FT Alphaville " The Swiss franc: proving a fundamental trilemma This is the Swiss franc and the euro over the past year: Note the wonderful stability that kicked in near the start of the calendar year? The admirable straight-linedness? Lovely looking, isn't it. But there are consequences... obviously. One such consequence is the build up of irritating euro-denominated assets we have written about before (here and here), which require speedy diversifaction and might potentially drive the Swiss National Bank towards more radical options - think capital controls and negative interest rates. And what that SFr1.20 level has also done is to prove a fundamental trilemma of international finance. Go on, you say? This argument is from Msrs Bordo and Humpage who, in a new paper at VoxEu, use the recent experiences of the Swiss franc and others to (re) demonstrate that a country cannot simultaneously peg an exchange rate, maintain an independent monetary policy, and permit free cross-border financial flows. At best only two of the three are feasible, but countries seem determined to forget this and seek to relearn the lesson. Of Switzerland, Bordo and Humpage say (with our emphasis): Switzerland has recently undertaken both sterilised and non-sterilised interventions. The former had no obvious lasting effects on the Swiss franc-euro exchange rate. The latter seemed successful, but posed a threat to price stability. In March 2008, the Swiss National Bank eased monetary policy in response to expectations of deflation, deteriorating economic conditions, financial-market distress, and a Swiss franc appreciation that resulted from the global financial crisis. In conjunction with this action, the Bank aggressively bought euros in the foreign-exchange market in 2009. Throughout March and April 2009, the Swiss National Bank did not seem to sterilise its substantial foreign-exchange purchases; the Swiss monetary base rose by more than the value of foreign assets on the Bank's books. In response, the Swiss franc depreciated. By April 2009, however, the Swiss monetary base had more than doubled from a year earlier, and the Bank - now concerned about latent inflation - began to sterilise the liquidity resulting from its huge interventions. The Swiss interventions continued through June 2010, but the Swiss monetary base either grew by less than the Swiss National Bank's holdings of foreign assets, or the monetary base actually declined. The Bank was clearly sterilising the operations, and the franc appreciated by nearly 10% between April 2009 and June 2010. On balance, from May 2010 to August 2011, the Swiss monetary base contracted and the franc appreciated, reaching an historic high on a real trade-weighted basis. In early August 2011, the Swiss National Bank announced a series of new measures to inject liquidity into financial markets with the objective of stemming the Swiss franc's appreciation. The operations included foreign-exchange swaps in which the Bank sold francs spot and repurchased them forward. The franc depreciated sharply, but undertook a stunning reversal late in the month. The Swiss National Bank then announced that it was prepared to buy foreign exchange in unlimited quantities to maintain a floor of SF 1.20 vis-à-vis the euro. The Bank's holdings of foreign exchange increased substantially, but the Swiss monetary base increased by even more. Since September, the Swiss National Bank has maintained an exchange-rate floor, by giving up control of its monetary base in conformity to the fundamental trilemma. So, there you go. If you wish to keep that floor you can kiss goodbye to any control of your monetary base. Fundamentally. Related links: The Swiss hill that may become a mountain - FT Alphaville The Swiss boson - FT Alphaville The SNB as victim of a decentralised market structure - FT Alphaville Temperature drops in currency wars for G20 - FT This entry was posted by David Keohane on Monday, June 18th, 2012 at 16:44 and is filed under Capital markets. Tagged with currencies, fx, snb, Swiss franc, Swiss National Bank.