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Switzerland and the Euro.

GEORG RICH [*]

Switzerland is not a member of the European Union and, therefore, does not belong to the euro area. Nevertheless, the exchange rate of the Swiss franc against the euro has remained fairly stable. This stability does not imply that the Swiss National Bank pegs the exchange rate to the euro. On the contrary, the Swiss National Bank continues to pursue an autonomous monetary policy since monetary autonomy conveys various benefits to the Swiss economy. (JEL ES, F3)

The introduction of the euro was a significant event for Switzerland, a country located in the middle of the euro area but not belonging to the European Union. In the period immediately preceding the transition to the euro, many Swiss were concerned about the prospect of a sharp appreciation of the Swiss franc against the planned unified European currency. The Swiss debate about the euro was strongly colored by the monetary developments of 1994 and 1995. At that time, a surge in the Swiss franc against all major currencies caused havoc with domestic industry and prolonged the recession that had started in 1991. The rise in the Swiss franc was widely attributed to distrust in European monetary unification, prompting investors to shift funds into the Swiss currency. In response to these developments, the Swiss National Bank (SNB), Switzerland's central bank, relaxed its monetary policy in several steps from the spring of 1995 onward, after it had already loosened its reins in the second half of 1992. As a resu lt, the upward pressure on the Swiss franc eventually subsided and real growth in Switzerland began to pick up again at the beginning of 1997, with a brief pause in the recovery caused by the Asian crisis.

In hindsight, the fears about an overly strong Swiss franc were clearly exaggerated. On the contrary, the exchange rate of the Swiss franc against the euro has been remarkably stable since the launch of the new currency. Even the most recent outbreak of euro anemia has caused only small movements in the euro/Swiss franc exchange rate. On the whole, the Swiss currency has followed the euro on its downward path. How can the stability of the euro/Swiss franc exchange rate be explained?

Some market participants believe that the SNB is sticking to an informal exchange rate target and trying to maintain a stable relationship between the Swiss franc and the euro. Although the SNB does not fix a formal or informal exchange rate target, it is true that until the spring of 1999, it paid significant attention to the exchange rate. However, its aim was not to push Switzerland toward a fixed exchange rate system. Rather, the SNB endeavored to shield the Swiss economy from the deflationary forces that had operated since the mid 1990s. For this reason, it was important to prevent a strong appreciation of the Swiss franc.

In the summer of 1999, there were increasing signs of renewed acceleration of Swiss economic growth. In these changed circumstances, a monetary policy that focused on preventing an appreciation of the Swiss franc was no longer appropriate. Thus, the SNB tightened monetary policy in the fall of 1999. Moreover, at the end of 1999, the SNB announced major modifications to its policy concept. In particular, it now places greater emphasis on three-year inflation forecasts. In this manner, it underscores its traditional determination to aim monetary policy at domestic price stability rather than at a stable exchange rate. Of course, this does not imply that the exchange rate no longer plays any role in setting monetary policy. The SNB's research suggests that in the long run, inflation is determined largely by the growth in the money supply, while in the short run, it is the cyclical state of the economy and the exchange rate that matter most. Thus, the exchange rate is one among other factors entering into the SN B's inflation forecasts.

Upon announcing its modified policy concept, the SNB tightened monetary policy once again. Since then, the SNB has come to the conclusion that it underestimated the strength of the Swiss economy and the inflation dangers. For this reason, in the first quarter of 2000, the SNB tightened policy further in several steps.

The SNB's shift in policy focus caused the exchange rate of the Swiss franc to appreciate against the euro to some extent. Nevertheless, the continuing stability of that exchange rate is remarkable. It is partly explained by the similarity of the economic recovery in the euro area and in Switzerland. Thus, the European Central Bank (ECB), like the SNB, was forced to tighten policy. However, because Swiss monetary policy had been extremely easy until the spring of 1999, the SNB was compelled to raise interest rates more strongly than the ECB.

Markets currently seem to be mesmerized by the excellent performance of the U.S. economy. They seem to believe that in contrast to Europe, the U.S. can do nothing wrong. The strength of the dollar reflects these sentiments. Markets may be right. However, it is equally plausible that the U.S. economy has entered a bubble situation with serious dangers of inflationary overheating. Perhaps, as time goes on, markets will cease to focus exclusively on the differences between economic developments of the U.S. and Europe, and will notice the variations within Europe again. Once this happens, greater movements may be seen in the euro/Swiss franc exchange rate again.

Considering the stability of the euro/Swiss franc exchange rate, some analysts argue that Switzerland might just as well give up its monetary autonomy. If Swiss authorities were to peg the exchange rate of their currency to the euro, the consequences for Swiss monetary policy would be minor because the SNB already shadows the ECB. However, the situation is not as simple as that. Admittedly, the SNB has often pursued similar monetary policies as the ECB or its predecessor, the German Bundesbank. This is not surprising because both the SNB and ECB aim at the same policy objectives and operate in a similar policy environment. Nevertheless, the SNB does not shadow the ECB. Switzerland benefits from an autonomous approach to setting monetary policy for two reasons. First, even though Swiss and European monetary policies are often similar, specific economic conditions in Switzerland may prompt the SNB to deviate from the course pursued by the ECB (or from the Bundesbank's course before 1999). For example, from 199 5 to the middle of 1999, the SNB followed a more expansionary monetary policy course--measured in terms of short-term interest rates--than either the Bundesbank or the ECB. In this manner, the SNB took account of the fact that Switzerland, unlike Germany and other European Union (EU) countries, faced a threat of deflation. The deflationary pressures not only emanated from the exchange rate turbulences of 1994 and 1995. They also reflected the far-reaching structural shifts in the Swiss economy that started earlier and with greater force than in most other continental European countries.

Second, the SNB's autonomous monetary policy and its determination to safeguard price stability to a large extent explain why investors regard the Swiss franc as a useful means of diversifying the currency composition of their portfolios. Because of strong demand for Swiss francs by foreign investors, Swiss interest rates have tended to be lower than in all the other European countries. Low interest rates convey a competitive advantage to domestic industry and provide benefits to domestic consumers. The Swiss are reluctant to forego the benefits of low interest rates by pegging their currency to the euro.

Needless to say, if Switzerland decided to join the EU, it would likely have to adopt the euro and give up its monetary autonomy. However, in this case, the decision would be based on a broad assessment of the merits of joining the EU. The costs and benefits of abandoning monetary autonomy would constitute one among other elements in this assessment.

(*.) Swiss National Bank--Switzerland.
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Title Annotation:Swiss National Bank
Author:RICH, GEORG
Publication:Atlantic Economic Journal
Geographic Code:4EXSI
Date:Sep 1, 2000
Words:1321
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