Switzerland is moving aggressively to weaken its franc and protect exports from watches to chocolates, sparking fears of an escalating currency war that would ripple through markets and other economies.
For months, the Swiss National Bank tried to rein in its surging currency by lowering interest rates and injecting francs into the market, but that did little to dissuade investors who viewed the franc as one of the few safe places to keep their money in a world of economic turmoil.
On Tuesday, the central bank decided it would wait no longer, setting a minimum exchange rate of 1.20 francs per euro. Investors immediately sold the currency, which sank by about 8 per cent to the SNB's target level.
"The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development," the SNB said in its statement. "The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities."
While the central bank portrayed its decision as a desperate attempt to shelter an economy increasingly squeezed by the robust currency, others fretted about the impact outside Switzerland's borders. Critics held it up as an example of foreign exchange wars, as countries restrain their currencies to stimulate their own economic growth at the expense of others. The move raises the possibility of other central banks following Switzerland's action, analysts say.
"There is a kind of beggar-thy-neighbour policy…" said David Bloom, head of foreign exchange strategy at HSBC in London. "Everyone does what's right for themselves but it doesn't work out to be right for everyone."
The Swiss are dealing with the fallout from being the world's most sought-after currency. They are used to the franc being a haven when times get tough, due to their stable political system and careful management of their economy.
This year, however, is different. The small country of 7.5 million people tucked in the Alps has watched as the franc jumped to all-time highs against other major currencies such as the U.S. dollar and euro. By August, some reckoned the franc was overvalued by more than 30 per cent.
The franc's leap is a big headache for a country that counts on exports for 50 per cent of its economy. Watch makers, chemical companies and food producers are all concerned as the strong currency cuts their margins and reduces demand abroad.
"Our products in the last couple of weeks and months have become more and more expensive," said Franz Schmid, director of the Swiss chocolate producer association Chocosuisse.
Businesses are also struggling at home. The tourism industry is suffering as fewer visitors come from abroad and those who do balk at spending $5 (U.S.) for a coffee or $12 on a key chain. Domestic retailers who want to pass on the currency gains to consumers are fighting with suppliers. One of the biggest, Coop, has removed some products from its shelves to pressure the suppliers. Many Swiss take a short trip across the border to France, Germany, Italy or Austria to scoop up bargains on everything from electronics to diapers to clothing.
It has started to take a toll on the economy. The chief economist of business lobby group economiesuisse warned this weekend in a Swiss newspaper interview that 25,000 jobs were at stake. Economic research institute BAK Basel said on Tuesday that the economy was on the verge of a recession, forecasting a slowdown in the gross domestic product to a 0.8-per-cent increase in 2012 from 1.9-per-cent growth in 2011.
The SNB's decision to peg the currency reflects these economic dangers and the overvalued Swiss franc, according to David Watt, a senior currency strategist at RBC Dominion Securities in Toronto.
"It's a response to an extraordinary situation," Mr. Watt said. "They got to a point where the market was so unbalanced they had to react … no central bank would sit idly by and let that degree of imbalance continue."
For now, the move has dealt a big blow to Switzerland's reputation as a haven. The currency cap removes the potential for gains arising from dramatic fluctuations. As well, the SNB has warned it expects the currency to weaken beyond that peg to reflect its fair value and it could step in again as required.
"The SNB has decided to lay down the battle lines," said Jane Foley, a senior currency strategist at Rabobank in London. While she says the peg may make sense from a domestic view, Switzerland is not the only economy that needs to boost growth and other central banks may follow its lead.
"The international stage may see this as another call to arms in the currency war," Ms. Foley said.
That term came into the spotlight a year ago when Brazil's Finance Minister said an "international currency war" had been sparked by countries dampening their currencies to make them more competitive.
The issue with intervention, analysts say, is that it passes the problem on to another country. When Japan sold yen after the March 11 earthquake and tsunami, it increased the attractiveness of the Swiss franc. Now that the Swiss franc has been quashed, other potential havens such as the Norwegian krone and Singapore dollar may come under pressure, according to Mr. Bloom.
But others argue that the SNB acted with restraint, and the peg it has set is still high for the Swiss economy.
"They are trying to limit the overextended strength of the Swiss franc, rather than weaken the currency to make the country more competitive," said Thomas Flury, who heads currency strategy for the wealth management business at UBS in Zürich.
Special to The Globe and Mail