Informal one‐sided target zone model and the Swiss franc

• Published date: 01 November 2018
• Author: Richhild Moessner,Yu‐Fu Chen,Michael Funke
• DOI: http://doi.org/10.1111/roie.12352
• Date: 01 November 2018

ORIGINAL ARTICLE

Informal one-sided target zone model and the Swiss

franc

Yu-Fu Chen

1

|

Michael Funke

2

|

Richhild Moessner

3

1

Business and Management Studies,

University of Dundee, United Kingdom

2

Department of Economics, Hamburg

University and CESifo Munich, Germany

3

Bank for International Settlements,

Basel, Switzerland

Correspondence

Richhild Moessner, Bank for

International Settlements,

Centralbahnplatz 2, 4002 Basel,

Switzerland.

Email: richhild.moessner@bis.org

Abstract

This paper develops a new theoretical model with an asym-

metric informal one-sided exchange rate target zone, with an

application to the Swiss franc following the removal of the

minimum exchange rate of CHF 1.20 per euro in January

2015. We extend and generalize a standard target zone

model by introducing perceived uncertainty about the lower

edge of the band. We find that informal soft edge target

zone bands lead to weaker honeymoon effects, wider target

zone ranges, and higher exchange rate volatility than formal

target zone bands. These results suggest that it would be

beneficial for exchange rate policy intentions to be stated

clearly in order to anchor exchange rate expectations and

reduce exchange rate volatility. We also study how

exchange rate dynamics can be characterized in models in

which financial markets are aware of occasional changes in

the policy regime. We show that expected changes in the

central bank’s exchange rate policy may lead to exchange

rate oscillations, providing an additional source of exchange

rate volatility, and to capture this it is important to take into

account the possibility of regime changes in exchange rate

policy.

1

|

INTRODUCTION

Since the outbreak of the euro area crisis, Swiss exchange rate policy has been a hotly debated topic.

From September 2011 to January 2015 the official exchange rate policy of the Swiss National Bank

(SNB) was to maintain a minimum exchange rate of CHF 1.20 per euro. To achieve this objective, the

central bank stated that it would be willing to buy foreign currency in unlimited quantities. On 15 Janu-

ary 2015, the SNB took markets by surprise with its decision to discontinue Switzerland’s currency

floor (Jerman, 2016; SNB, 2015).

Countering an appreciating currency ought to be easier than countering a depreciating currency.

A central bank trying to prop up the exchange rate can run out of foreign exchange (FX) reserves.

Received: 30 October 2017

|

Accepted: 18 April 2018

DOI: 10.1111/roie.12352

1130

|

wileyonlinelibrary.com/journal/roie Rev Int Econ. 2018;26:1130–1153.

© 2018 John Wiley & Sons Ltd

A central bank aiming for depreciation can credibly promise to buy as much foreign currency as it

takes, since it can print its own currency in unlimited amounts. By discontinuing the so-called “mini-

mum exchange rate”inJanuary 2015, the SNB showed that a theoretically unlimited strategy to defend

a currency floor may have practical bounds. In particular, there may be an upper limit tohow far a cen-

tral bank balance sheet can grow, including owing to concerns about potential future losses on FX

reserves, as suggested for example by Amador, Bianchi, Bocola, and Perri (2016). Amador et al.

(2016) provide a theoretical model in which a central bank wants to maintain an exchange rate peg,

and responds to increases in demand for domestic currency by expanding its balance sheet. They

model so-called “reverse speculative attacks”triggered by the concern of future balance sheet losses of

the central bank. They find that the interaction between the desire to maintain an exchange rate peg

and the concern about future balance sheet losses can lead the central bank to first accumulate a large

amount of reserves, and then to abandon the peg, and conclude that this was just as had been observed

in the Swiss case. The fact that a Swiss referendum was held on 30 November 2014 over the proposi-

tion that the SNB should hold at least 20 percent of its reserves in gold (The Economist, 2014), sug-

gests that there was some political pressure to limit losses on the central bank’s balance sheet, even

though the referendum was defeated. Thus there may be a limit to conducting central bank policy by

steering the exchange rate. As a consequence, the SNB resorted, like many other central banks, to cut-

ting interest rates with all the risks of feeding market distortions that such a policy may entail (see

Bank for International Settlements, 2010).

The model presented in this paper applies to the situation where there is no formal one-sided target

zone for the currency, but where there are market perceptions of an informal one-sided target zone.

This may have been the case following the discontinuation of the SNB’s currency floor in January

2015, since proxy measu res for the SNB’s foreign exchange interventions presented below suggest

that the SNB likely continued to intervene in the FX market.

In light of the fact that exchange rate regimes have been at the centre of academic debate and have

been a major concern for policymakers in recent years, this paper develops a new theoretical model

with an asymmetric informal (unofficial, not publicly announced) one-sided target zone. Such a model

incorporates the notion that the target zone can be seen as a partially credible commitment device. It

can be regarded as a generalization of Krugman’s (1991) simple target zone model of exchange rates.

In the standard model, the peg and the hard edge boundaries are publicly announced and credible, and

market arbitrage mechanisms and interventions take place in whatever amounts are necessary to pre-

vent the target zone from being violated. Our paper is not a normative analysis of the best exchange

rate policy or exchange rate target, especially given uncertainty about fundamental drivers of exchange

rates.

We find that informal soft edge target zone bands lead to weaker honeymoon effects, wider target

zone ranges, and higher exchange rate volatility than formal target zone bands. The honeymoon effect

stabilizes the exchange rate relative to its fundamentals. It refers to the phenomenon that, if the Swiss

franc is close to the informal floor, the probability increases that the Swiss franc will hit the floor, which

leads to perceived interventions by the central bank. These results suggest that it would be beneficial for

exchange rate policy intentions to be stated clearly in order to anchor exchange rate expectations and

reduce exchange rate volatility. We also study how exchange rate dynamics can be characterized in

models in which financial markets are aware of occasional changes in the policy regime. We show that

expected changes in the central bank’s exchange rate policy may in addition be a source of exchange

rate oscillations, providing an additional source of exchange rate volatility, and to capture this it is

important to take into account the possibility of regime changes in exchange rate policy.

The paper proceeds as follows. Section 2 presents the evolution of the Swiss franc–euro exchange

rate, and Section 3 presents proxy measures for the SNB’s foreign exchange interventions as a function

CHEN ET AL.

|

1131