FX market intervention by central banks

UPDATE: The Wall Street Journal just commented on the rumors discussed below in the article “SNB in strong position to raise Euro floor“. The piece argues in favor or raising the floor in order to stimulate export led economic growth. It does not comment on the issues I raise below, and my view remains unchanged. A higher floor may not cost the SNB much at the moment, but by pushing the exchange rate further from its underlying value, the potential profit from holding the CHF when the peg breaks becomes greater, thus attracting more flows into the Swiss Franc (see graphs below).

Central Banking, or monetary policy, can at times be surprisingly exciting. The Swiss National Bank (SNB) and the Hong Kong Monetary Authority (HKMA) both have made some bold moves in the past and at present. The HKMA was arguably the most successful central bank to resist the extreme pressure on Asian currency pegs during the Asian crisis. This defense did not merely include purchasing its own currency to support its value, the HKMA is also believed to have intervened directly in equity markets. At the peak of the crisis in October 2007, they supposedly purchased vast amounts of equities where short sellers were trying to profit from a double bet on a weaker HK$ and lower equity prices in the crisis expected to follow. The end result was a great victory to the HKMA, and an expensive defeat to the shorts. (A great book about this particular event is Intervention to Save Hong Kong: Counter Speculation in Financial Markets by Goodhard and Lu.)

Given the HKMA’s track record in FX intervention, one should perhaps not be surprised that they are again intervening (this time in a conventional manner) to defend their peg to the US dollar. The difference is that this time the market is pushing the HK dollar up and the HKMA intervenes to weaken its currency. According to Reuters, the HKMA sold 6.2 billion HK dollars today (Tuesday 11 dec) in the open market (800 mill USD). This came on top of an additional 1.5 billion HK $ sold since October 2012. It should be noted that defending currency weakness is much easier than defending its strength. The HKMA can sell as many HK$ as its heart desires, the only consequence being a growing portfolio of foreign reserves. However, at some point printing too much of your own currency may be problematic. The Swiss National Bank may soon learn this lesson.

The market chatter today has spread a rumor regarding a potential raising of the CHF-EUR floor. In 2011, the SNB unexpectedly (and somewhat controversially) imposed a floor on the Swiss Franc’s exchange rate to the Euro at 1.2 CHF/EUR. A higher floor would imply a weaker CHF, thus profits for the shorts and loss for the holders of CHF. The source of the rumor is unclear, and very little if any has been written about this. Some seem to think is is caused by a recent recommendation by UBS warning its clients against holding large amounts of CHF. In other words, they see a risk of CHF depreciation. Personally, I don’t see this to be a significant risk at the moment. The SNB is already forced to expand its foreign reserves (by printing CHF) at an extreme rate in order to defend the artificially weak exchange rate (see figure below).

This is a clear sign that market forces alone are not going to let the CHF depreciate. The only way this can happend is via SNB intervention such as raising the floor to, say, 1.25 CHF/EUR. But why would they do this?

The reason would be to support its exporters and stimulate growth. But the SNB has already forecasted positive inflation in 2013 (albeit conditional on their policy, which may potentially include such an intervention). And the benefits of a slightly weaker CHF will not necessarily justify the risk they take. The money base has exploded and this growth cannot be sustained indefinitely. Based on this picture (see below), one would rather expect the SNB to be forced to abandon its floor rather than raising it. Of course the SNB will not comment on rumors like these, because the rumor works very much to the benefit of the SNB. The more traders expect the CHF to weaken, the less CHF the SNB needs to print. The SNB would in fact benefit from spreading rumors like these, then lean back and let the short sellers to the job for them.

Data referred to above is available here on the SNB Statistics website.

Some additional sources for more information:

HK moves again to halt currency rise – FT.com