Wednesday, August 15, 2012

Is the Swiss National Bank really Chuck Norris?

I once got accused by Scott Sumner of having the silliest comment he had ever read back on this post. Recent events show that I wasn't being so silly.

Around that time, the Swiss National Bank (SNB) had announced a peg of 1.20 EUR/CHF. The argument going around the market monetarist blogs back then was that central banks were akin to Chuck Norris - they only needed to explicitly announce a target and that target would be effortlessly hit, just like how Chuck Norris can make a row of kung-fu masters fall like dominoes just by threatening to hit them.

I made a few other comments to the effect that a central bank has to build up credibility before anyone will accept it as Chuck Norris-like. Here is one comment:
On August 3, the SNB announced it would be purchasing CHF50b in assets to drive EUR/CHF up. Over the next five days it purchased this amount, but the CHF continued to strengthen. On the 10th the SNB announced it would be purchasing an additional CHF40b in assets, which it proceeded to purchase over the next five days. The CHF finally started to weaken. On the 17th, the SNB announced it would purchase another CHF80b in assets. The data shows that it executed this full amount by the end of the month.
EUR/CHF went from 1.02 on August 10 to 1.19 by August 28, so a lot of speculators were hurt. It fell back to 1.10 in the next four trading days, and then on September 6 the peg was announced. Presumably the announcement of the peg drove EUR/CHF back up to 1.20 but seems not have required as much effort, although I'd wait to see the SNB's next monthly bulletin to be sure.
The point of I was trying to make back then is that what made the 1.20 peg credible was the initial beating up by the SNB in August, so when it finally announced the peg, it didn't have much work to do. Had it not beat up long CHF specs in August, the target would have required an incredible amount of purchases to implement. A central bank that lacks credibility can't just announce and expect things to magically fall into place.

Fast forward to the present and something odd is happening. As the chart below shows, the SNB is buying up huge amounts of euros in order to defend the CHF peg.

According to the Chuck Norris theory of central banking, this shouldn't be happening. A central bank that announces an explicit target, as the SNB has done, shouldn't have to expend any effort to protect that peg. But SNB foreign currency holdings have increased from under CHF250b to over CHF350 in just two months.

The SNB shouldn't have to defend the peg because in promising to purchase infinite amounts of euro deposits at 1.2000 EUR/CHF, private European banks will in turn step in and purchase euro deposits with CHF 1.2000. That's because with the SNB backstopping 1.2000,  they know that they can't lose by purchasing all the euros offered at that rate. Indeed, other banks will be willing to purchase euros for CHF 1.2001, knowing that the first group of private banks will in turn step in at 1.2000 because the SNB in turn has committed to stepping in at 1.2000. In sum, by simply expressing a commitment to buy euro deposits at 1.2000, the SNB creates a self-fulfilling loop whereby others defend the peg on the SNB's behalf by buying all euros at some amount greater than 1.2000. That's Chuck Norris in action.

The fact that the SNB has been forced to purchase large amounts of euro deposits indicates that for some reason, private banks haven't been stepping in to do their part. As a result, the SNB has had to fill the gap they have vacated. This could be because the banks don't believe that the peg is credible. Or maybe the SNB was never Chuck Norris to begin with. If the SNB isn't, then why would the ECB or Fed be Chuck Norris-like?

No comments:

Post a Comment