Breaking The Peg At The Swiss National Bank Of Europe
Swiss FX reserves went up by 50% in Q2, about CHF127bn and are now close to 65% of Swiss GDP, a very large number. The assumption is that in the first instance almost all of the initial purchases were of EUR (to support the 1.20 peg). The question is how may of these euros were they able to get out of to limit the SNB’s exposure. As Citi's Steven Englander notes, the extent of diversification matters for EUR, CHF, GBP and small G10 currencies, because limited diversification, say if the SNB has sold less than 40% of the euros bought in Q2, will lead to expectations of selling down the road. By contrast if they have unwound 60 or 65% of their EUR buying more, they face less pressure to sell the rest and probably will have made a decent profit on their FX activities.
Given how much they had to buy and how much selling of EUR there was from other sources, the SNB probably had trouble unloading the EUR that they bought -- the surprise is more likely to be how high the EUR share in Swiss reserves is, rather than how low.
We get the answer when the SNB publishes its first half results on July 31 (about 1:30AM EDT). The SNB publishes the currency distribution of its FX reserves as part of these results (Figure 1 presents the end-Q1 percentage allocation of these reserves). In Q2 Swiss reserves increased by 54% in CHF terms. We estimate that about 2% of this increase was due to CHF depreciation against the currencies in its reserves basket – the rest is the buying of EUR to maintain the EURCHF 1.20 floor.
It has also been reported that the SNB is engaged in heavy diversification efforts. The data that are published will tell us how much they have been able to diversify. The intuition behind the calculation is as follows. If the SNB was unable to diversify any of its reserves, almost all of the 54 percent increase in reserves will show up in the EUR component and other currencies would be essentially constant. Doing the arithmetic, this would push up the EUR share to about 67% of reserves. Conversely if they were able to sell all the EUR that they bought, the EUR share would drop to about 33% of the reserves portfolio (Figure 3).
None of these extreme solutions are likely, but we can do calculations for more likely intermediate outcomes and these are also presented in Figure 3. For example if the SNB managed to sell only 25% of the euros that it bought the Q2 EUR share will be just under 60%; if it sold 75% it would be just over 40%. So if it turns out on Monday that the EUR share is less than 45% it is a good outcome from the point of view of diversification and below 40% an excellent one.
The risk is that if the SNB has been unable to diversify out of the euros they bought in Q2. If the EUR share runs above 55% or worse 60%, it would mean that the SNB has had to hang on to a large chunk of their euros. Investors will see greater risk of ultimate capital loss if the peg should break and greater risk of desperation selling of EUR down the road. This would lead to downward pressure on EUR, upward pressures on the likely diversification targets, and incipient selling of EURCHF. We do not think an attack on EURCHF is likely in the near term but as reserves accumulate and if the EUR concentration increases, there may be more willingness to bet that the SNB will ultimately crack.