THE SWISS FRANC IS THE NEW GERMAN MARK / THE FINANCIAL TIMES MARKETS INSIGHT ( VERY HIGHLY RECOMMENDED READING )

The Swiss franc is the new German mark

By Mansoor Mohi-uddin

Published: July 7 2010 15:05

Europe’s crisis has exposed the eurozone’s structural flaws, German citizens want the Deutschemark back, and foreign investors would like a hard currency alternative to the dollar. However, a break-up of the euro seems unlikely for now; instead, investors once attracted by the safety of the Deutschemark are likely to hold more Swiss francs as a substitute.

First, Switzerland’s currency already acts as a proxy for the German economy. Germany is the leading destination for Swiss exports, accounting for almost twenty per cent just last year. As a result, Switzerland’s economy is tied to Germany’s, with Swiss GDP growth and Germany’s IFO index of business confidence exhibiting a close relationship.

In the next decade Germany’s super-competitive economy will benefit even more from the weakness of the euro. In turn, Swiss exports and the franc will also benefit from increased German production.

Second, the Swiss franc’s safe-haven status will increase the Swiss National Bank’s international influence.

Since the onset of the credit crunch in 2007, the currency has been in much demand, and the euro has fallen to lifetime lows against the franc.

Last year, exchange rate strength prompted the SNB to begin unilaterally intervening in the currency markets for the first time since the early 1990s. As a result, the central bank’s foreign exchange reserves have ballooned since March 2009, rising by a whopping US$176bn to US$219bn. Including SNB gold and International Monetary Fund assets, official reserves total US$262bn.

The central bank’s assets now dwarf those of all other European central banks, with the exception of Norges Bank’s Global Pension Fund and the Central Bank of Russia’s foreign reserves. Indeed, the SNB has become one of the world’s largest reserve managers with international assets exceeding those of Singapore, India, Brazil and Hong Kong.

The SNB’s large reserves will increase confidence in the Swiss franc as a hard currency – just as the German mark was supported in the past by the Bundesbank’s foreign exchange and gold reserves.

In addition, the size of the SNB’s foreign assets will increase the influence of the central bank in global markets. Most central banks keep the bulk of their reserves in dollars. In contrast the SNB holds most of its reserves in euros. This is due to the SNB’s interventions over the past year having been primarily to check the strength of the franc against the euro. If the SNB decides to diversify its foreign reserves away from the euro over the next few years, it may have an impact on global exchange rates.

Thus Switzerland’s central bank now has the potential to influence international markets. Of course, the Bundesbank was a more powerful presence before the inception of the euro in 1999. But the SNB will become a significant force as its reserves continue to rise in 2010-2020.

Third, and most importantly, the Bundesbank achieved its past prominence because it was steering Europe’s main economy. The Swiss economy will clearly never overtake Germany’s, but as we head into a new decade, the SNB finds itself leading one of Europe’s strongest economies.

The Swiss economy has recovered faster than Germany and the rest of the eurozone, and its prospects are among the brightest in Europe. As a result the SNB is likely to pursue a tighter path for interest rates and monetary policy over the next few years.

In contrast, eurozone members face years of austerity to reduce large fiscal deficits. While this is the case for countries in the periphery such as Greece, Portugal and Ireland, large economies including Spain, Italy and Germany have also signalled their intent to reduce their budgets. Switzerland does not face such constraints. Indeed its fiscal position is enviable, with gross government debt less than forty per cent the size of the Swiss economy.

Tighter fiscal policy within the eurozone will result in the European Central Bank being unable to raise interest rates until well into next year. The SNB, on the other hand, is likely to start hiking rates in the second half of 2010. Though higher interest rates in Switzerland won’t force the rest of Europe to follow suit – as tighter Bundesbank policy had often done in the past – it will still underscore the stronger position that Switzerland now finds itself in.

As a result of all these influences, the Swiss franc is increasingly likely to be held as a proxy for the old German mark in what should constitute one of the foreign exchange market’s ‘mega trends’ over the next decade. This is likely to keep the SNB on intervention watch over the next few years - even when the central bank feels, as it does now, that the risks of deflation are receding and exchange rate strength may pose less of a threat to the economy.

Mansoor Mohi-uddin is managing director of foreign exchange strategy at UBS

Copyright The Financial Times Limited 2010.