Making sense of the Frankenshock: how can financial constraints force a central bank to exit a currency peg?

Abstract

Negative equity or insolvency concerns can force a central bank to exit a temporary currency peg earlier than it would have done absent such concerns. We show under which conditions such a reasoning can apply for a traditional inflation-averse central bank. We then build an exchange rate market pressure model fitting with a peg reality to forecast both the central bank future bond holdings under a peg as well as its future losses. The model encompasses important and realistic features such as open-mouth effects under a peg and unconventional monetary policies effects. Applying our model to the Swiss Franc peg, we show that the fear of staying with a negative equity for a long period of time could have motivated the SNB early 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 also adds to the literature on the limits of foreign exchange interventions for the particular case of central banks fighting appreciation pressures, a greatly under-researched area.