The Main Macro Effects on the Swiss Economy of an Increase in World Interest Rates
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THE MAIN MACRO EFFECTS ON THE SWISS ECONOMY OF AN INCREASE IN WORLD INTEREST RATES
The Swiss economy is an open economy. Its currency, Swiss franc (CHF) is traded in the foreign exchange (FOREX), and is considered to be a safe-haven. It appreciates against other currencies in uncertain times. As we have seen recently, despite the low level of inflation and interest rates offered by the Swiss banks its currency appreciated against the US$ and the €.
Figure 1, Economist big mac index, reference 1, Economist, 2012
The CHFs appreciation is a major cause of concern for Swiss industries, which export most of their products. As the CHF appreciates against the other currencies it becomes more difficult for the Swiss to export their products. They become more expensive for importers. Export of good and services decreased from 8.1% in 2010 to 3.7% in 2011, ref 2.
However the strong CHF makes imports cheaper, which results in a low level of inflation, this penalizes the Swiss producers and retailers in their home market. “Switzerland is the only country in Europe where the retail sales have declined in volume and value”, ref 3. The Swiss are travelling across borders to make their purchases, benefiting from the high value of the CHF. This growth in tourism shopping has forced Swiss retailers to reduce their prices. In 2011, the core inflation dropped below 0%. Figure 2 below shows the positive relationship between the exchange rate and inflation.
Figure 2, Relationship between exchange rate and inflation, data source: SNB. There are other variables that can influence inflation, for more details please refer to appendix 1.
The strength of the CHF is a source of instability in the Swiss Economy. The euro zones economic difficulties sent the CHF to an all time high against the Euro in August 2011. Investors speculation on the rise of the CHF may also have amplified this. To stabilize the Swiss economy and stop the speculation against its currency, the SNB (Swiss National Bank) responded by setting an exchange rate selling of 1.20 CHF per Euro. This is achieved by increasing the money supply M1, which contributes to the low level of interest rates in Switzerland as described in figure 3, and appendix 2.
Figure 3, relationship between money supply and exchange rate, data source SNB
The low interest rates created a Swiss housing boom, as described in figure 4. Some areas have shown signs of overheating. This housing boom is a major risk to the Swiss economy in the future because of the high level of household debt, particularly if the interest rate rises significantly.
Figure 4, relationship between interest rate and apartment under construction, data source SNB
What will happen to this already challenging situation, if the worlds interest rates increase? My assumptions that relating to this question are in appendix 4. An increase in the world interest rate will cause the following economic shocks to the Swiss economy;
a) Reduce demand: As the world demand reduces, demand for Swiss products will reduce. This will have an impact on its GDP, of which exports represent a high percentage, appendix 3.
Figure 5, AS/AD curve of the Swiss economy, following reduction in demand due to a world interest rate rise shock
Figure 6 shows the strong relationship between the world and the Swiss GDP.
Figure 6, relationship between World and Swiss GDP. The Swiss GDP increases/decreases in line with the World GDP, as it exports most of its products. Source data OECD.
b) Increase unemployment: The reduction of exports from Switzerland will increase unemployment in Switzerland.
c) Reduce the value of the CHF: The increase in the world interest rates will also reduce the value of CHF on the FOREX. The reduction in global demand for Swiss products due to higher world interest rates and the lower level of uncertainty in the world economies will reduce the overall demand for CHF, resulting in a reduction of its value, see figure 7 below.
Figure 7, reduction in demand for CHF from equilibrium (P1, Q1) to demand 1, result in excess supply, which reduce exchange rate to new equilibrium price P2, and quantity Q3.
d) Increase interest rates:
The reduction in the Swiss exchange rate will make the CHF more competitive against other currencies and goods exported will become cheaper. They will resume exporting and their GDP will grow. The reduction of the CHF will also make all the imports (oil for example) more expensive and this may increase inflation. In case of a positive output gap and inflation above target, the SNB will need to increase the interest rates, in order to cool the Swiss economy. The SNB are likely to increase the interest rates slowly, to avoid a housing shock, due to the high level of household debt.
Figure 8 below shows the strong relationship between Swiss and World interest rates.
Figure 8, relationship between World and Swiss interest rates. The Swiss Interest rates increases/decreases in line with the World interest rate (World interest rates = The interest rates of its main trading partners, except Japan and China). Source data OECD.
To conclude, we have seen that the world and Swiss economies are interlinked. A rise in the world interest rate would result a rise in the Swiss interest rate, in order to avoid an imbalance in interest rates, and exchange rates with other trading partners, which would result in strong capital flows.
THE ASSESSMENT OF THE VULNERABILITY AND MARKET EXPOSURE OF COOP
Introduction to the firm, its market and performance:
Coop is the second largest retailer in Switzerland. Its a cooperative founded in 2001, with the