Sunday, October 7, 2018

The Swiss Fallacy


On September 20th, 2018, the Wall Street Journal [1] remarked how, despite strong economic growth, the Swiss central bank is refusing to raise interest rates. On the surface, it may appear as though the Swiss economy is booming. Up until the past few quarters, Switzerland’s housing market has been booming. The Swiss economy has less than 3% unemployment, 3.4% annual economic growth as of the 2nd quarter, and the Franc has risen sharply since 2011. Only within the past few years did the Swiss national bank decide to depreciate the currency. Then why does it make sense to keep rates low if the Swiss economy is as strong as the WSJ claims it is?

If it seems like a contradiction, check the premises. One of them must be wrong. While mainstream economists tout increases in “private consumption” as an indicator of economic growth, real economic growth is borne out of production. A depressed manufacturing sector [2], falling housing prices, and a stagnant construction sector belie the conclusion that the Swiss economy is in expansion. Manufacturing isn’t a small piece of the Swiss economic pie. It stands at 18% of Switzerland’s economy. A hit to manufacturing would be devastating. This may be the reason behind the Swiss central bankers’ reluctance to raise rates. Currently, the Swiss National Bank has stalled policy rates at -0.75%.

For readers that do not know, negative interest rates are a specified rate at which the Swiss National Bank calls for commercial banks to pay in order to park their excess reserves with the central bank. Essentially, the repo rate, or the rate at which the central bank lends to commercial banks, is negative. Commercial banks then pass on these costs to depositors’ savings.

Some banks have risen fees attached to private accounts or implemented fees for savings accounts rather than stop offering interest or charging negative interest as a subtler approach that allows banks to continue netting profits while not entirely losing their allure for investors. Lombard Odier charges negative interest of -0.75% to depositors who hold assets of more than 100,000 at the bank. Other private banks may soon follow.

Alternative Bank was first Swiss retail bank to implement negative interest rates. Currently, it charges -0.235% on up to 100,000 Swiss francs held in each private account, and -0.75% for amounts in excess of 100,000 francs. Negative rates aren’t applicable towards amounts up to 100,000 Swiss francs in savings accounts, but do apply excesses over 100,000 francs. Those funds are subject to -075% rates.

But what is the purpose of negative interest rates? It is in the interest of the Swiss national bank to coerce commercial banks to loan out the excess reserves. Excess reserves are those assets purchased through bond buying programs. Assets include monetized stocks and bonds, which the Swiss national bank has actively been loading up its balance sheet with. The Swiss national bank hopes that by loaning out those reserves [3], the consumption-fueled artificial boom will continue.

In reality, negative rates only make an economy weaker, and inevitably induce a boom-bust cycle.

Negative nominal rates distort the structure of production, by pushing bond prices up, and yields down into negative territory. These rates force the ratio between outstanding debt and GDP to shrink. By keeping the cost of borrowing artificially low, consumers respond by investing a dangerous aggregate in real estate, stocks, and other high yielding assets. What this means for the Swiss housing market is that mortgage rates are kept artificially low. This encourages unsustainable investments in long-term projects, like building homes or pouring money into large infrastructure projects with high costs of capital. Eventually, it leads to their oversupply [4] when rising raw materials costs cause rising selling prices to increase past the point at which consumers are willing to pay. When selling prices fall, they fall across all asset classes. Because consumers become dependent on real estate for income instead of savings, private consumption decreases as a recession hits.

On the financial system side, if central banks continue to lower interest rates to fight a recession, it could paradoxically result in rising market interest rates [5]. Because a bank’s income depends on spread between interest rate it charges to borrowers and the amount it pays to depositors, the more negative rates become, the more adverse depositors are to placing their money in the bank. If this leads to enough withdrawals, the bank may have to start calling in loans to satisfy depositors, and raise rates to entice them back.

It seems that the outlook isn’t as rosy as it is portrayed. With a potential downturn on the horizon, and eventual hits by rate hikes on both the production and consumption sides set Switzerland’s economy for anything but smooth sailing.

Sources:
[1] Swiss Paradox: Booming Economy, Negative Interest, wsj.com
[2] Swiss economic confidence held back by manufacturing, ft.com
[3] Where Negative Interest Rates Will Lead Us, mises.org
[4] Swiss house prices continue to fall, globalpropertyguide.com
[5] The Absurdity of Negative Interest Rates, mises.org