This week Switzerland announced that the Swiss National Bank would put an upper bound on the value of its currency, at 1.2 Swiss francs per euro. News of the announcement sent the value of the franc plummeting nearly 10 per cent vis-à-vis the euro, down to the announced 1.2 per euro peg.
But will the peg hold? I, for one, have my doubts, as I believe it will be tested by currency speculators, and the speculators will be successful.
As The Globe's Barrie McKenna explained: "To make a peg work, a country's central bank must continually buy and sell its own currency on foreign exchange markets in return for the currency to which it is tied."
To prevent a currency from falling in value, a central bank must be willing to sell foreign reserves and buy its own currency back on foreign exchange markets. If the Bank of Canada wanted to set a lower limit for the Canadian dollar with the greenback, they would have to be willing to sell U.S. dollars and buy back Canadian dollars on foreign exchange markets. The risk the Bank of Canada runs under such a plan is that they might run out of U.S. dollars and other foreign reserves and be unable to maintain the peg.
This inability to hold a peg occurred in 1992, when under the European Exchange Rate mechanism, the British pound was pegged with the Deutsche Mark. George Soros short sold more than $10-billion dollars worth of pounds, as he believed Britain lacked the ability and necessary reserves to maintain the peg. Soros was correct and became known as "the man who broke the Bank of England".
What the Swiss are trying to do is the exact opposite -- they are trying to prevent their currency from appreciating. In order to do so, they must be willing to buy foreign reserves and sell Swiss francs on the open market. In theory, they can do this forever, as they can issue as many Swiss francs as they please. In practice, there are a couple difficulties with doing so. First, Switzerland risks ends up stockpiling a large reserve of foreign currencies which they cannot sell if they wish to retain the peg. Second, Switzerland runs the risk of high levels of inflation if they rapidly increase the supply of Swiss francs. There are practical limits on preventing a currency from appreciating.
Breaking a currency peg through appreciation is a fair bit more difficult than breaking one through depreciation, but I believe currency speculators will test Switzerland's resolve. Given Switzerland's relatively small size and the relatively small downside risk in holding Swiss francs (few believe that a significant depreciation is likely in the short to medium- term), there is a very good chance a speculative attack on the peg would be successful.