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Hong Kong dollar as a mirror image of the Swiss franc

After the SNB dropped its minimum exchange rate, an interesting comparison between the Swiss franc and Hong Kong dollar is discussed. Paul Krugman introduced this comparison in his recent blog post, mainly to depict how similar Swiss minimum exchange rate policy and Hong Kong’s currency board are, except for institutional setups and history of the system. If this is the case, it might be a good reason to worry about stability of Hong Kong dollar since these two countries used very similar mechanism. Krugman, however, further argues that “no chorus demanding the peg that the peg be abandoned” in Honk Kong because of “hard-money ideologues” which Hong Kong has and Switzerland did not.

On the other hand, the recent article by the WSJ focuses on difference between two countries, as the title of the article “Hong Kong Dollar Peg Doesn’t Fit in Swiss Hole” suggests. While the article also pointed out institutional difference just as Krugman does, it further says that Switzerland and Hong Kong are facing opposite pressure in terms of capital flow, which should lead the opposite implications for the currency management. Specifically, while the SNB probably worried about huge capital inflow comes in the country given widely expected the ECB’s QE and Greek election, Hong Kong would face pressure of capital outflow (thus devaluation pressure on the currency), since the Fed is widely expected to raise its interest rate later this year. And in terms of whether Hong Kong could drop its currency peg, the article insists it’s unlikely since Hong Kong has a long history of defending its currency board system even when other Asian currencies collapsed during the Asian financial crisis in 1998.

On similarity vs. difference discussion, I would rather agree with the WSJ’s argument especially because “the direction of capital flow” matters under their policy mechanism. In theory, while central bank can depreciate its own currency indefinitely by printing money to buy foreign currency, the opposite is not true if central bank used up all foreign reserves. In this sense, we could say Hong Kong dollar is a mirror image of what the Swiss franc was used to be, with severer restriction in maintaining currency peg.

So what about potential instability of the Hong Kong dollar? I’m not confident enough to say it won’t happen. In terms of institutional setup and history of currency peg in Hong Kong, we have to remind how the Gold Standard was abandoned after the Great Depression happened. Although the Gold Standard had been believed as the best policy to maintain currency stability, all major countries eventually gave up their currency peg to restore domestic economy. Thus, we cannot exclude possibility that Hong Kong will follow this case. What’s more, although the WSJ article argues that Hong Kong is unlikely to abandon the policy that has anchored the financial system for decades given the recent political instability, I would say the political instability might be an incentive for policymakers to give up its currency board, since people might not accept sharp economic slump driven by currency defending policy which was implemented during the Asian financial crisis.

The SNB’s decision and power of expectations in monetary policy

After the Great Recession hits, it’s becoming increasingly popular that central banks employ “expectations” as a part of their monetary policy. The Federal Reserve has been actively using communication policies (the most famous one is called “forward guidance”), which essentially means the Fed makes some promises regarding its future policy path to make the policy more effective. The Federal Reserve explains how this kind of policy works as follows:

By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.

This is a very clever idea as it sounds, since central banks could strengthen their policy without using “official” policy variable in their toolkit. Only they have to do is to put “language” into their communication with general public (such as monetary policy statement and press conference). And this is the part of reasons why many central banks employ the similar strategy. For example, in the middle of the euro crisis in 2012, the ECB president Mario Draghi said that “the ECB is ready to do whatever it takes to preserve the euro”, which became very popular phrase both among policymakers and financial markets. In response to this statement made in the press conference, yields on sovereign debts in troubled countries immediately went down. Yes, the policy (just one sentence!) to control “expectations” worked perfectly.

Then here comes the SNB. In the most recent policy meeting, the Swiss National Bank decided to give up its cap on the Swiss franc exchange rate. In other words, the SNB suddenly “broke a promise” that it does “whatever it takes” to stabilize its currency. The price of betraying expectations seems very high, since the Swiss franc exchange rate surged and Swiss stock market tumbled right after the decision. Although the SNB also decided to lower its policy interest rate further into deeper negative territory, it did little to offset the shock in financial markets.

Here is a lesson that other central banks have to learn: policymakers should be very careful when they incorporate expectations into part of their policy, and abandoning this kind of policy could result in huge turmoil in financial markets. And since different policy settings have different policy implications, central bankers have to be sure that how they keep consistency among the policy to control expectations and other economic policies.

SNB Decision and Economic Ramifications

The Swiss National Bank (SNB) shocked the entire world with its decision to remove their peg holding the Swiss franc at 1.20 euro’s. This move caused turmoil in all FX markets as well as across the world. The biggest ramifications of this shakeup will be felt in Switzerland (obviously). This was deemed necessary because the Swiss franc had surged in value. This move to remove the currency peg will affect retailers of Switzerland products because their goods now look more expensive. Since there products are now considered more expensive, Swiss retailers will find it harder to sell their products, and even harder to export them. As chief executive of Swatch Group, a luxury Swiss made watch corporation, said in the Economist article, Shaken, not Stirred, “The bank’s action was “a tsunami” for exporters, tourism, and “the entire country.”” This same article later says, “Luckily I was sitting down” when the SNB called to warn of its impending announcement, said Johann Schneider-Ammann, the federal economics minister charged with trying to keep the Swiss industry competitive. Exporters, he acknowledged, face a huge challenge.” As you can see from the chart pictured below, the euro has collapsed in Swiss franc terms. Meaning that one euro used to buy 1.2 Swiss francs, but now that same euro only will get you ~1 Swiss francs. This makes everything in Switzerland ~20% more expensive for foreigners. This has impacts that will be felt throughout the entire Swiss economy, including retailers, restaurants, hotels, tourism, and consumer goods.

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This impact was immediately felt as Swiss companies lost upwards of 10% of their share price as soon as the news hit. This was felt extra hard by Swatch, who has lost 18% since the SNB announcement. In response to this, as John Revill writes in his article, Watchmaker Swatch Announces Price Rises, “Swatch, based in Biel, said it would increase the prices charged outside of Switzerland for some of its brands by 5% to 10%. The move comes as the franc has gained more than 15% in value versus the euro following the Swiss central bank’s decision last week to scrap a long-standing currency cap.” This move is to try and offset the loss of future sales that they are no doubt going to see. This move will certainly hurt Swatch’s (and every other Swiss based company’s) bottom line (which caused the respective stocks to drop), but at least there are no more surprises coming… We hope!