How Can Financial Constraints Force a Central Bank to Exit a Currency Peg? An Application to the Swiss Franc Peg

Recent research recognize that two balance sheet constraints can be of particular concern for an independent central bank: central bank equity cannot turn negative without any political and credibility risk, and central banks should avoid going insolvent if they want to maintain control over inflation. In this paper, we analyze how such constraints can weigh on a central bank's decision to exit a temporary currency peg, such as the one put in place in Switzerland between 2011 and 2015. We show that negative equity or insolvency concerns can force a central bank to exit such a peg earlier than it would have done absent such concerns. We detail under which conditions such reasoning can apply for a traditional inflation-averse central bank. We then build an exchange market pressure model fi tting with current peg reality to forecast both the central bank future bond holdings under a peg as well as its future losses. Applying our model to the Swiss franc peg, we show that negative equity concerns could have motivated the Swiss central bank early and puzzling peg exit in 2015, thereby providing a potential explanation for the "Frankenshock". ECB QE policy appears as a potential key driver of this decision. The paper adds to the literature on the limits of foreign exchange interventions for the particular case of central banks fi ghting appreciation pressures, which is a highly under-researched area