07/01/2011: Currency strength: a blessing or a curse?

Skating below 1.25 against the euro and under 0.95 versus the US dollar, the Swiss franc has never been stronger. Understandably, many worry the muscle-bound currency will hurt Swiss exporters. Is that inevitable? Should Switzerland join the troubled Eurozone and adopt the euro, as some Swiss politicians suggest?

As usual in economics, a seemingly self-evident truth grows shaky when exposed to a bit of critical thinking. Consider this paradox: since the breakup of the Bretton Woods system in the early 1970s, the developed economies with fundamentally weak currencies have not been the export champs. That race has been won by countries whose currencies have appreciated quite dramatically versus their competitors: Japan, Germany and Switzerland.

These three countries still have sound industrial bases. They thrive by exporting “things,” high-value-added manufactured goods like sophisticated machinery, expensive cars, advanced electronics and high-end watches. At the other end of the scale, countries with currencies that have weakened over the past forty years – the US, the UK, France and Italy – have seen their industrial bases crumble.

How can we explain this? No doubt, a strengthening currency poses a stiff challenge to the competiveness of domestic industries. But that in itself turns out to be positive. After all, it encourages innovation, tight cost controls and an emphasis on high quality that cheaper imitators can’t replicate. In the long run, this recipe supports the survival of a country’s industrial base far better than the “no-brainer” strategy of chasing price competitiveness by devaluating the domestic currency.

Does this mean that Swiss exporters can blithely ignore the strengthening of the franc? Here again the answer is not simple. For one thing, it depends on timing. The prospect, say, in ten years’ time, of a Swiss franc at parity with the euro and around 0.50 against the US dollar should not be an insurmountable challenge for Swiss industry. But hitting such levels a year from now would surely be disastrous.

Given that neither the euro, swooning from the European sovereign debt crisis, nor the US dollar, awash in QE2 liquidity, are very attractive right now, we think the Swiss National Bank will be severely challenged to keep the franc from massively and brutally appreciating in the near future.