Tuesday, November 25, 2008

Swiss franc's safe currency status is hit by the storm

By Peter Garnham Published: November 25 2008 02:00 Last updated: November 25 2008 02:00 When global markets are volatile, the Swiss franc normally rises because it is regarded as a safe haven. Not this time. The currency's limited role in the global carry trade, deep interest cuts from the Swiss National Bank and concerns over Switzerland's banking sector all threaten to destroy its appeal as a refuge as volatility grips global markets. The loss of status can be seen in the fall of the franc against both the dollar and the yen since the collapse of Lehman in mid-September. The Swiss franc is down 7.5 per cent against the dollar and down 15.5 per cent against the yen. The franc is still up against some currencies - it has risen 3.7 per cent against the euro and 10.1 per cent against the pound since Lehman - but analysts say its prospects are increasingly bleak. That seems surprising given Switzerland's favourable external position. Relative to its size, Switzerland is not only the world's largest net creditor, but it also runs one of the world's largest current account surpluses. Were the loss of safehaven status to prove permanent, it would mark a reversal of the received wisdom that has been in place since currency trading took off in the 1970s. First, the franc has failed to benefit as much as expected from the unwinding of the global carry trade. The franc, dollar and yen have all been used to fund carry trades, in which the purchase of riskier, higher-yielding assets is funded by selling low-yielding currencies. Thus, when confidence in the global financial system and economic growth plunged, sparking a wave of deleveraging across markets, the franc, dollar and yen all rose as carry trades were unwound. Analysts say it is clear now, that the franc is the laggard. Steve Barrow, at Standard Bank, says this reflects the likelihood that the franc was used in a more limited way than the yen and dollar as a funding currency by carry trade investors. He says the yen was sold to fund carry trades in Asian currencies, against the Australian and New Zealand dollars and against some higher-yielding currencies, such as the pound. In contrast, the dollar was mainly sold to fund long positions in emerging market currencies, like the Brazilian real, South African rand and Turkish lira. Mr Barrow says the franc's use may have been narrower, confined for the most part to funding positions in other European currencies. "These suspicions about the relatively limited role [in the carry trade] for the franc have been borne out by the way it has fallen both against the dollar and the yen during the sharp riskreduction process of the last few months," he says. "Clearly, the currency has made some good gains elsewhere, but this could be in the process of changing." The Swiss franc not only dropped to a 16-month low against the dollar but also fell sharply against the euro after the Swiss National Bank delivered a surprise cut in interest rates last Thursday. The 100 basis point cut took the central bank's three-month Libor target down to 1 per cent. This was the third time the central bank had lowered rates outside of a regular meeting in two months, following a 25bp cut on October 8 as part of a globally co-ordinated move and a 50bp cut on November 6. The central bank said as a result of the decline in the prices of raw materials and oil, inflation was likely to fall below 2 per cent as early as the end of this year. Ulrich Leucthmann at Commerzbank says the Swiss authorities deliberately chose to shock the market in an attempt to undermine the Swiss franc. "The market is still worried about global risk aversion, but clearly the Swiss authorities are interested in the domestic economy, which is threatened by a slowdown in the eurozone and its reliance on the financial sector," he says. Concern over the health of the country's banking system has increasingly weighed on the franc. Switzerland has a larger banking system relative to gross domestic product than any major country - liabilities equal to 675 per cent - raising potential systemic concerns for its currency. Paul Meggyesi at JPMorgan says these worries have been fuelled by the adverse fate suffered by the currencies of other countries with bloated financial systems, notably the pound and the Icelandic krona. "In the boom times, the Swiss banking and financial system was seen very much as an asset for the country," he says. However, he says ever since the banking crisis reached its crescendo nearly two months ago, the market has become more concerned that the size of the banking system represents something of a liability for the franc. As well as the Swiss banking sector's size relative to GDP, the level of its foreign currency borrowing is also a cause for concern. Swiss banks have huge foreign currency balance sheets, with some SFr2,100bn ($1,751bn) denominated in foreign currencies at the end of September. At nearly 400 per cent of GDP, this FX exposure is larger than that of UK banks, though less than the 700 per cent built up by Icelandic banks prior to its banking crisis. Mr Meggysesi warns that the sheer scale of the Swiss banking sector and the extent of its foreign currency liabilities constitute a potential problem for the franc. "Large-scale FX borrowing by the banking system can be implicated in all manner of currency crisis, most notably the Asian currency crisis and latterly the collapse of the Icelandic krona," says Mr Meggyesi.

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