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Switzerland’s Opportunity

The global financial crisis is deepening again. Angela Merkel has caved to the political pressures and has taken out the (presumably) last restrictions on the EURO money printing presses. Perhaps there are some who view this as positive but market action does not support this view, thus far. The impact of ever larger monetary action on global asset markets has been decreasing over time as the necessary structural reforms have not been politically feasible, essentially leaving the global economy with even more debt than 5 years ago. Merkel’s face about, rather than a positive, may be more of a sign of desperation.

Much of the European Union is in dire straits, probably already in recession again. Globally, the state of all large economies has visibly deteriorated since the crisis broke 5 years ago: China, Japan, the USA, as well as the EU, all of them are facing increasingly limited and tough policy options. Unfortunately, everyone seems resolved to fighting the symptoms of too much debt with yet more debt, by now for most too much to be able to grow out of it.

However, there are a few countries standing strong in the storm such as Norway, Singapore or Switzerland. Sure they are too small to make a difference, even as a group. In fact, they are so small and economically tied into the global economy that is seems they will hardly be able to avoid the fallout, or will they?

Renowned economics professor Peter Bernholz explained in a recent interview how Switzerland may be able to avoid the worst, perhaps even turn the crisis into an opportunity. (for the German speakers here is the full interview ).

In essence Prof. Bernholz suggests that the Swiss Central Bank starts investing its growing balance sheet into real assets such as high quality businesses, raw materials or land.

How does that help Switzerland?

Switzerland is a small and wealthy economic island in the center of Europe. Obviously, today the Swiss are more than pleased for not being part of the European Monetary Union. However, despite its rock – solid fundamentals and scores of high quality businesses (perhaps with the exception of the risk posed by UBS and CS), the country is by no means immune to the fate of its neighbors and trade partners. Economically, Switzerland is by no means an island but globally intertwined and thus exposed to its partners’ health.

Ironically, on the financial plane, its stand-out strengths can quickly turn into risks.  Today, Switzerland remains as one of very few havens of fundamental strengths and stability, a place where markets look for shelter as and when things deteriorate elsewhere. But, for a country the size of Switzerland, global capital movements can very quickly become a big problem. In the 1970ies even negative interest rates to the tune of 12% (!) were struggling to stave off the flood.

Since 2008 the Swiss frank has appreciated from 1.6 CHF/EUR to 1.2, where the exchange rate was fixed by the Swiss Central bank in August 2011 after it briefly traded at parity. As Prof. Bernholz points out in the Interview, it may proof extremely difficult, i.e. costly to defend this rate when things take a turn for the worse again.

However, in order not to endanger its export economy, the Swiss need to depreciate its currency roughly in line with its trade partners whose policy direction has been – and is likely to remain – to reduce their debt by currency devaluation. In essence, that would require the Swiss to follow suit and risk to ruin their rock solid financial status.

Keeping the frank from appreciating means that the Central Bank has to meet demand for Swiss Franks with newly issued currency for which it receives foreign assets, mostly in the form of IOU’s from foreign governments, the EU, the USA. In order for this new currency not to expand the Swiss domestic money base (and create inflationary pressure) it then needs to buy back Swiss Franks from the market, mostly by issuing Swiss Government bonds. This means that the Swiss Central Bank will need to expand its balance sheet by buying foreign debt paid for with Swiss debt, the deeper the crisis, the larger this balance sheet will become.

Until recently, it was assumed that EU bonds or US government bonds are risk free. However, during the past 5 years debt levels have increased to a level that put this assumption in question as government policies show no signs of changing direction. Prof. Bernholz is openly questioning the future quality of US and EU government bonds and suggests that if Switzerland is forced to buy up these papers it should not keep them on its balance sheet but reinvest them into assets that will withstand the inflationary policies in Europe, the US, Britain, China and Australia.

Prof. Bernholz is not suggesting something completely novel as the experience of China or Signapore shows. Switzerland could very well end up the big winner in a crisis that is becoming increasingly daunting for many of its trade partners.

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