovereign default, 14 per cent default rate over the next five years and 20,000 euro default premium, given one million notional insured (CMA, 2010). Figure 29 displays the CDS premia, written on five-year government debt for countries perceived as safe and for those perceived as risky. Overall, as of April 2013 and over the next five years, the situation of the credit market implies a technical default for Greece, illustrated in red, 17 per cent probability of default in Spain, 17.7 percent in Italy, 24 per cent in Portugal, and 3 per cent in safe haven countries, illustrated in green. Such developments are likely to increase the cost of serving the debt and therefore contribute to the gradual increase in government debt to GDP levels. Figure 29. Sovereign CDS premia, in basis points per annum, for 5 years CDS, as of April 2013

Source: Authors elaboration with data from the CNBC.

65

The fact that the euro area problems remain unresolved justifies the necessity of examining the risk exposure of the two biggest Swiss banking institutions towards the peripheral countries of Europe. UBS (2013c, p. 150) shows in its annual report for 2012 insignificant risk exposures towards Greece of 48 million Swiss francs in total and all hedged. The number breaks down to 34 million of trading inventory such as bond and equity securities towards the Greek government and 9 million Swiss francs towards the corporates, insurance companies and funds. Likewise, the exposure towards Italy, Spain, and Portugal remains limited. At the end of 2012, UBS had 5,897 million Swiss francs risk exposure towards Italy of which 4,389 million is hedged. The risk exposure is divided into two main sectors, namely 2,679 million originating from banking products sold to Italian corporates, and 2,361 million sold to the Italian government. Overall, the bank exposure of unhedged products accounts for 1,508 million, from them 890 million is to the Italian government and 618 million to the Italian private sector. The situation with respect to Spain records a lower level of overall risk exposure of 4,567 million in total of which 3,712 million are supplemented by hedges. Further, UBS holds 97 million of unhedged positions in Portugal, although all the exposure towards the Portuguese government is complemented with synthetic hedge positions. In total, UBS has unhedged risk exposure towards the euro area peripheral countries of 2,460 million Swiss francs of which merely 890 million related to sovereign governments. The numbers are insignificant compared to the equity of 45,895 million Swiss francs the banks shareholders hold. Similarly, Credit Suisse, the second biggest Swiss bank in terms of equity capitalization, reports for the end of 2012 a consistent low and insignificant country risk exposure situation. Credit Suisse (2013, pp. 111 and 137) states 35,498 million Swiss francs worth of equity and 4.4 billion euros of sovereign credit risk exposure to the governments of Greece, Ireland, Italy, Portugal and Spain. However, only 600 million euros was the net and unhedged exposure of the bank towards these governments. In conclusion, the Swiss big banks seem to be adequately capitalized given the moderate credit risk exposure they have towards problematic peripheral European

66

countries. In addition, the two Swiss banks reduced their risk-weighted assets and expanded their loss absorbing capital in 2012. However, UBS and Credit Suisse are heavily exposed to the European banking sector and still stand below maximum compliance in terms of Basel III regulations. Such compliance would ensure banks resilience to the vulnerable global economy. In addition, the banks compliance to the regulations is likely to prevent them from effects of a spillover, triggered by a revived crisis, with contagious direction towards the core European countries, whose banks currently have high risk exposure and insufficient lossabsorbing capital.

67

Chapter 3 3. Swiss National Banks independence

This chapter examines the independence of the SNB with respect to its capacity to ensure price stability. Importantly for the long-term economic performance of Switzerland, the SNB independence to act flexibly in regard to balance sheet expansion and contraction is threatened by the challenges of the minimum level of gold holdings and foreign exchange rate floor. Due to the fact that each institution has specific defined independence that could only relate to its specific mandate, it first bears emphasizing the definitions of SNBs independence, mandate, and tasks given to the SNB by the Swiss Federal Constitution and the NBA. The chapter starts off with providing a theoretical justification in favour of the political independence of any central bank. Then, by breaking it down using the attributes from the work by Grilli et al. (1991), the chapter examines the degree of SNBs independence with regard to the political and financial autonomy regarding the SNBs decision-making process. The second section provides some conclusions regarding the overall state of Swiss monetary policy independence and by providing some recommendations. Next, the third section argues in favour of a complete sovereign independence of SNB, currently possessing all three of the attributes constituting the Mundell impossible trinity framework. Next, the chapter examines the impact of the SNB independence on the Swiss real economy by considering the dynamics in the main macroeconomic variables such as PMI, economic growth, and trade balance. It also argues that such macroeconomic improvements do not compromise on SNBs credibility by examining the effects of the foreign reserves expansion on the CPI. The underlying theoretical argument is that Swiss inflation rates have been moderating in the context of price stability, which in turn does not compromise the SNBs credibility to sustain price stability.

68

3.1.

The proper recognition of central bank independence

The proper recognition of the independence of the central bank deserves special attention because it can lead to higher credibility in the action of the monetary authority. Central bank independence means the lack of government intervention in monetary policymaking. Such autonomy is likely to result in greater credibility that delivers lower inflationary expectations and thus lower wage increases. The stronger argument for central bank independence, as Mishkin (2004) and Bernanke (2010) point out, rest on the view that if short-term political needs take on influence in the central banks decision-making process, this could overheat the overall economy by putting excessive short-term stimulus and thus exceeding the economys underlying potential. The effects of such measures are likely to support political election campaign by shortly increasing the performance of the economy through the means of monetary instruments such as agency mortgagebacked securities (MBS) purchase programmes, through which the central bank buys MBSs. However, these effects are unsustainable and soon fade away, causing sustainably long-term inflationary developments. The underlying reason stems from the fact that high money supply growth as a consequence of shortterm stimulus may lead to short-term interest rates fall, followed by an interest rate hike as the different sectors of the economy are likely to disproportionally heat up by reaching full capacity utilization. The consequent hike in short-term policy rates of interest affects the economy as a whole, leaving some sectors of it more vulnerable that others. As a result, political interference impairs monetary policy independence by creating short-term effects that ultimately lead to longerterm inflationary pressures and poor economic performance. The second reason why it is important that central banks retain their political independence lays on the possible monetary policy inefficiencies that are likely to result from political interferences. Such inefficiencies as those originating in time inconsistent monetary policy might cause undesirable changes in real and nominal magnitudes, such as lower employment level and higher inflation rates. Bernanke (2010) argues that time inconsistency of monetary policy, as analyzed by Barro and Gordon (1983), can hamper monetary policy credibility regarding its capacity

69

of maintain long-term price stability. In this regard, central banks from all over the world create expectations of moderate inflationary development in the public. By meeting public expectations and sustaining price stability over the long run, a central bank enhances its credibility by building trust in the public. As a result, households curtail their demands for higher wages and businesses ease their demands for higher prices, owing to lower inflationary expectations. However, by putting the government on control on the central bank, it is likely that the central bank would be less credible towards its fulfilling its long-term goal of low rates of inflation, as the voters could easily recognize the risk of long term inflation. In turn, the lack of independence could lead to higher inflation expectations and thus higher overall price level in a framework of already evaporated short-term economic effects. In this regard, the formally established mandate of the SNB of sustaining moderate inflation while taking into account the development of the economy requires the SNB to focus on price stability in the framework of a well-performing economy. However, owing to the fact that monetary policy works with time lags, the SNB has to focus its efforts over the longer run by taking a long-term perspective on any issue. In order for the SNB to achieve the best performance in driving the Swiss economy towards maximum capacity, it should take autonomous long-term decisions, independent from the government decisions, which normally regards to short-term economic stimulus that may distort the overall health of the economy. Another argument in favour of central bank independence is that influential governments may abuse their power on the central bank and exercise pressure on the monetary institution to monetize the government debt by using the production facility of Orell Fssli Security Printing Ltd or any other printing press company. It bears emphasizing that the government may abuse its power over the money creation process and use it as a means of financing its spending and increase its budget deficit. Such misallocation of monetary power inevitably compromises on both price and financial stability and may lead to a disrupted economy. In conclusion, provided with the ability to interfere in the policy of the central bank, a government could destabilize the whole national economy, increasing the

70

levels of inflation and interest rates, accompanied by a lack of sustained GDP or employment growth. Being a critical component of a sound macroeconomic framework, central banks should strike to enhance their credibility by avoiding governmental interventions.

3.2.

The measurement of central bank independence

This section has two objectives. First, it defines what central bank independence is according to the Group of experts (2001) and examines the criteria by which it is measured by Grilli et al. (1991). Secondly, it conducts an assessment using the same attributes to measure the level of SNBs independence in regard to the Swiss government. The section concludes with developing the position of significantly high Swiss monetary policy independence and provides further references guiding to absolute monetary policy autonomy. There are two different viewpoints of the elements forming central bank independence, namely the one of the Group of experts (2001) and the point of view of Grilli et al. (1991), who conducted and published a scientific study about political and monetary institutions and fiscal policies in industrial countries. Owing to the extensive range of criteria for gauging central banks independence in the work of Grilli et al. (1991), the second part of this section, whose aim is to measure the actual SNBs independence from governmental interference, focuses on and employs the framework for evaluating the central banks independence of Grilli et al. (1991). The Group of experts (2001, pp. 10-11) explains the SNBs independence by breaking it down to four fundamental aspects such as functional, institutional, financial, and personal independence. First, the functional aspect applies on SNBs ability to exercise its core monetary policy tasks autonomously and not influenced by external bodies. The second aspect is financial independence, which constitutes the SNBs budgetary autonomy as well as its prohibition to provide direct credit lines to the Swiss government. In this regard, the SNB is not allowed to buy Swiss government bonds on the primary market, although it may buy these bonds on the secondary market. The third type of SNBs independence is

71

institutional independence, which features the legal status of the SNB as a jointstock company with no government interest. The last, personal aspects of the independence manifest in the way members of the government board of the SNB are appointed and laid off. Grilli et al. (1991) propose a proxy for measuring central banks independence towards their governments by building an index, based on detailed criteria and attributes. The Grilli-Masciandaro-Tabellini (GMT) index described by Grilli et al. (1991, pp. 366-370) identifies the independence of monetary authorities by decomposing it into two major types of independence, namely political and economic independence. The authors claim that both independences are attributable for measuring the overall influence a government exercises on the monetary policy institution. Importantly, political independence is the capacity of the central bank to independently constitute its mandate and more precisely to decide on its main policy goals and instruments, whereas economic independence relates to central banks ability to autonomously implement its operational goals and use its monetary instruments. According to Grilli et al. (1991), the GMT index employs 8 criteria for measuring political independence. These criteria are structured in three subgroups, defining the appointment process of central bank members, the relationship of the monetary authority with its national government, and the constitutional positing regarding monetary policy. GMT also employs another 7 criteria for evaluating the economic independence of central banks. They are structured in two groups, one regarding the monetary financing of government debt and the other concerning monetary instruments. Assessing the independence of the SNB using the GMT model should provide an answer to the degree of independence the SNB currently possesses. The first criterion evaluates the procedure of governor appointment and the dependence of such election from national government authorities. In this regard, Articles 33 and 39 of the NBA (see Federal Assembly of the Swiss Confederation, 2003) state that the organizational structure of the SNB consists of four corporate bodies such as the Bank Council, the General Meeting of Shareholders, the Governing Board, and the Audit Boards. With respect to the first criteria, Art. 39 states that the Bank

72

Council should comprise six members elected by the Swiss government, particularly by the Federal Council, and another group of five members elected by the SNBs shareholders. Moreover, the Federal Council appoints independently the President and the Vice-President of the Bank Council. Such election procedures do not correspond to political independence and lessen the overall independence of the SNB. In addition, the relevant article provides information about the second criterion regarding the office term. Grilli et al. (1991) consider office term of more than five years as sufficient enough to ensure utter political independence. However, the Bank Council office terms are legally conceived of 4 years. Even though they can be re-elected, the 4-year office term lessens SNBs independence. The third criterion regards the government involvement in the Governing Board appointment. Art. 43 of the NBA states the three-member structure of the Board and their statutory election by the Federal Council. The latter also designates the chairperson and the vice-chairperson of the Governing Board. Despite the fact that the Federal Council acts on Bank Councils recommendation in the appointment process, the political independence is likely to be impeded by the government involvement in the election process. Further, the term of office shall be of more than five years. In this regard, the Governing Board members term office of six years and their optional re-election procedure both comply with the relevant criterion and contribute for greater political independence. In sum, the first group of indicators suggests strong political dependence in terms of appointments. The Swiss government as the institution electing the members of SNBs main functional bodies has strong influence and retains power from the SNBs shareholders. However, given the fact that public institutions such as cantons and cantonal banks hold the majority of SNBs registered shares, one can conclude that only a minority of private interests cannot exercise their election power and hence influence on SNBs election process. The second group of criteria descried by Grilli et al. (1991) measures the relationship between the monetary institution and the national government. Accordingly, no mandatory participation of government representatives in the Governing Board and no formal prior governmental approval of monetary policy decisions suggest a greater level of central bank independence. Concerning the

73

relationship of the SNBs Governing Board with the Swiss government, there is no government representative in the SNBs supreme managing body as all of the three members, namely Prof. Thomas Jordan, Prof. Jean-Pierre Danthine, and Dr. Fritz Zurbrgg have strong academic background and no political affiliation. The lack of political representation in the executive body of the SNB endorses the political independence of the central bank. Next, the SNB legal statute as stated in Art. 7 of the NBA obliges the SNB to discuss its most important monetary policy decisions with the Swiss government and notably with the Federal Council. The discussion process concerns both directions, as both institutions have to inform each other about significant decisions. Although the Federal Council must approve the SNBs both annual report and annual accounts, there is no such obligation as regards monetary policymaking. This endorses further the political independence of the monetary authority. In sum, the second group of criteria implies a strong political independence regarding the SNBs relationship with the Swiss government. The third set of attributes relates to the formal responsibilities of the central bank. It bears emphasizing that according to Grilli et al. (1991) the existence of legal directives describing the task of central banks and hence stating the goal of price stability, along with publication of formally established procedures in case of conflicts between the central bank and the government, further strengthens the political independence. Importantly, such political conflicts may arise in case of a crisis, when monetary policy becomes a substitute for fiscal policy and monetary institutions are forced by their government to stimulate economic activity. In regard to the first point, Article 99 of the Swiss Constitution (see Federal Authorities of the Swiss Confederation, 1999) vaguely states the mandate of the Swiss National Bank consisting in the obligation of conducting policy allied with the interests of the county as a whole. However, a much more detailed and explicit definition of SNBs tasks is specified in Art. 5 of the NBA of 2003. That article clarifies the mandate of the SNB in foreseeing for both price stability and the overall economic development. Importantly, it defines the SNBs mandate and differentiates between its primary goal of ensuring price stability and its subordinate goal of supporting the overall economic development. Such a legally

74

established primary goal of ensuring price stability in a broad framework of other secondary goals enhances the SNBs political independence. Secondly, the legally and explicitly specified procedure regarding any conflict between the central bank and the government is likely to contribute positively to central banks political independence. Art. 53 of the NBA specifies the procedure and the right of the SNB to file an appeal with the Federal Administrative Court against decision of the Federal Council relating lay-offs and to bring action before the Federal Supreme Court for disputes concerning the distribution of SNBs profits. Such disputes may arise between the Confederation and the cantons as both accrue part of SNBs annual profit distribution from which one-third accrues to the Confederation and two-thirds to the cantons. The amount of annual profit distribution, on another hand, demands the mutual agreement of the Federal Department of Finance and the National Bank. The formal existence of precisely formulated orders in case of conflict between the government and the central bank is supposed to facilitate the resolution of the issue, protect central banks position, and endorse its independence. In conclusion, this reflects the strong SNBs independence regarding the legal directives concerning its statutory goal of price stability and the legal procedure in case of political conflicts. The ability of the monetary institution to set and preserve its economical independence can be measured by examining two sets of criteria. The first one, as Grilli et al. (1991) suggest, focuses exclusively on the monetary financing of fiscal deficits. The process of financing government spending as examined by Mishkin (2006, p. 374) is possible when a central bank can go on the open market and purchase government debt securities by increasing the money supply. The government pays to the central bank the interest rate on the bonds, and although the central bank can spend a portion of the interest income on economic research, at the end of the financial year it channels back the receipts into the treasury of the country via its annual profit distribution. Thus, the government can borrow funds without needing to repay them. Grilli et al. (1991) argue that such a monetization process in which the government can decide on its quantity of borrowing from the central bank impedes the economic independence of the central bank. Owing to the parallel increase in central banks balance sheet, the government by issuing

75

more government securities increases the central banks assets and liabilities and therefore influences the money supply. In this regard, it bears examination of the five criteria for the opportunity of the Swiss government to use and gain access to the SNBs credit lines. The first attribute that can strengthen the economic independence of monetary policy is the lack of automatic government access to the central banks credit lines. Accordingly, Art. 9, par (e) of the NBA states the SNBs credit transaction counterparties such as banks and financial market participants. Further, although Art. 11 permits the access of the government to banking services provided by the SNB, it explicitly prohibits governmental access to loans and overdraft facilities. Such regulations enhance the economic independence of the SNB. The second criterion indicates that the credit facility provided to the national government, if any, shall only be extended at the current market interest rate. Accordingly, Art. 11, par. 2 enhances the independence of the SNB in this manner, as it sets the opportunity of the Swiss government to overdraft its account in the SNB only against sufficient collateral. Such legal directive implies possible credit extensions at market interest rates. The third criterion regards the time limitation of the credit lines and indicates greater economic independence if only temporary access to credit is legally permitted. Compliantly, Art. 11, par. 2 grants the Confederation intraday overdraft facilities on its account at the Swiss National Bank. Such an explicitly stated directive endorses further the independence of the SNB, and more particularly in regard to the process of monetizing government debt. The fourth criterion is about the amount of credit lines provided to the government and corresponds to greater independence, the lower the credit ceiling is. First observed in the former NBA of 23 December 1953, the Confederation overdraft was initially limited to the amount the Swiss government kept in its SNBs account. However, the NBA of 2003 removed the sealing for such credit lines and therefore impeded slightly the economic independence of the Swiss monetary authority. The last attribute is associated with the process of debt monetizing and regards the permission of central banks to execute government securities purchases on the

76

primary bond markets. In this regard, Art. 11, par. 2 establishes the prohibition for the SNB to buy newly issued government securities and therefore its participation in the primary debt market for Swiss government bonds. Despite the lack of no law provision limiting the SNBs participation regarding purchases executed on the secondary debt market, where the SNB may purchase government bonds from banks and other financial market participants, the explicit legal directive of Art. 11 restricts the SNBs direct access to the Swiss government bond market and hence further endorses central banks economic independence. Moreover, there are three additional arguments in favour of the SNBs economic independence regarding the process of debt monetizing. First, the notable size and liquidity characteristics of the Swiss financial market that permits full private purchase of government debt. Secondly, the relatively small amount of Swiss public debt and the relevant debt brake rule that sets the level of sustainable debt sealing. Lastly, as the Swiss National Bank (2013, p. 63) explains, the SNBs Swiss franc security portfolio, containing both bonds and assets corresponds to only 1 percent of the whole SNBs assets or 4.9 billion Swiss francs at the end of 2012. Additionally, the bond portfolio consisted of merely 35 percent of Swiss government bonds, which justifies the insignificance government debt level within the SNBs balance sheet. All these conditions justify the SNBs position as a small Confederation debt holder and disregard it with any kind of debt monetizing policies. Concludingly, owing to the SNBs prohibition of direct debt purchases along with the non-automatic overdraft procedure at a market interest rate and legally conditioned as temporary, the economic independence of the SNB is one of the greatest among central banks all over the world. The second set of criteria used by Grilli et al. (1991) to measure the monetary instruments independence ability of central banks as part to sustain their economic independence consists of two central bank responsibilities regarding the setting of policy rates of interest and supervision of the national banking sector. The authors differentiate between supervision done either individually, jointly with other institutions or merely not existing. The authors also argue that central banks that are not indulgent to supervise the financial sector posses greater instrumental independence, which they can employ in using more freely monetary instruments.

77

The monetary policy instruments employed by central banks may have financial and capital markets side effects such as prompting governmental borrowing by raising the cost of other investments. Therefore, greater operational independence and no formally set financial stability goal, provide for greater monetary instruments independence. The first aspect implying central banks instrumental independence is the ability of the central bank to control the discount rate of its repurchase agreements and therefore grove the short-term policy interest rate within the target range corridor. If this decision-making process depends on the government, the central banks independence as regards its ability to determine the main reference interest rate is significantly impaired. In this regard, Art. 46, par. 2 (a) of the NBA clearly and explicitly attributes to the Governing Board of the SNB the responsibilities to take autonomously operational decisions regarding the setting of policy rates of interest. This contributes for the greater instrumental independence of the SNB. The second aspect, namely, the responsibility of central banks to oversee the national banking sector and in particular the administrative instruments it possess in this regard, can facilitate the process of government debt monetizing by administratively increasing the private demand for government securities and consequently weakening the central banks independence by diluting its power away from the market. Importantly, the possession of instruments such as portfolio constraints on bank intermediaries or ceilings to private bank loans impairs central banks independence if the central bank is the only national body to guard for financial stability. As a result, a shared financial sector supervision responsibility gives rise to a less dependent central bank. Regarding the oversight of the Swiss payment and security settlement systems, Art. 21, par. 1 of the NBA delegates parts of that financial stability supervisions responsibility to the competent financial market supervisory authorities, particularly to the Swiss Financial Market Supervisory Authority (FINMA). Similarly, Art. 5 of the NBA express a strong assertion towards the contribution of the SNB to the stability of the financial system. In addition, Art. 19, par. 1 of the NBA accreditates the SNB with the responsibility of supervision of the Swiss payment and securities

78

settlement systems. Thus, the NBA intensifies further SNBs contribution towards stability of the financial system. In sum, owing to the legal directives that attribute the SNB with the task of supervising the stability of the Swiss financial system, the Swiss monetary institution can be considered as possessing relative and moderate independence. The degree of instrumental independence depends on the particular administrative instruments and the ability of such to exercise influence on the public debt market. Shall such instruments influence on the debt pricing by influencing on banks investment decisions by making specific asset classes less attractive, the lesser the SNBs independence is. In addition, measures that are likely to drive the cost of capital for those specific investments higher through increasing banks required capital, constitute in impeded central bank independence. In sum, instruments that may increase the private demand on the Swiss government bonds market via obscuring the free market driving forces of securities will result less SNBs independence. Importantly, by having the firepower to impose higher capital requirements in the form of a counter-cyclical buffer (CCB) as stated in Art. 44, par. 1 of the Capital Adequacy Ordinance of 2011 (Swiss Federal Council, 2012), the SNB could increase the cost of banks funding regarding residential mortgage loans and therefore shift banks demand toward the bond market. In conclusion, influential instruments are likely to make a negative contribution to the economic independence of the SNB, owing to the fact that the activation of the CCB on the 13th of February 2013, likely contributed to the declining yield on Swiss 10-year government bonds. However, there are other reasons for the legally established SNBs contribution to the stability of the banking sector and oversight of the securities settlement and payment systems. One of these reasons concerns the systemic importance of payment and securities settlement systems for the financial stability of the banking sector and the stability of the Swiss economy as a whole. It bears emphasizing the importance of the risks emanating from the banking sector, owing to the fact they can indirectly affect the SNBs ability to guarantee price stability. In this regard, the SNB ought to create an operational environment for its monetary policy, whose implementation, indeed, goes through the banking system

79

of the country. In order to fulfill its mandate, the Swiss monetary authority shall safeguard the national banking system. By doing this, SNB paves its ways and set the channels for the right implementation of its monetary policy. Thus, the stability of the banking sector has become an important prerequisite for the effective conduct of monetary policy. The second reason stems from the fact that an adverse shock on payment and securities settlement systems and particularly on the banking system could contaminate the whole economy. According to BAK Basel Economics, whose survey was ordered and published by the Swiss Bankers Association (2012), the banking sector in Switzerland has been making the greatest contribution to Swiss GDP in term of gross value added over the past 20 years. In addition, alongside with the fact that the financial sector remains an important consumer of goods and services, there is an indirect effect on the overall economy. The Swiss Bankers Association (2012) maintains that for every 100 employees in the banking sector, there are 115 employees or workers in the rest of the economy. Moreover, the direct economic significance of the banking sector accounts for 9.3 per cent of the overall Swiss economy, that is, 17 billion Swiss francs in value added. The number of people employed amounts to 146,000 in the banking sector and 240,000 in the financial sector as a whole, which includes insurance companies as well. These figures are relevant, because they correspond to 3.1 and 5.1 per cent respectively of the domestic economy. Taxes paid by the banking sector amount to 11.2 billion Swiss francs in 2011 (almost 10 per cent of the federal tax revenues). Further, Swiss banks are drivers of economic growth, providing favourable financing conditions for businesses, with small and medium-sized enterprises being the largest demanders of credit. Similarly, Danthine (2012) shows the importance of the Swiss banking system for the whole economy and the systemic risks emanating from it. He argues that adverse developments in the banking sector would pose a considerable risk for the whole economy. Because of that the SNB considers financial stability risks as unbearable, intolerable, and unacceptable. In conclusion, the SNB possesses high instrument independence, owing to the explicit directives regarding its monetary policy instruments. First, SNB can take

80

autonomously operational decisions regarding the setting of the main policy rates of interest. Secondly, the monetary institution shares the common responsibility for the supervision of the Swiss financial sector. In order to attain an absolute independence from the Swiss government, the SNB should have the legal right to appoint the chairman of its governing board as well as all of its board members, who should be appointed for more than five years. Notably, the process by which the board of governors of the SNB is appointed should be out of the control of the Swiss government, as to increase the SNB political independence. In addition, the SNB should not be authorized with any supervision responsibility of the financial system or any tasks pertaining to financial stability contribution, in order to enhance its economical independence.

3.3.

Monetary policy independence according to Mundells impossible trinity

This section examines the Mundell hypothesis of impossible trinity and applies it to the Swiss case and particularly to its monetary policy since the introduction of the minimum exchange rate of the Swiss franc against the euro. The hypothesis states that monetary authorities cannot simultaneously retain a fixed exchange rate in a framework of free capital movements and the independence of their monetary policy. Under current global economic conditions of high level of globalization and intense trade in goods and services, where capital controls are evaded, the impossible trinity narrows down to merely the trade-off between moderate exchange rate volatility or externally independent monetary policy. Accordingly, shall a central bank determine to sustain a fixed exchange rate and allows free capital flows, then it has to use its monetary policy to maintain the desired exchange rate level of its national currency. However, in order to successfully achieve it, the central bank might have to adjust the reference interest rate, so to prevent the germination of uncovered interest rate parity (UIRP) conditions. Such conditions concern the differences between the main interests rates of relevant central banks. Owing to the fact that international banks, such as UBS, are active in different countries and therefore have access to different money markets, they

81

are likely to engage in profitable trading activities where they borrow from the central bank demanding the lower cost of capital and simultaneously convert the proceeds at the fixed exchange rate into the other currency that offers much higher yields owing to the higher interest rates. Such transactions are called uncovered because investors do not execute a third transaction of selling the higher yielding currency proceeds forward. By selling forward, the investors hedge the probably future currency volatility. However, owing to the determination of the central bank to sustain a fixed exchange rate, such currency risks are not likely to manifest in the future. Hence, investors normally chose not to cover their trades, accepting no currency risk for trading the higher yield currency for lower yielding ones at the end of the period. It bears emphasizing the carry trades underlying assumptions of mobile capital, perfect liquidity, and no risk premia. In conclusion, the UIRP condition ensures that the differential between two interests rates should result in an equal change in the exchange rate, higher for the country where capital flows in and lower for the country where capitals flow out. However, in a situation where one of the central banks successfully sustains a fixed exchange rate regime, the exchange rate cannot change, implying equal level of policy rates of interest. This in turn implies that the central bank has no ability to set independently its nominal interest rate by outsourcing such responsibility to another central bank. In order to determine the level of independence of the SNB regarding the European Central Bank (ECB), let us focus on the evolution of the EUR/CHF exchange rate and the SNBs foreign currency reserves developments since September 2011, by considering as a reference point the dynamics in carry trade conditions, measured by the money markets conditions in Switzerland and the euro area. Such a statement of whether the Swiss and euro area money markets provide banking institutions with arbitrage opportunities of executing carry trades can be measured by specifically measuring the interest rate differential between the two main reference rates of interest. Owing to the fact that banking institutions constitute the majority of carry trade investors, it is relevant to observe the dynamics in the two interbank markets. Accordingly, the relevant reference rates of interest are the 3-month Euro Interbank Offered Rate (Euribor), which is based

82

on the averaged interest rates at which euro area banks offer to lend unsecured funds to other banks in the euro wholesale money market, and the 3-month Swiss Libor, that is, the interest rate in the Swiss interbank market. Figure 30 illustrates the difference in the recent money market conditions between the euro area and Switzerland by plotting two corresponding, daily measured, 3-month Libor rates: the blue line represents the Libor on euros and the red line the Libor on Swiss francs. Figure 30. Eurozone and Swiss interbank markets dynamics, 3-month LIBOR, January 2010 May 2013

Source: Federal Reserve Bank of St. Louis economic research data. Notably, the relevant interest rates have practically always been in disaccord. The discrepancy began to grow in the middle of 2010 when the ECB changed its policy stance to restrictive, whereas the SNB kept low the target range for the short-term interest rate. The divergence reached strikingly high levels in the autumn of 2011, with an interest rate differential between the reference rates of around 1.5 percent. Such a wide discrepancy creates conditions for carry trade, where investors borrow in Swiss francs and simultaneously convert the proceeds in euros. Contrary to what common sense would indicate, the euro failed to

83

appreciate, trading at its lowest level of around 1.05 Swiss francs for one euro in August 2011. In addition, as Figure 12 shows, for the third quarter of 2011, capital, mostly in the form of portfolio investments worth 60 billion Swiss francs, flew into Switzerland, resulting in a capital account surplus that had to be counterbalanced by the SNB with foreign currency purchases. Currently, the euro area and Swiss short-term interest rates are in accord, at record low levels. The interest rate differential has shrunk from 1.5 percent in 2011 to near 0.15 percent as of May 2012 and thus reduced the possibility of interest rate arbitrages. However, the difference in money market conditions, justified by the divergence in sovereign bond markets conditions in the euro area and Switzerland remains significant. Pisani-Ferry (2012) argues for three major structural reforms in order to sustainably solve the euro area issues that caused the crisis. The first reform regards the establishment of a legal directive, prohibiting the process of debt monetization, which the ECB does through buying sovereign debt securities on the secondary market. The other two reform necessities relate to the creation of a European banking union for restoring confidence in the banking system and a European fiscal union for sharing public debt responsibility. In conclusion, the Swiss monetary policy has been largely dictated by the needs of the domestic economy and not by international conditions and therefore it is able to preserve its decision-making independence. The difference between the interbank money market conditions in Switzerland and the euro area constitutes in carry trade conditions that imply for capital outflowing Switzerland. Despite the presents of such conditions, flows of capital have flown into Switzerland, justifying the premise of externally independent money markets and Swiss monetary policy. However, the still ongoing money market differences come along with a still growing up SNBs balance sheet. Such conditions could pose a challenge to the SNB regarding the implementation on the minimum Swiss franc exchange rate. If the Swiss economy sustains its better performance, capital will continue to flow into Switzerland, driving up the Swiss franc furthermore. The process of moderating the volatility of the appreciating Swiss franc requires an increase of the money supply. In this regard, the CPI inflation rate of around 2 per cent is likely to trigger either suspension of the current exchange rate regime,

84

or increase in the reference rate of interest. Exceptionally, the SNB has been managing to pursue all three objectives of the Mundell impossible trinity, namely monetary policy independence, stable exchange rates, and open capital accounts.

3.4.

The efficacy of SNBs independence and its implications

This section focuses on the positive economic effects stemming from exchange rate stability of the Swiss franc against the euro. Importantly, both demand for labour and investment decisions from companies that are exposed to currency risk are being affected by uncertainty with regard to future developments in the value of the Swiss franc. In addition, this section provides an answer to the questions of whether the SNBs independence affects the performance of the Swiss economy. It examines the dynamics of the CPI and its origin, the positive effect of exchange rate stability for the Swiss export industry, and for the Swiss trade deficit with the euro area countries.

3.4.1.

Price level

The way the consumer price index is calculated is of great importance for Swiss monetary policy. According to the State Secretariat for Economic Affairs (2011, p. 5), imports account for around 30 percent within the consumer price index. In addition, according to the Swiss Federal Customs Administration (2012, p. 10) the amount of Swiss exports totals to 16,491 million Swiss francs (9,234 million is exported in the EU). As of September 2012, EU countries constitute 56 percent of Swiss exports. Such significant figures reveal a significant exposure of the Swiss CPI to exchange rate volatility of the Swiss franc and more particularly as regards the level of the Swiss franc exchange rate against the euro. Figure 31 shows the evolution of the Swiss CPI from 2001 to 2012. Notice the deflationary pressures in 2009 and 2011, which can be traced back to the financial crisis of 2008 and the strongly overvaluation of the Swiss franc against the euro from 2011 onwards. Such overvaluation of the currency has its negative

85

implications on Swiss exports, whose international competitiveness could thereby be dampened, but has also positive effects on Swiss imports, whose affordability increase as they become relatively cheaper. Figure 31. Swiss inflation by origin, 2001-12

Source: UBS, Swiss Chartset 2012. On the 6th of September 2011 the SNB announced the unbearable risk for the whole economy. Its decision to maintain a minimum exchange rate of 1.20 Swiss franc per euro was intended to address the deflationary developments in the Swiss economy coming from an overvalued Swiss franc. The instrument that the SNB used during the European sovereign debt crisis was open market operations and specifically purchases of euro-denominated assets. The Swiss National Bank expanded its balance sheet by increasing its reserve assets and crediting the sight deposits accounts of depository institutions. The process of unsterilized foreign reserves purchases as illustrated in Figure 32 has been successfully diminishing the adverse effects of the appreciating Swiss franc. Accordingly, an increase in the sight deposits has always been accompanied with a drop in the value of the Swiss franc and upward pressure on the consumer price index.

86

Figure 32. Sight deposits, CPI, and Swiss franc exchange rate, 2007-12

Source: authors elaboration based on data by the Swiss National Bank. In sum, the reason why the recent significant increase in the money supply has not led to higher inflation rates in Switzerland is the existence of deflationary forces on the CPI. On one hand, the increase in banks sight deposits gives rise to higher credit volumes and money supply, and thus causes an inflationary pressure on the CPI. On the other hand, the undervalued EUR/CHF level leads to cheaper exports from euro area countries, exercising an opposite deflationary pressure on the Swiss CPI. Importantly, the inflationary pressures, originating in the increase of money supply in Switzerland, are not enough to counterbalance the imported deflationary pressures, stemming from the strong value of the Swiss franc.

3.4.2.

Production

One of the positive economic effects of the independent actions of the SNB and particularly those originating in the introduction of a minimum exchange rate for the Swiss franc can be observed in the recent increase in the annual GDP growth rate and in the purchasing managers index (PMI), which as calculated by Credit Suisse and procure.ch measures the activity by Swiss industrial companies. The

87

PMI is a weighted index consisting of five sub-indices. The biggest part of the index (weighting 30 percent) is the backlog of orders index, which measures the uncompleted orders, unfulfilled by producers. The backlog level is an important indicator of whether an economy is growing or not. Falling backlogs may be a sign that new orders are dropping and the old ones are being fulfilled, and that producers are less willing to hold large stocks of inventories. Next, with a 25 percent weight is the output index, and the employment index with 20 percent. The suppliers delivery times index accounts for 15 percent of the PMI, with levels of the index above 50 signaling delivery times improving, which usually means suppliers have become less busy owing to a falling demand for their products. Lastly, with only 10 percent of the whole, the stocks of purchases index measures inventories of raw materials, work in progress and finished goods not yet sold. Figure 33 illustrates the developments in the PMI and GDP annual growth rate, which went up respectably to 52.5 points and 0.5 per cent. Figure 33 Swiss Purchasing Managers Index and annual GDP growth rate, 1995-2013

Source: Credit Suisse (2013). Notably, the dynamics in the EUR/CHF exchange rate, PMI, and GDP growth rate have been quite correlated. It bears emphasizing the effects of the stable exchange rate for the Swiss franc that hold back the declining trend at both the

88

GDP growth rate and the PMI. Importantly, the PMI has been increasing as the Swiss franc leveled off at the end of 2011, and hence justifies the positive implications of the stable Swiss franc for the domestic economy.

3.4.3.

Trade balance and exports

The Swiss trade balance is the sum of three components, namely the difference between net revenues on exports minus payments for imports, labour and investment net income, and net current cash transfers. Owing to the relationship between the trade balance, exports, and imports, it is important to assess the effects of a stable Swiss franc on the Swiss trade balance and exports industry. The analysis carried out by Sturm and Lamla (2012) as shown in Figure 34 claims that the recent Swiss National Bank intervention and more particular the minimum exchange rate of 1.20 Swiss francs against the euro have dampened trade imbalances between Switzerland and its trading partners from the euro area. The authors argue that a much stronger currency would have widened further the Swiss trade deficit with the euro area, because euro area goods and services would have become cheaper. Figure 34. CHF/EUR exchange rate and Swiss trade balance, 2000-12

Source: Sturm and Lamla (2012).

89

Figure 34 shows the positive effect of exchange rate stability by pointing out a relationship between the value of the Swiss franc and the Swiss trade balance. Accordingly, when the Swiss franc was above 1.60 for one euro and the world economy was booming, the euro area trade deficit was reaching record high levels of 2.4 billion Swiss francs. In the year after the onset of the global financial and economic crisis, the trade deficit of Switzerland against the euro area declined to near 1.6 billion Swiss francs. However, at the end of 2010, it reached up 2.4 billion Swiss francs, owing to an already appreciating Swiss franc at that time. Let us investigate whether there are positive or no effects on the real economy from monetary policy interventions by the SNB, by applying statistical methods to two periods economic data. The analysis divides the period from January 2010 to February 2013 in two sub-periods and measures the effect of the minimum Swiss franc exchange rate against the euro on Swiss exports and trade balance against the euro area. This analysis considers three effects, namely, the volatility effect, the trend reversal effect, and the average change effect. It employs the sample formula for calculating the means and the standard deviation of the two sub-periods and analyses the results to conclude on the relationship between the variables. First, arithmetic means are used to conclude on the relative change in the levels of Swiss exports and trade balance towards the euro area, and secondly they are employed in the calculation of the standard deviations that are used to conclude for the existence of volatility effects, with less volatility signifying positive effects. Formula 1. Sample mean (a) and sample standard deviation (b)

Source: statistics.about.com.

90

The statistical data from SNBs monthly statistical bulletins show the average mean of Swiss exports for the first sub-period of 9,489 Swiss francs. Seemingly, the figure has not improved and has even altered slightly downwards to 9,399 Swiss francs for the second sub-period. However, the dispersion from the average exports values has slightly improved from 835 million to 779 million Swiss francs as the export industry got exposed to the stabilized Swiss franc. The statistical data regarding the Swiss trade balance towards the euro area in the first sample sub-period show an average trade deficit of 2,068 million Swiss francs, with standard deviation of 605 million Swiss francs. At the end of March 2010 the trade deficit towards the euro area reached its highest levels of 3,162 million Swiss francs with a EUR/CHF exchange rate of 1.28. By the end of February 2012 (at an exchange rate level of 1.20) the deficit had shank to 1,608 million Swiss francs. This dynamics is also reflected in the mean value of the trade deficit that felt down to 1,838 million Swiss francs for the whole second sub-period. Likewise, the deviation from the average decreased significantly with 33 percent to 407 million Swiss francs. As a conclusion, although the situation for Swiss exports has remained quite the same as regards average volumes, its volatility has declined owing to exchange rate certainty. The stable Swiss franc prevented a further widening of the trade deficit towards the euro area. In addition, by decreasing exchange rate uncertainty the SNBs decision significantly improved the volatility of the trade deficit, in conjunction with a 12 percent increase in its arithmetic mean. Figure 35 plots the results of the two analyses, one regarding the economic implications for Swiss exports and the other regarding the Swiss trade balance. The red line crosses the horizontal axis on the 6th of September 2011, when the SNB announced its decision to impose the minimum exchange rate and therefore indicates the two sample periods. The red and blue fainted areas in the figure both illustrate restrained volatilities in Swiss exports and trade deficits after September 2011. The exports towards Europe became more certain in the second period, as standard deviation from the mean drop with 56 million Swiss francs. Likewise, the Swiss trade deficit toward Europe experienced a significant improvement in terms of steady trend with lower volatility. The standard deviation dropped with

91

one third of its previous value or with 198 million Swiss francs. Another component of the figure are the solid black lines that show the arithmetic averages for the two variables in the two sample periods. Notably, there is a slight and unfavorable drop in Swiss exports of 90 million Swiss francs in the second subperiod and a significant reduction in the Swiss trade deficit of 230 million Swiss francs that felt to 1.7 billion Swiss francs at the end of 2012. Further, there is a reversal change in course of developments in Swiss exports towards Europe after September 2011. Figure 35 shows the new series of higher lows in the second sub-period. Likewise, the Swiss trade deficit reversed on its downward trend, as a result of the minimum exchange rate that stopped the euro from declining. Figure 35. Swiss exports and trade balance towards Europe, 2010-13

Source: Authors elaboration with data from the Swiss National Bank. In sum, all these developments justify the argument of positive real economic implications of the SNBs monetary policy: the minimum exchange rate of 1.20 Swiss francs for one euro imposed in September 2011 has had a diminishing effect on Switzerlands euro area trade deficit, along with a balancing out effect on Swiss trade surpluses with the rest of the world. In regard to the developments in the Swiss export sectors, although their confidence has improved slightly after

92

September 2011, there are other external factors such as foreign demand that exercise negative effects on Swiss trade growth.

3.4.4.

Tourism industry

The Swiss tourism industry is one of the most severely affected economic sectors in the aftermath of the global crisis. Figure 36 shows the strong volatility of the number of overnight stays in Switzerland since January 2010. There have been specific seasonal fluctuations in the tourism industry, namely a strong activity in the time periods May-September and November-February and sharp falls in the time periods August-November and March-May. Figure 36. Swiss tourism from EU15 guests, overnight stays in 1000s, 2010-13

Source: Authors elaboration with data from the Swiss National Bank. Let us point out a relationship between the value of the Swiss franc against the euro and the overnight stays in Switzerland by European tourists. Accordingly, the exchange rate of the euro at the beginning of 2010 was 1.50 Swiss francs, and lost 20 percent (to 1.21) in January 2013, in parallel with the drop in the number

93

of overnight stays by European tourists, which dropped 20 percent for the same timeframe. Such dynamics in both variables suggests a strongly correlated Swiss tourism industry to the value of the national currency. Similarly, Figure 36 illustrates a correlated movement in overnight stays and the SNBs monetary policy between two reference periods, illustrated in purple. The first period is in the framework of flexible exchange rates and goes from June to August 2011, and the other from June to August 2012 in the context of a stable Swiss franc. What is noticeable for the summer months in 2011 is that the number of overnight stays hiked from 807 thousands to 1,489 thousands. In other words, 84.57 percent more Europeans tourists viewed Switzerland as an attractive summer destination. Conversely, in 2012, the number of European jumped with merely 76.13 percent from 754 thousands at the end of June to 1,328 thousands at the end of September. In light of such developments, the minimum exchange rate of the Swiss franc against the euro did not have positive effects on the tourism industry in the short run. Therefore, in order to assess the long-term benefits of the monetary decision of the SNB in September 2011, Figure 36 derives the average number of stays and its variability between two sample periods. The first period from January 2010 to August 2011 corresponds to the lack of decisive monetary actions and the second period from September 2011 to February 2013 corresponds to a stable, but low exchange rate. By using Formula 1 (a) and statistical data from the SNBs monthly statistical bulletins, Figure 36 illustrates with a black line the mean values of 1,151 thousands overnight stays for the first sample period and 917 thousands overnight stays for the second sample period. Exchange rate stability could not encourage more European tourists, whose number dropped on average by 20 percent. However, the monetary decision of September 2011 reduced the variability of tourists stays in Switzerland. The analysis of the standard deviations measuring the dispersion from the means, as illustrated in light red in the figure, shows a significant decrease in the volatility of 22 percent in the second sample period. Precisely, the standard deviation felt from 289 thousands to 227 thousands for the subsequent period.

94

In conclusion, the actions of the SNB couldnt offset the adverse course of direction in the Swiss tourism industry. As opposed to the trade balance, which shrank as a result of the stable exchange rate, the number of European tourists in Switzerland continued to lower, unaffected by the certainty about the Swiss franc. However, the monetary policy decision brought less variability in the number of overnight stays in the subsequent period of time.

3.5.

Foreign reserves purchases in a price stability framework

This section explores the implications of the SNBs foreign currency purchase programme on its credibility to maintain price stability. By exploring the dynamics in the CPI as a major pillar contributing to greater monetary policy credibility, this section argues that the actions of the SNB do not compromise on the banks credibility to sustain price stability. The programme as illustrated in Figure 37 shows the SNB determination to maintain moderate CPI dynamics, by exercising inflationary pressure against the import originated deflation. The figure plots Swiss money supply, foreign currency investments, and CPI in Switzerland from 2007 to 2013. Notably, the relevant time period is characterized by a significant expansion in both liability and asset sides of the SNBs balance sheet, namely in money supply and foreign investments. In the framework of deflationary development observed since the end of 2011, when the SNB decided to impose a minimum exchange rate for the Swiss franc against the euro, total sight deposits surged to 239 billion Swiss francs at the end of September 2011. This increase came along with an increase in SNBs portfolio investments, constituted mainly by AAA-rated government bonds. The foreign assets of the SNB reached 305 billion Swiss francs by the end of the month when the programme was announced. In regard to the Swiss monetary policy in the context of moderate inflationary dynamics, it bears emphasizing the delicate act of the SNB in 2010 and 2011. The policy enhanced SNBs credibility to sustain price stability and justified the buildup of foreign currency reserves as part of SNBs independent decision-making process. In this regard, the magnitude of change in the money supply and SNBs

95

investments were not in accord as is the case since September 2011. Specifically, total sight deposits and portfolio investments have experienced extensive and unparalleled growth rates. In terms of banks portfolio investments, overall, they increased gradually throughout 2010 and 2011. By contrast, the total amount of sight deposits did not experience similar dynamics. Although from 2007 to June 2009 total sight deposits had been increasing, reaching 100 billion Swiss francs in June 2009, they decreased dramatically in 2010 and 2011. Figure 37. Money supply, foreign currency investments, and CPI in Switzerland, 2007-13

Source: Authors elaboration with data from the Swiss National Bank. Importantly, the SNB decreased the banks sight deposits and increased other liabilities such as the one from Swiss franc denominated repurchase agreements, which went up to around 25 billion Swiss franc, and SNB debt certificates, which went up to around 120 billion Swiss francs. Basically, the decrease in one liability was offset by an increase in other liabilities (Swiss National Bank, 2013e). Further, it is likely that monetary policy in the price stability framework that started in the middle of 2009 and continued in 2010 and 2011 depressed the value of the Swiss franc. Accordingly, by purchasing foreign currency denominated

96

assets, the SNB induced speculative inflows in Switzerland over the same and the forthcoming periods of time. Such monetary policy usually creates expectations of a future appreciation in the value of the national currency. Such expectations in and of themselves induce speculative capital inflows. Figure 12 shows the hike in SNBs foreign reserve assets of 157 billion Swiss francs for the last quarter of 2009 and the first half of 2010. The policy of currency depreciation resulted in adjustments in the Swiss capital account that for the same period accumulated an inflow of 102 billion Swiss francs. The capital inflow came as consequence of the created currency appreciation expectations. In conclusion, although some of the foreign market interventions by the SNB were carried out in a price stability framework and others in a highly deflationary environment, both did not compromise the SNBs credibility and independence to guarantee price stability.

97

Conclusion
The global crisis, consisting of two major crises, namely the US financial crisis and the European sovereign debt crisis, impacted differently on Swiss economic performance. The US financial crisis resulted in severe economic downsizing in the levels of Swiss GDP, particularly on its fixed investments and export sectors. Consequently, the Swiss unemployment rate increased relatively more, compared to the increase following the European crisis. Even though fixed investment remained resilient, the European sovereign debt crisis brought some negative implications for the Swiss economy. Exports experienced similarly adverse developments as they did in the aftermath of the financial crisis of 2007-8 and proved to be the most sensitive sector of the Swiss economy. As remarkable exceptions, the Swiss property and bonds markets remained resilient from the global crisis and even gained positive momentum. The CPI course of development in the period right after the crises experienced similar significantly negative shocks, running below the desired level of moderate inflation and even showing a deflationary trend. The price index as a result of monetary policy interventions ceased its downward trends in both cases. However, the price index was far more volatile following the credit crisis, as it was during the debt crisis. In addition, the decomposition and retrospective analyses that project the future path of the Swiss CPI both conclude on a 2 percent inflation breach in 2015. Such levels would result in SNBs threshold breach and a foregoing increase of the main policy rate of interest as early as in the fourth quarter of 2014. The most significant effects of the European crisis were the change of risk appetite, which along with the domestic condition of high real interest rate and the fiscal soundness, resulted in Swiss franc surge. The appreciation was due to the capital that flew into the Swiss stock and bond markets. The overvaluation of the Swiss currency and the resulting monetary policy measures, such as increasing money supply and foreign currency reserves, have their own costs and benefits for the whole Swiss economy and SNBs credibility. The overall analysis concludes that although the recent monetary policy contains the risks of financial instability,

98

it has positive effects on the consumer price index, on domestic production and on the trade deficit. The associated financial stability costs stem from the excessive credit volume that outreaches real GDP growth rate. The imbalance gives rise to the build-up of market excesses and a growing systemic risk, which are normally associated with future price corrections. In addition, Swiss banks seem to have minor or no risk exposure towards the fiscally unsound countries within the euro area. The statistical analysis finds some positive implications of the recent monetary policy on the real economy and therefore has increased SNBs credibility, with no compromising effects on its independence. The independent actions of the SNB constituted in a hampering effect on the formally declining PMI and deflationary CPI. Moreover, exchange rate stability may have reduced Swiss trade imbalances with the euro area. The results also suggest that the floor of 1.20 Swiss francs for one euro have no particular positive effects on the tourism industry, which has been continuing to shrink activities since the global crisis erupted.

99

References
Bernanke, B. (2005) The Global Saving Glut and the U.S. Current Account Deficit, Remark at the Sandridge Lecture, Virginia Association of Economists, Richmond, Virginia, April 14, 2005, available at http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/ Bernanke, B. (2010) Central Bank Independence, Transparency, and Accountability, Remarks at the Bank of Japan, May 26, 2010 available at http://www.federalreserve.gov/newsevents/speech/bernanke20100525a.pdf. Bernanke, B., Bertaut, C., DeMarco, L. and S. Kamin (2011) International Capital Flows and the Returns to Safe Assets in the United States, 2003-2007, International Finance Discussion Paper, No. 1014. Barro, R.J. and D.B. Gordon (1983) A Positive Theory of Monetary Policy in a Natural Rate Model, Journal of Political Economy, Vol. 91, No. 3, pp. 589-610. Buik, D. (2011) The City of London: Money & Power, BBC Documentary, recorded on 19.02.2011, available at http://www.youtube.com/watch?v=OD0lx9MKp7Q. Crowe, C., DellAriccia, G., Igan, D. and P. Rabanal (2011) Policies for Macro Financial Stability; Options to Deal with Real Estate Booms, Staff Discussion Note, International Monetary Fund, February 25, 2011. Credit Suisse (2013) Annual Report 2012, Zurich: Credit Suisse Group. CMA (2010) Global Sovereign Credit Risk Report, available at http://www.cmavision.com/learning/sovereign-risk-reports/.

100

Cukierman, A. (1992) Central Bank Strategy, Credibility and Independence, Cambridge, MA: MIT Press, 1992 Danthine, J.-P. (2012) Taming the financial cycle, Speech at the 30th SUERF Colloquium, Zurich, September 5, 2012., available at http://www.bis.org/review/r120907c.pdf Danthine, J.-P. (2013) Credit is the sky the limit?, Speech in Geneva, April 16, 2013, available at http://www.snb.ch/en/mmr/speeches/id/ref_20130416_jpd/source/ref_20130416_j pd.en.pdf De Santis, R. (2012) The euro area sovereign debt crisis, safe haven, credit rating agencies and the spread of the fever from Greece, Ireland and Portugal, European Central Bank Working Paper, No.1419. European Central Bank (2012) Euro area balance of payments January 2012, Statistical Press Release, European Central Bank, March 2012. European Central Bank (2013) Timeline of the financial crisis, available at http://www.ecb.int/ecb/html/crisis.en.html. Federal Authorities of the Swiss Confederation (1999) Federal Constitution of the Swiss Confederation, Berne: Federal Authorities of the Swiss Confederation. Federal Assembly of the Swiss Confederation (2003) Federal Act on the Swiss National Bank, Berne: Federal Assembly of the Swiss Confederation. Federal Department of Finance (2012) The debt brake a success story, Publications, Berne: Federal Department of Finances, December, 2012

101

Federal Open Market Committee (2012a), Longer-Run Goals and Policy Strategy, Press Release, January 25, 2012. Federal Open Market Committee (2012b), Press Release, December 12, 2012. Federal Open Market Committee (2013), Press Release, March 20, 2013. Federal Statistical Office (2013) Consumer price index, available at http://www.bfs.admin.ch/bfs/portal/en/index/themen/05/02/blank/key/basis_aktuel l.html. Grilli, V., D. Masciandaro and G. Tabellini (1991) Political and Monetary Institutions, and Public Finance Policies in the Industrial Countries, Economic Policy, Vol. 6, No. 13, pp. 342-392. Group of experts (2001) Rforme du rgime montaire: Nouvelle loi sur la Banque nationale, Rapport et projet, Berne: SNB Library. Haidar, J. (2012) Sovereign Credit Risk in the Eurozone, World Economics Journal, Vol. 13, No. 1, pp. 123-136. Hellerstein, R. (2011) Global Bond Risk Premiums, Federal Reserve Bank of New York Staff Report, No. 499. Hildebrand, P. (2011) Short statement by Philipp Hildebrand on 6 September 2011 with regard to the introduction of a minimum Swiss franc exchange rate against the euro, Zurich: Swiss National Bank, September 6, 2011. Jordan, T. (2012a) Speech given by Thomas J. Jordan to the General Meeting of Shareholders of the Swiss National Bank, Swiss National Bank, April 2012, available at

102

http://www.snb.ch/en/mmr/speeches/id/ref_20110906_pmh/source/ref_20110906 _pmh.en.pdf Jordan, T. (2012b) Challenges for Switzerland as a financial center, Speech at the Bank for International Settlements in Basel, September, 2012, available at http://www.snb.ch/en/mmr/speeches/id/ref_20120903_tjn/source/ref_20120903_tj n.en.pdf Jordan, T. (2012c) Geldpolitik und Anlagepolitik der Nationalbank im Zeichen der Frankenstrke , Speech, Bern: Volkswirtschaftliche Gesellschaft des Kantons Bern, November 28, 2012, available at http://www.snb.ch/de/mmr/speeches/id/ref_20121128_tjn/source/ref_20121128_tj n.de.pdf Lamla, M. and Lassmann A. (2011) Der Einfluss der Wechselkursentwicklung auf die schweizerischen Warenexporte: eine disaggregierte Analyse, KOF Analysen, Summer 2011, pp. 3149. Mangano, G. (1998) Measuring central bank independence: A tale of subjectivity and of its consequences, Oxford Economic Papers, Vol. 50, No. 3, pp. 468-492. Mishkin, F. (2006) The Economics of Money, Banking, and the Financial Markets, New York: Addison-Wesley, seventh edition. Pisani-Ferry, J. (2012) The euro crisis and the new impossible trinity, publications, Bruegel, available at http://www.bruegel.org/download/parent/674the-euro-crisis-and-the-new-impossible-trinity/file/1540-the-euro-crisis-and-thenew-impossible-trinity/. Prager, J. (2012) The financial crisis of 2007/8: misaligned incentives, bank mismanagement, troubling policy implications, New York University, June 27, 2012.

103

Roggo, S. and S. Rossi (2011) Is there a real-estate bubble in Switzerland? An empirical analysis, University of Fribourg, January 27, 2011. State Secretariat for Economic Affairs (2011) Weitergabe von Einkaufsvorteilen aufgrund der Frankenstrke, Working Paper, State Secretariat for Economic Affairs, November 2011, available at http://www.news.admin.ch/NSBSubscriber/message/attachments/24796.pdf. State Secretariat for Economic Affairs (2012) GDP and expenditure-side components (yearly and quaterly data), available at http://www.seco.admin.ch/themen/00374/00456/00458/index.html?lang=en&dow nload=NHzLpZeg7t,lnp6I0NTU042l2Z6ln1ad1IZn4Z2qZpnO2Yuq2Z6gpJCGdI B6g2ym162epYbg2c_JjKbNoKSn6A--. Sturm, J.E. and M. Lamia (2012) Swiss National Bank under attack, Voxeu.org, available at http://www.voxeu.org/article/swiss-national-bank-under-attack. Swiss Bankers Association (2012) The Importance of the Swiss Banking Sector: An Economic Perspective, Zurich: Swiss Bankers Association, August 2012. Swiss Federal Council (2012) Capital Adequacy Ordinance, available at http://www.kpmg.com/CH/en/Library/Legislative-Texts/Documents/pub20130314-circular-cao-92503-en.pdf. Swiss Federal Customs Administration (2012) Starkes Wachstum mit hohen Preisen, Press Release, Federal Department of Finance, Oktober 2012 Swiss National Bank (2004) Guidelines of the Swiss National Bank (SNB) on Monetary Policy Instruments, Zurich: Swiss National Bank, March 25, 2004.

104

Swiss National Bank (2008) Swiss balance of payments 2007, Swiss National Bank, September 2008. Swiss National Bank (2009) Swiss balance of payments 2008, Swiss National Bank, September 2009. Swiss National Bank (2009) Quarterly Bulletin, Swiss National Bank, March 2009. Swiss National Bank (2010) Swiss balance of payments 2009, Swiss National Bank, August 2010. Swiss National Bank (2011) Swiss balance of payments 2010, Swiss National Bank, August 2011. Swiss National Bank (2011) Quarterly Bulletin, Swiss National Bank, September 2011. Swiss National Bank (2012a) Quarterly Bulletin, Swiss National Bank, March 2012. Swiss National Bank (2012b) Financial Stability Report 2012, Swiss National Bank, June 2012. Swiss National Bank (2012c) Swiss balance of payments 2011, Swiss National Bank, August 2012. Swiss National Bank (2013a) Countercyclical capital buffer: proposal of the Swiss National Bank and decision of the Federal Council, Press release, Swiss National Bank, February 13, 2013. Swiss National Bank (2013b) Implementing the countercyclical capital buffer in

105

Switzerland: concretising the Swiss National Banks role, Swiss National Bank, Berne, February 2013, available at http://www.snb.ch/en/mmr/reference/CCB%20communication/source Swiss National Bank (2013c), Monthly Statistical Bulletin, Swiss National Bank, Vol. 88, No. 4. Swiss National Bank (2013d) Financial Sector: Analytical accounts of the banking sector , Swiss National Bank Statistics IMF Special Data Dissemination Standard, April 12, 2013, available at http://www.snb.ch/ext/stats/imfsdds/xls/en/imfsdds_S1_D1_M1.xls. Swiss National Bank (2013e) Historical time series 3: Swiss National Bank Balance sheets and income statements, Swiss National Bank, May 2013. UBS (2011) Inflation, the Return of a Difficult Relation, UBS Chief Investment Office Wealth Management Research, UBS, June 2011. UBS (2012) Switzerland in Figures, Wealth Management Research, UBS, 2012 UBS (2013a) Swiss Real Estate Market, UBS Chief Investment Office Wealth Management Research, UBS, February 2013. UBS (2013b) Swiss chartset, UBS Chief Investment Office Wealth Management Research, UBS, March 2013. UBS (2013c) Annual Report 2012, UBS, March 2013. Zurbrgg, F. (2012) Fiscal and monetary policy: interdependence and possible sources of tension, Speech , Lucerne, November 21, 2012., available at http://www.snb.ch/en/mmr/speeches/id/ref_20121121_zur/source/ref_20121121_ zur.en.pdf.

106