In the wake of Switzerland’s removing the cap on the Swiss franc’s value against the euro, debt owed by non-Swiss agents has become an emerging issue. That debt, denominated in either Swiss francs or in euros, is secured by collateral outside of Switzerland. Is this an unfolding foreign-currency-related debt problem? The answer appears to be yes.
Plunging Collateral
Russian businesses secured loans denominated in low-interest foreign currencies, including the Swiss franc. The franc was then pegged to the euro. The collateral for the loans depended on an assumption of $100 oil and a Russian ruble that has since plummeted. It appears that some of these agents now cannot pay.
Real estate speculators in Warsaw pledged their real estate to secure loans in Swiss francs. Why? The interest rate was very low – much lower than if they had borrowed in zlotys. Or they borrowed euros with the assumption that the Swiss peg against the euro would remain in place.
These borrowers around Europe and elsewhere in the world pledged collateral, took on foreign-currency risk, and based the risk-taking on the commitment of the Swiss National Bank (SNB) to maintain its currency peg at 1.2 francs to a euro. Many of these borrowers are now sweating bullets.
Will Markets Stay Rational?
Markets around the world are reacting in fear of contagion that could result from these debts. Is the reaction rational? We shall find out in due time.
We do not know how much debt there is, who the borrowers are, or what banks and intermediaries are involved in the loans. We do not know what supervision and regulation have been applied, since this is activity that is mostly outside the US and thus not supervised under the post-Dodd-Frank regulatory regime.
Markets can handle good news and they can handle bad news. Markets have trouble, however, with uncertainty. The pressure on stock markets and the volatility that has spiked due to the SNB’s move are the results of rising uncertainty about the foreign-currency-denominated debt and abrupt changes in central bank policy.
The SNB Made Its -- And Our -- Beds
The Swiss have punched new holes in their cheese. They have boiled their chocolate so that it smells bad. They committed to a course, reversed themselves and have now lost their credibility. This is the second governor of the Swiss central bank who has suffered a loss of credibility. The first one had to resign because a member of his household was allegedly trading a foreign currency position against the euro peg. The second governor has derailed billions in loans and pressured his citizens through his unexpected policy change.
When one central bank loses its credibility, all central banks suffer. The burdens on the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and others have now intensified.
David R. Kotok, Chairman and Chief Investment Officer.