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Unexpected changes in the financial markets are often followed by high-pitched discussions in the news media as to who the principal victims are and how badly they will be hurt. Usually, this is not a very fruitful undertaking, since the effects of such ripples tend to be limited and, above all, short-lived. The Swiss National Bank’s decision last week to kill the exchange rate peg for the franc is a different matter, however, since it has global repercussions that will prove long-lasting.

It was back in 2011 that the Confederation’s Central Bank declared “the current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development.” The institution announced that it would set a minimum value for the euro at 1.20 francs and that, to enforce this minimum, it was “prepared to buy foreign currency in unlimited quantities.” By drawing this line in the sand, the authorities clearly hoped that it would be a limited number of euros they would actually have to buy, and for three years the strategy worked.

It came, therefore, as a total surprise to just about everyone concerned when the National Bank last week abruptly, and apparently without much warning to anyone, announced that it had abandoned the peg. In its statement, it said that “the minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation.”

The Bank continued, arguing that “recently, divergences between the monetary policies of the major currency areas have increased substantially – a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar, and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified.”

It is not likely that anyone with even a fundamental understanding of economics and the exchange markets will accept this “explanation” at face value. Much more likely, the National Bank had become concerned that, with the European Central Bank getting ready to launch a “quantitative easing” program of its own, a fresh flood of euros was about to head for the safe haven of the Swiss franc, forcing it to buy even more euros to defend its position. The SNB’s balance sheet has already grown to where it is equivalent to 86% of the Confederation’s GDP. A further glut of francs would have created a risk of instability in the Swiss financial system, and it could have exposed the SNB to enormous losses on its FX reserves if it had been forced to backtrack later on.

Whatever the specific motives, the consequences have been serious and many of them will prove lasting. The Swiss franc immediately appreciated by almost 30% against the currencies of the Group of Ten industrialized nations and surged to a record against the euro. It has since given up some of the ground gained, but remains far above its previous ceilings. The first victims of the sudden move were foreign exchange traders who were, unaware, sitting on short-CHF positions they had to rush to cover at soaring costs.

Generally harder hit – since they cannot move as quickly – were the many retail FX traders whose ranks have grown by leaps and bounds in recent years, aided by brokerages offering their “clients” (“counterparties” would be more appropriate) enormous leverage. Typically, to trade USD 1 million of any currency pair, cottage traders used to have to put up a cash margin of only USD 5,000, which works out to a leverage of 200:1. The National Futures Association in the US limited this to 50:1, which, however, still leaves room for big losses on wrong bets.

Brokers were hurt too. In the United Kingdom, Alpari had to fold. It was one of the top 10 retail forex providers. In New York, Leukadia National, owner of the investment bank Jefferies, had to agree to provide a USD 300-million cash lifeline into FXCM, after this currency broker conceded it may be in breach of capital requirements. According to the Financial Times of London, Citigroup, the largest prime broker to FXCM, has incurred a loss of USD 150 million as a result of the Swiss franc’s appreciation, roughly on a par with losses at Deutsche Bank. Barclays is said to have lost USD 50 million.

Hedge funds may also be nursing big losses and, in general, so do “carry traders” who had borrowed low-interest Swiss francs to invest the proceeds in higher-yielding currencies. They now owe substantially more in dollar or euro terms. Then there are the many Swiss companies in export or tourist industries which will now find it much more difficult to compete internationally and attract customers. Hardly anyone in Switzerland found it necessary to hedge foreign currency exposures, as finance managers trusted the SNB to stick to its promise to maintain the franc’s peg against the euro.

The companies most severely affected are those in sectors with high costs in francs and substantial revenues in euros, the watchmakers, healthcare companies, drug makers such as Novartis and Roche, and banks, which have high costs that they cannot easily move out of Switzerland. Firms that do have substantial investments abroad will be hit when they translate foreign earnings into francs.

There will be dramatic implications also for lenders, including OTP Bank (Hungary’s largest), Vienna’s Erste Group and Italy’s Unicredit, which have lent some USD 14 billion to Hungarians in foreign-currency mortgages prior to the financial crisis, the bulk of them denominated in Swiss francs. A November law obliges them to convert these loans into forint at about HUF 257 per franc, while the actual cross rate last week hit 310:1. This implies huge losses for the banks involved. In other Central and East European countries, Poland and Bulgaria, for instance, where FX loans have been similarly popular but banks have not been obligated to take the loss, the burden will fall on the borrowers.

US companies will not escape unscathed, either, as the dollar’s already six-month old rally has just received a bit more fuel, considering that the SNB’s action has opened the way for further, faster euro weakness, which will come to the fore especially once the ECB opens the monetary spigots wide. This will damp growth in the US, offsetting the boost from lower oil prices. For now, joblessness is still coming down and consumer confidence remains robust, but an increasingly overvalued dollar could change this. Globally, the stage is now set for a growing currency war in which ultimately no one wins. As for Switzerland, it is now probably headed for a recession.

[March 7, 2015]