The paper assesses the competitiveness of Swiss exporters, and shows that the effect of nominal exchange rate on trade balance depends on the degree of exchange rate pass-through and on trade elasticities. It highlights that the degree of exchange rate pass-through should also be factored in monetary policy decisions. The authorities are considering legislative changes to strengthen macroprudential oversight by supporting the mutual cooperation between Financial Market Supervisory Authority (FINMA) and Swiss National Bank (SNB) over the financial stability. The scope of the too-big-to-fail (TBTF) proposal should also be broadened to address systematic risk.

Abstract

The paper assesses the competitiveness of Swiss exporters, and shows that the effect of nominal exchange rate on trade balance depends on the degree of exchange rate pass-through and on trade elasticities. It highlights that the degree of exchange rate pass-through should also be factored in monetary policy decisions. The authorities are considering legislative changes to strengthen macroprudential oversight by supporting the mutual cooperation between Financial Market Supervisory Authority (FINMA) and Swiss National Bank (SNB) over the financial stability. The scope of the too-big-to-fail (TBTF) proposal should also be broadened to address systematic risk.

I. Impact of Exchange Rate Movements on Export Performance and Consumer Prices1

A. Introduction

1. The effect of the nominal exchange rate on the trade balance depends on the degree of exchange rate pass-through and on trade elasticities. In the presence of price rigidities, the short-run expenditure switching effect of a nominal exchange rate appreciation on the trade balance will depend on the exchange rate elasticity of imports and of exports. The domestic value of the trade balance will worsen as a result of a real exchange rate appreciation if the sum of the absolute values of the two elasticities exceeds one.2 The exchange rate pass-through is an important parameter determining the response of domestic import demand to exchange rate fluctuations by allowing expenditure switching effects to operate. For example, with a high pass-through, the expenditure switching effect of a nominal appreciation is likely to be sizeable as an appreciation results in a decline in the domestic price of imports and therefore tends to increase the demand for imports.3 In contrast, with a low pass-through, the domestic price of imports, and therefore the demand for import, are not significantly affected by the nominal exchange rate.

2. The degree of exchange rate pass-through should also be factored in monetary policy decisions. With a high exchange rate pass-through, the impact of monetary policy on domestic activity might be dampened. For example, an increase in interest rates, by appreciating the nominal exchange rate, would tend to lower domestic prices of imported goods, thus raising real disposable income. The resulting increase in disposable income would then result in higher domestic demand, partially offsetting the contractionary effect of the interest rate increase on domestic demand.4

3. This paper first assesses the competitiveness of Swiss exporters, and shows that exports are somewhat sensitive to the exchange rate, although elasticities vary significantly across export markets. The overall elasticity of exports to the nominal exchange rate (estimated between 0.9 and 1.3) is economically significant and broadly consistent with the existing literature.5 However, elasticities vary across export markets, perhaps reflecting different pricing strategies, different characteristics of demand or of goods exported. Exports to emerging markets are sensitive to the exchange rate, while exports to more mature markets respond mostly to domestic demand.6 This suggests that Swiss exporters may have to adapt to a more a competitive environment in the fastest growing markets, while, in more mature markets, exports will be determined by the growth outlook.

4. The paper also estimates the exchange rate pass-through, which is found to be low for consumer prices, but large for import prices. These estimates are consistent with past work by the Swiss National Bank that found a relatively low pass-through for consumer price, and a large pass-through for an import price index (in local currency).7 They are also consistent with the existing literature. Pass-through has been found to be low in low-inflation developed countries, both at disaggregated levels and at the level of aggregate price indices (Engel, 2002). However, estimates of import price pass-through are usually found to be much higher than CPI pass-through in OECD countries, suggesting that exchange rate movements do result in some relative price adjustments at the import price level (see in particular Campa and Goldberg, 2005). These findings are consistent with Burnstein et. al., (2007) who show the importance of non-tradable goods in the price of final goods.

5. Various factors may explain the low pass-through to domestic CPI. For instance, if nominal prices are set in advance in the currency of consumers (the “local currency pricing” model, henceforth LCP), nominal exchange rate fluctuations have no effects, in the short-run, on prices faced by consumers.8 There are, however, alternative explanations for the low pass-through. Factors related to international trade (such as transportation and distribution costs) may segment national markets and limit the effect of international traded goods price on the CPI.9 The cost of the good for consumers may also include large non-traded components—reflecting marketing, distribution and retailing—that partially insulate consumers from an increase in import prices.10 Yet another possibility is that there is substitution between domestically and foreign produced goods in response to exchange rate fluctuations, and domestically produced import-competing goods substitute for more expensive imports in consumption baskets. A consequence is that, if this substitution effect affects intermediate products, expenditure switching effects remain significant even if the impact on CPI is low (Obstfeld, 2001).

6. The paper is organized as follows. Section 2 describes recent development of export performance and of domestic prices. Section 3 presents estimates of export elasticities. Section 4 focuses on estimates of exchange rate pass-through. Section 4 concludes.

B. Recent Developments in Export Performance and Inflation

Recent Exchange Rate Developments

7. During 2009 and 2010, the nominal and real effective exchange rates appreciated significantly. The real effective appreciation in 2009–10 has been of about 25 percent. The SFr/euro rate, after several years of relative stability, registered an 18 percent appreciation in 2009–10. The SFr/US$ rate also appreciated while exhibiting an appreciation trend over the last ten years (a cumulative 64 percent gain since 2000), but it has been more volatile than the SFr/euro rate. Between May and December of 2010 the appreciation vis-à-vis the US$ (respectively the euro) was about 22 percent (respectively 13 percent).

uA01fig01
Sources: Information Notice System; and International Financial Statistics.

Indicators of Export Performance

8. Simple indicators suggest that Swiss exports have weather the recent appreciation of the Swiss franc well. Overall, the performance of exports of goods has been satisfactory during the recovery in spite of the appreciation of the Swiss franc. Moreover, the ratio of export prices (expressed in Swiss francs) to the CPI has remained relatively stable, but domestic costs (proxied by the CPI index) have risen somewhat faster than export prices suggesting that exporters have reduced their profit margins and refrained from increasing their export prices to offset the effect of the exchange rate appreciation on profit margins.11

uA01fig02

Exports of goods, constant prices

(2007 Q1=100)

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Sources: WEO and IFS.

9. Various indicators suggest that Swiss producers remain internationally competitive. Growth of unit labor costs (ULC) in the last decade has remained in line with the G7 average, though it has not been as contained as in Germany. Switzerland has maintained its share of exports of goods to advanced economies, and its share of advanced economies’ exports to the world has improved lately. Switzerland’s exports have declined as a share of exports to emerging markets and developing countries, but this may be the consequence of the growing participation of emerging markets in world trade.

uA01fig04

Export Market Shares

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Source: DTS.
uA01fig05

Unit Labor Cost

(2000=100)

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Source: OECD.

10. Exports of services are doing relatively well, even if a downward adjustment of financial services is likely. Tourism has remained a stable share of GDP for the past 10 years, even if tourism exports have somewhat weakened lately. Financial services exports have declined relative to GDP from the pre-crisis peak, which could be partly due to a cyclical or a more structural adjustment. But Switzerland’s share of world financial services has also been on a medium-term downward trend since 2000.

uA01fig06

Net Exports of Financial Services

(Share) 1/

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Source: International Financial Statistics.1/ share of total (Hong-Kong, Luxembourg, Singapore, Switzerland, United Kingdom, United States)

C. Impact of the Exchange Rate on Export Performance

Estimates of Aggregate Price Elasticity

11. We estimate a standard error-correction model linking export volumes to foreign demand and relative prices. Following the existing literature (see e.g., Bayoumi, 1998; Hooper, Johnson and Marquez, 1998), export volumes (X) are determined by the real effective exchange rate—split into the nominal effective exchange rate (NEER) and relative price level (RelCPI)—and foreign demand (Demand*).12 The error correction model is estimated at a quarterly frequency for exports of goods and exports of services, and at various lags, with all variables expressed in logs, according to the following error-correction specification, where the “long-run” elasticity is given by aNλN:

ΔXt=α+(+Σj=1N1λtj.ΔXtj+Σj=0N1aj.ΔNEERtj+Σj=0N1bj.ΔRelCPItj+Σj=0N1cj.ΔDemandtj*)+(λN.XtN+aN.NEERtN+bN.RealCPItN+cN.Demand   tN*)+εt(1)

12. Specification tests suggest that a co-integration approach is appropriate, implying the existence of a long-term relationship between the variables considered. Dickey-Fuller tests do not reject the null hypothesis of unit roots in most cases, whether a trend is included or not. Johansen tests confirm the existence of a co-integrating vector (see appendix tables).

Unit Root Tests

article image
Note: Augmented Dickey-Fuller unit-root test on log of X with and without a time trend (H0: unit root), Dickey-Fuller test statistic and MacKinnon approximate p-value are reported

Real domestic demand, weighted by trade exports to advanced economies (source: GEE)

Co-Integration Tests

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Note: Johansen tests for cointegration with 2 lags; model 1 includes NEER, relative prices, real foreign demand; model 2 includes NEER, relative prices, real foreign demand and real GDP.

Cointegration rank based on 5 percent critical values.

13. Long-run price elasticities of aggregate exports of goods are economically significant. Estimated elasticities of exports of goods with respect to the NEER vary between -90 percent and -130 percent, while relative price level elasticities are even larger between -158 percent and -185 percent.13 Hence a 10 percent appreciation of the nominal effective exchange rate will result in a 9 percent decline in export volume. By contrast, exports of services are not significantly correlated with fluctuations of the NEER.14

Table 1.

Long-Run Relationships at Various Lags

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Newey-West Standard errors in parentheses; *** p<0.01, ** p<0.05, * p<0.1.

14. The short-term dynamics suggests that the impact of relative prices on exports of goods materializes relatively fast. After two quarters, about half of the long-run effect has affected export volumes.

uA01fig07

Elasticity of Exports of Goods

(Percent)

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Source: IMF staff calculations.

Export Performance by Destination

15. Advanced countries remain the main destination of Swiss exports, but large emerging markets are becoming important trading partners. Switzerland’s largest trading partner is the euro area, with links especially tight with Germany. But emerging markets, in particular the “BRICs” (Brazil, Russia, India and particularly China) are the fastest growing markets for Swiss exports. While Switzerland has a structural trade deficit with the euro area, it enjoys a growing trade surplus with other advanced economies and emerging markets, which bodes well for future trade balances.

Geographical Composition of Trade in Goods

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Source: IMF Direction of Trade StatisticsNote: share of trade among 20 largest trading partners

Bilateral trade balances

(in percent of GDP)

article image
Sources: DTS and WEONote: only top 20 trading partners

16. Given the growing importance of new export markets, it is important to assess elasticities by destination of exports. We estimate a long-run cointegration relationship based on equation (1), with exports of goods broken down by country of destination.15 We consider the following specification, where Exportit is total bilateral exports of Switzerland to trading partner i during year t, RERit is the bilateral CPI-based real exchange rate between Switzerland and country i, and DomDemandit is total domestic demand of trading partner i, fi is a set of country fixed effects, dt is a set of year dummies and εit is a residual.16

log(Exportit)=α+β.log(RERit)+δ.log(DomDemandit)+fi+di+εit(2)

17. Swiss exports to non-euro area countries are sensitive to bilateral real exchange rates movements, but exports to individual euro area countries are not.17 The exchange rate elasticity of exports to non-euro area is estimated at 70 percent; in contrast, the point estimate of the RER elasticity of exports to individual euro area countries is very small (0.4 percent).18 Exports to euro area countries—which account for about 60 percent of Swiss exports—are therefore only sensitive to the domestic demand of trading partners. The difference in price elasticities could reflect differences in the types of goods exported, in pricing behavior, or in the characteristics of demand in destination markets, but it could also be because the Swiss franc has remained somewhat stable against the euro during the period studied, making it difficult to assess how exports would be affected by large exchange rate movements.

Bilateral Export Regressions

article image
Robust pval in parentheses*** p<0.01, ** p<0.05, * p<0.1

18. To further our understanding, we estimate elasticities specific to emerging markets and other advanced economies. Results reported in the appendix table show that price elasticities of exports are the largest for exports to the BRICs, and exports to other emerging markets.19 Price elasticities are sometimes significant for exports to the U.S., the U.K., Canada and Australia, but this finding lacks robustness.

19. The composition of exports varies significantly across countries. Exports to the euro area are very diversified, ranging from pharmaceutical products (classified in the “chemicals” category), various manufactured goods such as machinery and equipments, and watches and precision instruments (classified in “miscellaneous manufactured articles”). Other advanced economies—in particular the U.S.—import a larger share of pharmaceutical products than other countries. The BRIC import a large share of machinery and equipment than other countries. Finally, watches and clocks are a large share of exports to other emerging markets.

uA01fig08

Sectoral Breakdown of Exports by Destination

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Source: World Integrated Trade System (2009).

20. In spite of differences in the composition of exports by destination, the type of goods exported does not explain differences in exchange rate elasticities. A regression analysis based on a specification similar to equation (2), but with a sectoral breakdown of exports, does not reveal any clear pattern in real exchange rate elasticities across sectors. Thus, alternative explanations—such as different pricing strategies across different markets, or characteristics of demand—are more plausible explanations for the differences in exchange rate elasticities by destination markets.

D. Estimates of Exchange Rate Pass-Through

Empirical Approach

21. A micro-founded model of export pricing behavior predicts a relationship between the price level and the exchange rate. The import price index of a country is a weighted average of export prices of trading partners expressed in domestic currency. Export prices in turn depend on marginal costs and on mark-ups of producers. The marginal cost depends on foreign wages, which we approximate with foreign price levels, and demand conditions, proxied by the real GDP of the import market; the mark-up is assumed to be a function of the exchange rate and of other, non-observable factors.20

22. The empirical specification is a standard error-correction model of domestic prices estimated at various lags. We estimate the pass-through for two key price indices: the consumer price index (excluding energy, food, and administered prices), and the import price index. Explanatory variables include the nominal effective exchange rate (NEER), real GDP (RealGDP) and the price level of trading partners (PX).21 Formally, the model, estimated at a quarterly frequency and at N lags, is given by the following equation, where the long-run exchange rate pass-through is given by aNλN

Δpt=α+(+Σj=1N1λtj.Δptj+Σj=0N1aj.NEERtj+Σj=0N1bj.RealGDPtj+Σj=0N1cj.PXtj)+(λN.ptN+aN.NEERtN+bN.RealGDPtN+cN.PXtj)+εt

E. Findings

23. Specification tests suggest that a co-integration approach is appropriate, implying the existence of a long-term relationship between the variables considered. Dickey-Fuller tests do not reject the null hypothesis of unit roots in almost all cases, whether a trend is included or not.22 Moreover, Johansen tests confirm the existence of a co-integrating vector between the domestic price index, the nominal effective exchange rate, the foreign price level, and real GDP.

Unit Root Tests

article image
Note: Augmented Dickey-Fuller unit-root test on log of variable, with and without a time trend (H0: unit root), Dickey-Fuller test statistic and MacKinnon approximate p-value are reported. All variables at monthly frequency, except real GDP (quarterly).

Co-Integration Tests

article image
Note: Johansen trace tests for cointegration with 2, 4, 5 and 6 lags; the model includes REER, real GDP, and trading partners’ prices.

Cointegration rank based on 5 percent critical values.

24. The long-run pass-through is typically low for the consumer price index, but noticeable for import prices. Error-correction models estimated at various lags (from 2 quarters to 6 quarters) suggest that the long-run exchange rate pass-through for core CPI is very low ranging from 2 percent to 4.7 percent. It is also very low—but very imprecisely estimated—for the headline CPI. In contrast, the exchange rate pass-through is typically much larger for import prices (after accounting for the effect of oil prices), ranging between 31 percent, to 56 percent within 6 quarters, but is also imprecisely estimated.23 Short-term dynamics suggest that the effect on import prices materializes mainly after 3 quarters.

Estimates of Long-Run Pass-Through

article image
Newey-West robust standard errors in parentheses, *** p<0.01, ** p<0.05, * p<0.1

Error correction model also includes log of oil prices assuming pass-through of oil prices occurs during the same quarter.

Short-Term Dynamics

uA01fig09

Exchange Rate Pass-through (cummulative response)

(In percent)

Citation: IMF Staff Country Reports 2011, 116; 10.5089/9781455284610.002.A001

Source: Author’s calculations

F. Concluding Remarks

25. Based on past experience, the recent appreciation of the Swiss franc is unlikely to cause significant deflationary pressures, but it may result in a reduction in the external trade surplus. Given the low short-run and “long-run” exchange rate pass-through for the CPI, an appreciation of the Swiss franc is unlikely to exert major downward pressure on domestic prices. For example, the estimated pass-through at four quarters (respectively six quarters) implies that a 20 percent nominal effective appreciation of the Swiss franc would result in a 0.02 percent decline (respectively 0.66 percent decline) in overall CPI. This suggests that deflationary mechanisms would be unlikely to materialize as a result of a nominal appreciation. However, the large exchange rate pass-through of import prices tends to suggest that exchange rate movements would result in expenditure switching effects for imported goods and therefore have an impact on the external balance of Switzerland, in spite of a low pass-through to the consumer price index.

26. Swiss exports have so far remained competitive even if the real effective exchange rate appreciation was sustained. The growing importance of large emerging markets in the world economy has benefited Swiss exporters, contributing to a growing trade surplus which bodes well for the future. However, significant elasticities with respect to the exchange rate—that could reflect different pricing strategies or characteristics of demand in export markets—could dent export volumes in these markets, unless productivity is fostered. In contrast, exports to advanced economies might be less likely to be affected by exchange rate fluctuations.

References

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Annex 1 Export Regressions Country Sample

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Export Regressions

(by destinations)

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Robust pval in parentheses*** p<0.01, ** p<0.05, * p<0.1
1

Prepared by Thierry Tressel (EUR). We are very grateful to our colleagues from the Swiss National Bank for useful exchange of views and comments, including in particular Thomas Moser, Tommaso Mancini, and Caroline Schmidt.

2

The Marshall-Lerner condition.

3

The argument was put forward by Milton Friedman (1953): “A rise in the exchange rate …makes foreign goods cheaper in terms of domestic currency, even though their prices are unchanged in terms of their own currency, and domestic goods more expensive in terms of foreign currency, even though their prices are unchanged in terms of domestic currency. This tends to increase imports [and] reduce exports”.

4

Monacelli (2005) develops a model of monetary policy in an open economy with low exchange rate pass-through.

5

The estimated export elasticities are somewhat smaller than estimates for other advanced economies (Hooper et. al., 1998).

6

A study by the SNB in contrast finds significant exchange rate elasticity for exports to euro area countries, and in particular to Germany. The difference in the findings could be explained by the use of bilateral quarterly data and of trading partner’s GDP growth as a proxy for foreign demand.

7

Jonas Stulz, 2007, “Exchange rate pass-through in Switzerland: Evidence from vector auto regressions”, Swiss National Bank Economic Studies No. 4 2007. The exchange rate pass-through to consumer price is found to be low (0.02) for the post-1993 period. Recent inflation figures, on the contrary, seem to imply a large pass-through, but this could reflect price movements of specific goods. Amstad and Fischer (2010) find a pass-through from import prices to CPI of 0.3.

8

See Choudhri, Faruqee and Hakura (2005) for evidence that low pass-through may be attributable to sticky prices and LCP. Berman et al. (2009) present a theory of how pricing to market by exporters depend on distribution costs and on their productivity.

9

In other words, there may not be one single international price for all goods, and price discrimination may be more likely when there is not a single “international price”.

10

The import price index also includes goods used as intermediate products in production.

11

A recent study by the Swiss mechanical and electrical engineering industries found that a significant share of surveyed firms have reduced their profit margins in response to the appreciation of the Swiss Franc. The January and February survey of the SNB also found that manufacturing firms suffered from the appreciated currency and adapted by reducing margins (Swiss National Bank Quarterly Bulletin, March 2011).

12

Export volumes are from the World Economic Outlook (October 2010), the REER, NEER and relative CPI from the INS, and trading partners’ demand is proxied by advanced countries domestic demand from the GEE. A higher NEER/REER corresponds to an appreciation. The specification follows Campa and Goldberg (2005) in estimating different elasticities for the NEER and relative CPI, instead of a single REER elasticity. The relative CPI is a proxy for the production costs relative to trading partners.

13

In unreported regressions, we show that the elasticity to the REER is broadly of the same order of magnitude.

14

This model tends to underestimate the export performance observed during the post crisis period.

15

The sample of countries includes all countries that were among the top 20 largest export destinations for any year during 1990–2009 (see appendix table for the list of countries). Nominal exports are from the Direction of Trade Statistics, and are deflated by the aggregated export deflator (WEO), the bilateral real exchange rate is constructed from IFS and WEO data, and total domestic demand in constant price is from the WEO. Bilateral exchange rates follow the convention that a higher real exchange rate corresponds to depreciation.

16

Standard errors are clustered by country to correct for potential serial correlation of the error term.

17

Import regressions were also estimated. We found that imports are not significantly correlated with exchange rate fluctuations.

18

Findings are similar to estimates for euro area countries (see for instance, Chen, Milesi-Ferretti and Tressel (2010).

19

Other emerging markets include Korea, Thailand, Singapore and Vietnam.

20

A similar theoretical approach is found in Campa and Goldberg (2005).

21

The CPI index and the import price index are from the Swiss Federal Statistical Office, real GDP from the State Secretariat for Economic Affairs, and the REER and NEER from the INS. The foreign price level is defined as: pj=CPICHE.NEERREER. Data are at a quarterly frequency over 1980Q1–2010Q3.

22

The test however rejects the null hypothesis in a few cases, including for core inflation and foreign prices when a trend is included.

23

Such estimates are of the same order of magnitude as those typically found in the literature (see Campa and Goldberg, 2005).

Annex 1: Selected Country Examples for Macroprudential Tools

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Source: Western Hemisphere Regional Economic Outlook, IMF, October 2010.

Annex 2: Selected Country Examples for Macroprudential Mandates

European Union—A European Systemic Risk Board has been established comprising EU and national central bankers and financial sector supervisor, chaired by the ECB President, responsible for monitoring the financial system, identifying and prioritizing systemic risk, issuing risk warnings and recommendations to competent agencies and the Ecofin Council and monitoring the follow-up to such warnings and recommendations. The legal framework is silent on the scope of requirements that could be covered in the recommendations. Regulatory authority remains with the competent EU and national agencies.

United States of America—A Financial Stability Oversight Council has been established comprising Treasury (chair), the Fed, and relevant federal financial sector supervisors, with a view to identifying systemically important financial entities and systemically risky market activities, and issuing non-binding recommendations to competent authorities, which should comply or explain. The Fed has regulatory and supervisory powers over the systemic entities subject to enhanced supervision, and a back-up authority regarding systemic activities. The legal framework details enhanced prudential standards and the powers of the Fed and other competent agencies. The affirmative vote of Treasury is required for critical decisions.

United Kingdom—In 2009 the BoE was given a financial stability objective next to its existing monetary stability objective; however, without new powers. Currently, the U.K. is in the process of integrating financial sector supervision into the BoE. A new Prudential Regulatory Agency (PRA) will be established as a subsidiary of BoE with its own Board chaired by the BoE Governor and a BoE Deputy Governor as its CEO. In addition, a Financial Policy Committee within the BoE chaired by the BoE Governor will be provided with macroprudential tools aimed at financial stability. The PRA and, where relevant, a new Financial Conduct Authority will implement these tools.

France—A new unified financial sector prudential oversight agency (the Prudential Control Authority) has been established chaired by the BdF Governor—and staffed mainly by the central bank—with objectives that include financial stability.

Italy—Three “credit authorities” must take into account, inter alia, the overall stability of the financial system. These authorities are an Inter-Ministerial Committee (chaired by the Minister), the Ministry of Economy and Finance, and the Bank of Italy. The latter formulates proposals for the Committee and implements its decisions; constituent agencies are legally required to cooperate, including through exchange of information. In March 2008, a Committee for the Safeguard of Financial Stability was established through a protocol. The Committee, comprising the Ministry, the Bank of Italy, and the securities and insurance supervisors, assesses financial system risks and vulnerabilities, and promotes crisis prevention and preparedness.

Malaysia—The Central Bank of Malaysia’s (CBM) objectives are monetary and financial stability. It is fully in charge of prudential regulation and supervision, and has broad powers to act in case of systemic risk provided that the Financial Stability Executive Committee (FSEC) chaired by the CBM Governor and including the Ministry of Finance approves such action. In addition to approving or revising regulatory and supervisory action in case of systemic risk, the FSEC decides on liquidity assistance and solvency support.

Annex 3: Possible Swiss Macroprudential Mandates & Institutional Arrangement

1

Prepared by Atilla Arda (LEG). We are very grateful to the authorities for useful discussions, including in particular Hans Kuhn, Oliver Wünsch, and Dina Beti.

2

This Note does not discuss crisis management and resolution frameworks. Neither does it discuss other components of what is called macroprudential policies, e.g., tax and fiscal policies, and capital control.

3

Macroprudential Policy—An Organizing Framework, IMF, March 2011.

4

For purposes of this Note, ‘oversight’ includes regulation (i.e., setting rules and standards), supervision (i.e., enforcement of rules and standards) and the policies informing regulation and supervision.

5

The following caveats should be made: (i) the survey does not distinguish between central banks that are solely or primarily responsible for monetary policy and central banks that are also banking or financial sector supervisors, and (ii) the survey does not clarify the nature of the financial stability mandate vested in central banks.

6

This was also stressed by the Group of Thirty in its report ‘Enhancing Financial Stability and Resilience: Macroprudential Policy, Tools and Systems for the Future’ (October 2010) The legal framework of central banks should be clear with respect to the objectives of monetary policy and macroprudential policy. It may be necessary to assign both policy areas a primary objective, e.g., price stability for monetary policy and financial stability for macroprudential policy, clearly distinguishing between the policy tools available for these distinct policies.

7

In addition, one could argue that ministries of finance need to be involved in such policy committee, because in the end they will be responsible for recapitalization/bail-out of insolvent systemic financial institutions.

8

Moreover, the aim of financial market supervision and FINMA’s purpose also informs FINMA’s decision whether it may refuse sharing information with SNB. (Article 40 of the FINMA Act) See further paragraph 20 of this Note.

9

As explained in paragraph 6, for purposes of this Note the term ‘mandate’ includes a consistent set of objectives, functions, and instrument/powers.

10

According to the explanatory note accompanying the SNB Act, the clause “serving the interest of the country as a whole” (i) clarifies that the integration of SNB’s monetary policy in the general economic policy of the federal government, (ii) shows that SNB must ensure optimal monetary conditions for the economy, (iii) indicates that SNB must bridge, in the interest of the country as a whole, any conflict between its price stability objective and economic developments, and (iv) stresses that SNB’s monetary policy must be based on the needs of the Swiss economy as a whole and not on the problems of individual regions. (paragraph 2.1.5.2.1, page 6179/6180).

11

See also the explanatory note accompanying the TBTF proposals. (paragraph 2.1.3, page 24).

12

For purposes of this Note the terms ‘function’ and ‘task’ are interchangeable—the author prefers the former term.

13

While the German and Italian versions of the SNB Act use the clause “in diesem Rahmen” and “entro questo ambito,” respectively, which can be translated as “within this framework,” the French version of the Act uses the clause “dans les limites ainsi fixées,” which can be translated as “within these set limits.” Both “framework” and “limits” refer to the SNB’s price stability objective.

14

Articles 6 and 9 of the SNB Act refer to the tasks listed in Article 5 as “monetary tasks.”

15

Paragraph 1.5.6.1, page 6136.

16

Paragraph 2.1.4.3.5, page 6186.

17

See in particulars paragraph 1.5.6.6.3.2, page 6171 and paragraph 2.1.5.3.3, page 6185.

18

That is not to say that price stability does not contribute to financial stability, but the SNB Act only acknowledges and regulates how financial stability supports price stability.

19

Article 19 of the SNB Act authorizes SNB to oversee payment and securities clearing and settlement systems “in order to protect the stability of the financial system.” SNB’s oversight also extends to “payment and securities settlement systems whose operators are domiciled abroad, provided that substantial parts of the operation or leading participants are located in Switzerland.”

20

Article 20 of the SNB Act. These minimum requirements—laid down in an SNB Ordinance—“may in particular relate to the organizational basis, the terms and conditions of business, operational security, participants’ access to the system, the implications of a system participant’s payment difficulties and the payment instrument used.”

21

The SNB Act does not explicitly regulate SNB’s LLR function. Instead, Article 9.1.e authorizes SNB to provide credit to banks and other financial market participants. According to the explanatory note this is the legal basis for SNB’s LLR function. (paragraph 2.2.2.6, page 6199) See also Section 6, page 6 of SNB’s Guidelines on Monetary Policy Instruments for a discussion of its emergency lending assistance (ELA). The tension between ELA and monetary policy objectives is illustrated by the warning in the explanatory note, (paragraph 2.1.4.3.5, page 6186) cautioning that money creation through liquidity operations for financial stability purposes could jeopardize monetary policies aimed at price stability.

22

Articles 14 and 15 of the SNB Act.

23

Article 7 of the MoU between FINMA and SNB provides that “SNB may carry out its own enquiries with systemically important banks, and may request that these banks provide information.” However, this authority is not supported by the SNB Act and a MoU cannot create legal powers, which is also confirmed by Article 1(2).

24

Article 12 of the SNB Act.

25

Article 10 of the SNB Act. See also paragraph 2.2.3, page 6200 of the explanatory note.

26

Article 1.1 of the FINMA Act. English versions of only the FINMA Act and the Anti-Money Laundering Act were available to the author; translations of provisions from other legislation are by the author. Insurance Supervision Act (Article 1): “protecting insured persons against insolvency of insurance undertakings and abuse.” Collective Investments Act (Article 1): “protecting investors as well as transparency and proper functioning of markets for collective investments schemes.” Stock Market Act (Article 1): “ensuring transparency and equal treatment of investors …ensuring proper functioning of the stock exchange.” The Banking Act, the Insurance Contracts Act, the Anti-Money Laundering Act, and the Mortgage Bond Act do not contain any specific objective.

27

This appears to be based on the French and Italian versions of the FINMA Act, both using the terms ‘protecting’ and ‘ensuring’ distinctly: ‘protéger …les créanciers, les investisseurs et les assurés, et d’assurer le bon fonctionnement des marchés financiers’ and ‘protezione dei creditori, degli investitori e degli assicurati, nonché la tutela della funzionalità dei mercati finanziari.’ The German version uses twice the term ‘protecting:’ ‘Schutz der Gläubigerinnen und Gläubiger, der Anlegerinnen und Anleger, der Versicherten sowie den Schutz der Funktionsfähigkeit der Finanzmärkte.’

28

Explanatory note accompanying the FINMA Act, paragraph 2.1, pages 2859/2860.

29

Neither the FINMA Act nor the explanatory note distinguishes between different types of creditors (e.g., depositors and bond holders).

30

Paragraph 2.1, pages 2859/2860.

31

FINMA’s focus on the risks incurred by supervised entities—as opposed to the risks caused to the system by supervised entities—can also be found in Article 7.2.c of the FINMA Act. This provision establishes that FINMA in using its regulatory powers should take into account, inter alia, “the various business activities and risks incurred by the supervised persons and entities.” Consequently, FINMA can use its powers related to capital, liquidity, risk diversification, corporate governance, business models, etc. only to ensure the soundness of the individual financial institution and not to protect the financial system as a whole.

32

Paragraph 2.8.2.1.1, page 6277 of the explanatory note to the SNB Act states, when clarifying Article 1bis of the Banking Act, which was introduced by the SNB Act, that oversight over payment and securities settlement systems is based on a division of labor between SNB and EBK (i.e., FINMA’s predecessor): SNB oversees these systems with a view to ensuring financial stability and EBK exercises microprudential supervision over the system operators. In the same vein, paragraph 2 of Article 2 of the MoU between FINMA and SNB (“the bilateral MoU”) provides that SNB “monitors developments in the banking sector from the perspective of the system as a whole,” while paragraph 5 states that FINMA “monitors developments at the institutions being supervised and in the financial markets from the perspective of the individual banks and financial groups.”

33

Article 29 of the FINMA Act.

34

Article 24 of the FINMA Act.

35

Article 7 of the FINMA Act.

36

The Report of the Control Committees of the Federal Assembly raises the concern of the Swiss authorities’ ability to detect financial market crises being impaired by “the lack of follow-up of their own criticisms and the lack of a critical attitude on the part of all the authorities involved”. In the same vein, a report by FINMA on ‘Financial Market Crisis and Financial Market Supervision’ refers to the warnings issued by SNB in its financial stability reports about the high level of debt of Switzerland’s large banks in terms of their unweighted capital ratio upon which SFBC (FINMA’s predecessor) reportedly decided, given the lack of internationally agreed standards, not to act.

37

The macroprudential proposals by Mr. Jordan, SNB Vice-Chairman in his remarks of December 16, 2010 would appear to require a revision of the existing legislation.

38

Article 50 SNB Act.

39

Article 23bis (3) of the Banking Act, Article 80 of the Insurance Supervision Act, and Article 34bis(1) of the Stock Market Act.

40

The areas of common interest are as follows: (i) assessment of the soundness of systemically important banks and/or the banking system; (ii) regulations that have a major impact on the soundness of banks—including liquidity, capital adequacy and risk distribution provisions, where they are of relevance for financial stability; and (iii) contingency planning and crisis management.

41

The Steering Committee meets at the least twice a year and the Standing Committee at the least four times a year. (Articles 4(3) and 4(6) of the bilateral MoU).

42

Article 23bis (4) of the Banking Act and Article 34bis(2) of the Stock Market Act.

43

The SNB Act includes the power to impose minimum reserves requirement under the heading ‘Monetary policy powers’ and the explanatory note (paragraph 2.3.2.1.2, pages 6212/6213) confirms that this is a monetary policy instrument.

44

Interestingly, Article 15(3) of the SNB Act, while giving SNB the authority to regulate the statistical date provision to SNB by financial institution, this provision does not require SNB to consult with FINMA.

45

Under the comply-or-explain principle the agency receiving recommendations should either comply with these recommendations or (publicly) explain why it does not comply (in full) therewith.

46

Article 14(2) of the SNB Act.

47

Article 1(3) of the bilateral MoU.

48

The TBTF legislation follows a proposal from the Swiss Commission of Experts for Limiting the Economic Risks Posed by Large Companies.

49

Paragraph 2.1.2, page 24.

50

It should be noted that the autonomy of SNB with respect to monetary policy is enshrined in Article 99 of the Federal Constitution: “[SNB] as an independent central bank, shall pursue a monetary policy.”

51

In this context, cooperation would facilitate the exercise by SNB and FINMA of their respective current responsibilities; a different issue relates to cooperation mechanisms for the performance of macroprudential oversight.

52

Paragraph 1.4.3, page 13.

Switzerland: Selected Issues Paper
Author: International Monetary Fund