The Swiss Peg

In January 2015, the Swiss Central Bank de-pegged the Swiss Franc. Within a few hours, the amount of euro you could buy with Swiss francs decreased by 20%. What does this mean and why was this significant?

Let’s start at the very beginning (in the words of a famous song.) In the global society that we live in, people want to buy and sell stuff between countries. That means, buying things that use different currencies. For centuries now we have had exchange rates, which decide what one currency is worth compared with another. They determine how many euro you can buy with your pound when you go on holiday.

Who decides what the exchange rate should be ? Who decides how many euro you will get for your pound (or dollar or yen) Well, in most Western countries the exchange rate is set by “the market”. Every day the banks match up buyers and sellers of currency across the world and that decides the price, ie the exchange rate. People want to change currency for a number of reasons, pushing and pulling the exchange rate up and down. For example, maybe millions of Americans want to come to the UK to watch the Olympics, that will put up the exchange rate – they will get fewer pounds for their dollars. But at the same time, Apple might bring out an exciting new iphone that everyone wants to buy, that will raise the price of the dollar, making it even again.

We can see how the foreign exchange markets work by looking at ebay. Pretend you want to sell your VW beetle lego model on ebay. If you set the price too high, no one will want to buy it but other people who own a lego VW will see it and decide that they want to sell theirs too. There would be too many sellers and no buyers and the price would start to go down. The opposite is also true. If you put your lego model on ebay at a low price, no one else in the lego community would think it was worth selling theirs. Then lots of buyers would bid for your model, which would push the price up. At a certain point, other lego bods would decide it was worth selling their models too and the price would stabilize. It finds a natural level.

Now, some countries do not want to be part of the free market, so they control their currency. The government sets a price and their currency can only be bought and sold at that price. It reduces the amount that other countries want to trade. (In recent years, this has happened in China and the old USSR.) Or, sometimes a dictator will decide to set the price of their currency too high (in recent times, this happened in Zimbabwe) then people decide to just ignore it and an illegal black market is formed.

In the open market place prices are also affected by fashions, rumours and what people think will happen in the future. So, when the Conservative government won the last election, whatever your own personal views might be on that, the international market thought that the UK was worth more and the price of the pound went up by 4%. Nothing had changed, we didn’t suddenly have great weather and become a tourist destination, it was just that people’s view of our economy changed and that altered the markets. It reflects what causes most changes in the exchange rate. It is more about optimism and fashion and less about physical things, real economy or cash flow.

In the last five years, there have been lots of worries about Europe. There have been worries that some countries (Portugal, Ireland, Greece) might collapse and the Euro might go down in value. In comparison, the Swiss franc has looked very stable, very safe and so its value has gone up. That’s good for the Swiss people right? Well, not necessarily. It means their foreign holidays will be cheaper. But if they are an exporter, wanting to sell their chocolate, watches or knives abroad, then it makes their goods more expensive, fewer people will buy them. For the Swiss, their core industries are their exporters (if you have forgotten what that means, read the article about the European Union.) Therefore, too high an exchange rate is generally bad for Switzerland.

So, the Swiss government decided to do something. In 2011 the Swiss Central Bank set a target maximum price for Swiss francs, they said they would act in the markets so it would not go above a certain rate. This is called pegging. They agreed they would always sell Swiss francs at a certain price, so no one would go elsewhere and buy them at a higher price, therefore no one bothered to try and sell them at a higher price. The bank then had to actually sell francs at the declared price (to make it real) so it was regularly buying other currency (which it stored.) Now, because they were a strong, trusted bank, saying they would buy other currency, which kept the Swiss franc below a certain price, everyone believed them. This continued for several years.

Then, in January 2015, they announced that they were removing the peg. The exchange rate changed by nearly 20% in a morning, the biggest one day change in a single major currency for decades. Wow.