Overvaluation of the Chf

Overvaluation of the CHF: short and long-term consequences

On September 6, 2011 the Swiss National Bank (SNB) pegged its currency against the euro, thus heralding a new era in the development of the Swiss economy. Previously the franc was pegged to the deutschmark after the oil crisis in 1978, but authorities suffered from their decision substantially since this induced inflation from 1 to 5 %.

The reasoning behind the above mentioned policy is complex. Firstly, since the beginning of 2011 the CHF/EUR exchange rate increased by 13%, having almost reached parity with the European currency. Now according to The Economist's Big Mac index the Swiss franc is 62 % overvalued. If the new exchange rate doesn't equalize the price of consumer's basket, that could serve as a problematic issue. For quite a long period of time the CHF represented a 'safe haven', i.e. it generated profitable investment from abroad. Interest rates were always kept at about 0 %, meaning that saving in Swiss banks became less attractive. The country should have stabilized its currency because even higher over-valuation would lead to a massive decrease in competitiveness. But for such a small state as Switzerland a drop in exports would be totally detrimental. Even nowadays many farmers face shrinking demand for their production (e.g. cheese). The sphere of tourism is worsening off as well: since the prices in Switzerland are significantly higher in terms of their national currencies, Switzerland is not an attractive destination anymore.

Therefore the new policy of the SNB was the most relevant for the Swiss economy at those times.

We would like to analyze the consequences of the CHF peg to the euro using ISLMBP framework. The core of this model consists in portraying different combinations of interest rates and GDP, at which money market, market of goods and services and balance of payments intersect.

In terms of long-run effects, one could assume that those who tended to save in francs would switch to earn interest on gold. (Both the franc and gold were the safest assets prior to the peg). Secondly, the SNB would devalue the franc more since it is still overvalued (even after having been pegged to the euro at a rate of 1.2 franc per 1 euro. Figure 2 shows that due to higher demand for euros (we could suppose and other foreign currencies), the Swiss Central Bank will sell its foreign reserves, thus increasing the supply of euros in the economy.

Figure 3 says that after the franc was pegged to the euro the stock market encountered a drastic shock in a day. In our opinion, among some short-run consequences is immediate capital outflow, since foreigners doubted about the CHF's sustainability (the euro was fluctuating). Because of high volatility people are stressed and they respond very sensitively to