Fritz Zurbrügg: A new premise for Swiss National Bank monetary policy?
Speech by Mr Fritz Zurbrügg, Member of the Governing Board of the Swiss National Bank, at
the KOF Forecast Conference, Zurich, 1 October 2015.
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Ladies and Gentlemen
I would like to thank you for your invitation to the KOF Forecast Conference. Economic
forecasts play an important role in investment and consumer decisions. They are also a central
parameter in the economic decision-making process of public institutions. At the same time,
we know that economic forecasts are associated with considerable uncertainty. Even
comprehensive models only represent a very simplified presentation of a complex reality.
Assumptions based on the forecasts can quickly be overtaken by events. In this regard, 2015
is a very special year for the forecasting institutions in Switzerland. The decision by the Swiss
National Bank (SNB) of 15 January to discontinue the minimum exchange rate of CHF 1.20 to
the euro and to lower the interest rate on sight deposit accounts at the SNB to -0.75% rendered
important assumptions of the existing forecast obsolete. After the decision, the Swiss franc
appreciated sharply. At the same time, interest rates in the money and capital markets
continued to fall and are now predominantly in negative territory.
Some market analysts have asked themselves whether this situation has brought about a
fundamental change of premise or creates an entirely new set of parameters for the Swiss
economy and the SNB's monetary policy. Even if the extent of the slowdown in growth was
assessed differently by the different forecasting institutions, there can be no doubt about it:
The SNB's decision has had far-reaching consequences for the Swiss economy.
Notwithstanding this, I will argue in my remarks that - while the current situation is unique -
with regard to both the Swiss franc exchange rate and the interest rate environment - it is not
fundamentally new. I will therefore focus first on the magnitude of the Swiss franc strength.
Afterwards, I will examine the importance of the negative interest rate in the current
environment. Finally, in the last part of my speech, I will discuss the impact of low interest rates
on financial stability.
Consequences of the strong Swiss franc
Let me start by looking at the exchange rate. Since the discontinuation of the minimum
exchange rate, the Swiss franc has appreciated considerably, and many industries and
companies have been - and continue to be - affected. The export industry, in particular, is
suffering. However, companies exposed to competition from abroad, retail businesses close
to the border, the tourism industry and domestic suppliers of exporters are also facing major
challenges. While the current situation is difficult, a strong Swiss franc does not in itself
fundamentally change the parameters for Switzerland. Switzerland's economic and political
stability and the structural current account surplus has created considerable demand for our
currency in the past, too. Moreover, uncertainties or crises have often cemented the Swiss
franc's safe haven status, resulting in additional cyclical appreciation.
The favourable position of our economy by international standards shows that a strong
currency can have a positive overall impact in the long term. Companies are under constant
pressure to cut costs and innovate and this strengthens the economy's adaptability, flexibility
and productivity. Quality improvements and specialisation ensure that foreign customers have
few comparable alternatives to many Swiss export products. Companies therefore have a
certain pricing power. At the same time, the strong Swiss franc helps to further integrate the
Swiss economy into the global value chain. Here, too, the negative impact for Swiss suppliers
contrasts with positive long-term effects. A SECO study shows that greater integration in the
global value chain - thanks to the associated natural hedging - helps to alleviate the negative
effect of an appreciation on profit margins.1 Many companies are therefore able to absorb the
effects not only by adopting internal cost-cutting measures, but also via lower import prices.
Overall, then, we may assert that specialising in high-quality products and services which
exhibit high value added and cannot be easily substituted, on the one hand, and natural
hedging on the other hand, make the Swiss economy more resilient to appreciation shocks.
My comments so far may appear overly positive. This is why it is important to me to make three
reservations. First, using the trade-weighted real exchange rate, chart 1 shows that the Swiss
economy has already had to live with exchange rate fluctuations in the past. However, the
appreciation since 2007 is of an entirely different quality and even the appreciation shocks of
the 1970s and 1990s pale in comparison. In particular, it must be borne in mind that the speed
of appreciation was particularly high this time around. It is much more difficult to digest a rapid
appreciation since it leaves companies with less time to initiate the process of adaptation. Even
companies that would normally be in a position to absorb an appreciation and maintain their
competitiveness are coming under pressure.
Second, it must be emphasised that, on average, the export volume of Swiss products has
reacted comparatively little to exchange rate movements. The qualification on average is an
important one. In fact, the dependence on exchange rate movements of the two largest sectors
in terms of export share (chemicals, including pharmaceutical products, and precision
instruments and watches) is distinctly below average. Thus, these sectors' share of total
exports has gone up over time. By contrast, the adjustments some companies and industries
have made to the strong franc have been - and still are - so far-reaching that they are having
to completely rethink their future in Switzerland.
Third, I am aware that it is easy for an outside observer to talk about the advantages of a strong
currency. At the same time, the SNB's various direct contacts with companies allow us to gain
concrete insights into current problems. During the last six months, my colleagues from the
Governing Board and I have held frequent meetings with representatives of the business
community; these discussions were very heated. It is therefore clear to me that adjustments to
a strong currency do not happen just like that. On the contrary. Adjustment processes as a
result of appreciation shocks are always very painful. Underlying these processes is a great
willingness to take risks on the part of companies and investors, and a high level of
commitment and flexibility from employees.
In addition, our eight delegates for regional economic relations are constantly in touch with
companies from different industries throughout Switzerland. The results of the special survey
on the effects of Swiss franc appreciation conducted in the last two quarters show that a large
portion (70%) of the companies surveyed are being negatively affected by Swiss franc
appreciation. Many companies' margins have come under pressure. However, the surveys
also illustrate how quickly - and differently - companies have reacted to the challenges. The
fact that our most current survey suggests a slightly improved economic outlook is
encouraging.
Economic developments abroad are even more crucial for Swiss exports than the exchange
rate. The importance of global economic trends for our country can be clearly seen in chart 2.
It shows that downturns in world trade and dips in growth in Switzerland occur almost
concurrently. But the characteristics of demand from abroad differ in important ways. Internal
SNB studies have shown that short-term changes in demand from neighbouring countries have
an especially strong effect on exports; in the case of demand from emerging economies,
however, long-term developments play a more significant role than they do in the advanced
economies. This is why, in recent years, the export industry has increasingly orientated itself
towards these emerging economies, where growth has also been considerably stronger. The
greater importance of these regions was particularly beneficial during the financial crisis
because demand from emerging economies fell much less, and recovered more quickly, than
demand from the traditional export markets of Europe and the US.
What support can the Swiss economy currently expect from global demand? In the monetary
policy assessment two weeks ago, the SNB stated that the US and the UK saw robust
economic development in the first half of the year. The muted recovery in Europe continued
as well, due partly to the favourable exchange rate situation. By contrast, the emerging
economies presented a mixed picture. Some countries registered a decline in growth, and
uncertainty regarding economic developments in China has increased. Consequently, growth
was not broad-based internationally, which was also reflected in the lack of momentum in
global trade (cf. chart 2).
We nevertheless expect the moderate pace of global economic recovery to continue.
Expansionary monetary policy and low commodity prices are supporting economic activity in
the advanced economies. This is a positive development for the outlook in Switzerland. If
global economic growth continues at the same moderate pace, this will help mitigate the
negative effects of the strong Swiss franc. Export activity should thus become a growth driver
again. Domestic demand will also support the economy. For these reasons, we anticipate that
economic conditions will improve somewhat in the second half of the year. However,
uncertainty remains high. For 2015 we expect real gross domestic product (GDP) to grow by
just under 1%.
The difference is in the differential
Let us now turn to the interest rate environment. Did our decision of 15 January cause a
fundamental shift in parameters in this area? No. I am, of course, aware that, since the
introduction of negative interest on banks' and other financial market participants' sight
deposits at the SNB, many money and capital market interest rates start with a minus sign
rather than a plus. For instance, yields on Confederation bonds with terms of up to ten years
are currently negative. So, mathematically speaking, the parameters have indeed shifted.
But what is important for the Swiss franc, and thus for the Swiss economy, is not domestic
interest rates in an absolute sense, but relatively speaking - i.e. the differential between Swiss
and foreign interest rates. Historically, Swiss nominal interest rates have tended to co-move
with those in other countries, albeit usually at lower levels, especially when compared to the
euro area. The comparatively low interest rates in Switzerland are, first, the result of low and
stable inflation. Second, they provide incentives for capital outflows, which are the counterpart
of the traditional current account surplus. Since the financial crisis, interest rates have dipped
towards the zero lower bound in many advanced economies, so that this classic rate differential
has virtually disappeared. In order to re-establish a clear differential, the SNB has lowered its
reference interest rate into negative territory, exerting downward pressure on the entire Swiss
interest rate curve. As chart 3 shows, using yields from Swiss and German five-year
government bonds, since then the interest rate differential to other countries has widened
again. Similar developments can also be observed for all other bond maturities. Thus, the
situation as regards the interest rate differential has not changed since 15 January; rather, it
has partly normalised thanks to the negative interest rate.
So the introduction of negative interest achieved an important objective. Lower interest rates
make Swiss franc investments less attractive compared to foreign investments. Of course, the
interest rate differential is not the only factor behind the demand for Swiss francs. For this
reason, it is not always easy to determine when, and how strongly, it will influence the Swiss
franc exchange rate. However, if all other factors remain the same, there is less demand for
investments in Switzerland - and thus for Swiss francs - when Swiss interest rates decline.
But I am also aware that negative interest rates do not constitute business as usual. In addition
to the interest rate differential, nominal interest rates will themselves also return to normal. For
this to happen, economic conditions abroad will need to improve to the point that interest rates
in Switzerland can rise without causing the Swiss franc to strengthen further. This is currently
not the case. At the most recent monetary policy assessment, we decided to leave the target
range for the three-month Libor unchanged at between -1.25% and -0.25%. The interest rate
on sight deposits at the SNB remains at -0.75%. Despite a slight depreciation, the franc is
currently still significantly overvalued. We are convinced that negative interest rates and the
SNB's willingness to intervene as required in the foreign exchange market will make
investments in Swiss francs less attractive; both of these factors serve to weaken the Swiss
franc. The provisional inflation forecast in chart 4 is also based on a depreciation, along with a
Libor rate of -0.75%. The chart shows that, over the short term, inflation will be lower than
forecast in June, owing to the lower oil price. However, it will return to positive territory in the
medium term.
Negative interest and financial stability
So the negative interest rate is currently essential to ensure appropriate monetary policy
conditions for the Swiss economy. But we also know that low interest rates, and in particular a
prolonged period of low rates, pose a risk to financial stability. Experience in many countries
has shown that such conditions provide fertile ground for imbalances to develop in credit
markets and asset prices.2 Indeed, under normal circumstances, lower money market interest
rates lead via transmission channels to lower credit and mortgage rates. In Switzerland, the
focus is on the mortgage and real estate markets, as around 85% of private domestic loans
are in the mortgage segment. Chart 5 shows that, despite negative money market rates,
mortgage rates have not fallen; they have even risen slightly. Movements in mortgage market
rates seem to have become decoupled from SNB monetary policy. How can this development
be explained?
It is true that a lowering of interest rates into negative territory differs from a conventional
interest rate cut in terms of its transmission to mortgage rates.3 This is because interest on
deposits and savings make up a considerable portion of banks' refinancing costs. Whereas, in
a positive interest rate environment, banks would not hesitate to pass on falling money market
rates to holders of deposit and savings accounts, when rates are negative, they are reluctant
to do so. This reluctance can partly be explained by the fact that retail bank customers regard
cash holdings as an attractive alternative to bank deposits, and could withdraw their deposits
if interest rates turn negative, thereby depriving the banks of an important refinancing source.
Thus, uncertainty over the collective behaviour of bank customers could be seen as a factor
dissuading banks from passing on negative interest rates. As a result, banks' liability margins
- the difference between the interest on a maturity-matched alternative funding source and the
interest on deposits - have dipped into negative territory.4 This is clearly illustrated in chart 6.
Banks have responded to the pressure on liability margins by raising mortgage rates (i.e. by
increasing the asset margin).
In principle, the slight rise in mortgage rates is good news from a financial stability standpoint.
So can negative interest rates even be regarded as a tool to combat imbalances on the
mortgage and real estate markets? In my opinion, the answer is no, since, in a longer-term
perspective, mortgage rates are still at very low levels. And imbalances on the mortgage and
real estate markets remain high. Chart 7a illustrates this using the relationship between
developments in real estate prices and rents, while chart 7b does the same using the ratio of
outstanding mortgages to GDP. In addition, despite a slight rise in mortgage rates, there are a
number of other channels through which the prevailing low interest rate environment could
further increase the risks to financial stability. I would now like to look at three of these risks in
greater detail.
Risks to financial stability
First, in the real estate market, there is an increasing focus on movements in the prices of
residential investment property. Both private and institutional investors, such as pension funds
and insurance companies, can boost the demand for real estate investments even further,
either through the search for yield, or because of a lack of other investment opportunities.
Yields on real estate investments continue to be well above those on alternative investments,
as shown in chart 8a, which compares yields on ten-year Confederation bonds with those on
investments in residential real estate.5 This yield difference could cause demand to stay high
for the near future, thereby pushing prices up even further. Although the borrowing component
in investment property financing tends to be lower than in owner-occupied real estate,
domestically focused banks are exposed to this segment. One-third of new mortgages are
issued for residential investment property, yet the affordability risk for such property owned by
private individuals is roughly as high as for owner-occupied real estate. Moreover, a correction
in this segment can affect other real estate market segments, via changes in market confidence
and expectations (spillover effects). So we need to keep a close watch on the residential
investment property segment.
A second risk arises due to falling liability margins in an environment of low interest rates. To
offset these, a bank essentially has two options - apart from increasing its lending interest rate.
Both options are associated with higher interest rate risk, which in turn increases the risks to
financial stability. First, it can grant a higher proportion of long-term loans at higher interest
rates, as they generate higher interest revenue than short-term loans. However, this also
increases the so-called maturity mismatch.6 The greater the maturity mismatch, the higher the
interest rate risk, and thus the potential economic losses for the bank in the event of a sudden
interest rate rise. This is because the larger the maturity mismatch, the quicker the rise in
refinancing costs compared to long-term fixed interest income when interest rates go up.
Second, a bank which has hitherto hedged against interest rate risk might be tempted to
dispense with such hedging, and the associated costs. Chart 8b shows that interest rate risk
has indeed risen in periods of low interest rates or, as happened between 2009 and 2014, has
remained at high levels. At the current margin, we are seeing first signs that risk has once
again increased slightly since the introduction of negative interest.
A third potential risk to financial stability arises from the fact that, in the prevailing interest rate
environment, non-banks such as insurance companies and pension funds in search of yield
also find the prospect of granting mortgage loans attractive. Even though currently only a
relatively small portion of mortgages is granted by non-banks, it is doubtful whether the banks
will be able to maintain the current elevated asset margin on new mortgage loans in a
prolonged period of negative interest rates. The increased competition as a result of non-bank
participation could reduce banks' scope for raising mortgage rates. From a financial stability
perspective, the resulting squeeze on profits could ultimately lead to banks having insufficient
reserves with which to increase or maintain their capital levels. This reduces the resilience of
the banking system and increases the risks to financial stability.
In sum, I can say that particular attention needs to be paid to financial stability in an
environment of persistently low interest rates, especially when combined with negative interest
rates. Therefore, the slightly slower momentum currently being observed on the mortgage and
real estate markets is welcome, but we should nevertheless remain alert.
Conclusion
In a number of respects, the current situation is unusual for Switzerland and its economy. The
significant overvaluation of the Swiss franc and the very low, or even negative, interest rates
pose a major challenge for economic agents and authorities - in particular the SNB. Yet, as I
have explained, our monetary policy has not changed fundamentally. As a small economy that
is strongly interconnected with the rest of the world, Switzerland is heavily dependent on
economic developments abroad, and will remain so. These developments can explain the
current strength of the Swiss franc, but they are also part of what has driven the exceptionally
low interest rates in Switzerland.
Neither the strong currency nor low interest rates are new phenomena. Rather, they are
traditional characteristics of the Swiss economy, which have had a positive effect on living
standards in the past. But the weak recovery of the global economy and persistently high
uncertainty since the 2008 financial crisis have meant that these characteristics have become
much more pronounced. The Swiss economy is accustomed to dealing with difficult exchange
rate conditions, and has demonstrated its versatility time and time again. However, the Swiss
franc is particularly overvalued at the moment. The SNB's current monetary policy reflects this
challenging environment. The negative interest rate on sight deposits, together with the
willingness to intervene on the foreign exchange market as necessary, make it less attractive
to hold Swiss francs and thereby support a further weakening of the currency. At the same
time, the SNB continues to monitor carefully the effects of low interest rates on financial
stability.
Charts
Chart 1
Chart 2
Chart 3
Chart 4
Chart 5
Chart 6
9
BIS central bankers' speeches
Charts 7a und 7b
Charts 8a und 8b