How Can Financial Constraints Force a Central Bank to Exit a Currency Peg? An Application to the Swiss Franc Peg

49 Pages Posted: 25 Apr 2019

See all articles by Julien Pinter

Julien Pinter

Charles University - Institute of Economic Studies

Marc Pourroy

CRIEF, Université de Poitiers

Date Written: March 26, 2019

Abstract

Recent research recognize that two balance sheet constraints can be of particular concern for an independent central bank: central bank equity cannot turn negative without any political and credibility risk, and central banks should avoid going insolvent if they want to maintain control over inflation. In this paper, we analyze how such constraints can weigh on a central bank's decision to exit a temporary currency peg, such as the one put in place in Switzerland between 2011 and 2015. We show that negative equity or insolvency concerns can force a central bank to exit such a peg earlier than it would have done absent such concerns. We detail under which conditions such reasoning can apply for a traditional inflation-averse central bank. We then build an exchange market pressure model fi tting with current peg reality to forecast both the central bank future bond holdings under a peg as well as its future losses. Applying our model to the Swiss franc peg, we show that negative equity concerns could have motivated the Swiss central bank early and puzzling peg exit in 2015, thereby providing a potential explanation for the "Frankenshock". ECB QE policy appears as a potential key driver of this decision. The paper adds to the literature on the limits of foreign exchange interventions for the particular case of central banks fi ghting appreciation pressures, which is a highly under-researched area.

Keywords: Swiss Franc Peg, Exchange Rate Regime, Exchange Market Pressure, Central Bank Solvency, Central Bank Capital

JEL Classification: E42, E52, E58, F31, F33

Suggested Citation

Pinter, Julien and Pourroy, Marc, How Can Financial Constraints Force a Central Bank to Exit a Currency Peg? An Application to the Swiss Franc Peg (March 26, 2019). Available at SSRN: https://ssrn.com/abstract=3360443 or http://dx.doi.org/10.2139/ssrn.3360443

Julien Pinter (Contact Author)

Charles University - Institute of Economic Studies ( email )

Celetná 13
Praha 1, 116 36
Czech Republic

Marc Pourroy

CRIEF, Université de Poitiers ( email )

93 avenue du recteur Pineau
Poitiers, 86000
France

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