Swiss National Bank might have a look at Chile's 'encaje'

With North Atlantic sovereign debt crises frightening investors around the world and with resource-backed currencies weakening as well, the only place to hide in the industrialised world seems Japan and Switzerland these days. Since late 2007, the Swiss franc has thus been rising relentlessly - up to some 60% against the Euro, the currency used by the bulk of its trading partners. Watchmakers, pharma and tourism are reeling.

While Japan is a big economy and thus relatively closed, Switzerland is a typical small open economy of which the emerging-markets sphere abounds. In a world of full capital mobility, small economies in particular confront the problem of the 'impossible trinity': they must give up on one of three policy goals - monetary independence (price stability, that is); stable exchange rates (that allow the real economy to compete); or free capital markets. They cannot have all three at once.

I understand that currently the SNB is debating the idea to peg the Swiss franc to the Euro. That policy has repeatedly proven quite dangerous. The central bank would give up monetary control as it would have to buy up foreign exchange to defend the exchange rate; sterilising those inflows so as to avoid an unfettered rise of the monetary base would starve the local economy of domestic credit. Worse, the peg would amount to a one-way bet to currency speculators should the Eurozone disintegrate further (which cannot be excluded after this week's disappointing Franco-German summit at the Elysée) until a two-speed Europe is fully put in place. So what should the Swiss do?

Once again, the North can learn from the South. In 1991, Chile's central bank imposed a one-year unremunerated reserve requirement (encaje) on foreign loans. Subsequently, the rate of the encaje was increased to 30 per cent and its coverage extended to cover virtually all foreign inflows except foreign direct investment. The one-year minimum holding period effectively implied a tax on inflows, inversely tied to their maturity. Prudential regulation complemented these curbs on inflows. Except for trade credits, banks could not lend domestically in foreign currency. And maximum open foreign exchange positions were set at 20 per cent of banks’ capital and reserves. As short-term flows dried up in 1998, the encaje was reduced to 0 per cent, but not abolished. As it is difficult to quantify the intensity of inflow restrictions and to control for prudential regulations, macroeconomic policies and other conditions that impact on capital inflows, the effectiveness of Chile’s measures was hotly debated then. Banco Central de Chile (thanks to Klaus Schmidt-Hebbel, then Head of Research) provided the OECD Development Centre in 1999 with a set of unpublished internal studies on the impact of the encaje*. These authoritative studies did show that the encaje had been effective in providing some monetary autonomy and in influencing the mix of capital inflows. The Swiss should try.

* Helmut Reisen (1999), After the Great Asian Slump: Towards a Coherent Approach to Global Capital Flows, OECD Development Centre Policy Brief #16.