Posted by on January 21, 2015

By now everyone knows that last Thursday the Swiss did what the orderly and predictable Swiss are never supposed to do: they shocked the world.  Or at least the financial world.  They did this by suddenly refusing to defend the “cap” that they had set on their currency back in 2011, and which they had pledged to defend by buying foreign currencies in “unlimited quantities”.  Last Thursday, the Swiss National Bank (“SNB”) reminded everyone that, despite the now fashionable focus on “forward guidance”, the word of a central bank is money good until it no longer is.

With the removal of the “cap”, the Swiss Franc (“CHF”) shot from roughly 1.20 CHF to the Euro to about 0.85 CHF to the Euro, before settling down at about parity.  The damage is still being tallied.  Deutsche Bank and Citibank, those ne’er-do-wells of global banking, are reported to have lost about $150 million each, with Barclays, another perpetual underperformer, close behind at $100 million.   A couple of currency brokers that specialized in letting retail clients make leveraged bets on currencies – which sounds like a very prudent business model to me – hit the skids, with the largest, FXCM, having to quickly borrow $300 million to cover its cash needs.   And a major “hedge” fund, Everest Global Capital , had to shutter because, well, someone apparently forgot to “hedge” and lost pretty much everything, which begs the question again of why anyone invests in these vehicles.[1]

The losses of a couple of big banks can be viewed with equanimity; particularly because their very sophisticated “value at risk” models show that these losses are basically impossible, so I am sure that they are illusory.[2]  The demise of a couple of retail brokers that basically should have been licenced by the Nevada Gaming Control Board and not by the UK’s Financial Conduct Authority, along with yet another misnamed “hedge” fund, can be positively applauded.  But there is one reason to look at this event more closely, and that is the light it sheds on China.  Because the policy that the Swiss have been pursuing since 2011, and which they have now emphatically rejected, is exactly what China has been doing for a much longer time.  The reaction of the Swiss, who have been at the game of central banking for a lot longer and much more successfully than the apparatchiki in the People’s Bank of China (“PBOC”), is precisely why I am so confident that the China’s economic miracle will end badly.

Here is a nifty graph that shows the foreign exchange holdings of the SNB since the financial crisis began in 2008.  (You might have to play with the toggle in the upper left hand corner of the graph to get this to work; set it to “2008”.)  They have exploded from less than CHF 100 billion in 2008 to over CHF 500 billion in 2014 as the SNB has tried to fight off waves of “safe haven” CHF buying.  To give you an idea of magnitude, the total Swiss GDP was about CHF 650 billion in 2013.   So, compared to the size of its economy, the Swiss FX reserves are much greater (at over 75% of GDP) than they are in China (at about 35% of GDP).

Now, how did this happen?  Did world demand for chocolate, tax evasion, Rolex watches and tacky cuckoo clocks[3] suddenly explode, turning Switzerland into an export powerhouse?  Sadly, no.  The Swiss FX reserves exploded because, in order to prevent the appreciation of their currency, they had to print fresh CHF and use them to buy foreign currencies, principally the Euro.   Since they can do this in “unlimited quantities” – remember the pledge of the SNB – they can manufacture foreign exchange reserves pretty much at will.[4]

So, the first lesson is this: The next time that someone talks to you about the economic powerhouse that is China, offering its vast FX reserves as proof of this statement, you are hereby instructed to blow a large raspberry in his face.  Large FX holdings are, in today’s fiat currency world, often just the mark of a currency manipulator.

Now, the SNB has a balance sheet.  Foreign exchange shows up on the asset side, which means that something has to be on the liability side because, after all, balance sheets should balance.[5]  In common parlance, the stuff on the liability side of a central bank is called “money”, which means that a central bank that is bound and determined to depress the value of its money by buying foreign exchange, loses control over its domestic money supply.  And this is why the Swiss finally threw in the towel on their “cap”.   They ultimately became very uncomfortable with having their monetary policy run by Mario Draghi, an Italian sitting in Frankfurt.  Particularly when it appears that the Germans might finally be letting Mario off his lease to explore the dubious benefits of full-bore quantitative easing in Europe.  (Note: As I am writing this, the ECB has just announced a EUR 1.1 trillion QE program.)

The same logic applies to the PBOC.  Since 2000, the PBOC’s balance sheet has gone up by 10 times, for an annual growth rate of about 18%.  On this, the Chinese have built a pyramid of debt that has risen from 150% of GDP in 2008 to over 250% of GDP presently, and this despite rapid economic growth.  This debt pile has fed through into a series of bubbles and malinvestments, including in the real estate sector, steel, solar panels, stock margin lending, etc., etc., etc.  It is precisely these types of distortions that the Swiss have sought to avoid by breaking their link to the Euro.  They judged their risk to be sufficiently great that they are willing to suffer a sharp deterioration in Swiss international competitiveness today in order to avoid the consequences of bubbles bursting tomorrow.

So, we are left with a question: Either the Swiss have scored a massive own goal,  pointlessly crippling their export and tourism sectors through a huge currency appreciation, or the Chinese (and much of the rest of the world) are underestimating the consequences of a Chinese “hard landing” from its multiple bubbles.  I know where I stand on this question.

There is one last observation to make.  After a period of unearthly calm as the financial markets were anesthetized by massive doses of money printing, we finished off 2014 and are starting 2015 with some serious volatility.  A major currency, the CHF, rises by over 40%, before falling back to a 20% overnight gain.  Other currencies, such as the Russian rouble, tank.  Oil and other commodities plummet.  Default risk in the high yield market increases sharply, particularly in certain sectors, and emerging market debt and equity markets sell off rapidly.  The traditional “safe havens” – the USD, Treasuries, Bunds and gold – catch a strong bid.   None of these are signs of a healthy world economy.  All of them are signs that the myriad distortions and imbalances created by the fiscal and monetary responses to the financial crisis – such as an SNB balance sheet multiplying by five in six years — may no longer be ignorable.   We may very well be starting to hear the thunderous noise of chickens coming home to roost.

Roger Barris, London

[1] Any bets on whether the managers of this fund will be returning any of the “performance” fees they have pocketed before this 100% write off?

[2] I think that it is a great idea that banking regulators around the world continue to allow banks to use these risk models to justify their wafer-thin capital bases.

[3] Here I am feeding a popular misconception.  In fact, cuckoo clocks come from the Black Forest region of Germany, not Switzerland.  My bad.

[4] That is, so long as they can persuade someone to sell them foreign currencies for their newly printed CHF, which the Swiss were able to do since a lot of people are happy to hold CHF in these troubled times.  This caveat explains why we are not speaking in awed tones of the massive FX reserves of hyper-inflating Zimbabwe, which could have pulled off a similar trick if it had had a centuries-old reputation for fiscal rectitude like the Swiss.

[5] Johann Wolfgang von Goethe once called double-entry bookkeeping “one of the finest inventions of the human mind”, which goes to prove that even geniuses have their off days.

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