Switzerland
2005 Article IV Consultation-Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Switzerland
Author: International Monetary Fund
Publication Date:
10 Jun 2005
eISBN:
9781451807288
Language:
English
Keywords:
ISCR; CR; authority; deficit; government; rate; General government balance; operating income; financial system; real GDP; private sector; debt ratio; price level
Download PDF (557.5 KB)

This 2005 Article IV Consultation highlights that the Swiss economy has returned to growth with supportive external demand and domestic policies. However, the recovery has been fragile, and business indicators suggest that activity is currently experiencing a soft patch. The IMF staff projects growth of 1¼ percent in 2005, from 1.7 percent in 2004, with some risks on the downside if demand from partner countries were to falter. Potential growth is estimated at 1½ percent and is projected to decline in the medium term to ¾ percent as a result of population aging.

Abstract

This 2005 Article IV Consultation highlights that the Swiss economy has returned to growth with supportive external demand and domestic policies. However, the recovery has been fragile, and business indicators suggest that activity is currently experiencing a soft patch. The IMF staff projects growth of 1¼ percent in 2005, from 1.7 percent in 2004, with some risks on the downside if demand from partner countries were to falter. Potential growth is estimated at 1½ percent and is projected to decline in the medium term to ¾ percent as a result of population aging.

I. Introduction

1. Switzerland is affluent but slow-growing. Switzerland has an educated labor force, technological prowess, and a business-friendly environment. Flexible labor markets have kept unemployment among the lowest in international comparison. And skillful monetary management has delivered excellent inflation results (Table 1). However, the slow pace of structural reform is eroding economic dynamism and average growth is now among the weakest and most volatile in industrial countries (Figure 1). This is producing strains in the public finances. Staff estimates suggest that on current policies future potential growth will decline to below 1 percent a year, with slowing demographics and tepid productivity gains.

Table 1.

Switzerland: Basic Data

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Sources: IMF, World Economic Outlook database; Swiss National Bank; and Swiss Institute for Business Cycle Research.

Fund staff estimates and projections unless otherwise noted.

Change as percent of previous year’s GDP.

Including railway loans as expenditure. In 2005 exncludes revenue from gold sales equal to 4.6 percent of GDP.

Excluding privatization proceeds and gold sales; smooths erratic revenue items.

Based on relative consumer prices.

Figure 1.
Figure 1.

Main Economic Indicators in International Perspective

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: IFS; and WEO.
uA01fig01

Per capita growth has been volatile.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

1. Ratio of standard deviation of growth to average growth.

2. The main policy challenges are boosting potential growth and developing an intertemporally consistent strategy to manage aging. Concerned about low growth, the authorities launched last year a reform agenda to open sheltered sectors and bolster competition in the economy. But the preparation for aging had a setback in 2004 with the rejection in a referendum of measures to strengthen the social security finances. More than half of the electorate will be over 50 years of age by 2010, swelling the constituency averse to reform.

Implementation of Fund Policy Advice

Implementation of Fund policy advice has been mixed. The authorities’ monetary, fiscal, and financial sector policies have been well-aligned with Fund advice. However, Fund recommendations to accelerate structural reform have met with less success. The federal authorities have proposed reforms, but they face complacency afforded by the (still) high living standard, reinforced by extensive vested interests. Also, political power in Switzerland is particularly diffused among lower levels of government and the voters tend to call referenda on reforms.

Recent Fund advice has centered on the monetary and fiscal frameworks, namely the shift from targeting monetary aggregates to medium-term price stability and the debt-brake rule. The monetary policy framework is evolving along the lines suggested in consultations and is working well. The debt-brake rule has been fine tuned to allow greater cyclical responsiveness. While the authorities’ efforts to restore balance in the federal finances have been in line with Fund advice, important challenges remain in addressing aging-related pressures. Also, strengthening competition in domestic markets through opening up sheltered sectors remains a recurring and difficult theme.

II. Recent Developments: A Moderate Recovery

3. The economy has pulled out of recession, but the recovery is fragile and dependent on external demand. A moderate recovery has been in place since mid-2003, initiated by supportive monetary and fiscal policies, and growing external demand. In 2004, investment and construction benefited from improving prospects and low interest rates, while a soft labor market and rising energy costs held back household consumption. However, an unexpected dip in investment contributed to a contraction of GDP in the last quarter. For the year as whole, real GDP expanded by 1.7 percent, narrowing the output gap to 1 percent. In early 2005, business indicators continued to be relatively weak (Figures 2 and 3).

Figure 2.
Figure 2.

Switzerland: A Moderate Recovery is Underway 1/

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Source: IMF, World Economic Outlook.1/ Seasonally adjusted annualized growth rates in percent, unless otherwise indicated.2/ Year-on-year percent change.3/ Moving average of annualized growth rates in percent
Figure 3.
Figure 3.

Switzerland: The Recovery May Have Peaked

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: KOF database; and Bloomberg.

Switzerland: Aggregate Demand Components

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Sources: SECO; and IMF staff estimates and projections.

Contribution to growth.

Projections.

4. The return to growth has not yet improved labor market conditions. Employment was flat as enterprises improved productivity before stepping up hiring. In manufacturing, which is more exposed to international competition, employment declined (Figure 4). Simultaneously, labor supply growth was muted by workers moving into training and retirement. As a result, unemployment rose to 3.9 percent in 2004.

Figure 4.
Figure 4.

Switzerland: Return to Growth Has Not Yet Eased The Slack in the Labor Market

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: IMF, World Economic Outlook; and KOF Institute.1/ Percentage points.
uA01fig03

The recovery is reflected in productivity gains…

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

… rather than employment.

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Source: BfS, SAKE and ESPOP

5. Inflation remained low, the oil shock notwithstanding. In early 2005, headline CPI inflation picked up to 1.4 percent and core inflation rose from ¼ to 1 percent (Figure 5). Second-round effects have been virtually absent. Average wages rose by 0.9 percent in 2004 and are likely to increase by around 1¼ percent in 2005.

Figure 5.
Figure 5.

Switzerland: Concerns About Deflation Have Abated

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Source: KOF database.

6. Monetary conditions remained expansionary. With activity picking up in early 2004, the SNB raised the three-month policy rate in June and September 2004 by 25 basis points each after having kept it historically low at 0.25 percent for more than a year. Still, the three-month rate remained negative in real terms. Since markets remain confident about inflation, long-term interest rates hardly moved (Figure 6). The rapid monetary growth of previous years subsided—as shifting into liquidity ran its course—and credit expansion was tame with increasing credit to households tempered by declining credit to enterprises (Figure 7). Equity prices improved to 30 percent below their peak of end-2000, in line with other markets. Average real estate prices remained subdued (Figure 8).

Figure 6.
Figure 6.

Switzerland: Monetary Conditions Remain Accommodative

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: KOF database; Bloomberg; International Financial Statistics; and IMF staff estimates.1/ Actual rates minus 12-month change in CPI index.
Figure 7.
Figure 7.

Switzerland: Money and Credit Aggregates Provide Mixed Signals

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Source: IMF, World Economic Outlook; and KOF Institute.
Figure 8.
Figure 8.

Switzerland: Asset Prices

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: KOF database; BIS; Bloomberg; and IMF, International Financial Statistics; and IMF staff estimates.

7. The Swiss franc strengthened, removing some monetary stimulus. Since end-2003, the franc has appreciated by 3.7 percent in real effective terms and by 1.2 percent in nominal terms, reflecting an appreciation vis-à-vis the US dollar (the franc-euro rate remained stable). The franc is now close to its long-term upward trend.1

uA01fig04

The nominal effective exchange rate…

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: IMF, International Financial Statistics; and staff calculations.
uA01fig05

…and the real ones are close to their long-term trends.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: IMF, International Financial Statistics; and staff calculations.

8. Fiscal policy was slightly restrictive. The federal government deficit was below budget because of tax buoyancy and lower interest payments. Subnational governments also consolidated their finances. The general government deficit is estimated to have narrowed to 1 percent of GDP in 2004, despite some widening of the social security deficit (Tables 2 and 3).

Table 2.

Switzerland: General Government Finances

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Sources: Federal Ministry of Finance; and IMF staff estimates.

Excludes in 2005 transfers from SNB gold sales of SwF 21 billion, 4.6 percent of GDP.

Table 3.

Switzerland: Federal Government Finances

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Sources: Federal Ministry of Finance; and IMF staff estimates.

Excluding in 2005 transfers from SNB gold sales of SwF 7 billion, 1.5 percent of GDP.

9. The external current account surplus remained high. Three-quarters of the current account surplus of 12 percent of GDP in 2004 reflects investment income from large net foreign assets, and the trend improvement in the terms of trade as exporters are oriented toward specialty high-value-added markets (Table 4).2

Table 4.

Switzerland: Balance of Payments

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Sources: IMF, World Economic Outlook database; and Swiss National Bank.

Fund staff estimates and projections unless otherwise noted.

III. Report on the Discussions

10. The consultations focused on the costs of inaction in bolstering long-term growth, the need for sustained fiscal adjustment, and the appropriate current policy stance. Staff estimates suggest that future potential growth will trend to below 1 percent a year, driven by demographics, declining average hours worked and low TFP growth. Moreover, absent measures, the public deficit would gradually rise to unsustainable levels. Against this background of slow growth and challenging public finances, the discussions focused on the need to accelerate product and labor market reforms, recalibrate the long-run social security finances, and fine-tune the “debt brake” to anchor better the public debt. The discussions addressed also the pace and timing of the withdrawal of the monetary stimulus and progress in the adjustment of the financial sector. There was substantial agreement on the general direction of policies, with the authorities striving to build consensus on steps to bolster the social security accounts and to implement structural reforms.

uA01fig07

Output growth is projected to decline.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Sources: BFS and IMF staff projections.

A. Short-Run Outlook

11. The authorities, staff, and private forecasters shared similar views on the short-run outlook. The staff was cautiously optimistic that the easing of growth in late 2004 reflected a temporary soft patch that would be overcome in the course of 2005 with a renewed pick up in external demand (as in the WEO), and continued support from monetary policy. With improving corporate balance sheets and enterprise profitability, staff did not see major domestic imbalances to hold back the recovery. However, because the carry-over in growth from 2004 was weak, average growth would be somewhat lower at 1¼ percent in 2005, with activity gaining strength in the second half. The authorities were more sanguine about domestic demand and projected growth at 1½ percent.

12. The outlook is cautious, but there remain some downside risks. So far in 2005, indications of an upturn are weak and the projections for euro area growth (comprising 60 percent of Swiss exports) are being trimmed. Moreover, the authorities noted that Switzerland could be adversely affected if global imbalances were to unwind suddenly, triggering a safe-haven appreciation of the franc. Also, corrections in international financial markets could strain Switzerland’s important financial sector. Persistently high oil prices also pose risks for Switzerland, despite its low oil dependency, because they could reduce further partner countries’ growth.3

uA01fig08

Swiss oil intensity is low.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Source: IEA, Fund staff calculations.

13. Inflation is projected to remain below 2 percent through 2006. This favorable outlook reflects the SNB’s strong credibility, which has firmly anchored expectations, and flexible labor markets, which reduces second-round effects.

B. Monetary and Exchange Rate Policy: Supporting the Recovery

14. Monetary policy is applied pragmatically. With inflation projected to remain moderate through 2006, even at the current very low interest rates, the SNB has maintained its accommodative policy stance. On indications that activity eased again toward end-2004 and with the appreciating franc already slightly tightening monetary conditions, the SNB paused raising the policy interest rate. Staff agreed that the lifting of the policy rate through mid-2004 was opportune. This did not inhibit activity, but provided a useful signal of leaning against the wind of oil prices—thus helping to anchor expectations. Also, the move created some room for policy maneuver downward if that were necessary.

15. The staff saw room for continued patience with policy rates until the recovery regained traction. Patience was warranted by the negative output gap and the absence of price pressures. The lagged effects from the appreciation of the franc would already withdraw some stimulus. The SNB agreed, but would remain vigilant for signs of price pressures. In its quarterly assessment of monetary policy in March, it left the policy rate unchanged.

uA01fig09

Monetary conditions remain expansionary and…

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

1/ The MCI is calculated as a weighted average of the 3-month interest rate and the de trended nominal effective exchange rate with respective weights 0.75 and 0.25.
uA01fig10

…the policy interest rate is in line with the Taylor rule.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

1/ The Taylor Rule rate, RTR, is derived from: RTR=1.1+π-1+0.5 (π-1- π*)+0.5 outputgap-1 for two alternative target inflation rates, π* = 0.5 and 2 percent.

16. Looking further out, the SNB and the staff agreed that further withdrawals of monetary stimulus would be needed at some point. Real interest rates have been well below neutral levels for two years and, until recently, broad money had been growing rapidly. Given that monetary policy operates with long lags, the authorities were mindful of the risks associated with unduly delaying a return to more neutral policies. Staff agreed that the question was not whether monetary policy should move to a more neutral rate eventually, but rather about the timing of this move. Markets expect little tightening in 2005.

uA01fig11

Markets expect little tightening in 2005

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

17. The authorities noted some concern about spillovers from global current account imbalances. A rapid exchange rate appreciation of the franc against the U.S. dollar could take inflation toward negative territory. With current low interest rates, the SNB would have little room for maneuver and would include in its options some foreign exchange intervention.

18. On the exchange rate, the authorities shared the staff assessment that a gradual appreciation of the franc along its long-run trend could continue. Staff estimates suggest that the franc might be slightly undervalued, based on the macroeconomic balance approach, fundamental equilibrium approach and panel estimates of purchasing power parity—adjusted for factors such as terms of trade and net factor income. While the long-run trend appreciation has resulted in a decline in manufacturers export market shares, this development has been offset by improving terms of trade as Swiss firms increasingly focus on high value-added markets. The trend appreciation was also seen as beneficial to the Swiss financial sector. Lastly, the high domestic price level (compared to the EU) reflected weak competition in sheltered sectors, for which the solution remained product market reform, rather than depreciation.

19. Private sector representatives commended the SNB’s communication strategy and were supportive of the monetary policy framework. They valued the open communications policy which avoided surprises on interest rate decisions. To fine-tune this strategy, the SNB had started releasing quarterly its 3-year ahead inflation forecast together with an assessment of monetary conditions. Moreover, to enhance public accountability, as stipulated in the new National Bank Act, the SNB had started submitting to parliament an annual report on the fulfillment of its tasks. Staff agreed that the monetary policy framework was working well,4 having delivered average inflation of 0.9 percent since its inception in 2000 while steering clear of deflation, and thereby maintained strong credibility.

C. Fiscal Policy: Restoring Balance and Addressing Long-Term Challenges

20. The public finances are managed carefully, but longer-term strains are nevertheless visible. The general government deficit in 2004 was moderate and consistent with approximate short-run stability in the debt ratio. However, strains are building up in the pension and healthcare systems, which in recent years were running a combined deficit (before budgetary subsidies) of over 5 percent of GDP. With unchanged policies, the impending demographic shift and unabated rise in healthcare spending are projected to widen the fiscal deficit, even increasing the public debt to unsustainable levels over the medium-term—as shown in the extended debt sustainability analysis until 2060 in the accompanying Selected Issues. The authorities explained that a public consensus how to address these long-term fiscal challenges was still lacking, and that recent efforts to raise the retirement age and increase the VAT rate to finance social security had been rejected in a referendum.

uA01fig12

Under current policies, aging would raise public debt to unsustainable levels.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

Source: IMF staff estimates. Baseline paths assuming that the general government runs a primary surplus of 6 percent of GDP (excluding transfers to the pension system and healthcare). See Chapter I of the accompanying Selected Issues.

21. The federal government is leading fiscal adjustment:

  • Federal fiscal policy was guided by the debt-brake rule.5 The authorities’ objective is to eliminate the recent federal structural deficit in the short run, while allowing automatic stabilizers to operate around this path. They had introduced two expenditure-based consolidation programs (Entlastungsprogramme 2003 and 2004)—the second is now passing through the legislature—based on slowing annual expenditure growth to 1.5 percent (slightly below nominal GDP growth).

  • The subnational governments had achieved consolidation in 2004 as well, but were expected to spend a share of gold sales in 2005-06 (see below), and were facing increasing spending pressures on health care. In additional, some measures may be needed to offset spillovers from consolidation at the federal level.

22. An important event in 2005 is the transfer to the government of 4.6 percent of GDP in proceeds from SNB gold sales.6 The government decided that ⅓ of these proceeds will be transferred to the federal government and ⅔ to the cantons. The staff strongly urged the authorities to apply these amounts to debt reduction. The federal authorities indicated their intention to do so, and they projected that cantons would use 80-85 percent of their allocation for debt reduction as well. However, they underscored that they could not force the cantons to do so. The staff agreed with the SNB that the gold sale is a one-time event that reduces future SNB profit distributions, and that the proceeds should therefore be saved.

Overview of Federal Consolidation Programs 2003 and 2004

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23. The authorities felt that risks to the medium-term fiscal outlook were manageable. Staff cautioned that competition from other financial centers could erode withholding taxes and stamp duties and that the current level of profit distribution from the SNB would decline in future. The authorities acknowledged some pressures on financial (and corporate) taxes and indicated that revenue losses would need to be compensated with expenditure cuts. In a broader context, they noted that while the debt brake rule had been very valuable as a guide for fiscal policy, the accompanying annual adjustment programs were beginning to cause adjustment fatigue, and thus they were searching for structural longer-lasting solutions to deficit pressures in an expenditure review for the federal government.

uA01fig13

Withholding tax and stamp duty revenues have been eroding.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

24. The authorities shared the staff’s concerns regarding long-run fiscal pressures from population aging. Switzerland’s old-age dependency ratio is projected to increase by 16 percentage points over the next thirty years and, under current policies, this puts the first pillar of the pension system and the health care system (Box 2) on a path of sharply rising deficits. Staff estimated the net present value of future liabilities of these programs at 180 percent of GDP, roughly the equivalent of a 7½ percentage point hike in the VAT. Cognizant of these problems, the authorities were reviewing social security entitlements and had begun to frame proposals to strengthen the finances of disability insurance.

25. Officials agreed that long-term fiscal sustainability required a coordinated strategy, embracing fiscal consolidation and reforms. Staff noted that the financing gap of social security was too large to be closed by fiscal consolidation alone, especially since tax increases could worsen distortions and adversely affect Switzerland’s already slow output growth. On their part, the authorities felt that a potential rise in the retirement age would need to be accompanied by the creation of work opportunities for older workers. There was agreement that a viable strategy would involve a balanced mixture of pension and healthcare reforms to reduce social security deficits; product market reforms to raise output and employment growth; and expenditure-based fiscal consolidation to close any remaining gap. In this regard, staff saw the need to aim fiscal policies at a downward path for the public debt-to-GDP ratio beyond 2007. Staff also recommended the publication of comprehensive periodic reports on the long-run sustainability of the public finances as a policy guide and to improve public awareness and catalyze reform.

The Challenge of Healthcare Costs1

Switzerland has become the second most expensive country for health care in the world. The ratio of health costs to GDP was 11.5 percent in 2003--more than double its level in 1970. In real per-capita terms, health expenditures grew by 3 percent per year.

High prices rather than large quantities characterize the Swiss health sector, which suggests distortions on the supply side. In particular, the system suffers from regional fragmentation with small units, financial fragmentation, supply-pushed demand in medications and treatments, and insufficient competition.

Switzerland’s health care system is financed largely by the private sector, much in contrast to the rest of Europe. High growth in insurance premia and out-of-pocket payments have a regressive effect on income distribution, which the government tries to counter by subsidizing low-income households. This strategy has the virtue of keeping non-wage labor costs low.

However, because there is little cost control, healthcare subsidies in the public finances could grow rapidly in the future. Staff calculations show that on present trends, the share of subsidized households would rise from 34 now to over 60 percent in 2015 and 90 percent in 2050.

uA01fig14

Swiss health cost are second highest in OECD.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

uA01fig15

Public subsidies are under pressure to go up.

Citation: IMF Staff Country Reports 2005, 190; 10.5089/9781451807288.002.A001

1 See Chapter II in the accompanying Selected Issues.

26. Proposals for overhauling Switzerland’s system of intergovernmental fiscal relations were accepted in a referendum (Box 3). The staff shared the authorities’ view that this reform has strengthened fiscal federal relations. Key elements were the improved assignment of tasks and responsibilities between federal and subnational governments, and improved inter-regional equity. The reform also sharply reduced perverse spending incentives for poor cantons. Nevertheless, staff noted that, given the pronounced autonomy of the cantons in the Swiss federal system, and the relatively small size of the federal government (representing less than ⅓ of general government spending), it will remain difficult for Switzerland to run a coordinated fiscal policy stance unless the cooperation between federal and cantonal governments is further strengthened.

D. Financial Sector Stability

27. The authorities underscored that the banking sector remained resilient, adequately capitalized, and dynamic. In 2004, bank profitability has risen helped by cost cuts and consolidation. Balance sheets have strengthened further (Tables 5-8, Figure 9). Low interest rates have stimulated a rapid mortgage lending to households but supervisors’ simulations suggest that a rise in interest rates would not impair households’ ability to service debts as loan-to-value ratios were moderate and price increases in the real estate market had remained subdued. Lending to enterprises has been declining for several years. Supply has declined as banks have tightened lending practices and introduced risk-based interest rates, thereby increasing the intermediation spread. Demand has also moderated due to lower investment and enterprises’ efforts to strengthen their balance sheets. The overall decline has been mitigated by increased lending from regional banks, which does not appear to have compromised their lending standards.

Table 5.

Switzerland: Financial Development in Major Financial Institutions, 2002-04

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Source: Company reports; and IMF staff calculations.

Data for Swiss Life is for the first half of the year.

Profit before taxes and minority interests.

Table 6.

Switzerland: Core Set of Financial Soundness Indicators

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Source: Swiss National Bank.

Mining and extraction, production and distribution of electricity, natural gas and water, financial intermediation, social security, ex-territorial bodies and organizations, other.

Table 7.

Switzerland: Encouraged Set of Financial Soundness Indicators

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Sources: Swiss National Bank; and Social Security Administration.

Simple ratio of capital to total assets, without risk weighting.

Large exposure = larger than 10 percent of tier I capital.

Difference between lending rate on loans <= 1 year and deposit rate on term deposits >= 1 month and <= 1 year.

Table 8.

Switzerland: Structure of the Financial System

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Source: Swiss National Bank.

Credit institutions governed by the Swiss law, including those with Swiss-majority and foreign-majority shareholdings.

Share in percent of three largest banks in total assets of the sector.

Herfindahl’s index