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.

On May 18, 2015, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Switzerland.

Switzerland’s economy has performed relatively well in the aftermath of the global financial crisis, with growth reaching 2 percent in 2014. However, the economic environment became more complicated in late 2014, as increased capital inflows forced the Swiss National Bank (SNB) to start intervening heavily to defend its exchange rate floor of 1.20 francs per euro. The SNB eventually exited the floor on January 15, 2015, while also cutting its policy rate (the interest rate on deposits at the SNB exceeding 20 times required reserves) to -0.75 percent. Following these moves, the exchange rate appreciated substantially before stabilizing at around 1.05 francs per euro.

In the near term, economic growth in Switzerland is likely to slow, as the strong franc, which is now likely overvalued, reduces net exports. Consistent with this view, leading economic indicators have declined so far in 2015. For the full year, GDP growth is projected to slow to about 0.75 percent and to about 1.25 percent in 2016. This growth slowdown is expected to increase unemployment, but only modestly, in part due to the cushioning effects of short-time work arrangements. Inflation, which is already very low at -1.1 percent as of April 2015, is expected to fall further in 2015, as the effects from exchange rate appreciation and the recent decline in oil prices continue to pass through into final prices.

Over the medium term, the economy is expected to recover gradually. As the economy adjusts to the exchange rate appreciation, growth is projected to rise gradually back to around 2 percent over the medium term while inflation increases to around 1 percent. Switzerland’s fiscal rules are expected to keep the structural fiscal deficit near zero and government debt low.

However, this central scenario is subject to important risks. One key risk is that very low levels of inflation may complicate the operation of monetary policy by making it more difficult to reduce real interest rates as necessary in response to shocks. Indeed, yields on 10-year government bonds are negative and the lowest in the world, indicating significant risks of a protracted period of very low inflation and sluggish growth. Other important risks include uncertainty about future immigration policy and its effects on EU relations, global and regional economic developments, the effects of ongoing changes in the international financial regulatory landscape, and the potential for price reversals in the housing market, which has been buoyant in recent years.

To help address risks and medium-term challenges, the authorities have recently undertaken or proposed a numbers of reforms. These include various financial sector reforms (e.g., adoption of tighter lending standards for mortgages), proposed reforms to bolster the sustainability of the pension system, and proposed reforms of corporate taxation and financial controls to help comply with international initiatives aimed at limiting money laundering and cross-border tax evasion and avoidance.

Executive Board Assessment2

Executive Directors commended Switzerland’s continued strong economic fundamentals underpinned by sound policy management. Directors noted, however, that following the exit from the exchange rate floor earlier this year and the subsequent appreciation of the franc, the economy faces currency overvaluation and weakened near-term growth and low inflation prospects.

Directors agreed that further monetary easing would support growth and reduce exchange rate overvaluation. In addition, they noted that moving inflation closer to the upper end of the target range over the medium term could mitigate risks associated with low inflation. However, a number of Directors considered that controlling inflation to this extent may not be feasible for the small and open Swiss economy.

Given the limited room for conventional monetary easing, Directors saw need to explore various options. In this regard a pre-announced program for asset purchases could be an option, although many Directors were not convinced about the effectiveness of such a program at this juncture. Looking ahead, Directors agreed that the policy rate should be maintained at its current level for now, as this has been helpful in reducing deflationary pressures. More broadly, they encouraged the central bank to further enhance communication of its monetary policy framework and to continue to prioritize provisioning over transfers to its distribution reserve to ensure that its capital remains in line with risks.

Directors commended Switzerland’s fiscal rule which has helped maintain low deficits and debt. They concurred that for fiscal policy to support growth, automatic stabilizers should be allowed to operate fully, as permitted under Switzerland’s debt-brake rule, while avoiding budgeting over-performance against the rule. Directors generally agreed that in the event of a severe or protracted recession, discretionary fiscal stimulus could be employed by triggering the rule’s temporary escape clause to help boost growth and inflation and avoid overburdening monetary policy.

Directors welcomed the progress made in financial sector reforms and encouraged further action in line with the Brunetti Report and the FSAP update. They highlighted the need to closely monitor financial stability risks in the housing market and adopt further prudential measures as needed. These could include raising minimum leverage ratio requirements of the two large international banks and improving their resolvability, increasing banks’ disclosure of information of risk weights, further refining FINMA’s use of external auditors, and overhauling deposit insurance. Directors also called for continued monitoring of the effects of the low-interest rate environment, especially for life insurers and defined-benefit pension plans.

Directors underscored the need to sustain structural reforms to support medium-term growth and address challenges. In this regard, they called for action to reduce uncertainty related to future immigration policy and its effect on relations with the European Union. Directors looked forward to the timely completion of the corporate tax reforms and financial controls, consistent with international initiatives aimed at limiting money laundering and cross-border tax evasion and avoidance. Reforms to boost full-time female labor force participation, such as lowering marginal tax rates on second incomes, could also enhance potential growth. Directors welcomed the proposed pension reforms, which would help ensure the sustainability of the social safety net and its continued availability for future generations.

Switzerland: Selected Economic Indicators, 2012–16

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

Contribution to growth.

Unconsolidated and reflects GFSM 2001 methodology, which values debt at market prices.

Based on relative consumer prices.

1

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

2

At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. An explanation of any qualifiers used in summing up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.