SWITZERLAND
A EUROMONEY SURVEY – MARCH 1996
BACKGROUND
From 1994 to 1995 the Swiss economy reached positive year-on-year growth rates despite the tough competition brought about by the sharp appreciation in the Swiss franc’s value. The Swiss franc is one of the key parameters driving the Swiss economy. The Swiss franc is expected to stay strong and there is a good chance that the Swiss National Bank will become more expansionist in order to stimulate the desired effects on the exchange rate.
MARKET CHARACTERISTICS
The Swiss franc
In the most recent in-depth survey of foreign exchange market transactions by the Bank for International Settlements (BIS), Swiss franc spot transactions were ranked sixth both by value and turnover in currency trading worldwide. The Swiss franc was involved in 14% of all transactions carried out. Its average trading volume was $87 billion per day.
The Swiss franc’s reputation as a safe haven remains unshaken. But political developments and economic conditions stimulated spot market trading among other major currencies. On the one hand, dramatically increasing volatilities among European currencies over the three years to 1995 prompted a considerably higher trading volume in the dollar, Deutschmark, yen, pound and French franc. And the approaching deadline for European monetary union raised speculation that induced hedge trades in the above currencies. On the other hand there has been a shift away from pure interbank trading towards more customer-oriented trading during the last three years.
The share of customer trading in the whole foreign exchange market increased from 19% to 22% in the three years to April 1995. The Swiss franc, with its low volatility, continues to be sought after as a safe haven currency. As the Swiss franc traditionally is more a vehicle for preserving value than for active trading, its importance is declining as the share of the interbank market in overall volume declines.
The Swiss foreign exchange market
The BIS survey indicates the important role Switzerland plays as a marketplace within the international foreign exchange market. It currently ranks as the sixth most important currency marketplace in the world. Switzerland continues to stand ahead of Germany and all other European countries except the UK. This position underlines the traditional dominance of Zurich, after London, as the second most important forex trading centre in Europe. In Switzerland, spot trading in foreign exchange still accounted for 51.1% of all transactions, while the volume of forward transactions is on the rise. The dollar is still the most traded currency. Dollar/Deutschmark and dollar/Swiss franc trades make up 50% of all deals settled on Swiss territory.
The Swiss derivatives market
At the end of March 1995 a notional $1,546 billion (2.7% of the world market) in international derivatives contracts was outstanding in Switzerland. Over-the-counter (OTC) business made up 94% of the total. The market value of the total contracts outstanding was $86.5 billion, which was up 32% from 1992. Of the outstanding contracts, 68% were ascribable to currencies, followed by interest rates, equities and commodities.
As Switzerland is a small open economy it is naturally very export-oriented and faces, as a result, significant currency risks. The currency fluctuations in recent years, partly caused by the chaotic movements in the European currency system, have grown to an unacceptable level for some companies. This has triggered tremendous growth in currency derivatives, most notably in OTC currency options, as they ensure unique flexibility with respect to hedging characteristics, hedging levels, terms, amounts and currencies. Nowadays market participants are also increasingly making use of exotic options in order to cope with companies’ specific risk profiles and to keep their hedging costs as low as possible. Today’s Swiss treasurers are increasingly using the entire range of products to hedge the various forex risks. It is therefore not surprising that Switzerland is home to some of the most sophisticated currency risk managers.
Hedging strategies
One of the frequently-applied hedging instruments is called the basket option, which is used as a tool to hedge multiple currency cash flows. A basket option provides the right to exchange two or more currencies for a base currency at expiration. For example, a company expects to receive income from exports to various countries. A put on the basket option consisting of these currencies gives the company the right to exchange the currencies for Swiss francs at expiration. The option is cash settled and the main advantage of this product is its low cost. The option is generally 15% to 20% cheaper than a strip of standard options. In some cases savings of up to 30% can be achieved. The lower the correlation between the currencies, the cheaper the basket. Basket options are also very flexible and can be tailored to exactly match a particular set of multiple currency cash flows. In addition, basket options are easier to administer, eliminating the need separately to monitor, revalue and exercise a strip of options.
Asset managers in Switzerland have also had to become very sophisticated, because the current low interest rate environment in Switzerland is not very encouraging to investors. Many market players have therefore been looking for opportunities to improve the return on their Swiss franc investments by taking advantage of specific events in other financial markets, while having the principal amount and a minimum rate of return guaranteed. A very popular strategy in this respect is the GRIP (guaranteed return on investment product). Investors who do not expect a significant movement in the $/Swfr exchange rate purchase a GRIP. The GRIP guarantees a minimal interest rate and offers a better return on investment, provided the $/Swfr exchange rate stays within a given range and strike levels are never touched during the lifetime of the product. For example, with the $/Swfr at 1.1650, the investor receives 0.50% pa guaranteed. If the $/Swfr rate stays within the range of 1.1100-1.3100 during the next six months, the investor receives 4.50% pa. This compares favourably with a six-month money market deposit, which would only yield 1.60% pa.
These strategies show that by varying the guaranteed returns and the foreign exchange ranges, different potential returns can be achieved. The same product can be offered with other currency pairs, maturities and foreign exchange ranges. The investor can apply his own view of the market.
Today’s investors are highly demanding. Swiss banks are offering them market liquidity, a wide range of products and competent advice. Successful currency risk managers are depending more and more on sophisticated technology to support their currency management and they need a strong commitment to educate their employees in order to cope with today’s market environment. Swiss banks already play a major role as internationally trusted partners.
EXCHANGE RATE AND THE ECONOMY
The Swiss franc’s shock-like appreciation
Switzerland is a small open economy and relies heavily on international trade. In such an environment the exchange rate is one of the key parameters driving GDP growth and inducing structural changes. The recent Swiss experience is a typical example of the way the economy is affected by a shock-like appreciation.
In 1995 the nominal trade-weighted exchange rate index (TWI) rose by a real 6.4% according to preliminary calculations by the Federal Office for Economic Affairs. Over the past three years the TWI has increased by about 16%. Such a huge increase over an extended period can be considered an exchange rate shock on the domestic economy. The largest appreciation step took place during the last week of February and in March 1995, when the TWI rose by 7%. The rise in the Swiss franc’s value had a major impact on GDP and its components, prices, short- and long-term interest rates and on the SNB’s policy.
In general, an appreciation of the home currency results in a contraction of net exports and an expansion of net imports in the medium term. As a consequence GDP growth falls as domestic prices are not fully flexible. Higher exchange rates reduce international competitiveness, which can only be regained by an increase in productivity and/or product quality. At the same time, producers feel some relief in their cost function through lower interest rates. Decreasing capital costs in turn induce investment.
The Swiss franc’s impact on GDP
One of the methods to measure the interdependent impact of exchange rate shocks on growth, prices or interest rates is the vector autoregression (VAR) model. In the text below it is used to calculate the partial interdependencies of variables in order to extrapolate their development. Since the VAR only observes the past behaviour of the parameters, policy responses are incorporated, ie an expansion in the monetary base in a period of Swiss franc strength in accordance with the SNB’s past behaviour. The results of the VAR have proven relatively stable. Caution must be exercised, however, when forecasting with the help of regression models, because a political institution can decide to change its long-term objectives.
Before the recent appreciation hit the economy, GDP growth had been in recession from 1991 to 1993. From 1994 to 1995 the economy managed to reach positive year-on-year growth rates despite the tough competition induced by the Swiss franc’s strength. However, since the beginning of 1995, growth rates have fallen from their relatively low level of about 1.8% in the first quarter of 1995. The chart on response of key variables takes this situation as its starting point.
The zero level on the vertical axis represents the trend behaviour of the variables and the curves show the deviation from trend due to a 7% exchange rate shock in Switzerland. It is clear that the Swiss economy reacts normally to the shock, as the impact is immediately negative on all variables measured. For the first six to seven quarters of growth, long- and short-term rates fall below trend. The yield curve steepens. During this time industry and consumers have to adapt their behaviour. The model shows that this has been done with quite some success in the past, as growth shifts above the old trend level for the next one-and-a-half years.
During this second phase, inflation expectations begin to rise and the SNB slows money supply in order to prevent an overheating of the economy. The yield curve turns flat or even negative on an above-trend level. After three to three-and-a-half years the cycle produced by the shock is over and a new trend is established. The combined effects of lower interest rate costs and the high external value of the domestic currency keep the price level down even though the economy is already expanding.
In the chart on response of selected sectors, the VAR model is used to show the impact on selected production sectors. Swiss banks profit immediately from the appreciation. This is to a large extent the response to the below-trend interest rate costs. As long as the SNB acts expansively, the banks have the possibility of financing their reserve requirements at below-average cost. During this time they profit from a maturity shift, since they have the possibility of financing long-term liabilities with cheap short-term funds, as long as the interest rate curve is steep. After about six quarters their situation turns flat, together with the interest rate curve.
Industry always loses in the beginning. The response of the sectors can be divided into four categories with two dimensions. The response to the shock is either slow or fast and the impact is either low or high. A quick and strong response is common in the watch industry, tourism, chemicals and transport. A quick but relatively weak response is typical for electronics, plastics and the textile industry. Machinery and clothing tend to respond slowly and strongly, whereas retail reacts slowly, but in a relatively weak manner.
The chart below shows that the Swiss franc is one of the key parameters driving the Swiss economy. A shock-like appreciation of 7% in the TWI produces a growth cycle that lasts for about three years. The VAR model incorporates the response of fiscal and monetary policy in the effects of the appreciation. How these policies are currently conducted is the subject of the following section. The question behind the evaluation of the political response to shocks must always be: to what extent is the policy able to prevent cyclical phenomena and/or how strong does fiscal and monetary policy re-enforce the underlying business cycle?
Swiss economic policy
In 1995 the SNB was very successful in guiding money market rates lower without provoking inflation expectations in the market. By now the SNB is in a comfortable position, as base money growth is well below medium-term target and the immediate inflation outlook gives no reason for concern. However, as SBC Warburg expects the Swiss franc to stay strong and GDP growth to remain sluggish, there is a good chance that the SNB will become even more expansionist. There is a real danger that inflationary potential is building up, as can be seen from the chart. The VAR model underestimates this potential.
After two periods where monetary policy was dominated by exchange rate considerations in 1978 and 1986, the SNB is faced with excessive Swiss franc strength for the third time. While SBC Warburg expects that the SNB will try everything to prevent a repetition of the two earlier experiences, some compromise between the current implicit exchange rate target of 80 Dm/Swfr and price stability will have to be struck. While wider monetary aggregates should continue to grow strongly, the bank believes that M0 will not show a significant increase, as the demand for notes in circulation (90% of M0) will not increase. Changing spending habits and consumption growth of just 0.5% in 1996 and 1.5% in 1997 should lead to a slowdown in the demand for cash. Furthermore, credit demand remains rather weak.
Fiscal policy is going to remain neutral for the coming year, as the discussion of the 1996 budget has hardly taken the slow growth prospects for 1996 into account. The current deficits are the result of a mounting spending mentality among members of parliament and a fall in the willingness to raise fiscal revenues. The wider this gap gets, the smaller the margin for the government to act becomes. The fact that half of the spending cuts will be swallowed by new expenses demonstrates that a turnaround has not yet taken place. Over a quarter of budgetary expenses are used to finance social security, which has seen an average annual budget increase of 8% since 1980. These developments give reason for some concern, as a cutback on social security would be very difficult to achieve. While this may sound alarming, it should be noted that Switzerland’s debt-to-GDP ratio currently lies at only 46.6%.
CURRENCY OUTLOOK
The Swiss franc and the Deutschmark
Through its impact on other European cross rates, the Deutschmark is by far the most important foreign currency for the Swiss economy. The EU receives 62% of Swiss exports and is responsible for 80% of imports. After the strong appreciation of the Swiss franc in the recent past, the question of whether or not the period of extreme Swiss franc overvaluation is over appears to be legitimate. For one thing, the strength of the Swiss franc against the Deutschmark has fundamental reasons:
* The inflation differential towards Germany is expected to widen again. While German inflation is expected to slowly creep up from its latest impressive figures of around 1.5%, Swiss inflation will fall from last year’s average of 1.8% to less than 1.0% in 1996.
* Swiss net assets in Germany have grown at a tremendous rate over the last few years. This is mostly in the form of German bonds. Since 1990, Switzerland’s capital exports to Germany have been roughly Dm40 billion. However, this figure does not deduct any interest or capital payments on bonds. Swiss citizens buy German bonds because the yields are greater. To compensate for this, the Swiss franc needs to permanently appreciate against the Deutschmark. The situation is very similar to that of the (strong) yen against the dollar.
Furthermore, there will be more depressing data from the real economy during the coming months. According to SBC Warburg estimates, GDP growth for 1995 should come in at an uninspiring 0.9%, the job market should continue to deteriorate, and business climate and consumer confidence will be stagnant. To most market participants a strong Swiss franc seems to be justified only on monetary grounds. As well as these considerations, the uncertainties surrounding the Emu have led to an even higher Swiss franc. With the Intergovernmental Conference under the Italian presidency starting on March 29th, European integration as a whole will move into the centre stage of investors’ attention again. The effect on the Swiss franc should be:
* The subjective probability of a realization of Emu of German investors will rise as non-economic issues in European integration start to be discussed in the media.
* Some concessions, possibly in the form of the exchange rate regime for non-participants, will have to be made to achieve progress in the integration process. Both effects should result in further capital flows into the Swiss franc.
The Swiss National Bank’s role
It is questionable how far another round of Swiss franc strength can go. A key factor will be the reaction of the SNB towards such a development. In contrast to its claims, the exchange rate with Germany has played a significant role in determining monetary policy in the past.
A 1.0% appreciation of the Swiss franc against the Deutschmark has induced the SNB to lower money market rates by 10bp in addition to the other usual considerations of inflation and output development or international interest rate trends. In 1995 the SNB delivered in accordance with its historical track record. As the Swiss franc appreciated by 4.5% against the Deutschmark, the SNB cut the discount rate four times by a total of 200bp. As a result, the spread in three-month Euro-money towards Germany increased from -99 bps at the beginning of 1995 to -196 bps in early January. Another way of judging the influence of the SNB on the performance of the Swiss franc is to look at the distribution of monthly deviations in the DM/Swfr rate from its purchasing power parity (PPP).
The mean of the percentage deviations of -1.6% indicates that the Swiss franc is structurally stronger than PPP would suggest – a finding which corroborates SBC Warburg’s general view that net foreign asset positions contribute significantly to exchange rate movements.
Under normal circumstances deviations from PPP should be symmetric. Obviously this has not been the case with the Deutschmark/Swiss franc. The distribution of deviations is much steeper on the downside, ie, for overvaluations of the Swiss franc. The maximum overvaluation of 9.1% is only 7.5% away from the mean, while the maximum undervaluation of the Swiss franc of 11.4% is 13% away from the mean. Thus the overvaluation potential appears to be limited. Even under the assumption of a normal distribution, the likelihood of more than a 10% overvaluation of the Swiss franc against the Deutschmark lies well below 5%. The downside in the Deutschmark/Swiss franc rate under circumstances of a neutral monetary policy would thus be limited to 78.00. As the bank expects that the SNB will go a long way to keep the Deutschmark/Swiss franc above 80.00, we believe that this level should hold even under short-term speculative attack.
SBC Warburg’s forecast
The bottom line of SBC Warburg’s considerations is that it still sees a chance that the market will test the lower levels in the Deutschmark/Swiss franc rate, with a big chance of another rate cut by the SNB in the spring. If the Emu process unfolds with increasing difficulties for even core currencies to fulfil the Maastricht criteria, the exchange rate will have clear upward potential. In addition, the SNB’s current expansionist monetary policy will leave its imprint on medium-term inflation performance, which could weaken the Swiss franc significantly on a two-to-three-year horizon.
GRIP returns at $/Swfr = 1.165
| maturity | deposit | minimum | enhanced | $/Swfr |
| date | rate (pa) | rate (pa) | rate(pa) | range |
| 6 mo | 1.6% | 0.5% | 4.50% | 1.11-1.31 |
| 6 mo | 1.6% | 0.25% | 5.25% | 1.11-1. 31 |
| 6 mo | 1.6% | 0.5% | 9.25% | 1.11-1.25 |
P.O. Box, CH-8010 Zurich
Tel: +41 1 239 43 11
Martin Wiedmann
FX Sales Switzerland
Christoph Meier
FX Trading Switzerland
Klaus Wellershoff
Corporate Economic Services, SBC
