Monthly Archives: July 2012

David Merkel is short infinity. More precisely, he’s conceptually long the EUR/CHF exchange rateĀ  (via an imprecise route, but let’s not nitpick). The trade is based on the common fallacy that a central bank running a fiat currency cannot maintain an exchange rate cap. Let’s attempt explaining why this idea is misguided.

The Swiss National Bank (SNB) introduced a cap on the EUR/CHF at 1.20 last year, because too many people have been using the Swiss Franc as a form of synthetic gold, just to store value in times of uncertainty, or as a hedge against Euro breakup. Both motivations result in the same trade: buying and holding CHF denominated cash.

This has a negative impact on the Swiss economy as it makes the Swiss franc overvalued compared to what it would be worth without these financial market bets, which are not related to the state of the real life Swiss economy. Exports become prohibitively expensive, unless nominal Swiss salaries go down at the same speed as people are stockpiling CHF denominated cash, which tends to be supremely impractical.

The way the cap is implemented is in essence that the SNB has placed an order to buy euros on forex exchanges at a rate of 1.20 CHF for 1 Euro, with a lot size of infinity. So when people sell Euros to buy CHF, and nobody offers better value than the SNB, their correspondent banking intermediary (at the end of the brokerage chain) conceptually has the Euros as a cash balance at the European Central Bank (ECB), and this amount is credited to the SNB’s account at the ECB. In exchange, the SNB credits the account of the trader’s delegated Swiss bank’s account at the SNB with 1.20 times the Euro amount in Swiss Francs.

Importantly, the trade is asymmetrical. The SNB does not sell Euros to buy CHF. It’s a cap, not a peg. Given the way markets are currently imbalanced, it behaves like a peg, but the SNB has made no commitment to maintain a peg, only a cap. The SNB could not place an order to sell Euros with an infinite lot size, because it has only a finite supply of Euros. Conversely, it genuinely has an infinite supply of Swiss Francs.

The creation of these Swiss francs is conceptually just a SNB operator changing a number in their spreadsheet of client banks balance. In exchange the SNB gets an increased balance of their Euro account at the ECB. What do they do with these Euros? They can keep them there as an ECB cash balance, or buy Euro assets, like core Eurozone member states’ bonds. If they were wild they could buy European stocks, Spanish bonds, or whatever else they fancy.

This is one point where the short infinity traders come in: they say that these Euros or assets bought with that influx of Euros can lose value. It is totally correct. And it totally doesn’t matter. Let’s take an extreme example and assume the SNB keeps all the Euros acquired as part of this programme as an ECB cash balance, and then EU governments mandate the ECB to confiscate these Euros by setting the number for the SNB’s account at the ECB to zero in the ECB’s own master spreadsheet.

The SNB would then have lost 100% of the proceeds of the rate cap programme. On its balance sheet its capital would go negative. For a private company, having more liabilities than assets is the definition of insolvency; but for a central bank, liabilities, in the form of the sum total of all client balances on the master spreadsheet, need not be matched with assets, in the form of credit items at other institutions or market operators. This is why the trade is short infinity, because it imagines there is a limit on the sum total of issued currency. There isn’t, as such. A negative capital for the SNB would record the fact that it has done a program buying lot of Euros and lost the proceeds. It documents history, but has no, as such, economically significant impact.

So then comes a second wave of short infinity traders, who may have admitted that the SNB is not constrained on how many CHF it can issue, and move on to argue that all these Swiss francs in circulation will create inflation in Switzerland and thus devalue the Swiss franc.

It could be. But for inflation to happen you need someone to give money to real world people or businesses to spend within the Swiss economy, and for them to go out and buy things they wouldn’t have otherwise been able to buy, in vast quantities.

The short infinity traders are totally not interested in buying Swiss francs and then giving them away to Swiss people so that they can splash on a new car or office block. They keep a cash balance. Swiss banks who maintain these accounts on their behalf could use the cash and lend it wildly, but they would then risk going bankrupt if they did it more than the real solvency of their borrowers allow, and that criteria hasn’t changed a iota since the financial pressures that caused the traders to buy CHF. So they don’t. In technical terms it means narrow money (the master spreadsheet’s sum) grows while broad money (including banking sector monetary creation) remains stable. Which is all good.

In the unlikely event that the financial people long CHF, or their agents, started giving away the stash of CHF to people who spend it in the actual Swiss economy, the SNB wouldn’t run out of ammunition. It could take the interest rate higher — up to infinity if need be — to make it worthwhile for people to park back the new windfall as cash instead of spending it, or coordinate with the Swiss Federal Department of Finance to mop up the excess CHF in circulation using taxes — up to infinity if need be as well.

So there’s no way the SNB can fail to maintain the cap, or fail to control inflation, other than gross incompetence in spreadsheet maintenance, or through a political decision to stop doing what is an eminently sensible and secure policy.

A floor could be attacked by markets, if they had more firepower than the SNB has assets to support a floor, but the SNB has only set a cap, and you can’t beat infinite resources: all potential attckers have finite access to Swiss Francs and Euros. At most, they could sell all world assets to the SNB in exchange of CHF balances. And the SNB would still not run out of CHF. The only attacker with unlimited firepower is the ECB, who could buy an infinite quantity of CHF with a newly minted infinite quantity of Euros. This would be absurd, as well as harmless: the reciprocal infinite balances between the ECB and SNB would still have no way to reach people doing actual spending to create inflation.

So it seems the long EUR/CHF trade is very unlikely to work out. I would argue the risk is on the other side. It’s very hard to formally pin down what the optimal value of a currency for its real economy would be when this currency is being impacted by influences outside the real economy itself. But there seems to be many indices that the Swiss franc is still overvalued at 1.20 and the SNB could thus decide to tighten the cap, to say 1.15, or move it progressively one notch at a time. In those case, the long EUR/CHF trade would be loss-making. A real loss for traders who are not themselves central banks.

It is also amusing to remark that as long as the current tensions that caused this state of affair remain, and the SNB does its job sensibly, which is not hard, the cap is a de-facto peg because there’s very little pressure on the downside. That is, Switzerland has joined the Eurozone, at least momentarily. It can exit technically more easily than countries that have adopted the Euro itself, but it would probably cause significant damage to the Swiss economy so it seems unlikely in the immediate future. And that happened without any notable political will to participate in the European integration project. Basically for Switzerland becoming a de-facto member of the Eurozone was a rational commercial decision. Welcome to the party.