The Global Economy

Case Study: Commitment to a Fixed Exchange Rate Regime

Key questions

• What does a central bank need to do to fix its exchange rate?

• Why might a fixed exchange rate regime be unstable?

• What motivates speculative attacks?

• What can a country do to make its fixed exchange rate a stable one?

Background

Credibility is at the core of central banking. When a credible central banker speaks, households,
businesses, and governments listen and adjust their behavior.

But credibility is tough to earn and easy to lose. To be credible, central banks must commit to a
strategy that works over time. Most important, people must believe that the central bank will not
renege on that strategy in the future. When, instead, future incentives to renege are expected to be
strong, the commitment lacks credibility. Economists say that such plans lack time consistency.

Time consistency is the Achilles heel of fixed-exchange rate regimes. In a world of free capital
flows, central banks can either fix their exchange rate or they can pursue a discretionary monetary
policy, but — at least over time — they can’t do both. This problem is known as the trilemma of
open-economy monetary policy. The promise of a fixed exchange rate means that the central bank
must buy and sell its currency not to influence the domestic economy, but to keep the exchange
rate fixed.

At the end of World War II, when capital controls were widespread, so were fixed exchange rates.
By the start of this century, with capital controls largely eliminated (aside from key exceptions like
China), most economies had shifted from a fixed to a floating exchange rate regime. The principal
reason is that doubts frequently arise about a central bank’s promise to refrain from exploiting
monetary policy discretion. Such doubts invite speculative attacks, making the fixed-exchange
rate promise very costly or impossible to maintain. As a result, in a world of free capital flows,
fixed exchange rate regimes are famously fragile.

Trying to defend an overvalued currency that faces pressure to depreciate commonly invites spec-
ulative attacks. Speculators know that the central bank has a limited volume of foreign currency
to sell to maintain the peg. Raising interest rates to make the currency more attractive can work
temporarily when high interest rates are consistent with domestic business cycles, but eventually
the fragility is revealed.

This case involves a currency that was not facing a threat of depreciation. Rather, it faced strong
pressure to appreciate that the central bank could resist by purchasing (rather than selling) foreign
currency.
The Global Economy FX Regimes

The Swiss experience, 2011–2015

In 2011, the Swiss franc (CHF) was appreciating sharply versus the euro (see Figure 1). The Swiss
National Bank (SNB) sought to counter a “massive overvaluation” of the franc that posed “an
acute threat to the Swiss economy” and “the risk of a deflationary development.” Accordingly, it
set a floor of CHF1.20/A
C, promising to ”buy foreign currency in unlimited quantities.” Translation:
The SNB would no longer use discretionary monetary tools (like interest rates) to set policy, but
would buy and sell francs to maintain the exchange rate floor of CHF1.20/A C.

For more than three years, the pledge worked, with the exchange rate settling slightly above
CHF1.20/A C. To achieve this goal, the SNB purchased an enormous quantity of euros. Foreign
currency assets soared from CHF210 billion at the start of 2011 to CHF510 billion as of December
2014 (see Figure 2). This surge accounted for more than all of the rise of SNB assets over this
period. The foreign currency holdings alone reached nearly 80 percent of Swiss GDP (currently
about CHF 650 billion) — the largest ratio for any major central bank.

From an economic perspective, the policy was consistent with Swiss cyclical conditions and with
price stability. Deflation abated, moving from –0.7% in 2012 to –0.1% in 2014, while economic
growth remained between 1 and 2 percent. Forward-looking prospects also remained consistent
with policymakers maintaining the currency floor: for example, the IMF World Economic Outlook
in October 2014 projected 2015 Swiss economic growth of 1.6% and inflation of 0.2%, both slightly
higher than 2014.

However, on January 15, 2015, the SNB unexpectedly discontinued its minimum exchange rate
regime, describing it as a ”temporary and exceptional measure.” As a result, the Swiss franc soared
versus the euro (see Figure 1).

What drove the SNB to abandon its exchange rate commitment? What was the source of the time
inconsistency?

One possibility is the influence of political developments on the credibility of the central bank’s
commitment. The SNB’s massive accumulation of euros became politically controversial because
it exposed Swiss taxpayers (who receive the benefits of SNB profits) to large losses if the euro
were to plunge in value. Popular concern about such losses was sufficient to trigger a November
2014 referendum in Switzerland that would have forced the SNB to increase its gold holdings
and effectively constrain foreign currency holdings. While the Swiss overwhelmingly defeated
the referendum, the controversy nevertheless affected the currency policy: speculators knew that
a large further increase in the SNB balance sheet would be politically risky, casting doubt on the
sustainability of the policy commitment.

Subsequent developments — like the Greek post-election crisis and the prospect of ECB quanti-
tative easing — probably made the SNB worry that it would have to acquire a large additional
volume of euros to maintain the minimum exchange rate policy. Had the SNB policy commitment
been more credible, speculative flows into the Swiss franc might have been smaller, but the irony
of speculative attacks is that they can become self-fulfilling. In this case, ever-larger positions in
the euro would have increased the SNB’s eventual losses in the event of a policy reversal, raising
doubts about its willingness to continue purchasing euros. As it is, the 17 percent surge of the
currency to CHF1.00/A C (as of January 21) that followed the currency policy reversal may have
cost Switzerland more than 10 percent of GDP in losses on SNB foreign currency holdings.

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The Global Economy FX Regimes

Yet, the aggregate economic losses from a sustained bout of unexpected deflation could be even
larger. Swiss prices already are falling (albeit partly due to the welcome plunge in oil prices). The
currency surge will hit import prices directly and domestic prices through the shock to aggregate
demand (Swiss trade in goods and services accounts for more than 130 percent of GDP).

Figure 1: Swiss francs per Euro

1.30

1.25

1.20

1.15

1.10

1.05

1.00

0.95
2011 2012 2013 2014 2015

Figure 2: Swiss National Bank assets (bil. CHF)

total assets
500

400

foreign assets
300

200

100

0
2011 2012 2013 2014 2015

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