Sunday, January 18, 2015

Swiss National Bank's currency cap removal and It's effect on Indian Economy

Swiss National Bank (SNB) surprised the global markets with its 1.20Franc(CHF)/Euro(EUR) exchange cap removal. No one factored in such a surprise move and it resulted in Franc's appreciation by upto 30-35% in just few seconds. 

With such drastic step taken by the SNB, in short term, it would definitely hurt their luxurious export oriented products manufacturing as well as the tourism industry. Rapid appreciation of currency in few hours can be detrimental to the export driven economy with huge reliance also on the tourism front.

But was this step necessary to be taken? SNB in its statement made it all crystal clear.

"The minimum exchange rate was introduced during a period of exceptional overvaluation of the Swiss franc and an extremely high level of uncertainty on the financial markets. This exceptional and temporary measure protected the Swiss economy from serious harm. While the Swiss franc is still high, the overvaluation has decreased as a whole since the introduction of the minimum exchange rate. The economy was able to take advantage of this phase to adjust to the new situation. Recently, divergences between the monetary policies of the major currency areas have increased significantly – a trend that is likely to become even more pronounced. The euro has depreciated considerably against the US dollar and this, in turn, has caused the Swiss franc to weaken against the US dollar. In these circumstances, the SNB concluded that enforcing and maintaining the minimum exchange rate for the Swiss franc against the euro is no longer justified." 

The Quantitative Easing which in next few weeks would become a reality in Europe would further weaken the Euro and so accumulating the Euro on its ballooning balance sheet would be more of a liability. Hence, removing the cap would be a long term measure for sustainability.

What it means for India? Structurally, India is poised for a tremendous growth trajectory with a persistent focus on manufacturing and infrastructure. If required, ordinance route can be used to keep up the pace for developmental reforms (though it is debatable, as ordinances stifle the democratic structure). These factors make India poised to receive hot money that would be disseminated by the QE in Europe. Losing the sheen as a safe investment destination by the Swiss can be a boon for the emerging economies, especially India which has the engines revved up for the coming 3-4 years.

But with the rosy picture comes the unenthusiastic scenario as well. The Hot Money we are talking about is not sustainable money pouring in the economy. It can create bubbles which in turn generates ripples in the economy that may be tremendously harmful. This fact has been reiterated by Dr. Rajan at various platforms and this is where the regulators and the government should focus more upon. Encourage Foreign Direct Investments than Foreign Institutional Investments.