Switzerland: Staff Report for the 2015 Article IV Consultation

KEY ISSUES Switzerland has once again had to contend with capital flow volatility. Following the exit from the exchange rate floor in mid-January 2015 and the subsequent appreciation of the franc, the Swiss economy faces exchange rate overvaluation, slower near-term growth, and deflation. Both growth and inflation are expected to recover gradually over the medium term—to around 2 percent and 1 percent, respectively—as the economy adjusts to the shock. However, this relatively benign scenario is subject to important risks, most notably that operating in a low inflation environment may prove more difficult than assumed in the central scenario. Monetary and fiscal policies can support faster adjustment and reduce risks. Further monetary easing via purchases of (mainly foreign) assets would help limit the near-term growth slowdown, reduce risks related to low inflation, and lessen franc overvaluation. Central bank communication should also be geared toward building an understanding of policy objectives and ensuring that inflation expectations do not become entrenched at low levels. Scope for fiscal policy to support aggregate demand is limited by Switzerland’s fiscal rule and the small, open nature of Switzerland’s economy. That said, fiscal policy can still support recovery by allowing automatic stabilizers to operate freely, as allowed under the rule. The rule’s escape clause should be triggered in the event of a severe downturn to allow discretionary fiscal stimulus, as monetary policy would likely be overburdened in such a scenario. The financial sector reform agenda should also be completed. The Swiss authorities have made important progress in this regard, and further steps are planned. Specific priorities, as laid out in last year’s Financial Sector Assessment Program (FSAP) update, include raising the leverage ratios of the two large international banks, increasing public disclosure of information on risk weights, reforming FINMA’s use of external auditors, overhauling deposit insurance, and containing housing- and mortgage-related risks. Over the medium term, Switzerland faces a number of structural challenges; the authorities’ ongoing efforts to address them are welcome and should continue. Priorities include adopting proposed pension reforms to ensure the sustainability of the system for future generations; completing ongoing reforms of corporate taxation and financial controls in ways that ensure full compliance with international initiatives aimed at limiting money laundering and cross-border tax evasion and avoidance; and reducing uncertainties related to future immigration policies and relations with the European Union.

Abstract

KEY ISSUES Switzerland has once again had to contend with capital flow volatility. Following the exit from the exchange rate floor in mid-January 2015 and the subsequent appreciation of the franc, the Swiss economy faces exchange rate overvaluation, slower near-term growth, and deflation. Both growth and inflation are expected to recover gradually over the medium term—to around 2 percent and 1 percent, respectively—as the economy adjusts to the shock. However, this relatively benign scenario is subject to important risks, most notably that operating in a low inflation environment may prove more difficult than assumed in the central scenario. Monetary and fiscal policies can support faster adjustment and reduce risks. Further monetary easing via purchases of (mainly foreign) assets would help limit the near-term growth slowdown, reduce risks related to low inflation, and lessen franc overvaluation. Central bank communication should also be geared toward building an understanding of policy objectives and ensuring that inflation expectations do not become entrenched at low levels. Scope for fiscal policy to support aggregate demand is limited by Switzerland’s fiscal rule and the small, open nature of Switzerland’s economy. That said, fiscal policy can still support recovery by allowing automatic stabilizers to operate freely, as allowed under the rule. The rule’s escape clause should be triggered in the event of a severe downturn to allow discretionary fiscal stimulus, as monetary policy would likely be overburdened in such a scenario. The financial sector reform agenda should also be completed. The Swiss authorities have made important progress in this regard, and further steps are planned. Specific priorities, as laid out in last year’s Financial Sector Assessment Program (FSAP) update, include raising the leverage ratios of the two large international banks, increasing public disclosure of information on risk weights, reforming FINMA’s use of external auditors, overhauling deposit insurance, and containing housing- and mortgage-related risks. Over the medium term, Switzerland faces a number of structural challenges; the authorities’ ongoing efforts to address them are welcome and should continue. Priorities include adopting proposed pension reforms to ensure the sustainability of the system for future generations; completing ongoing reforms of corporate taxation and financial controls in ways that ensure full compliance with international initiatives aimed at limiting money laundering and cross-border tax evasion and avoidance; and reducing uncertainties related to future immigration policies and relations with the European Union.

Macroeconomic Context

Switzerland has once again had to contend with capital flow volatility. Following the exit from the exchange rate floor and the subsequent appreciation of the franc, the Swiss economy faces exchange rate overvaluation, slower near-term growth, and deflation. Both growth and inflation are expected to recover gradually over the medium term, to around 2 percent and 1 percent, respectively. However, this relatively benign scenario is subject to important risks, most notably that operating in a low inflation environment may prove more difficult than assumed in the central scenario.

A. Recent Developments

1. The Swiss economy grew steadily in 2014. Output expanded by 2.0 percent, driven by strong external demand and private consumption (Table 1, Figures 12). Solid growth narrowed the output gap to around -0.3 percent, with capacity utilization nearing its historic average. The unemployment rate stabilized at 3.2 percent.

Table 1.

Switzerland: Selected Economic Indicators, 2010–18

article image
Sources: Haver Analytics; IMF’s Information Notice System; Swiss National Bank; and IMF Staff estimates.

Contribution to growth.

Reflects new GFSM 2001 methodology, which values debt at market prices. Calculated as the sum of Federal, Cantonal, Municipal and Social security gross debts.

Based on relative consumer prices.

Figure 1.
Figure 1.

Switzerland: The Long View, 2000–15

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Haver Analytics; Information Notice System; State Secretariat for Economic Affairs; and Swiss National Bank.
Figure 2.
Figure 2.

Switzerland: Recent Economic Developments, 2011–14

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Haver Analytics; Swiss Federal Statistical Office; Swiss Institutefor Business Cycle Research; and Swiss National Bank.

2. In 2015, the outlook shifted following the exit from the exchange rate floor.

  • The floor of 1.2 francs per euro, which had been in place since 2011, faced little pressure for most of 2013–14. However, in late 2014 the Swiss National Bank (SNB) started intervening heavily to defend the floor in response to increased capital inflows arising from a combination of events, including anticipation of the European Central Bank’s quantitative easing program and geopolitical turmoil in Europe. In response, in December 2014 the SNB announced a cut in the interest rate on SNB deposits from zero to -0.25 percent (effective January 22, 2015), but significant interventions were still required to maintain the exchange rate floor.

  • At the same time, the franc’s depreciation against the dollar since mid-2014 had reduced the likelihood of franc overvaluation, raising risks that further intervention would ultimately result in losses on the SNB’s balance sheet, which was approaching 90 percent of GDP. In addition, the SNB was concerned that, once the magnitude of its interventions became public, speculation about exit from the floor would mount, fueling a vicious cycle of rising inflows and a rapidly growing balance sheet.

  • In this context, the SNB decided that the costs of maintaining the floor were no longer worth its benefits. The SNB thus exited from the floor on January 15, 2015. It also announced a cut in its effective policy rate from -0.25 percent to -0.75 percent (effective January 22, 2015). The policy rate applies on deposits at the SNB that exceed a high threshold (for domestic banks, the threshold is 20 times a bank’s required reserves as of the reporting period ending November 19, 2014; minus (plus) any increase (decrease) in cash held). In this way, the effect of negative interest rates on bank profits is limited, while still creating incentives at the margin for agents to shift out of franc deposits and thereby depreciate the franc.

  • Following significant intervention (purchases of roughly CHF 40 billion,1 or 6 percent of GDP) during the subsequent two weeks, the franc has since hovered between 1.00 and 1.10 per euro, with limited intervention since end-January.

3. Following the appreciation, near-term growth indicators have weakened. After exhibiting modest growth during 2012–14, KOF survey indexes of the current and future business climate have declined sharply following the exit from the exchange rate floor, as has manufacturing PMI. The current climate index has sunk to its lowest level since the 2009 recession.

4. Inflation has fallen deeper into negative territory. The strong franc, together with lower oil prices, drove headline CPI inflation down to -0.9 percent in March 2015, with positive inflation for domestically produced goods (0.3 percent) being more than offset by sharply negative inflation for foreign goods (-4.3 percent). Measures of underlying inflationary pressures were similarly contained at end-March—core inflation was -0.2 percent, and unit labor cost growth remained muted near zero (Figure 3).

Figure 3.
Figure 3.

Switzerland: Selected Monetary Indicators, 2010–14

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Haver Analytics; Swiss Federal Statistics Office; and Swiss National Bank.1/ Nominal rate minusinflation.
A01ufig1

Switzerland: KOF Business Survey Indices

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Source: Haver Analytics.

5. The initial effects from negative interest rates and the exit from the exchange rate floor on the financial sector appear to have been fairly limited. The stock market and stock prices for major banks have returned to levels similar to those before the immediate sharp drop following the exchange rate floor exit (Figures 4-5). Similarly, CDS spreads for the major banks have not moved much. However, it is too early to clearly see what the full effects will be. The large global banks foresee some fairly small negative effects, but are taking measures to adjust; some business segments will also benefit due to the increased FX market activity. The effect of negative interest rates on banks’ profits is mitigated by the fact that (i) the rate applies only on deposits at the SNB over a high threshold (20 times reserves) and (ii) banks are passing on the negative rates to wholesale depositors. However, these effects vary across banks, such that some specific smaller banks may be more adversely affected.

Figure 4.
Figure 4.

Switzerland: Selected Financial Indicators, 2010–15

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Bloomberg;and Datastream.
Figure 5.
Figure 5.

Switzerland: Indicators for Global Systemic Banks, 2006–151

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Bankscope; Bloomberg; and IMF staff calculations.1/ Switzerland numbers are for Credit Suisse and UBS. “Other”includes Citigroup, Deutsche Bank, HSBC, JP Morgan Chase, Barclays, BNP, Bank of America, New York Mellon, Goldman Sachs, Mitsubishi, Morgan Stanley, Royal Bank of Scotland, Bank of China, BBVA, BPCE, Crédit Agricole, ING, Mizuho, Nordea, Santander, Société Générale, Standard Chartered, State Street, Sumitomo, UniCredit, Wells Fargo, Commerzbank, and Lloyds.
A01ufig2

Switzerland: Retail Deposit Interest Rates

(Percent)

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Source: Swiss National Bank.

6. The most affected parts of the financial sector are likely life insurers and private banks.

  • Life insurers have been under pressure due to a low-yield environment for several years now, forcing them to make significant adjustments. As a result, they actually recorded stronger positions, on average, in FINMA’s latest Solvency Stress Test (based on end-2013 data) relative to two years earlier. Still, the recent drop in yields will create further challenges for life insurers, and the authorities should remain vigilant and support consolidation as needed.

  • The same applies to private banks, which have significant revenue in foreign currency, but most of their costs in Swiss franc. Moreover, private banks were already facing pressure from international initiatives aimed at increasing transparency (e.g., the automatic exchange of tax information and AML/CFT-related initiatives). So far, the fallout on smaller Swiss private banks from the policy changes in 2015 appears to have been more limited than initially feared, but the situation must be continuously monitored.

7. The appreciation of the franc also had outward spillovers.

  • Franc appreciation affected several economies in Eastern Europe with a sizeable stock of franc-denominated housing loans, notably Croatia and Poland, where such loans accounted for 6.3 and 7.7 percent of GDP, respectively. In general, the immediate macroeconomic impact of the franc’s appreciation appears somewhat limited and is partly offset by lower franc interest rates; however, the Croatian government temporarily prevented pass-through to borrowers by fixing the applicable exchange rate at the pre-appreciation parity while a permanent solution is being negotiated between banks and borrowers. The contained effect is also partly due to actions by supervisors in some Eastern European countries to halt the provision of new franc-denominated mortgages in recent years and to manage related risks. Hungary mandated the conversion of all FX mortgages into domestic currency in November 2014.

  • The exit from the exchange rate floor might also have modest effects on aggregate demand in other countries. In particular, the appreciation of the franc might increase external demand in trading partners, though such effects are likely to be modest given the relatively small size of the Swiss economy (only 0.5 percent of global GDP on a PPP basis). Any positive effects on aggregate demand in trading partners may also be at least partially mitigated by higher interest rates in these countries due to lessened SNB intervention to defend the floor.

B. External Assessment

8. Switzerland has long run high current account surpluses. Over the last 15 years, Switzerland’s current account surplus has averaged around 10 percent of GDP (Table 2 and Figure 6). However, these surpluses are in some ways misleadingly high because they are driven by non-traditional flows, such as merchanting activities, commodity trading, financial and insurance services, and net FDI earnings (Annex 1), that are highly affected by the operations of large multinationals, financial firms, and wealthy foreigners for whom Switzerland is a desirable destination to centralize income and assets—reflecting Switzerland’s economic stability and tax competitiveness, among other factors—but whose savings may not be fundamentally Swiss. For example, Swiss multinational firms are often partly owned by foreigners through portfolio shares. Thus, a part of these companies’ retained earnings really belong to foreign shareholders, generating an upward statistical bias to the current account of about 3 percent of GDP. Similarly, Switzerland, like other low-tax economies that host large multinational corporations and their affiliates, is susceptible to attempts by those firms to minimize their taxes by booking profits in the country, thereby inflating net exports and net investment income, though such effects are difficult to quantify.

Table 2.

Switzerland: Balance of Payments, 2010–18

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Sources: Haver Analytics; Swiss National Bank; and IMF staff estimates.
Figure 6.
Figure 6.

Switzerland: External Accounts and Exchange Rates, 2000–14

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Swiss National Bank; and Haver Analytics.

9. Staff views Switzerland’s external position as having been broadly in line with fundamentals in 2014, though this assessment is subject to high uncertainty.

  • The External Balance Assessment’s (EBA) current account regression methodology suggests a current account norm for Switzerland of about 6¾ percent of GDP, reflecting Switzerland’s financial center structure, demographics, and high per capita income. This norm is slightly below preliminary estimates of Switzerland’s cyclically-adjusted current account surplus in 2014 (7½ percent of GDP), implying a slightly strong current account and slight undervaluation of the exchange rate.

  • However, the EBA methodology does not fully take into account the special factors and anomalies in Switzerland’s current account statistics discussed above. In addition, estimates of REER overvaluation in 2014 based on EBA methodologies (text table) suggest a moderate degree of overvaluation, not undervaluation. The lack of a trend in Switzerland’s net international investment position (NIIP) to GDP ratio over the last 10 years (Table 2) also suggests that Switzerland’s large current account surpluses do not result in explosive dynamics for the NIIP, whose large size is partly explained by the volatility of capital flows.2

  • Adjusting for these considerations, staff assesses a current account gap for 2014 centered close to zero. However, the uncertainty band is wide, with the estimated gap ranging from -3½ percent of GDP to 2½ percent of GDP, reflecting the significant uncertainty introduced by the various idiosyncrasies of Switzerland’s external statistics (Annex 1). Similarly, staff assesses the franc to have been broadly in line with fundamentals in 2014, with this assessment also subject to significant uncertainty.

Switzerland: EBA REER Analysis, 2014

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Source: Staff estimates.

10. The appreciation in early 2015 is likely to weaken the external position and to have left the franc overvalued. As of April 2015, the REER has appreciated by about 10 percent relative to its average 2014 value. This appreciation is likely to reduce net exports due to lessened competiveness and has likely left the franc overvalued. This overvaluation partly reflects a policy gap of insufficiently easy monetary policy—simple Taylor rules suggest an optimal policy rate well below current levels—which in turn reflects various operational challenges associated with unconventional monetary policy (see monetary policy discussion in the next main section).

A01ufig3

Real Effective Exchange Rates-Unit Labor Cost Basis

(January 2010=100)

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources IMF International Financial Statistics.

C. Outlook and Risks

11. The appreciated franc will weigh on growth during 2015–16, but the economy is expected to recover over the medium term. Staff and consensus forecasts expect real GDP growth to slow to around ¾ percent and 1¼ percent in 2015 and 2016, respectively, mainly due to weaker net exports (Table 1). Unemployment is expected to rise only modestly (peaking at 3½ percent in 2015), as widespread use of short-time working arrangements in Switzerland lessens the adverse impact of weaker demand on unemployment. The output gap, almost closed at end-2014, is projected to widen in 2015. Over the medium term, this gap is expected to close and growth is expected to rise gradually as the economy adjusts to the shock and as increasing divergence between Switzerland’s monetary policy stance and that of some other major advanced economies (due to a gradual increase in policy rates in the latter) helps ease appreciation pressure on the franc, supporting recovery of external demand.

12. Inflation is projected to trough in late 2015 before becoming slightly positive over the medium term.

  • Headline inflation is projected to fall near -1½ percent by late 2015, as the gradual pass-through from franc appreciation and lower commodity prices reaches peak effects. As these one-off effects dissipate, inflation is projected to gradually rise back into positive territory by early 2017.

  • Assessing where exactly inflation will stabilize in the medium term is difficult, in part due to the lack of market-based measures of inflation expectations. However, if one assumes that real yields are similar to those in other safe havens (Germany, UK), then Switzerland’s nominal government bond yields—which have recently set world-record lows (Figure 4)—imply that markets expect inflation to be roughly 1 percent 3–4 years from now.

  • Similarly, an analysis of the recent relationship between core inflation and the output gap shows that the Phillips curve crosses the vertical axis at around ½ percent, implying that steady-state inflation expectations are anchored around that level.

  • Taking both considerations into account and assuming unchanged monetary policy, staff project medium-term inflation in the range of ½-1 percent (Table 1), an outcome consistent with the SNB’s definition of price stability of “less than 2 percent” inflation.

A01ufig4

Switzerland: Core Inflation and Output Gap

(Correlations between CPI(t) and output gap(t-1), 2000–14)

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Source: IMF staff calculations.

13. However, this central scenario is subject to important risks (see Annex 2 for further discussion of key risks).

  • Risks related to low inflation. One key risk is that operating in an environment of very low inflation may prove more challenging than assumed in the central scenario. In particular, low levels of inflation may make it difficult for monetary policy to reduce the real interest rate as needed to ensure full employment, given constraints on further significant reductions in nominal interest rates (i.e., “a liquidity trap”). Moreover, this risk may be higher than in previous periods due to the global drop in equilibrium real interest rates over the last decade. Such difficulties arising from low inflation may become especially acute if various risks to external demand (see below and Annex 1) are realized. Low equilibrium rates of inflation also imply low equilibrium nominal interest rates, posing challenges for some sectors such as defined-benefit pension plans and life insurers, and may make relative wage and price adjustments more difficult due to resistance to nominal wage and price cuts.

  • Uncertainty about EU relations and immigration. Last year’s vote to move away from the free movement of labor with the EU has created substantial uncertainty about medium-term growth prospects, as such a move may reduce labor force growth, restrict firms’ ability to recruit personnel, increase the fiscal challenges of population aging, and reduce Swiss firms’ access to EU markets if existing cooperation agreements with the EU are revised. This uncertainty may also weigh on investment (see later section for further discussion of this issue).

  • Global economic environment. This risk goes in both directions. On one hand, downside surprises to global growth and further bouts of market risk aversion (e.g., due to a protracted period of turmoil in Greece or geopolitical events) could fuel franc appreciation and deflationary pressures and reduce growth. On the other hand, growth in Europe and other advanced economies could also surprise on the upside (e.g., due to a larger-than-expected boost from lower oil prices), supporting a more competitive franc, faster Swiss growth, and a quicker exit from deflation.

  • Financial Sector. The banking sector is highly globally interconnected; the largest banks (UBS and Credit Suisse) remain highly leveraged in comparison with most other global systemically important banks and still have large investment banking operations. Consequently, they could be a source of outward spillovers and remain vulnerable to inward spillovers from instability in global financial markets.

  • Housing Market. Though it has cooled recently, Switzerland’s house prices have had a rapid run-up over the last decade, and mortgage debt is high as percent of GDP (see later section for more details). The economy could thus be vulnerable to a sharp decline in house prices, which would weaken household balance sheets and impede growth. Such a decline would also adversely affect the banking and insurance industries, with their large respective exposures to the mortgage market and real estate.

Authorities’ views

14. The authorities broadly agreed with staff’s assessment of macroeconomic developments and risks. They agreed that the franc was now overvalued. They also agreed that the sharp appreciation of the franc has depressed growth prospects in the short run and presents a challenge for the export sector, especially in those industries where the market power of Swiss firms is limited. On the low-inflation environment, they noted that domestic inflation was still positive and viewed the current deflation as a transitory phenomenon, driven by lower energy prices and currency appreciation, and projected inflation to move back into positive territory over the medium term. On spillovers to Eastern Europe from the franc’s appreciation, the SNB noted that the authorities in Eastern Europe had been aware of risks related to franc-denominated mortgages for some time.

Macroeconomic Policies: Supporting Sustainable Growth

Further monetary easing via purchases of (mainly foreign) assets and strong communication of the SNB’s objective to boost inflation over the medium term could help lessen the near-term growth slowdown, reduce risks of entrenching low inflation, and limit franc overvaluation. Scope for fiscal policy to support aggregate demand is limited by Switzerland’s fiscal rule and the small, open nature of its economy. That said, fiscal automatic stabilizers should be allowed to operate freely, as allowed under the rule, and the rule’s escape clause should be triggered in the event of a severe downturn to allow discretionary fiscal stimulus. Pension and corporate tax reforms are key priorities for fiscal structural reforms.

A. Monetary and Exchange Rate Policies

15. Further monetary easing would support economic adjustment and reduce risks. The output gap is expected to widen in the near term, and the negative rates for both core inflation and 10-year bond yields suggest significant risks of a protracted period of low inflation. In this context, monetary easing would helpfully limit the growth slowdown, reduce risks of inflation expectations becoming anchored at low levels, and lessen exchange rate overvaluation.

A01ufig5

Switzerland: Core Inflation and Bond Yields

(percent)

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Source: Haver Analytics.

16. However, with the policy rate already at -0.75 percent, room for further conventional easing appears limited. The policy rate should remain at its current negative level for now, as this helps ease franc appreciation pressures and encourages domestic consumption and investment. However, additional deep policy rate cuts could risk adverse nonlinear effects, such as increased cash hoarding. This in turn could reduce financial intermediation and weaken monetary transmission mechanisms. In this regard, the SNB has appropriately intensified the monitoring of depositors’ behavior. So far there are few signs of significant cash hoarding.

A01ufig6

Switzerland: Currency in Circulation

(Year-on-year growth; percent)

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Haver Analytics; IFS; and Swiss National Bank.

17. Monetary easing could instead be achieved via a pre-announced program of asset purchases.

  • Purchases of foreign assets could help directly address deflationary pressures arising from the overvalued exchange rate. The amount of foreign-asset purchases could be preannounced (e.g., X billion per month, to be continued until further notice) and adjusted as necessary to achieve inflation objectives. Compared to the previous approach of setting the exchange rate floor, fixing the quantity of foreign-asset purchases would not unduly suppress exchange rate volatility, thereby reducing the risk of a “one-way bet” in the market. Fixing the quantity also avoids an unlimited commitment of the SNB’s balance sheet. Compared to the current approach of ad hoc interventions, pre-announced interventions might help signal monetary dovishness, thereby raising inflation expectations, spurring franc depreciation, and further supporting higher inflation.

  • Purchases of domestic assets could also be considered. However, the scope for such purchases is more limited, given that domestic yields are already very low (yields are negative out to 12-year maturities as of late April) and given the limited supply of domestic assets. In particular, the outstanding stock of federal government bonds is only 12 percent of GDP.

18. The SNB could also further enhance communication and the articulation of its monetary policy framework. The SNB’s decision to abandon the floor has created some uncertainty about its monetary policy framework going forward. The SNB could therefore helpfully elaborate on its medium-term monetary policy objectives. More specifically, it may be useful to indicate a preference for moving inflation back near the upper end of the target range (i.e., closer to 2 percent) over the medium term, given the benefits to re-anchoring inflation expectations at higher levels to avoid the complications of operating monetary policy at low levels of inflation.

19. The SNB’s capital buffers should be kept in line with risks. The SNB’s balance sheet is likely to remain large for a prolonged period, with large fluctuations in mark-to-market profits (Table 3). Although a central bank’s main objective is to achieve price stability, not maximize profits, the SNB could nonetheless encounter reputational problems if it incurred a large capital deficiency. To reduce related risks to the SNB’s operations and independence, the SNB should continue to prioritize provisioning over transfers to its distribution reserve and maintain a prudent profit distribution policy.

Table 3.

Switzerland: SNB Balance Sheet, 2009–14

(Millions of Swiss francs; unless otherwise indicated)

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Sources: Swiss National Bank; and IMF staff estimates.

Currency in circulation and sight deposits of domestic banks.

Authorities’ views

20. The SNB agreed with much of staff’s analysis, but preferred to see how the outlook develops before taking further monetary policy action. The SNB agreed that monetary conditions were too tight, the franc was overvalued, and preannounced purchases of foreign assets was one option for further monetary easing. However, the SNB wanted to allow more time to see how the outlook develops in both Switzerland and elsewhere in Europe before taking further monetary policy action. On the communication strategy, the SNB did not see a strong case for announcing a preference for moving inflation back near the upper end of the target range (i.e., closer to 2 percent) over the medium term. The SNB considers inflation in the range of 0–1 percent to be consistent with its monetary policy framework and, therefore, does not share staff’s risk assessment.

B. Fiscal Policy

21. Switzerland’s fiscal rule has helped it maintain low deficits and debt. In place since 2003, Switzerland’s “debt brake” rule requires that the federal government budget be in structural balance ex ante and that any ex post overruns be made up by running structural surpluses in subsequent years. Parliament can temporarily suspend the debt-brake rule in cases of “exceptional financial requirements” (e.g., war, severe recession) by a simple majority vote in both houses, but this option has rarely been invoked. The federal rule and similar rules for cantons have helped keep the budget in balance and helped limit general government gross debt to 46 percent of GDP at end-2014 (Tables 45, Annex 3).

Table 4.

Switzerland: General Government Finances, 2010–18

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

Includes the balance of the Confederation and extrabudgetary funds (Public Transport Fund, ETH, Infrastructure Fund, Federal Pension Fund).

Includes old age, disability, survivors protection scheme as well unemployment and income loss insurance.

Data are unconsolidated.

Table 5.

Switzerland: General Government Operations, 2003–12

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Source: Federal Ministry of Finance.

22. The mission recommended continued compliance with the rule in the central scenario. Suspending the rule in response to the mild growth slowdown envisaged in the central scenario would set a precedent that could undermine the rule’s ability to restrict fiscal irresponsibility over the longer run. In addition, exchange rate overvaluation suggests that relying more heavily on monetary, rather than fiscal, easing to boost demand should lead to better external balance. Fiscal multipliers may also be small in Switzerland given its openness.

23. However, fiscal policy should do what it can to support demand. In the central scenario, fiscal automatic stabilizers should be allowed to operate fully, as allowed by the rule. The authorities should also avoid budgeting overperformance against the rule in 2016, as this would add an unnecessary contractionary impulse. If a deep or prolonged recession materializes, discretionary fiscal easing should be employed to support growth and inflation and avoid overburdening monetary policy. Such easing could be achieved by temporarily suspending the rule under established procedures.

24. Pension reforms will help address longer-term fiscal challenges. Population aging is projected to substantially increase fiscal costs related to pensions over the longer run. To help address this challenge, the government has submitted a comprehensive reform proposal to parliament. The reform includes measures to equalize retirement ages for men and women and to reduce the rate at which pension savings are converted into pension annuities by reducing this conversion rate from 6.8 to 6.0 percent per annum. In addition, the government has proposed to increase VAT rates by 2 percentage points by 2029 to ensure more stable funding for the pension system. Such reforms will help ensure the sustainability of the social safety net and its continued availability for future generations. In relation to the second pillar, staff recommended reducing the minimum guaranteed return on invested assets, as such returns have become more difficult to achieve in the low interest-rate environment (Box 1).

25. Switzerland has prepared a comprehensive corporate tax reform (Corporate Tax Reform III). Switzerland has faced international pressure in recent years to reduce the favorable tax treatment provided to multinational corporations in many cantons. In this context, the authorities have developed a corporate tax reform, expected to be submitted to parliament this summer and implemented by 2019, that intends to reform special tax regimes that give more favorable treatment to income from foreign operations than income from domestic operations. As this will in some cases result in a net revenue loss, the federal government has proposed to provide fiscal support to cantons to assist the reform—the current estimate of the needed transfer is approximately ¼ percent of GDP. Staff welcomed efforts to reduce distortions in the corporate tax code and encouraged the authorities to finalize the reform in ways that are consistent with ongoing international initiatives to counter base erosion and profit shifting.

Authorities’ views

26. The authorities emphasized the value of the fiscal rule and the importance of pension and corporate taxation reforms. The authorities agreed that automatic fiscal stabilizers should operate freely and saw no need for discretionary fiscal stimulus, including because the expected growth slowdown was expected to be limited. The authorities also indicated that they did not expect budgetary overperformance to occur either this year or next. They instead emphasized the importance of structural fiscal reforms, especially those related to pensions and corporate taxation. On the minimum guaranteed rate of return, the authorities noted that it is reviewed each year on a regular schedule and the next review will be undertaken in the autumn of 2015.

Guaranteed Rate of Return in Swiss Pension Funds

The Swiss pension system consists of three pillars. The first pillar is universal old age, survivors, and disability insurance. Currently, the age of retirement is 65 years for men and 64 years for women. It is a pay-as-you-go system, financed by contributions from employees and employers (both pay 4.2 percent of the employee’s income). The second pillar consists of fully funded, occupation-based pension plans. These are compulsory for employees and financed by both employees and employers. Contributions depend on the rules of the individual pension fund, but the contribution of the employer must be at least as large as the contribution of the employee. The third pillar includes private voluntary pension schemes.

Guaranteed nominal rate of return. Swiss pension funds that operate in the second pillar are required to provide their members with a guaranteed rate of return on members’ invested assets. The rate of return is not constant and is determined administratively each year. During 2003–09, the average nominal required rate broadly matched the average yield on 10-year Swiss government bonds. However, after 2010, the required rate has not declined in line with declines in headline inflation, resulting in a large increase in required real returns. In 2015, the real guaranteed return stands around 3 percent—by far the highest in the last decade.

A01bx1ufig1

Swiss Pension Funds: Required Return

Citation: IMF Staff Country Reports 2015, 132; 10.5089/9781513553603.002.A001

Sources: Credit Suisse; and IMF staff calculations.

Consequences of the high required rate of return. A too-high guaranteed rate of return risks the insolvency of pension funds and may also encourage them to take excessive risks. It could also lead to refunding, in which both employers and employees are required to pay additional funds and/or pension benefits are reduced to restore solvency.

Policy advice. In the short run, consideration should be given to lowering the nominal guaranteed rate of return when it next comes up for review later this year to bring it more into line with market yields. Eventually, consideration could also be given to linking the nominal guaranteed rate of return more closely and automatically to market-based measures of achievable returns.

Completing Financial Sector Reform

The financial sector reform agenda, as laid out in last year’s FSAP, should also be completed. Priorities include raising the leverage ratios of the two large international banks to safer levels, increasing public disclosure of information on risk weights, reforming FINMA’s use of external auditors, overhauling deposit insurance, and ensuring that risks related to housing and mortgage markets are contained.

A. The Big Banks

27. Switzerland’s two global systemically important banks (G-SIBs) have continued their strategic adjustments, and their balance sheets appear strong by many metrics. Both banks have met the 10 percent minimum CET1 capital ratio required under Swiss Too-Big-To-Fail legislation well in advance of the 2019 deadline and are in line with or comfortably above the average ratio for other G-SIBs. Both banks are above the Liquidity Coverage Ratio minimum of 100 percent, effective in 2015 in Switzerland, and had, based on a not-yet-final methodology, estimated Net Stable Funding Ratios above 100 percent as of spring 2014. The NSFR is not yet part of Swiss regulation but planned to be introduced in 2016. Both banks have remained profitable in 2014, though substantial provisions for litigation and regulatory issues (e.g., those related to foreign-exchange market manipulation, U.S. and other cross-border tax matters, and legacy issues related to the sale of residential mortgage-backed securities and U.S. mortgage crisis fines and penalties) weighed on the results.

28. However, there are still important areas for further improvement, as identified by last year’s FSAP (Annex 4).

  • These banks’ leverage ratios are above current regulatory minima. However, their ratios remain low by international standards (Table 6, Figure 5, and text chart). Given the risks to the Swiss economy posed by the large size of these banks, the authorities should tighten minimum leverage ratio requirements for G-SIBs to ensure that they are more ambitious than international minima and that the quality of capital is aligned with or more demanding than international standards.3 In addition, the authorities should encourage the large banks to further strengthen their capitalization, including multi-year plans to increase their leverage ratios, and promote conservative dividend policies to bolster the capital base.4

  • The authorities should also vigilantly challenge risk weights from internal ratings-based models and increase banks’ disclosure requirements regarding capital-weights to enhance transparency and bolster understanding of, and credibility in, banks’ soundness and business strategies.

  • Continued action is needed to improve the resolvability of the G-SIBs through strengthened cross-border coordination and further restructuring. Given the global reach of these banks, reaching agreements with partner supervisors is critical. While both banks have made structural changes, including by organizing through holding companies, and have updated their global recovery and resolution plans in 2014 to improve their resolvability, this process needs to continue to further improve resolvability.

  • The authorities must also continue to proactively address operational risks by intense supervision of risk management practices and provisioning, to avoid and mitigate effects from negative surprises related to, for example, trading activities and investigations of tax evasion or money laundering.

Table 6.

Switzerland: Financial Soundness Indicators, 2007–14

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Source: Swiss National Bank.

Based on parent company consolidation. This consolidation basis equals the CBDI approach defined in FSI compilation guide plus foreign bank branches operating in Switzerland, and minus overseas deposit-taking subsidiaries.

Until 2004, general loan-loss provisions were made; as of 2005, specific loan-loss provisions have been carried out.

As percent of total credit to the private sector.

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

These ratios were calculated from numbers that originate from the Basle I as well as from the Basle II approach. Therefore, interpretation must be done carefully since they can vary within +/- 10%.