Swiss May Not Be Able to “Save Our Gold”

Mon, Nov 10, 2014 - 8:02am

The euro has slipped to its lowest level against the Swiss franc since late 2012. It has come within about 20 pips of the floor that the SNB has imposed at CHF1.20. The referendum at the end of the month is capturing the attention of market participants.

The referendum, dubbed "save our gold initiative" will be held on November 30. If it is ultimately approved by the voters and the cantons, the Swiss National Bank would be required to 1) keep 20% of its reserves in gold, 2) no longer be able to sell gold, and 3) retain possession of its gold holdings in Switzerland.

After having sold an estimated 1500 tonnes of gold between 2000 and 2008, and rapidly increasing its hard currency reserves during the financial crisis; first by buying foreign bonds in its version of QE, and second by imposing and defending the euro floor/franc cap in 2011. This has left SNB's gold holdings at about 8% of their reserves.

In order to bring the gold holdings to 20% of reserves (~CHF544 bln), it would need to buy about 1500-1800 tonnes of gold, depending on the price and the value of its reserves. It would have five years to implement the measure. Most observers conclude it would have to sell some of its currency holdings (primarily euros, but also perhaps some dollars as well). Some observers suspect the SNB's demand for gold would lift the price of the precious metal as much as 18%.

However, we are less sanguine. First, we do not expect the referendum to be approved. The latest polls suggest support is waning for the referendum, which was forced upon the electorate by the Swiss People's Party securing 100k signatures, after the parliament refused to take it up (Swiss population ~8.1 mln). All major Swiss parties and the Swiss National Bank are opposed. The SNB has gone further to argue that if the referendum does become law, it will interfere with its ability to achieve its mandate.

Second, the referendum is just the first step in the process. The next step is to get the cantons to approve. A majority of cantons are also reportedly opposed. The cantons typically receive dividend payments from the SNB's reserves. The SNB warns that the profit distribution to the cantons would be in jeopardy if it held so much of the non-interest bearing gold. The cantons use the funds from the SNB to pay for social services. Last year, the drop in gold prices (-28%) forced the SNB to cancel the dividend.

However, even if it the proposal passes these first two steps the SNB still has other options. In principle, the SNB does not have to sell euros or dollars to buy gold, it can create new reserves (print money) to buy gold. In addition, the SNB could form a sovereign wealth fund as many other central banks have done. In this new sovereign wealth fund the SNB can allocate the bulk of its currency reserves outside of a modest amount needed for liquidity purposes.

The gold holding requirement is the most controversial of the referendum's measures. The inability to sell the gold has received somewhat less attention, but also would seem to hamper the conduct of monetary policy. It means that the amount of gold it holds is permanent, becoming a fixed part of its reserves, denying officials of the divestment option unilaterally. The referendum also would require the repatriation of the gold back to Switzerland. A little less than a third of the SNB's gold holdings are held abroad (primarily in the U.K. and Canada). Other countries, including Germany, have brought official gold holdings back to their territory. The liquidity and safety arguments for having kept some of the gold holdings offshore seem somewhat less compelling now.

If our analysis proves wide of the mark, and the SNB is forced to buy 1500-1800 tonnes of gold over the next five years, it would be buying around 7%-10% of the annual gold production. Many observers think that this would be sufficient to put a floor under the prices of the yellow metal. This seems to assume that all other conditions remain constant, which is rarely the case. The prospects of a stronger U.S. dollar and higher U.S. short-term rates are often associated with weaker gold prices. The euro accounts for about 45% of the SNB's currency reserves. Should the referendum be implemented, and the SNB reduces its currency holdings, it will be yet another source of pressure on the single currency.

Meanwhile, the SNB should be expected to defend its euro floor/franc cap. It can do so through intervention if needed. The SNB meets again on December 11. With the ECB expanding its balance sheet and looking at additional assets it can purchase within its mandate, the downward pressure on the euro can be expected to increase. The SNB can adopt a negative target rate for LIBOR. Already, interbank rates are negative out six months, and government bond yields are negative out four years.

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Managing Partner and Chief Markets Strategist
Bannockburn Global Forex