Switzerland
2007 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Switzerland

This 2007 Article IV Consultation highlights that Switzerland’s economy is performing well. The expansion moved into its fourth year with above average growth and employment, and few signs of inflation. This favorable outcome can be traced to a vibrant external environment, including in global financial markets, strong macroeconomic policies, and key structural reforms in retailing and labor markets. The financial sector is performing well in a favorable cyclical setting. Bank profitability is strong, and financial soundness indicators have improved. Economic growth, employment, financial markets, financial sector, bank profitability, and financial soundness indicators have improved.

Abstract

This 2007 Article IV Consultation highlights that Switzerland’s economy is performing well. The expansion moved into its fourth year with above average growth and employment, and few signs of inflation. This favorable outcome can be traced to a vibrant external environment, including in global financial markets, strong macroeconomic policies, and key structural reforms in retailing and labor markets. The financial sector is performing well in a favorable cyclical setting. Bank profitability is strong, and financial soundness indicators have improved. Economic growth, employment, financial markets, financial sector, bank profitability, and financial soundness indicators have improved.

I. Recent Developments and Outlook

1. The economy is performing well. The expansion is entering its fourth year with low inflation and strong employment growth. Confidence is high, and growth is projected at 2.0 percent in 2007, exceeding trend. The budget moved to a surplus one year ahead of schedule, and the external environment remains broadly favorable.

2. Switzerland holds parliamentary elections in October. The election cycle is subdued, but high fiscal revenues are inducing some expenditure pressures. The outgoing parliament is not taking up new reforms, so the mission aimed the discussions and its outreach at post-electoral progress.

3. Stronger policies and global growth have reactivated the economy. Performance has long been hampered by sheltered sectors (e.g., agriculture) that limited productivity growth and contributed to a high domestic price level. As a result, average per-capita growth lagged peers for two decades through 2003 and Switzerland's relative income position declined. However, since 2004 the economy has rebounded with stronger fiscal policies (the debt brake) and reforms in retail and labor markets—while taking advantage of buoyant global activity (Figures 1 and 2).

Figure 1.
Figure 1.

Main Economic Indicators in International Perspective

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Sources: IFS; OECD; and WEO.
Figure 2.
Figure 2.

Switzerland: The Recovery is in its Fourth Year 1/

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Source: SECO; and IMF, World Economic Outlook.1/ Seasonally adjusted annualized growth rates in percent, unless otherwise indicated.2/ Year-on-year percent change of goods and non-factor services.3/ 4-quarter moving average of annualized growth rates in percent.
uA01fig01

Productivity has improved.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

4. Growth accelerated and became broad based in 2006. Private consumption picked up with rising employment, and business investment with high capacity utilization; construction rebounded from weather-related lows in 2005. Pharmaceutical, precision instruments, and financial services' exports boomed with the EU recovery and some weakening of the franc. GDP growth of 2.7 percent in 2006 closed the output gap.

uA01fig02

Capacity utilization is at a record high.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

uA01fig03

Net migration and cross-border commuter flows have boosted labor supply.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

5. Full-time employment increased in manufacturing, construction, and the financial sector. Unemployment fell to 3 percent recently and surveys suggest a further decline ahead. Opening the labor market to EU workers helped to fill skill gaps and keep wage growth down, underscoring the value of flexible labor markets and effective migration policies (Figure 3).

Figure 3.
Figure 3.

Switzerland: The Labor Market

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

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

6. CPI inflation and wage pressures have been low. Inflation was 1 percent in 2006 and real wages grew by 0.7 percent. Labor market openness, reduced exchange rate pass through, rebounding productivity, lower oil prices, and increased domestic retail competition together with higher policy interest rates contained inflation. February 2007 inflation even dropped to zero. When excluding housing rents linked to rising policy interest rates, it was negative. Nevertheless, producer prices are rising somewhat faster, consistent with the weaker exchange rate (Figure 4).

Figure 4.
Figure 4.

Switzerland: Inflation is Low

(12-month percent change)

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Source: KOF database.
uA01fig04

The output gap appears positive...

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

uA01fig05

...but inflation is absent.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

7. The SNB has raised policy rates in five quarterly steps of 25 bp each to 2.25 percent by March 2007. Real rates at 1¾ percent are now close to those in the U.S. and euro zone. In the March policy statement, the SNB leaned toward continuing lifting interest rates, partly based on the high level of capacity utilization and the weak exchange rate, but noted the need to remain flexible. Market participants on average price in a slight rate increase for June 2007 (Figures 5 and 6).

Figure 5.
Figure 5.

Switzerland: Monetary Conditions Have Been Supportive

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Sources: KOF database; Bloomberg; International Financial Statistics; and IMF staff estimates.1/ Actual rates minus 12-month change in CPI index.
Figure 6.
Figure 6.

Switzerland: Money and Credit Aggregates

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

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

8. The systemically important financial sector is doing well in a favorable setting. This sector has a large impact on GDP, accounting for 5 percent of employment and 15 percent of value added in the economy. Financial soundness indicators have improved and bank profitability is strong. The two large banks (UBS and Credit Suisse) are global enterprises in wealth management, derivatives markets, and as prime brokers to hedge funds and private equity firms. The pension and life insurance sectors are recovering from balance sheet pressures, low interest rates, and the downturn earlier this decade in financial asset prices. Real estate prices have increased but remain well below their peak before the crisis of the mid-1990s—there are no signs of price bubbles (Figures 7-9).

Figure 7.
Figure 7.

Switzerland: Financial Sector Indicators

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Source: Bloomberg, SNB, and IMF staff calculations.1/ The index includes 15 listed banks, in addition to UBS and Credit Suisse. The Distance to default Index is defined as the number of standard deviations away from a default event.
Figure 8.
Figure 8.

Equity Prices for Bank and Insurance Sectors

(As ratio to total market index; January 2000 = 100)

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Source: Datastream.
Figure 9.
Figure 9.

Switzerland: Asset Prices

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Sources: KOF database; BIS; Bloomberg; and IMF, International Financial Statistics; and IMF staff estimates.
uA01fig06

The financial sector plays a key role in the economy.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

9. The 2006 fiscal result exceeded the budget. With tight expenditure control and buoyant revenues, the general government achieved a surplus of 0.8 percent of GDP—versus a budgeted 1 percent deficit. Together with the proceeds from Swisscom share sales, this reduced gross debt to 48.2 percent of GDP.

Staff Medium-Term Projections, 2006-2011

(Percentage change from the previous period, unless otherwise indicated)

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In percent of GDP.

10. The outlook is favorable but tail-end risks warrant monitoring. External demand, even discounting some slowing, remains supportive overall. Investment and consumption are expected to remain buoyant (Figure 10). Staff projections are in line with consensus. While low-probability events, a disorderly unwinding of global imbalances or a shock from hedge funds or private equity could have pronounced consequences given Switzerland's large role in financial intermediation. Another downside risk would include increased currency volatility linked to Swiss franc carry trades. Upside potential could materialize if the franc were to continue being weak or migration and employment growth accelerated further.

Figure 10.
Figure 10.

Switzerland: Leading Indicators Suggest That the Expansion Will Continue

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Sources: KOF database; and Bloomberg.

11. The main long-run challenge for Switzerland relates to population aging, its associated fiscal pressures and decline in potential growth. Driven by demographics, the staff projects potential growth to slow to around 1¼ percent by 2020. Although there is upside potential with improved competition and migration, unchanged fiscal policies would nevertheless generate a large primary deficit from higher entitlement costs, as shown below.

II. Policy Discussions

12. With the economy performing well, the mission focused on core issues:

  • Potential output: Reforms in goods and labor markets are bearing fruit with increased productivity and lower inflation. Discussions focused on whether these supply improvements could sustain more rapid growth without price pressures.

  • Monetary and exchange rate policies: The exchange rate has weakened despite the SNB tightening and a growing current account surplus. These conditions, and uncertainty about cyclical and inflation turning points, complicate monetary policy.

  • Financial sector: Switzerland would be sensitive to a disorderly resolution of global imbalances. The November FSAP update mission assessed these and other risks.

  • Fiscal sustainability: The debt brake has limited spending in recent years, but the authorities are now placing extraordinary spending off-budget. Also, the debt brake is not robust to aging pressures, and measures to address these need to be formalized.

A. Potential Output

13. The authorities were guarded about the possibility that potential growth had increased. They estimate current potential growth of 1½ percent a year; the staff thought that it could be closer to 2 percent for now. The authorities agreed that opening the labor market and tighter domestic retail competition had facilitated the rebound, and that Switzerland was a large beneficiary of globalization, putting downward pressure on domestic prices. Their caution centered on whether improvements were temporary or permanent. There were logistical and political limitations to (im)migration. Also, their analytical work did not yet suggest higher potential. They would monitor indicators for policy implications because if potential growth were higher, financial policies could be slightly easier.

Staff Projections of Long-Run Potential Output Growth

(Average percentage change a year, unless otherwise indicated)

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B. Monetary and Exchange Rate Policies

14. The normalization of interest rates was close to ending. The SNB agreed that short-term inflation pressures appeared absent, but (in their estimate) a positive output gap, high credit growth, weak exchange rate, and falling unemployment signaled higher prices in the medium-term. Exchange rate and wholesale price pass-through effects could reappear. Moreover, monetary policy had been accommodative for a while—which would impact expectations at some point. The staff considered that econometric modeling grounded in past data would have difficulty picking up the benefits from reform on higher potential growth, as these affect the economy in a forward looking way. Still, some of the SNB’s models indicated a neutral rate of 2.5 percent (real 1.5 percent; inflation 1 percent), and the SNB tightened further in March.

uA01fig07

Staff estimates of natural real interest rate.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

uA01fig08

Monetary conditions have been supportive for a while.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

1/ A weighted average of the 3-month interest rate (3/4) and the detrended nominal effective exchange rate (1/4).

15. While the SNB leaned toward further rate increases, they noted that upcoming decisions were not clearcut. The SNB stressed foremost the need to stay ahead of inflation expectations (the yield curve has flattened, Figure 5). On the exchange rate, as long as its weakness did not affect expectations, it was not a concern. The policy stance would respond flexibly to unfolding events.

16. The monetary policy framework and communication strategy serve Switzerland well. The SNB publishes every quarter a three-year inflation projection as a communication device, which appears to have contributed to keeping financial markets well informed about policy intentions. On a technical level, the staff continued to feel uneasy about the regulated link between interest rates and housing rents, which creates a policy distortion (higher rates causing rental inflation). Moreover, cantonal banks are under (local) political pressure to keep mortgage rates stable as policy rates rise—evidence of a second distortion related to public ownership of banks.

17. The exchange regime is an independent float. The value of the franc is determined by demand and supply. The SNB reserves the right to intervene, but has not done so in years. The system is free of restrictions except for security reasons notified to the Fund.

18. Competitiveness is strong and the external surplus large. Despite strong fundamentals, the franc has depreciated by 2½ and 6½ percent in nominal and real effective terms since 2002. Calculations using the Fund's macroeconomic balance approach (CGER) suggest the franc is 0-20 percent undervalued. The staff projects the current account surplus to remain at 16-17 percent of GDP, in part reflecting earnings on Switzerland's large foreign assets from occupational pension funds, insurance companies, and corporate holdings (Figure 11). Moreover, financial service earnings have grown fast as new IPOs and M&As increased underwriting fees and commissions; natural disaster related premium adjustments boosted insurance company receipts; and high commodity prices and trading activity raised merchanting revenue. At the same time, the strong demand for precision instruments and pharmaceuticals increased the merchandise trade surplus to 1 percent of GDP.1 The authorities noted that the current account surplus largely went into direct investment outflows, especially by foreign controlled holdings. Neverthless, interpreting the surplus is complex, and its connection to domestic demand is not straightforward (Box 1).

Figure 11.
Figure 11.

Switzerland: External Competitiveness

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Sources: Direction of Trade database, IFS, OECD, SNB, WEO, and IMF staff calculations.
uA01fig09

The Swiss franc has depreciated in nominal and real terms.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

uA01fig10

Saving balances have grown since 2002.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

The Swiss Current Account Surplus

Interpreting the large current account surplus is complex. The (entirely private sector) surplus reflects structural and cyclical components that have grown with globalization and as Swiss multinationals expand. The surplus does not connect in a simple way to domestic absorption, or even to Swiss nationals.

  • Net foreign assets exceeding 110 percent of GDP mostly reflect pension plans' and Swiss multinational foreign assets. Even at moderate returns of some 6 percent, these assets alone contribute (a structural) income of 7 percent of GDP.

  • Swiss multinationals are very profitable. The global upswing has boosted profitability of Swiss firms in chemical, pharmaceutical, machine tool, and financial services industries. They are world leaders in their field, conducting mostly business overseas. In comparison with a small home base, their global profits are structurally improving and also currently cyclically strong, thus exerting a large impact on the Swiss balance of payments.

  • Merchandise trade account. The trade balance was around zero in the 1990s and a small surplus more recently, reflecting slow average growth. Going forward, absorption is likely to increase as the economy continues to strengthen, and reforms further liberalize internal markets. Investment is picking up and consumption taxes are low (see chart in para. 29), yet stronger absorption could only reduce part of the large external surplus.

  • Foreign holding companies. Switzerland is home to foreign controlled holdings, who are attracted by location, a stable political system, excellent legal, physical, and financial infrastructure, and moderate tax regime. As residents, their profits are in the Swiss balance of payments. Most of their earnings are in-and-out, but their net retained earnings abroad are a Swiss surplus—these have grown from -1 percent of GDP in 2001 to nearly 3 percent in 2006.

  • Not all of the surplus is “Swiss.” Balance of payments data reflect residency. Many firms in Switzerland are fully (foreign holdings) or partially (foreign share ownership in Swiss firms) owned by foreigners. A preliminary staff analysis based on data received from the authorities suggests that nearly 7 pps of GDP of the current account surplus in 2005-2006 is attributable to foreigners.

19. The authorities agreed that it was unclear whether recent exchange rate weakness would be sustained or was temporary:

  • Strong fundamentals and narrowing interest differentials point to the franc resuming its century long trend appreciation at some point.

  • However, reforms that are lowering nontradable prices are consistent with a depreciating equilibrium exchange rate (a “reverse” Balassa-Samuelson effect).

  • Moreover, hedge fund and retail carry trades (contracting SwF mortgages in Eastern Europe) may have contributed to weakening the franc. Even some exporters have discontinued hedging their contracts. The limits to this process are uncertain, but the SNB warned that carry trades were risky, and would remain alert for cross-border spillovers (Box 2).

  • The emergence of the euro (franc weakness is mainly against the euro) may have reduced the safe-haven role of the franc (Box 3). Nevertheless, the authorities felt that this effect, and low volatility, could be temporary—and that currency appreciation would resume as risk appetites normalized.

uA01fig11

REER appears to be off its long-run trend…

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Carry Trade Spillovers

Low interest rates and volatility have made the Swiss Franc the currency of choice for mortgage and other private loans in Eastern Europe. This carry trade is growing rapidly, particularly through Austrian banks, with a stock at over SwF 100 billion by mid-2006 (25 percent of Swiss GDP). Swiss banks have limited direct exposure. The originating banks hedge currency exposure, but could be hit by counterparty risk.

uA01fig12

Total Private Sector Loans in Swiss Franc in Selected Countries

(Bilions SwF, mid 2006)

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Spillovers could take different forms. Repercussions for Swiss banks are unclear. Net external interbank lending from Swiss banks is growing but represents only ½ percent of their international claims. To the extent these funds are used to finance foreign SwF retail loans, a sharp appreciation of the SwF could stress retail borrowers in Eastern Europe and reverberate back into Switzerland. Moreover, some foreign banks directly place paper on the Swiss exchange and international markets. Swiss policies or exogenous shocks that appreciate the franc could stress retail borrowers and carry traders and eventually affect their SwF lenders.

The authorities agreed that a floating exchange regime was best to handle these uncertainties.

Has the Swiss Franc Lost Its Luster?

The franc has weakened lately after appreciating by 0.7 percent annually in real effective terms for a century.

One factor has been carry trades as the yen and Swf were main funding currencies (2006 BIS Annual Report). Carry traders short low yielding currencies, with the proceeds going long on high yielding assets. SwF futures contracts on the CME indicate a marked increase in short positions since 2004.

uA01fig13

Swf/Dollar Exchange Rate

(Right axis)

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

Two, the Swf may have lost status as a safe haven currency. In 2001, the Swiss constitution was amended to allow SNB gold sales and, in 2005, a substantial amount of gold was sold with the proceeds distributed to government. The response of the Swf to gold prices appears to have weakened recently, and global turbulence has not caused Swf appreciation as in the past.

Three, the Swf has lost share as official reserve currency. As global reserve holdings increased from 4 percent of GDP in 1990 to 10 percent in 2005, the Swf share has diminished (BIS data). Given the more active reserves management, this might reflect low yields in Switzerland, the currency's decoupling from gold, and substitution to the euro as the new preferred asset.

C. The Financial Sector and FSAP Update

20. The authorities welcomed the FSAP update accompanying the consultation. The FSAP team and SNB designed stress scenarios, including a weaker dollar and higher U.S. interest rates that the large banks applied in their proprietary risk models. The banks and supervisory authorities felt that the stress exercises were helpful, and would explore how they could be used to improve risk management. The accompanying Financial System Stability Assessment reports on the findings and recommendations in detail.

21. The FSAP update found the financial system resilient to significant shocks, but identified several areas for policy attention. An abrupt unwinding of global imbalances could have strong effects because a large repricing of financial assets or currencies would adversely affect banks and portfolios of insurance and pension funds. The growing importance of hedge funds, private equity leverage, and derivatives trading merited closer monitoring. Indeed, while challenging for a small country, it was crucial to maintain a proactive supervisory stance to guard against falling behind in understanding the evolving operating models and risk exposures in the large institutions. Counterparty default and ring-fencing needed to be examined in stress testing models, complemented by targeted audits.

22. The FSAP update felt that there was scope to strengthen the draft Act establishing the Financial Market Supervisory Authority (FINMA). The FINMA will become operational in 2009 and unify banking, insurance, securities, and anti-money laundering supervision. The draft Act could be strengthened through additional budgetary and policy independence, and by granting FINMA independent authority to impose civil money penalties. The staff also recommends dealing with concerns about the costs of regulation in the Guidelines for Financial Market Regulation, rather than explicitly in the law itself, to avoid regulatory capture. The authorities agreed that funding and regulatory independence are crucial, but were less concerned than staff about risks of regulatory capture. They also noted that powers to impose civil money penalties already exist in the Ministry of Finance and on the cantonal level (criminal prosecution), which they consider sufficient.

23. The implementation of Basel II capital adequacy was well advanced; now additional efforts were needed to bolster liquidity supervision. Supervisors need to keep an ongoing dialogue with the banks on Basel II, and internal models need to be continuously evaluated given their high unweighted leverage ratios, and other risks not evaluated by the stress tests including systemic events in hedge funds and the derivatives markets. Additional on-site audits are underway and lead auditors are periodically rotated. After a delay, the authorities are now updating their liquidity regulations along BIS standards.

24. Reforms in transition through 2010 will move Switzerland's insurance regulation to international best practices. Through the application of the Swiss Solvency Test (SST), the authorities are moving toward a risk-based system equivalent to EU solvency II. Meanwhile, some weaknesses are present in the system, as several companies were found to be too vulnerable to financial and real asset price drops. The authorities were considering more focused inspections to assess and address risk exposures of these firms.

25. The authorities noted that there was no political consensus to centralize pension supervision. The FSAP update found that pension supervision remained fragmented and uneven among cantons, carrying risks for fiscal sustainability and contingent liabilities. Also, underfunding needs to be resolved and integrity standards and rules governing investment structure upgraded. While the central authorities do not have formal jurisdiction over pension supervision, a central High Supervisory Board would coordinate regulation, moving to a risk-based solvency system with higher valuation reserves and tighter integrity standards.

26. The FSAP update recommended that cantonal banks focus on profit maximization and be granted further operational independence. It found that cantonal banks were less efficient than private banks, partly because they had to carry out social functions with contingent risks. The authorities agreed that the banks needed to minimize costs as their state guarantees could be withdrawn. Meanwhile, the banks had become more efficient since the real-estate crisis in the mid-1990s. They also noted that social mandates were decided by cantons that could not be revoked by national authorities.

D. Fiscal policies

27. The authorities were satisfied with the operation of the debt brake, but recognized its limitations. The staff agrees that the debt-brake, which seeks balance over the cycle, has been instrumental in reaching the 2006 surplus. However, it applies only to the confederation, excluding social security, and does not provide an anchor for long-term fiscal sustainability. Long-term solutions would need to fit within the devolved federal system, but significant progress was unlikely during this election year.

28. Spending pressures were building but officials were confident that medium-term offsets could be found. The budget aims at a surplus in 2007, but extraordinary off-budget expenditures exceeding 1 percent of GDP were planned for 2008. These include the creation of a new permanent off-budget infrastructure fund and funding of a public pension obligation—all outside the debt brake.2 To compensate, the authorities cut discretionary spending, were negotiating structural reductions in government tasks and subsidies, and planning a VAT increase for the disability fund (see below).3 The staff expressed concern about the extraordinary expenditures and that fiscal policy was becoming procyclical. The authorities explained that their objective is to bring all outlays into the fiscal target over the medium-term—safeguarding the spirit of the debt brake. However, they said that some operations are lumpy and one-time and can not be accommodated in the annual debt brake rule. They would continue debt reduction, including with further sales of Swisscom shares.

Fiscal Developments and Staff Projections 1/

(In percent of GDP)

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Not including planned VAT increase.

29. The authorities saw cantonal tax competition as part of fiscal federalism. Cuts in income tax rates reflected the reduction in cantonal debt with the distribution of gold sales proceeds; robust cyclical revenues; and the move to a new financial equalization system.4 Officials said that while the cantons were free to set their local rates, there was a natural limit to cuts based on revenue impact. The combined confederation and cantonal profit tax burden was average for Europe, but consumption taxes were relatively low. The authorities preferred tax cuts over expenditure hikes, but agreed that they were procyclical.

uA01fig14

Profit taxes are at the OECD average.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

30. To cut long-term fiscal pressures, the government is working in several areas:

  • Health care. Use of generic drugs has increased, hospital budgets tightened, and physician reimbursements linked to specific services rather than the length of stay.

  • Disability insurance. Eligibility is being tightened, and reintegration of the disabled back into the workforce is showing early success.

  • VAT. The authorities plan to resubmit for approval the VAT increase of 0.8 pps, earmarked to reduce debt in the disability insurance fund. They are also developing plans for the unification of VAT rates and abolition of exemptions.

  • First pillar pensions. A proposal to raise the female retirement age from 64 to 65 is in parliament, and plans are to raise the threshold for early retirement. In addition, the CPI weight in pension indexation would be increased, moderating benefit growth.

  • Second pillar pensions. To cut underfunding, the conversion rate (translating capital into a retirement annuity) and regulated minimum interest rate can be reduced.

uA01fig15

Under current policies deficits increase...

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

uA01fig16

...and the debt reaches unsustainable levels.

Citation: IMF Staff Country Reports 2007, 186; 10.5089/9781451807318.002.A001

31. Nevertheless, the authorities agreed that dealing successfully with population aging would require further structural adjustments. To inform the public about needed fiscal adjustments, so important in Switzerland's referendum/political system, the authorities are preparing a Long Run Sustainability Report (LRSR) for end-2007. It will contain the baseline fiscal projections at unchanged policies. A follow-up report, including options to address booming health care costs, is expected in 2008. The staff strongly supports these efforts and noted that the LRSR could include a preliminary inter-temporal public sector balance sheet (Table 4) to show that unfunded future liabilities are over 2 times the size of today's gross debt. Indeed, the mission's projections suggest that government net worth (including the implicit liabilities) is improving, but a large long-run shortfall still exists.

Table 1.

Switzerland: Basic Data

Area and population
Total area41,293 square kilometersGDP per capita (2006)50,176
Total population (end-2006)7.5 millionGNP per capita (2006)54,063

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 excludes 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.

Table 2.

Switzerland: General Government Finances 1/

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

Excludes VAT increases initially planned for 2008, since it has not yet been approved.

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

Includes the balance of the Confederation, Railway Infrastructure Financing Fund, and Swiss Federal Institute of Technology.

Excludes revenues from Swisscom share sale (2002: SwF 3,703 million, 2005: SwF 1350 million, 2006: SwF 2100 million).

2004 total expenditures exclude policy reserves of the ETH, Swiss Post, Skyguide (SwF 1,071 million) and capital injection to Skyguide (SwF 50 million). 2008 total expenditures include extraordinary spending (SwF 5,331 million). 2008-2011 total expenditures exclude transfer out of the special. Infrastructure Fund created in 2008, due to lack of data.

Includes old age pensions (AHV), disability insurance (IV), unemployment insurance (ALV), and loss of earnings insurance (EO). Excludes subsidies for health care premia (KV), which are included in the federal budget.

Structural balance excludes cyclical and one-off items.

Includes debt of confederation (and special funds), cantons and communes. Social security cannot issue debt.

Table 3.

Switzerland: Federal Government Finances 1/

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

Includes the balance of the Confederation, Railway Infrastructure Financing Fund, and Swiss Federal Institute of Technology.

Excludes VAT increase initially planned for 2008, since it has not yet been approved.

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

Exclude revenues from Swisscom share sale (2002: SwF 3,703 million, 2005: SwF 1350 million, 2006: SwF 2100 million).

2004 total expenditures exclude policy reserves of the ETH, Swiss Post, Skyguide (SwF 1,071 million) and capital injection to Skyguide (SwF 50 million). 2008 total expenditures include extraordinary spending (SwF 5,331 million). 2008-11 total expenditure exclude transfer out of the special Infrastructure Fund created in 2008, due to lack of data.

Excludes cyclical and one-off items.

Table 4.

Preliminary Public Sector Balance Sheet

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Sources: Swiss National Bank, Federal Finance Administration and IMF staff calculations.

Reflecting mainly future deficits in social security.

III. Staff Appraisal

32. The economy is doing well, growth prospects are positive, and risks appear balanced. After two decades of sluggish performance, the economy has perked up, benefiting from strengthened policies and a favorable external environment. The outlook holds promise but care should be taken that fiscal policies do not become procyclical. Short-run capacity appears stretched, but inflation is low as globalization and tighter domestic competition limit pass-through and the opening to EU citizens keeps wage pressures in check. Downside risks could emerge if external growth were to slow significantly or global imbalances unwind abruptly. Continued weakness in the franc and accelerating employment constitute upside risks.

33. A key challenge is to avoid complacency and consolidate the good performance with structural reforms. The expansion is in its fourth year, reflecting cautious monetary and fiscal policies, and reforms can further support potential growth and lower prices. Switzerland needs to seize this opportunity to address long-term structural and fiscal issues, especially since population aging pressures are not resolved.

34. Monetary policy needs to remain flexible in the face of greater uncertainty. The SNB has anchored inflation expectations by tightening policies as the expansion progressed. Judging the correct stance becomes more difficult going forward, however, as growth appears to have peaked. Labor supply and productivity improvements suggest that growth can be higher than in the past without generating inflation. Nevertheless, the SNB needs to remain alert as weakness in the exchange rate could still affect costs.

35. The recent Swiss franc weakness is a conundrum. Improving fundamentals (a large external surplus and international investment position, and above average growth) point to an appreciation in the franc. However, the strong euro as a competing safe-haven currency and lower domestic prices point to a depreciation in the franc. Carry trades—which weaken the currency—provide persistent noise. The floating exchange rate regime is best to handle this uncertainty.

36. Competitiveness is strong. Currency weakness, the large stock of NFA, and the large financial companies play a key role in the strong external position. Switzerland's excellent conditions for the location of multinational holdings may also contribute to the external surplus. Deeper internal reforms could further energize domestic demand and make a contribution, appropriate to Switzerland's size, to the reduction in global imbalances.

37. The FSAP update found that the financial sector is performing well, but risks persist. While stress testing indicates that the financial sector is generally resilient to shocks, bank operations are increasingly complex, involving exotic instruments and high-leveraged counterparties; some insurers remain vulnerable to asset price adjustments; and occupation pension funds continue to experience underfunding and fragmented regulation. The main downside risk is that healthy balance sheets and profits may be building a degree of complacency, creating vulnerability to increased volatility or shocks.

38. Therefore, regulatory and supervisory arrangements need to be first-best. The new consolidated regulator (FINMA) needs to have the operational independence and financial resources to be a constructive and appropriately forceful supervisor and regulator of the very large systemic financial institutions. Continuing efforts are needed to evaluate the large banks' operating models and to ensure that liquidity and capital regimes are sufficient.

39. Fiscal policies have been sound, generating a surplus one year ahead of schedule. The debt brake has functioned well and the authorities are to be commended in their steadfast implementation of the two sizable expenditure reduction programs. This strong record needs to be extended into the medium term to meet the challenges of population aging.

40. Procyclical fiscal policy should be avoided and the integrity of the debt brake maintained. Fiscal policy for 2007-08 is projected to be expansionary, reflecting large extraordinary expenditures and overdue pension funding outside the debt brake. These expenditures should be compensated within the debt brake mechanism in the medium term. Similarly, while cantonal tax cuts partly reflect the move to a new equalization system, they demonstrate how Switzerland's competitive federalism can generate procyclical tax cuts—in the face of unresolved longer-term social security deficits.

41. The main fiscal challenge is to resolve structural spending pressures. The debt brake applies only to the confederation and is not robust to pressures from population aging. The authorities have taken important steps to limit future obligations, but more will be needed. The long-run fiscal sustainability report needs to offer insight into fiscal dynamics under current policies and provide the public with clear tools to understand the impact and distributional effects of possible solutions.

42. Policy making requires timely statistics. Cantonal and local governments provide fiscal data with long lags. Inflation assessments are hampered by inadequate wage data.

43. It is recommended that the next Article IV consultation with Switzerland be held on the standard twelve-month cycle.

Table 5.

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.

Includes errors and omissions.

Official gold sales in 2005.

Table 6.

Switzerland: Major Financial Institutions, 2002-06

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Source: Company reports; and IMF staff calculations.