SNB / Uncategorized

Letter to James Grant: No Alchemy at the SNB

I revere James Grant, the Austrian-leaning publisher of “Grant’s Interest Rate Observer“. However I must strongly object to his opinion that the SNB is getting “something for nothing” by buying US stocks for newly created Swiss Francs. While far removed from the truth, such an opinion can easily lead to resentment and retaliation by the American giant against the Swiss dwarf. Once bitten, twice shy: Switzerland should have learned its lesson in the past confrontations with the US regarding dormant accounts and tax evasion. It should therefore reply early and decisively against such interpretations of what the SNB is doing.

Dear Mr. Grant

You have repeatedly voiced the opinion that the SNB is getting “something for nothing” by buying US stocks – real income-producing companies – with Swiss Francs newly created “out of thin air” (e.g. in your May 11th, 2016 speech before Google employees “The Forgotten Depression of 1921” starting at the 12′ mark). Depending on the audience, you do voice a degree of comprehension for the position of the SNB: squeezed between a loose-money ECB and an at least perceived need to moderate the appreciation of the Swiss Franc to protect domestic producers (e.g. in your article in “Finanz und Wirtschaft” of December 11th, 2017: “Markets Trust Too Much in the Presence of Central Banks“).

Comprehension however falls short of approval. And without approval, the SNB and indeed Switzerland as a country are exposed to potential and entirely undeserved resentment and eventually retaliation by the US. I contend however that a hard-money advocate like you should approve of the actions of the SNB. Why? Because the SNB is creating money from real savings like in the days of the Gold standard.

There is a fundamental misunderstanding as to how the SNB creates Swiss Francs. It is not by re-hypothecation of domestic assets such as is arguably the main conduit employed by the Fed and the ECB. The SNB by contrast accepts deposits of real Swiss claims against foreign entities and creates Swiss Francs as notes of receipt of such claims.

For more than 200 years, Switzerland has been a creditor nation to kings and states. In recent years, the current account has oscillated around a high 10% of GDP, the result of a habit of industry and frugality perhaps dating back to the Reformation. Under normal circumstances, and indeed until 2007, the claims resulting from this culture of saving would be re-invested abroad. Since the Financial Crisis however, the Swiss are queueing up to bring this capital home. Indeed, the increase of the SNB balance sheet by 100% of GDP since that pivotal moment corresponds almost to the Swiss Franc to the cumulative current account balances since then.

In the days of the Gold standard, the SNB would have exchanged the claims against foreign entities that found their way onto its balance sheet for gold. This is not possible any more. It should be noted that it was rather against the will of the SNB that gold was curtailed as a reserve asset, a move brought about by considerable US pressure of the none-too-pleasant sort.

While the SNB got off the gold standard, it is still acting in its spirit: Swiss Francs are created as depositary receipts of real savings of the Swiss in their dealings with the rest of the world that they subsequently refrain from spending. The only difference between now and then is that in past days, these unspent savings would be settled in gold. Today, they are locked in abroad and the SNB is left holding receipts herself.

Up to this point, we have established that fresh Swiss Francs are not created “from nothing” but correspond to real Swiss savings. Two follow-on questions are: Is it ok for the SNB to hold 20% of its claims against foreign entities in the form of stocks? And should the SNB accept deposits of these claims at all rather than letting the Swiss Franc appreciate naturally?

[Actually morally it should – in the past, the banks did the same, but they are refusing to do it themselves now and in part they can claim it is because of government and indeed SNB pressure via regulations and oversight to de-leverage and to reduce foreign exposure]

As regards the composition of the foreign reserve assets on the SNB balance sheet, I would argue that 20% is rather on the lower side. Since the source of the reserves, the current account, is dominated by a positive balance in the trade of real goods, it is fitting that the proceeds are not entirely changed into nominal values.

Looking at the SNB reserves from an asset allocation point of view, the proportion of stocks is also very low considering that the rest is mainly composed of USD and EUR denominated government bonds. With value preservation in mind, and especially today, it is almost irresponsible.

The only reason for the low proportion of real assets is that the SNB has to maintain extremely high liquidity standards. If the holders of Swiss Francs should want to take their capital abroad like before the Crisis, the SNB will have to fulfil their demands for foreign currency immediately if it does not want the CHF to devalue sharply.

If the allocation to stocks can be defended, is the same true for the sheer size and rapid expansion of the SNB  balance sheet since the Crisis? For answering this question, one should take into account that there is a size factor of 40 (four-zero) between Switzerland and the US. The foreign assets and liabilities of Switzerland are roughly 5trn and 4trn USD, respectively (7.5x and 6x GDP; in US terms and to scale, this would correspond to 200trn and 160trn in foreign exposure, respectively).

These figures should make it clear that under conditions of free movement of capital, it is at least defensible for the SNB to take upon itself a limited buffer function to ease the calculation problem for companies and to buy some time for the necessary adjustment processes in terms of salaries, prices and the very fabric of industry. This is especially true in a period of uncertainty that is (one dares hope) transitory.

To prove the limited nature of the SNB’s actions, one has but to look at the external value of the Swiss Franc that has appreciated in real terms by upwards of 0.5% p.a. against Switzerland’s trading partners for as long as such statistics exist. For a Swiss company to each year increase its productivity by half a percentage point more than its not-too-lazy Southern German competitors can hardly be construed as monetary stimulation of the economy.

The same orders-of-magnitude argument can also be made for the first question about the SNB’s asset allocation. Giant Swiss companies traded in Zurich in Swiss Francs can be bought by foreign acquirers at any time thanks to the free flow of capital enabled by the SNB. When ChemChina buys Syngenta for 43bn USD in cash, to US scale this would correspond to a foreign entity buying Apple and Alphabet. Why would the SNB not want to hold the USD proceeds of this sale of CHF-denominated real assets in the form of other USD assets? After all, since Switzerland is so small, the assets of most of its large companies are in fact foreign assets themselves. So such a sale can be seen as a swap of company assets on the asset side (Syngenta assets for SNB stock holdings abroad) and a swap of Swiss shares on the Zurich stock exchange for Swiss Francs on the liabilities side.

Is the SNB’s policy without flaw? Certainly not. There are internal distortions in the real-estate market that the SNB tries to quell with rather limited success. Its policy also has distributive consequences but at least as regards the share of income between owners of productive capital and employees, the policy of managed appreciated shares the burdens and the spoils rather evenly. The price stability of recent years while maintaining a generally positive real interest rate certainly qualifies as a success.

But how should one look at the role of the SNB as a facilitator of a sort of reverse capital flight? After all, it takes on its (pubilc) books the (private) exchange-rate risk of Swiss holders of foreign capital. Is this not socialising private risk? Yes, but this also offers an alternative view for the negative interest rate charged by the SNB on “excess” reserves: it is an insurance premium for the exchange rate risk of deposited foreign assets. This interpretation is by the way also congruent with the way the SNB’s negative interest rate is levied: it only applies to excess liquidity created after the Crisis (the correspondence is imperfect but essentially true – since money does not bear a mark on how it was created).

In summary, the SNB is not creating Swiss Francs from nothing but form real savings. This is the same process as in the time of the Gold standard. Switzerland lacking gold mines, it had to acquire gold by real savings and only then can coin it or emit notes against it. Old habits die hard.

The size of the foreign-exchange reserves of the SNB is defensible under conditions of free flow of capital considering the sheer extent to which Switzerland is financially interwoven with the economies of its partners. The SNB does no more than provide limited buffering of domestic savings (for a fee) during a time of uncertainty while generally giving free reign to the natural trend of the CHF to appreciate in real terms.

Finally, the allocation of 20% of foreign exchange reserves to stocks is in my opinion rather low. In more “moral”, or maybe less trusting, times foreign claims would be settled quickly in gold. Nowadays, the currency of choice for settling such claims are government bonds. An admixture of 20% of stocks is maybe not foreseen in the rules, but certainly not morally wrong. It does however expose Switzerland to potential resentment by nations seeing this as unfair.

This kind of resentment is familiar to creditor nations throughout the ages. I hope that the line of argument above manages to shed light on the situation from a different perspective and maybe even contributes to changing comprehension into approval.

Best regards

***
SW/2017-12-19

Who is buying something for nothing? New York hedge funds, private equity etc. that pay in dollars backed by debt.

Certainly not Swiss companies who acquire with equity, i.e. with money saved up-front.

Certainly not Swiss banks whose deposits M1-M3 are mainly backed by real assets and not by debt.

Certainly not the SNB whose deposits M0 are backed by real savings (unfortunately converted into debt).

 

 

 

 

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