Can the SNB Afford to Keep the EUR/CHF Peg?

It appears that keeping the EUR/CHF peg is getting more and more expensive for the Swiss National Bank (SNB). Last week, the SNB came out with report saying that their reserves surged to a record high in May as the heightening turmoil in the euro zone forced the central bank to fortify their defense of the EUR/CHF peg.

The central bank’s foreign currency holdings, according to the report, rose to 303.8 billion CHF in May from 237.6 billion CHF the month before. The increase, which amounts to 66.2 billion CHF, is not something to scoff at. It may not seem much on paper, but that amount is actually one and a half times larger than the size of Switzerland’s monthly GDP!

The upsurge in reserves was the result of none other than the central bank’s currency purchases to defend the minimum exchange rate they had previously set for EUR/CHF. Policy makers said that there was a considerable amount of upward pressure on the Swiss franc as investors moved their money into safe haven assets.

If you recall, back in September 2011, the SNB decided to put a 1.2000 peg on EUR/CHF. SNB ex-Chairman Philipp Hildebrand announced that they were willing to buy unlimited amounts of foreign currency to keep the Swiss franc from appreciating versus the euro. In doing so, the SNB hoped to somehow stabilize the export industry as well as the whole economy in general.

A look at EUR/CHF’s daily chart will show that the SNB has been doing a spectacular job of holding 1.2000. Apart from the small dip below 1.2000 on April 5 and the weird jump to 1.2077 on May 24, the pair hasn’t really moved much.

However, the worsening euro zone debt crisis is making the situation much more difficult and costly for the SNB. Over the past few months, we’ve had concerns about a Grexit, speculations of a euro zone break-up, and rising bond yields in Spain and Italy. While these events typically drive investors out of the euro and into the franc, the SNB has been fighting tooth and nail just to keep the EUR/CHF peg in place.

It doesn’t help that the euro zone is still facing plenty of uncertainties, such as the upcoming elections in Greece and bond auctions in other member nations, which could make it even more expensive for the SNB to maintain their intervention efforts in the future.

Does this mean that we can expect the EUR/CHF floor to break sooner or later? Economic seers over at Morgan Stanley already predicted that the SNB will eventually throw in the towel by the third quarter of this year as the central bank could run out of funds to defend the peg. After all, their intervention policy is forcing them to stock up mostly on the euro, a currency that might not even survive until the end of 2012.

Of course the decision is still up to the SNB, which has pledged again and again to hold on to the peg at any cost. In this case, they’d probably have to keep buying more euros later on as there seems to be no light at the end of the tunnel just yet for euro zone’s debt situation. For all we know, this could wind up being a huge test of how deep SNB’s pockets are.