SNB Decision: Substantial Setback to Growth With Major Price Declines
The exchange rate shock which the SNB's decision has imparted upon Swiss exporters and import-competing sectors is likely to slow growth in Switzerland substantially, but a recession should be avoided.
Inflation will turn sharply negative this year, and might not recover even in 2016. Sectors with a combination of low margins, high domestic labor content and high exposure to exports (especially tourism, retail and machinery) will likely be hard hit, whereas pharma and food producers as well as healthcare are fairly immune.
Given that the CHF is now clearly overvalued, the SNB should be able to gradually stabilize or even weaken the currency. Even lower interest rates are a possibility. The SNB will effectively target a currency basket. Within it, the EUR remains at risk. Fuller currency stabilization requires global economic stabilization.
The shock of last week may improve chances that other Swiss policy issues are dealt with in a more cooperative manner, in particular the implementation of the mass immigration initiative and corporate tax reform.
Sharp CHF appreciation substantially tightens monetary conditions, despite lower interest rates
Following the announcement of the Swiss National Bank (SNB) on 15 January that it is abandoning the EUR floor, the CHF has appreciated sharply against all currencies. At the time of writing, it is trading close to parity against the EUR. Against the USD, the CHF has risen back to levels close of June 2014. On a trade-weighted basis, the appreciation since 14 January is approximately 17 percent.
Meanwhile, interest rates have declined across all maturities, with the 3-month Libor at –0.43 percent; for the first time ever, the yield on 10-year government bonds has also fallen into negative territory. Nonetheless, monetary conditions in Switzerland have tightened considerably. Based on a monetary conditions index similar to the one used by the SNB, we estimate that the overall tightening is equivalent to an increase in the interest rate (3-month Libor) of two to three percentage points.
Sharp drop in growth, but recession not the base case
The dust has not yet settled following the removal of the EUR floor, and the full extent of the disruptions cannot yet be accurately gauged. However, a small open economy like Switzerland is obviously strongly exposed to exchange rate movements. Our empirical analysis shows that a 10 percent appreciation of the CHF, on average, lowers the growth rate of gross domestic product (GDP) by around 0.3 percent. On the assumption that the CHF will depreciate slightly from current levels, we revise our forecast for GDP growth in Switzerland for 2015 down to 0.8 percent from previously 1.6 percent. The Swiss economy should thus avoid slipping into recession but the forecasted growth profile is extremely flat. In addition, we lower our 2015 inflation forecast to –1.3 percent (from 0.0 percent) due to the combined impact of oil prices and the stronger CHF.
The Monetary Condition Index (MCI) estimates how monetary conditions have changed relative to a reference point (in this case 1 January 2011). It includes the relative change in the interest rate (3-month Libor) and in the exchange rate. Given the uncertainty around the impact of the exchange rate on the economy, two weightings are used. The 3:1 and 5:1 MCIs assume, respectively, that a one percentage point increase in the interest rate is equivalent to a three or five percentage point increase in the exchange rate. For the exchange rate we used the percentage deviation from our estimation of the fair value of a currency basket consisting of 50 percent EUR and 50 percent USD.
Zero growth of exports, with downside risks
We expect export growth to come to a full stop in 2015 as the sharp appreciation of the CHF will cause a substantial loss of competitiveness for Switzerland's exporting industries. The risks are even to the downside, though two factors mitigate the negative effect to some extent: first, as Swiss exporters have been increasingly able to position their goods as highquality, top-class products, the exchange rate elasticity of exports has diminished, i.e. price "wars" with foreign producers are less severe. The share of exported goods with a competitive advantage over foreign competitors in quality terms increased from 55 percent in 2000 to approximately 61 percent in 2013 measured by the so-called unit value. Second, the economic expansion of the USA and the UK as well as of most Asian economies and the appreciation tendency of the USD have reduced the negative effects. That said, some export-intensive sectors such as machinery could be hard hit.
Domestic investment hurt, consumption boosted, import leakage higher
Weaker export demand and the major pressure on profit margins that will result from this, together with higher uncertainty over the exchange rate outlook will, in our view, put downward pressure on corporate investment. Given that interest rates were already very low, the cut in rates by the SNB into negative territory will have almost no offsetting positive effect on investment.
Swiss consumers, on the other hand, should benefit substantially from increasing purchasing power thanks to negative inflation. Still lower borrowing rates and debt service will also be slightly supportive. However, an increasing share of consumer spending will once again "leak" out of Switzerland in the form of imports due to the weaker EUR. "Shopping tourism" will become more important again. Mirroring the development after the appreciation of the CHF in 2010, the increase in such imports could exceed CHF 2 bn, and thus approximately 0.6 percent of private consumption. Overall imports are expected to increase by 2 percent. In combination with stagnant exports, the Swiss trade balance is expected to weaken from CHF 53 bn to about CHF 40 bn.
Moderate weakening of the labor market, longer-term risks
Owing to slower GDP growth, we expect employment growth to slow down as well. In fact, many companies in the export sector or in import-competing sectors are likely to impose a hiring freeze, at least for some time. The public sector, where much of the hiring has taken place in recent years, has already started to become more restrictive given the worsening fiscal outlook for a number of cantons and communes. The overall slowdown is also likely to be reflected in a slightly higher unemployment rate. That said, we do not expect companies or the public sector to lay off staff in any substantial manner given that the growth slowdown should be temporary and many sectors have suffered from staff shortages to date. Uncertainty over the longer-term outlook is high, however, given the pending implementation of the mass immigration initiative.
Significant negative effects for tourism and the retail sector...
The appreciation of the CHF will have an immediate impact on a broad array of Swiss sectors. In most cases, the impact will be negative. The sector that will probably be hit hardest is tourism. Overnight, Switzerland has become much more expensive for foreign tourists and foreign visits much cheaper for Swiss tourists. Moreover, the sector's cost base is almost exclusively in CHF and wages make up a comparatively high percentage of production costs, which reduces the ability to improve cost-efficiency. We expect significant job losses in this sector which will hit foreign workers and mountain regions, in particular. In terms of overall GDP, the setback to tourism will, however, be very limited.
Another sector that is directly affected by the strong CHF is retail trade. We expect "shopping tourism" – already at a high level – to increase again. Food as well as nonfood prices are likely to fall, and retail sales are expected to turn out weaker than in 2014. A partial offset will be lower import prices, which will in part be passed on to consumers and should thus stimulate demand. This applies to food as well as, for instance, to the automotive trade. However, due to a record high in new car registrations in 2012, we expect only a limited pick-up in demand.
...but other sectors such as machinery also at risk
Alongside export orientation, other factors determine how an industry sector will be affected by the exchange rate shock. These include profit margins (profits provide a buffer to ride out the shock), the percentage of products invoiced in foreign currency, the percentage of costs incurred in Switzerland and the price sensitivity of customers. Based on these factors, the export-oriented machinery, electrical engineering and metals industry (MEM) will, in our view, be particularly affected by the exchange rate shock. This sector's growth path was already bumpy before the recent CHF appreciation. The expected slight pick-up in global economic momentum will only slightly mitigate the negative monetary shock.
Sales of the chemicals and pharmaceutical industry, as well as the revenues of watchmakers, are also unlikely to grow more than marginally in 2015. However, since these sectors should be better able to absorb the appreciation through their margins, producers of pharmaceuticals and watches will generally be hit less than companies from other industries. The watch industry, in particular, is strongly exposed to Asia which continues to grow and has currencies closely aligned to the USD.
Purely domestic sectors could suffer indirectly
Other mainly domestically focused sectors such as the construction industry, healthcare and nursing services as well as telecommunications, are unlikely to be affected directly by the exchange rate shock. However, there will be second-round effects that will most likely have an adverse impact on demand in these sectors as well. Overall, the appreciation of the CHF will reduce demand for labor, which will over time dampen employment and immigration. But this may not be felt much until 2016.
Banks under pressure due to large domestic cost base
For the banking industry, the SNB's decision has two consequences. First, banking activities are labor intensive in Switzerland and thus have a relatively large cost base in CHF. International asset managers will therefore see their earnings in foreign currency fall, while costs will remain elevated. For domestically oriented banks, the interest margin could decline further, depending on their ability to pass on the negative SNB rates to their customers. Interest rates on corporate and mortgage credits will tend to decline further, although the negative zero bound is quite unlikely to be broken. In any case, margin pressures in banking will tend to intensify with likely negative effects on the employment situation. Overall, the trend toward outsourcing will intensify across almost all Swiss sectors.
Cooling trend in the real estate market will be reinforced somewhat
The Swiss real estate market should not be very substantially affected by the exchange rate shock so long as our base case for growth and employment holds. The slowdown in growth will most strongly affect demand for commercial space, which is already low. We expect additional pressure on rents, and vacancy rates for offices are likely to increase further. The residential rental market, which is still healthy, will also face challenges in the future but probably not yet this year – so long as employment and immigration hold up. On the other hand, the further decline of interest rates has again increased the yield spread of real estate investments compared to other asset classes. This will have positive effects on real estate prices. We will therefore likely see a further decoupling of the capital-driven real estate markets from the occupier markets. That said, foreign investment in Swiss real estate is likely to cool down further due to the appreciation of the CHF. Regarding the housing market, lower financing costs render homeownership even more attractive than renting. Nevertheless, the impact on the housing market will be limited as strong regulatory standards remain in place. Therefore, we expect a further cooling of the price dynamic.
Credit Suisse Forecasts
(Seco, Credit Suisse)
|Unemployment rate in %||3.2||3.2||3.4||3.8|
Perspectives for 2016: Two-sided risks
While it seems rather unlikely to us that Switzerland falls into outright recession in 2015, the question arises as to how fast the Swiss economy will be able to digest the appreciation shock (and of course, how long the CHF remains overvalued). By nature, if short-term uncertainty is high, longer-term uncertainty is even higher. Taking into account that the lag from an appreciation shock into real demand is more than half a year, GDP growth in 2016 will likely also be lower than previously anticipated, even under the assumption of a slight depreciation of the CHF on a one-year horizon. We thus lower our GDP forecast for 2016 to 1.2 percent from 1.5 percent. As the price level reacts with a certain lag as well, inflation will, in our base scenario, be zero, on average, in 2016 (previous forecast 0.5 percent). Uncertainty regarding the forecast for 2016 is heightened because of two factors. On the positive side, we should finally see economic growth in the Eurozone picking up steam in 2016. On the negative side, the risk is that uncertainty over the outcome of negotiations with the EU over immigration worsen the climate for investment and weaken the labor market, adding to the impact of the currency shock.
Exchange rate shock could trigger positive political responses
That said, we believe that one of the outcomes of the exchange rate shock of 15 January may be more positive domestic policy responses to the challenges Switzerland faces. First of all, we believe that the leading political parties may now agree to handle the implementation of the mass immigration initiative in a more pragmatic way. We note that the "noise level" in this debate has already begun to subside despite the fact that parliamentary elections are looming. We think that the consensus to preserve the Bilateral Agreements with the EU will be strengthened. Second, we also believe that we may see a constructive solution emerging for the Corporate Tax Reform III.
In fact, given zero to negative borrowing rates for the federal government, greater fiscal support from the Federation to compensate for tax cuts by the cantons would seem to make a lot of economic sense. While cuts in corporate taxes are not very effective in stimulating demand in the short term, they would be useful to improve the competitiveness of Switzerland over the longer term.
As regards short-term stimulus, it should be pointed out that the fiscal position of the Federation is still very strong, so means are available if needed to provide at least a temporary offset if the exchange rate shock is more severe than expected. That said, historical evidence suggests that it is difficult to devise and implement effective stimulus packages. However, one of the most effective – and proven – measures would be to financially support short-term work programs in case the labor market does worsen more than expected. Preserving jobs and skills is extremely important for the longer-term.
SNB policy: Probably moving to a virtual currency basket; EUR thus still at risk
While not explicitly using this term, the SNB has announced that it will now be moving to a system of "managed floating." Effectively, the SNB will try to stabilize the value of a broader currency basket which more or less reflects the export exposure of Switzerland. However, it is very unlikely that the SNB will make any announcements about the exact composition of this basket. It is clear, nevertheless, that the weight of the EUR in such a basket will drop significantly from the recent 100 percent to maybe 50 percent, while other currencies, in particular the USD, GBP and possibly some Asian currencies, will also figure in it. It should therefore be pointed out that investors should no longer focus on "magic numbers" such as EUR/CHF parity when trying to forecast SNB actions. In fact, the SNB will likely deliberately want to de-emphasize such levels. If the ECB does implement significant QE while the Fed tightens policy, the risk remains that EUR/CH drops below parity for longer.
Interest rates could become even more negative
In principle, the SNB will continue to be able to use changes in interest rates and currency interventions to manage the CHF. Given the SNB's obvious reluctance to expand its balance sheet much further, it may need to drive interest rates into more negative territory. This risk is especially high if the Fed does not tighten and the USD appreciation stops. The current regime of differentiating between interest rates on deposits of large (institutional) investors and cash balances held essentially for transaction purposes will likely remain in place. If the gap between these rates gets too large, there is a risk, however, that investors will find ways to circumvent negative rates. In that case, the range of deposits affected by negative rates might need to be expanded. As the CHF is now clearly overvalued following last week's sharp appreciation, neither a further significant drop in interest rates nor substantial currency interventions will, however, be necessary. That said, fuller stabilization of the CHF will, in our view, have to await a stabilization of the global economic recovery, and especially that of the Eurozone. It should be noted that EUR/CHF was very stable as of about 2004 and the trade-weighted CHF even depreciated in this period. Such a period of stability – when safe-haven currencies are in lesser demand – may be some way off, but hopefully much closer than when the EUR floor was introduced.
SNB Decision: Key Reasons
Why Did the SNB Abandon the Floor? And Why Now?
The decision of the SNB to abandon the EUR floor is a highly controversial one. It seems clear that the action was not warranted based on short- or medium-term economic considerations, but was motivated by longer-term stability concerns.
Price Stability Target Effectively Suspended
Recent Swiss economic performance as well as medium-term forecasts clearly did not call for monetary policy tightening. Even on the SNB's own forecasts, inflation was going to remain negative in 2015, before rising gradually over the coming years; given recent developments in the oil market and in the Eurozone, the SNB would most likely have had to revise down that forecast even further. Swiss economic activity was also likely to have remained fairly subdued, with no further decline in unemployment until 2016 and very moderate wage gains. Finally, it also appeared that the overheating tendencies in the real estate market were subsiding. As outlined in this Alert, the abandonment of the EUR floor and the associated CHF appreciation will substantially dampen growth and drive inflation into deeply negative territory. We can therefore conclude that the SNB has at least temporarily suspended its macro-economic targets, especially the goal of achieving price stability (inflation below 2 percent) over the medium term.
Key Reason: Worry Over an "Exploding" Balance Sheet
Nevertheless, basic economic considerations did, in our view, play a key role in the SNB's decision. Essentially, the SNB must have come to the conclusion (as we have 2 Substantial setback to growth, with major price declines 19/01/2015 Credit Suisse - Research Alert done) that the Eurozone would remain in a prolonged period of slow economic growth and extremely low inflation, if not deflation. This would, in turn, warrant a long period of very expansionary monetary policy by the ECB and thus a "weak" EUR. This would then also have implied a weak CHF compared e.g. to the USD, and potentially excessively easy monetary conditions. More important, we feel, were worries over the balance sheet. If the SNB had wanted to maintain the EUR floor, it would have had to continuously weaken the CHF through EUR purchases, thus shadowing the ECB's quantitative easing (QE) program and increasing foreign reserves. Such a policy might over time have become inconsistent with required monetary conditions in Switzerland, and would then have required an exit from the floor at a time when foreign assets on the balance sheet were far higher and the losses therefore much greater. Essentially, the SNB thus decided to take a big "hit" now rather than a possibly much bigger one later.
Better US and UK Economic Outlook as a Risk-Mitigating Factor
Although the SNB must have been aware that exiting the EUR floor exposed the Swiss economy to considerable risks, the gradually improving global economic backdrop played a role, in our view. In contrast to the past two years, economic momentum in the USA as well as the UK, in particular, is now much stronger. Moreover, the central banks of both countries are on course to gradually tighten monetary policy which should provide a further lift to their currencies. In an environment in which the USD, GBP and a number of other currencies make gains against the EUR, abandoning the EUR floor therefore looked less risky. It should be noted, however, that if the Fed does not tighten policy (not our base case but a risk), monetary conditions in Switzerland will become even tighter.
Doubts Over Timing
Nevertheless, we think there are serious questions over the timing of the exit. External uncertainty appeared very high at this time which, in our view, probably exacerbated the market reaction to the SNB's decision. In particular, we wonder whether it would not have been better to await the outcome of the Greek elections and, more importantly, the launch of QE by the ECB. A period in which economic data in the Eurozone turned more positive, probably in the course of the next six months, would also have been preferable, in our view. We also wonder whether the SNB should not have waited until signs of Fed tightening became stronger. In contrast, an earlier exit would probably have been difficult. First, economic data in the USA, and the USD itself, were still weaker some months ago. Second, in the autumn, the unfortunate "gold initiative" put the SNB under the spotlight and drew considerable international interest. Removing the floor at that time might have been interpreted as a form of capitulation and could also have had an impact on the vote. Nevertheless, we wonder whether the SNB could not have waited somewhat longer. It is therefore our feeling that the SNB did in some sense "panic": EUR/CHF came ever closer to its floor in recent weeks, foreign currency interventions had to be restarted and the balance sheet started to re-expand rapidly.