Weak franc, strong franc: Focus on value concepts
Value concepts such as the fair value model and the well-known Big Mac Index are used to assess the value of a currency. Under the fair value model, the Swiss franc is overvalued against the euro. Indeed the strength of the currency causes difficulties for many a Swiss company. However, past data from the Big Mac shows that this wasn't always the case.
Strong Swiss franc makes life difficult for exporters
A strong Swiss franc is a thorn in the side for exporters in particular. The Swiss franc has been rising in value against the euro for some time now. This is primarily because prices in Switzerland have been increasing more slowly than prices in the euro zone. Based on the calculations of Credit Suisse economists, the Swiss franc is still around 10% overvalued against the euro. However, estimates based on fair value show that this wasn't always the case.
Assessing the value of a currency: Big Mac Index
Various concepts are used to calculate the value of a currency. One of the best-known is indisputably the Big Mac Index. This index was launched by UK weekly magazine "The Economist" in 1986, and has since evolved into a well-known indicator of the purchasing power of different currencies.
The calculations of the Big Mac Index are based on the assumption that the exchange rate between two currencies moves toward purchasing power parity over the long term. This is the case where the same basket of goods – including a Big Mac, for example – can be purchased using one unit of currency in both currency areas.
Assessing the value of a currency: Fair value
Credit Suisse uses purchasing power parity to assess fair value in a similar way to the Big Mac Index. However, the economists also use other key factors. Fact is, the forces that drive exchange rates toward purchasing power parity are muted for the following reasons:
- Far more than half the consumer spending of households is on non-tradable goods and services such as haircuts, rents, and healthcare services. Here, international price arbitrage is either very limited or non-existent.
- Currencies are also a popular form of financial investment. The risk and return expectations of investors therefore affect the value of a currency.
To take account of any factors determining the risk and reward premiums of a currency, Credit Suisse uses an enhanced purchasing power parity model to calculate fair value. This model indicates that the Swiss franc's fair value against the euro currently stands at 1.22. However, the EUR/CHF exchange rate has hovered around 1.10 for a number of years. This shows that the Swiss franc is currently around 10% overvalued against the euro.
Strong Swiss franc a relatively new phenomenon
It's nevertheless a myth to suggest that the Swiss franc has always been overpriced. Fact is, between 2003 and 2010 the EUR/CHF exchange rate was significantly higher than would have been indicated based on fair value. The Swiss franc was therefore undervalued against the euro for many years.
The fair EUR/CHF exchange rate has also tended to decrease at an increasing rate, and has fallen by around 20% since 2002. This is due in particular to the stronger inflation trend in the euro zone versus Switzerland, as well as to an easing of the substantial upward pressure on the Swiss franc.
Fair value is likely to fall in the future
Swiss inflation is likely to remain lower than inflation in the euro zone in the future too. This creates ideal conditions for the Swiss franc to gain against the euro, while the fair value of the EUR/CHF exchange rate is likely to continue falling gradually. Fair value can therefore be expected to match the current EUR/CHF exchange rate in around five years' time.