Stefan Gerlach, Chief Economist at EFG Bank, argues that changes in the real exchange rate of the Swiss franc do not, in themselves, determine the degree of overvalution…

After the SNB abandoned the exchange rate floor of 1.2 CHF per euro in January 2015, the Swiss franc appreciated sharply. Between the end of December 2014 and the end of May 2015 it rose by 14%. Of course, it had appreciated strongly already in the years before. Overall, from the end of August 2008, the month before the collapse of Lehman Brothers that triggered the financial crisis, to the end of May 2015, the Swiss franc appreciated by 36% against the euro. However, between May 2015 and December 2017 it depreciated 11% against the euro.

But is the Swiss franc overvalued now? To think about that question it is helpful to make a distinction between bilateral and effective exchange rates, between nominal and real exchange rates and to consider the uncertainty that surrounds the “equilibrium” real exchange rate.

Some exchange rate concepts

While the euro area is Switzerland’s single largest export market, exports to other economies are also important.

In assessing whether the Swiss franc is overvalued it is therefore not sufficient to look solely at the bilateral exchange rate to the euro. One should also look at theexchange rate against Switzerland’s trading partners more generally, that is, at the effective exchange rate of the Swiss franc.

Furthermore, since exchange rates often move to offset inflation differentials, it is helpful to look at the real effective exchange rate, which captures the relative price of Swiss goods and services against a broad set of countries. It can be computed by multiplying the nominal effective exchange rate of the Swiss franc with the Swiss CPI, and dividing by the consumer price indices in Switzerland’s trading partners.[1]

Figure 1. shows that both the nominal and real exchange rates of the Swiss franc appreciated over the period 1973- 2017.[2] The two exchange rates are export-weighted, that is, they are effective exchange rates. Between December 2014 and May 2015, the real effective exchange rate rose by 11%. The total real appreciation from August 2008 to May 2015 was 29%. Between May 2015 and December 2017, however, the Swiss franc depreciated by 10% in real effective terms.

As can be seen in the figure, over short periods of time, changes in the real exchange rate are dominated by changes in the nominal exchange rate. The reason for this is that the Swiss and foreign price levels evolve only slowly. Thus, while the exchange rate can change by a few percentage points in a day, price indices typically change by a few percent in a year.

When talking about exchange rate changes over a month or even a few years, there is therefore little to be gained in making a distinction between real and nominal exchange rates. But over longer time horizons the distinction becomes important; the figures show that the real exchange rate of the Swiss franc has appreciated much less than the nominal exchange rate.

While monetary policy strongly influences the real exchange rate in the short-term, it has no impact over longer periods of time. The reason is that it has two offsetting effects. While tight monetary policy leads the Swiss franc to strengthen, after some time it also reduces Swiss inflation. The effects of monetary policy therefore wash out.

Figure 1. shows that the Swiss real exchange rate appreciated from an index value of 72 in January 1973 to a value of 112 in December 2017, or by about 56% (or by 1.3% per year). If monetary policy does not explain that appreciation, what does?

Since the real exchange rate is a relative price, it is determined by the same factors as other relative prices – changes in demand patterns. Thus increases in the demand for Swiss goods and services will tend to appreciate the real exchange rate. Switzerland exports high-end products, ranging from watches to specialty chemicals, whose demands tend to increase strongly as world income rises. Furthermore, these goods are relatively price-insensitive. It is therefore natural to expect the Swiss franc to appreciate over time.[3]

Is the Swiss franc overvalued?

Is the Swiss nominal exchange rate too high, given prices in Switzerland and in the rest of the world? To answer that question, it is necessary to form a view about the “equilibrium” real exchange rate. Unfortunately, that level is unknown and must be estimated. One way to do so is to fit a statistical model to the real exchange rate and compare the current level with forecasts made in the past (since such forecasts will settle at the equilibrium level after any temporary dynamics have worked themselves out).

Figure 2. provides the results of such an exercise. Here a simple model of the real exchange rate is estimated on data from 1973 to 2006. The model assumes that the equilibrium real exchange rate follows a linear trend, and thus implies that the Swiss franc is expected to continue to appreciate in real terms in the future. If the actual real exchange rate deviates from the equilibrium level, it is expected to revert to the equilibrium level. It is worth pointing out that this approach assumes that on average over the estimation period the exchange rate was at the equilibrium level.

Next the model is used to forecast the real exchange rate over the period January 2007 until the end of 2017. Since the equilibrium level is estimated, it is subject to some uncertainty. To assess the degree of uncertainty an approximate 70% confidence band is plotted.

The figure shows that the real exchange rate was quite weak at the end of 2006. Consequently, forecasts made at that time suggested that it would strengthen quite quickly towards the equilibrium level, and subsequently appreciate further together with the equilibrium level.  At the end of the sample, in December 2017, the actual real exchange rate index is 112.1 and the equilibrium level is estimated to be 107.1, with a 70% confidence band of 100.6 – 113.9.

Overall, these results suggest that while the real exchange rate is about 5% stronger than the estimated equilibrium level, it is well within the margin of uncertainty surrounding the equilibrium real exchange rate.

Conclusions

The Swiss exchange rate appreciated strongly after the SNB abandoned the floor against the euro in early 2015. While this was a complication for Swiss exporters and the Swiss tourist industry, the Swiss franc has historically been appreciating. Furthermore, the real exchange rate of the Swiss franc – the relative price of goods and services in Switzerland – has also increased gradually over time, although a slower pace.

But looking at changes in the exchange rate is not enough to determine if the Swiss franc is overvalued. To do so, the real exchange rate must be compared to its “equilibrium” level, which must be estimated. It appears that in December 2017 the Swiss franc was a little overvalued, but not so much as to be outside the margin of error that is inherent in the estimation.

[1] The real exchange, Q equals E × P/P* where E denotes the price of the Swiss franc, P the Swiss consumer price index and P* the foreign price index.

[2] The real exchange rate is measured using consumer prices and is against Switzerland’s 24 most important export markets.

[3] Another reason is that Switzerland has a large service sector which naturally displays a higher inflation rate than the goods sector since productivity growth in services is lower.

Stefan Gerlach, Chief Economist at EFG Bank, argues that changes in the real exchange rate of the Swiss franc do not, in themselves, determine the degree of overvalution…

After the SNB abandoned the exchange rate floor of 1.2 CHF per euro in January 2015, the Swiss franc appreciated sharply. Between the end of December 2014 and the end of May 2015 it rose by 14%. Of course, it had appreciated strongly already in the years before. Overall, from the end of August 2008, the month before the collapse of Lehman Brothers that triggered the financial crisis, to the end of May 2015, the Swiss franc appreciated by 36% against the euro. However, between May 2015 and December 2017 it depreciated 11% against the euro.

But is the Swiss franc overvalued now? To think about that question it is helpful to make a distinction between bilateral and effective exchange rates, between nominal and real exchange rates and to consider the uncertainty that surrounds the “equilibrium” real exchange rate.

Some exchange rate concepts

While the euro area is Switzerland’s single largest export market, exports to other economies are also important.

In assessing whether the Swiss franc is overvalued it is therefore not sufficient to look solely at the bilateral exchange rate to the euro. One should also look at theexchange rate against Switzerland’s trading partners more generally, that is, at the effective exchange rate of the Swiss franc.

Furthermore, since exchange rates often move to offset inflation differentials, it is helpful to look at the real effective exchange rate, which captures the relative price of Swiss goods and services against a broad set of countries. It can be computed by multiplying the nominal effective exchange rate of the Swiss franc with the Swiss CPI, and dividing by the consumer price indices in Switzerland’s trading partners.[1]

Figure 1. shows that both the nominal and real exchange rates of the Swiss franc appreciated over the period 1973- 2017.[2] The two exchange rates are export-weighted, that is, they are effective exchange rates. Between December 2014 and May 2015, the real effective exchange rate rose by 11%. The total real appreciation from August 2008 to May 2015 was 29%. Between May 2015 and December 2017, however, the Swiss franc depreciated by 10% in real effective terms.

As can be seen in the figure, over short periods of time, changes in the real exchange rate are dominated by changes in the nominal exchange rate. The reason for this is that the Swiss and foreign price levels evolve only slowly. Thus, while the exchange rate can change by a few percentage points in a day, price indices typically change by a few percent in a year.

When talking about exchange rate changes over a month or even a few years, there is therefore little to be gained in making a distinction between real and nominal exchange rates. But over longer time horizons the distinction becomes important; the figures show that the real exchange rate of the Swiss franc has appreciated much less than the nominal exchange rate.

While monetary policy strongly influences the real exchange rate in the short-term, it has no impact over longer periods of time. The reason is that it has two offsetting effects. While tight monetary policy leads the Swiss franc to strengthen, after some time it also reduces Swiss inflation. The effects of monetary policy therefore wash out.

Figure 1. shows that the Swiss real exchange rate appreciated from an index value of 72 in January 1973 to a value of 112 in December 2017, or by about 56% (or by 1.3% per year). If monetary policy does not explain that appreciation, what does?

Since the real exchange rate is a relative price, it is determined by the same factors as other relative prices – changes in demand patterns. Thus increases in the demand for Swiss goods and services will tend to appreciate the real exchange rate. Switzerland exports high-end products, ranging from watches to specialty chemicals, whose demands tend to increase strongly as world income rises. Furthermore, these goods are relatively price-insensitive. It is therefore natural to expect the Swiss franc to appreciate over time.[3]

Is the Swiss franc overvalued?

Is the Swiss nominal exchange rate too high, given prices in Switzerland and in the rest of the world? To answer that question, it is necessary to form a view about the “equilibrium” real exchange rate. Unfortunately, that level is unknown and must be estimated. One way to do so is to fit a statistical model to the real exchange rate and compare the current level with forecasts made in the past (since such forecasts will settle at the equilibrium level after any temporary dynamics have worked themselves out).

Figure 2. provides the results of such an exercise. Here a simple model of the real exchange rate is estimated on data from 1973 to 2006. The model assumes that the equilibrium real exchange rate follows a linear trend, and thus implies that the Swiss franc is expected to continue to appreciate in real terms in the future. If the actual real exchange rate deviates from the equilibrium level, it is expected to revert to the equilibrium level. It is worth pointing out that this approach assumes that on average over the estimation period the exchange rate was at the equilibrium level.

Next the model is used to forecast the real exchange rate over the period January 2007 until the end of 2017. Since the equilibrium level is estimated, it is subject to some uncertainty. To assess the degree of uncertainty an approximate 70% confidence band is plotted.

The figure shows that the real exchange rate was quite weak at the end of 2006. Consequently, forecasts made at that time suggested that it would strengthen quite quickly towards the equilibrium level, and subsequently appreciate further together with the equilibrium level.  At the end of the sample, in December 2017, the actual real exchange rate index is 112.1 and the equilibrium level is estimated to be 107.1, with a 70% confidence band of 100.6 – 113.9.

Overall, these results suggest that while the real exchange rate is about 5% stronger than the estimated equilibrium level, it is well within the margin of uncertainty surrounding the equilibrium real exchange rate.

Conclusions

The Swiss exchange rate appreciated strongly after the SNB abandoned the floor against the euro in early 2015. While this was a complication for Swiss exporters and the Swiss tourist industry, the Swiss franc has historically been appreciating. Furthermore, the real exchange rate of the Swiss franc – the relative price of goods and services in Switzerland – has also increased gradually over time, although a slower pace.

But looking at changes in the exchange rate is not enough to determine if the Swiss franc is overvalued. To do so, the real exchange rate must be compared to its “equilibrium” level, which must be estimated. It appears that in December 2017 the Swiss franc was a little overvalued, but not so much as to be outside the margin of error that is inherent in the estimation.

[1] The real exchange, Q equals E × P/P* where E denotes the price of the Swiss franc, P the Swiss consumer price index and P* the foreign price index.

[2] The real exchange rate is measured using consumer prices and is against Switzerland’s 24 most important export markets.

[3] Another reason is that Switzerland has a large service sector which naturally displays a higher inflation rate than the goods sector since productivity growth in services is lower.