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Hot Money

Speculative capital inflows have wreaked havoc in the destination economies.

K. K. Fung

In the first half of 2011, Novartis, a Swiss pharmaceutical company, had a 9% earnings gain in dollar terms. This gain turned into a 16% loss in Swiss-franc terms (Economist 7/23/2011).

This happened because the Swiss franc rose by 30% against the US dollars over 12 months since July 2010 (WSJ 7/26/2011). Similarly, the Swiss franc rose by 27% against the euro in the 10 months prior to August 2011 (WSJ 9/7/2011).

In theory, the exchange rate of a currency in a floating exchange rate system should reflect mostly the balance of trade in real goods and services. A country experiencing a persistent trade surplus will see its currency appreciating in exchange value as demand for it increases. Although Switzerland does enjoy an overall trade surplus, the rapid rise of the Swiss franc is in no way a normal response.

Rather this rapid rise is due to the inflow of hot money looking for a safe haven from the financial turmoil in the euro bonds market and the US cheap money policy.

While this flight to safety is understandable, the collateral damage to the Swiss economy is real. The strong Swiss franc has pushed some weaker exporters into bankruptcy. Others have been forced to lower prices to hold on to their export markets. Tourists have stayed away and asset bubbles have started to form (9/7/2011).

So in a desperate move to stem the rise, the Swiss National Bank has instituted a ceiling to the exchange value of the Swiss franc. As of 9/6/2011, it will no longer tolerate the euro falling below 1.20 francs. In other words, it will buy an unlimited amount of euro with Swiss franc to keep the exchange rate at 1.20 franc per euro. To further discourage speculative capital inflow, the SNB slashed interest rates to close to zero.

Switzerland is by no means the only destination for hot money. Japan, Brazil and Hong Kong are similarly affected.

Notes:

  1. Update: 4/11/2015. On January 15, 2015 the Swiss National Bank (SNB) unexpectedly eliminated the Swiss franc’s peg to the Euro which caused the currency to appreciate up to 30% that day before settling 15% higher, near parity with the Euro. This caused significant losses to Swiss stock values as investors dumped them in anticipation of lower sales prospects in the eurozone due to the franc appreciation. The peg was unsustainable due to the need to buy euros and sell francs by the SNB in ever greater quantities to counteract the quantitative easing of the European Central Bank. WSJ. 1/17/2015. "<a href="http://www.wsj.com/articles/switzerland-could-act-on-currency-again-central-banker-says-1421501547?KEYWORDS=swiss+franc+appreciation">Switzerland Could Act on Currency Again, Central Banker Says.</a>"

References:

  • Economist. 7/23/2011. "Swiss gold."
  • WSJ. 9/7/2011. "Swiss fight currency turmoil."
  • WSJ. 7/26/2011. "Swiss franc gives shelter in storm."

Glossary:

  • capital flow
    The movement of money across countries to buy foreign financial assets as well as to make direct investment in foreign plants and equipment. Money that is moved for short-term speculation is characterized as "hot" money because they can be quickly withdrawn. The movement of hot money often leads to financial asset bubbles in the destination economies and volatile fluctuations in the exchange rate of the destination currencies.
  • exchange value
    Value derived from selling a good for money as contrasted to using the good for self consumption. For example, full-fledged property rights have exchange value because they can be sold. On the other hand, de facto rights cannot be sold and have only use value to the current owners.
  • quantitative easing
    A way for the central bank to increase the money supply by buying lower-quality securities from the market when very low short-term interest rates are no longer sufficient to revive the weak economy.

Topics:

Trade and Foreign Exchange, Money and Credit

Keywords

capital flows, contagion, euro crisis, exchange rate, hot money, market intervention, money economy, price ceiling, quantitative easing, real economy, Swiss franc, trade balance