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Paul Marson, chief investment officer at Lombard Odier Darier Hentsch

Comment: The CHF, just a stamp of excellence?

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The turn of the year saw the CHF hit record highs. The trade-weighted exchange rate was up 15% in 2010, and is 30% higher from the start of the financial crisis in October 2007. Paul Marson (pictured), chief investment officer at Lombard Odier Darier Hentsch, examines the factors driving this upwards run.

The most obvious explanation lies in the safe haven features of the CHF, brought to the fore again by the financial crisis, and by European debt issues in particular. This haven status is not a given, but the result of a long history of geopolitical stability and financial discipline.

With a double budget and current account surplus, Switzerland has more than enough domestic savings to finance itself and needs not rely on foreigners’ willingness to buy Swiss assets. Public debt is remarkably low compared to peers (45% of GDP), and while private sector debt is high (176% of GDP, vs. 95% in Germany and 172% in Spain) and skewed towards mortgage debt (like Spain), the value of housing assets is more than double that of debt, providing a substantial buff er in the event of a housing bust.

Lastly, financial stability was quickly restored by a successful bailout of UBS in late 2008, and credit intermediation was actually never disrupted during the crisis.

In a context where most developed countries are struggling with their balance sheets and banking systems, the strength of the CHF can thus largely be considered as a “stamp of excellence” for Switzerland’s strong fundamentals.

That said, another factor played a part in the franc’s move, namely the SNB’s reaction. The central bank intervened massively from March 2009 to May 2010, to counter deflation risks from the CHF surge versus the EUR (as 70% of Swiss imports come from the Euro zone).

These unsterilised FX interventions not only failed to curb the franc’s rise, but substantially altered the SNB’s balance sheet, and raised the risk of fuelling a housing bubble down the road. A near tripling in FX reserves, skewed towards EUR holdings (now 55% of all currency reserves), has led to risk management issues. Losses on FX reserves, though mostly a political issue for the SNB at this stage, already amounted to CHF 21 bn in the first three quarters of 2010, leaving the bank with a total loss of CHF 8.5 bn (vs. a near CHF 7.0 bn profit the prior year), and provisions to absorb future losses are shrinking (now a mere 20% of FX and Gold reserves vs. 74% before interventions).

These balance sheet constraints have most likely kept the bank from taking further action since May despite persistent deflation risks, leaving the door wide open to speculation. The testing of the SNB’s “tolerance level” by speculators helps explain why the franc continued to rise in an environment of growing risk appetite.

So all in all, the SNB’s unilateral interventions proved counterproductive, and substantially limit its leeway for further action. It will now be a matter of weighing balance sheet issues and long term inflation concerns (housing) against immediate deflation risks from a strengthening CHF.

Whilst deflation is a clear risk in our view, we think balance sheet issues and signs of overheating in regional housing markets will prevail for the SNB, and keep it on the sidelines for now. Also, unless major disruptive currency moves trigger systemic risk, the current backdrop of heightened currency competitiveness makes concerted action with other central banks less likely.

Where next then? 2011 will be another year of high currency market volatility, as the global rebalancing moves on. Excess speculation on the CHF suggests a pullback is likely near term. Beyond, flight to safety will remain a major driver, especially versus the EUR as sovereign issues are far from solved, and the SNB is constrained.

The CHF may thus overshoot in overvaluation territory, particularly vs. the EUR. Our CHF-based accounts therefore carry no exposure to the EUR, whilst our EUR accounts on the other hand, are exposed to the CHF.
 

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