Switzerland: Staff Report for the 2016 Article IV Consultation

The economy has adapted well to the appreciation that followed the exit from the exchange floor. Growth is expected to reach 11/2 percent this year and to stabilize at around 1¾ percent over the medium term. A resurgence of capital inflows, a sharp adjustment in property prices, renewed concerns over large global banks and changes to Swiss-EU relations pose risks to this outlook. The two-pronged approach to monetary policy helped avert a prolonged slowdown and sustained deflation by limiting further appreciation, with some support from fiscal policy. Elevated exposure to mortgage debt continues, and low interest rates could rekindle a credit-driven upswing in house prices. Population aging and slower immigration will create funding gaps in the public pension system, while minimum mandated interest rates for private pensions that exceed market rates could affect viability. The Swiss systemically-important global banks are continuing to build their financial strength. Corporate tax reform is expected to trim future tax revenue.

Abstract

The economy has adapted well to the appreciation that followed the exit from the exchange floor. Growth is expected to reach 11/2 percent this year and to stabilize at around 1¾ percent over the medium term. A resurgence of capital inflows, a sharp adjustment in property prices, renewed concerns over large global banks and changes to Swiss-EU relations pose risks to this outlook. The two-pronged approach to monetary policy helped avert a prolonged slowdown and sustained deflation by limiting further appreciation, with some support from fiscal policy. Elevated exposure to mortgage debt continues, and low interest rates could rekindle a credit-driven upswing in house prices. Population aging and slower immigration will create funding gaps in the public pension system, while minimum mandated interest rates for private pensions that exceed market rates could affect viability. The Swiss systemically-important global banks are continuing to build their financial strength. Corporate tax reform is expected to trim future tax revenue.

Context

1. The Swiss economy has performed solidly during 2010–15. GDP growth averaged 1¾ percent, the unemployment rate has been broadly steady around 3 percent, and the external sector performed well, with the current account surplus averaging 11 percent of GDP. In addition, real incomes had been boosted by sustained decreases in prices of imported products. More generally, growth has been in line with the average for advanced economies, supported by a favorable business environment (for 2016, the World Economic Forum again ranked Switzerland the globally most competitive country).

2. This solid performance occurred despite challenges stemming from Switzerland’s status as a safe haven. Global risk-off episodes (most recently following the Brexit vote) and monetary policy easing by the major central banks have triggered intermittent capital inflow surges into Switzerland. As a result, the nominal and real effective exchange rates (NEER and REER) appreciated by 40 percent and 24 percent, respectively, since 2008, leading the authorities to introduce and subsequently remove an exchange rate floor against the euro.

3. Switzerland’s direct democracy and close EU relations have contributed to political stability and widespread support for domestic policies. With Switzerland located in the center of Europe, the EU is a key partner, and their economies, labor markets and policies are closely linked. Notwithstanding this close relationship, the Swiss population adopted a popular initiative in February 2014 to limit mass immigration (Box 1). A solution agreeable to both the Swiss and the EU is being sought.

Recent Developments

4. The economy weathered relatively well the sharp appreciation that followed the exit from the exchange rate floor. Activity was dented in early 2015 by the abrupt strengthening of the franc. However, growth subsequently returned, aided by the flexibility of firms and the labor market, to reach 0.8 percent for the year, although this was less than half the pace of 2014. Unemployment edged up to 3.3 percent and the output gap widened to 0.8 percent of potential GDP by the end of the year. The external sector held up well despite the currency shock, aided by some redirection of exports from the euro area (where competitiveness had been eroded) toward countries with currencies linked to the dollar (where Swiss products had gained competitiveness), although profit margins at some companies were sharply squeezed. The drop in the price level helped to cushion domestic spending.

5. The appreciation in early 2015 led to a discernible fall in inflation, but the impact on the current account was muted:

  • After remaining flat the previous year, consumer prices fell by 1.1 percent in year-average terms (1.3 percent on a year-on-year basis) in 2015. Prices of domestic products dipped only marginally (consistent with the limited widening of the output gap), but import prices fell sharply, reflecting the appreciation of the franc and the drop in world energy prices.

  • The current account surplus widened by 2½ percentage points to reach 11.3 percent of GDP in 2015. The increase reflects mainly the improved terms of trade from lower oil prices, the resilience of exports in key sectors and a larger income balance owing to a wider interest rate differential between foreign and domestic financial assets.

6. Economic performance has continued to firm during 2016. Both domestic and external demand have supported the pickup in growth. Deflation continued to unwind as the effect of the early-2015 appreciation dissipated and the Swiss franc remained broadly stable against the euro, with prices in September 2016 decreasing by 0.2 percent over the previous year. Medium-term inflation expectations, which fell sharply in response to the appreciation, have stabilized at (positive) 0.5 percent alongside the pickup in actual inflation. With activity gradually strengthening, the output gap continues to narrow.

7. Swiss interest rates have fallen and the yield curve has flattened in tandem with other advanced economies, although the franc has appreciated more than most other currencies. Yields on Swiss government bonds fell and the franc strengthened sharply following the exit from the exchange rate floor and shift to negative policy rates in late 2014-early 2015. Sovereign yields across all maturities (the longest dated is 50 years) became negative, although longer rates again turned positive in recent weeks. After appreciating by about 15 percent against the euro in early 2015, the franc has steadied in recent months, representing a 12 percent depreciation relative to its strongest level, while the REER has depreciated by 5 percent, although this is still 6 percent stronger than before the exit from the exchange rate floor. As in other countries, equity prices have been supported by low interest rates, although the benchmark SMI index is down 8.5 percent so far this year, possibly reflecting the large share of banks in the index.

Report on the Discussions

A. Outlook and Risks

Staff’s views

8. Growth is expected to remain on a recovery path, and to stabilize at a moderate 1¾ percent over the medium term. For 2016, GDP is forecast to increase by 1.5 percent, with inflation approaching zero by year end. The pickup in growth is projected to gradually close the output gap, returning inflation to the middle of the target band. However, inflation is expected to remain below levels in key trading partners, facilitating a steady reduction in the REER. The underlying external position in 2015 was moderately weaker than implied by medium-term fundamentals and desirable policy settings (see Box 2). External demand is likely to make a smaller contribution to growth than in the past owing to the more subdued outlook for global trade, leading also to some narrowing of the current account surplus.

9. Risks to this outlook for the Swiss economy, while two sided, maintain a negative skew (Annex II). On the positive side, a faster than envisaged pace of world growth could materialize if consistent and comprehensive policy frameworks were widely adopted, thereby providing a boost to Switzerland’s large export sector. However, several adverse global factors—a further decline in the trade content of world demand, increased political risk and inward-looking policies, and an unmooring of inflation expectations that raises forward-looking real interest rates—would weaken demand from abroad. In addition, a resurgence of global financial market volatility or a further loosening of monetary policy by a major central bank could trigger renewed capital inflows into Switzerland, appreciating the already overvalued franc and denting GDP growth. Elevated household debt and banks’ concentrated exposure to mortgages could amplify shocks, especially if unemployment were to increase sharply on a sustained basis. Renewed concerns about the financial health of large cross-border banks could spill over to the domestic economy given their interconnectedness and large size relative to Swiss GDP. In addition, Swiss-EU economic relations could be affected in the event no mutually acceptable solution is found in the ongoing discussions regarding immigration.

Authorities’ views

10. The recent positive momentum of the Swiss economy is expected to continue, supported by sustained global demand and the waning effects of the past appreciation. Growth is expected to reach 1.5 and about 1.8 percent, respectively, in 2016 and 2017, with both exports and the domestic demand experiencing an upward trend. Continued population growth due to net immigration—although at a somewhat slower pace than in recent years—is also expected to support growth. Strengthening activity is projected to raise inflation to 1 percent by end 2018, gradually reverse the slight pickup in unemployment that occurred since 2015 and eliminate the negative output gap. However, not all industries have benefitted equally from the recovery, and profit margins at a large number of companies have come under pressure, consistent with the SNB’s assessment that the Swiss franc remains significantly overvalued.

11. Risks to growth remain tilted to the downside. Given the very open Swiss economy, external shocks would directly impact economic growth. Key external risks include a downgrading of global growth or a resurgence of financial market volatility. Switzerland also faces a number of domestic risks, including the possibility that a timely agreement on curtailing immigration is not achieved. A sustained increase in unemployment that spills over to house prices is a tail risk. Further downward pressure on global interest rates, if sustained for an extended period, would pose a significant risk to longer-term financial stability.

B. Securing Growth with Macroeconomic Policies

Monetary and Exchange Rate Policy

Background

12. Since eliminating the exchange rate floor in early 2015, the SNB has pursued a two-pronged approach to monetary policy. The SNB’s price stability objective is defined as inflation between 0 and 2 percent. To achieve this goal, the interest rate on sight deposits placed at the SNB is currently set at minus 0.75 percent, the midpoint of the target range for three-month Libor (minus 1.25 to minus 0.25 percent), and which has been kept unchanged since January 15, 2015. The SNB also intervenes in the foreign exchange market, periodically purchasing large amounts, as well as smaller quantities on a more frequent basis.1 This combination of tools is intended to reduce the attractiveness of Swiss franc-denominated assets, thereby easing appreciation pressures.

A01ufig1

Switzerland: Sight Deposits and Exchange Rate

(Millions of CHF)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Bloomberg; and IMF staff calculations.

13. Compared with other major central banks, the SNB’s policy interest rate is the most negative and, relative to GDP, its balance sheet is the largest.2 Despite the very low rate, the negative interest differential against the ECB policy rate has narrowed considerably to 0.35 percentage points from about 1½–2 percent prior to the GFC. Moreover, with the negative policy rate applying only to balances above elevated exemption thresholds (tiering), the effective policy rate is considerably less negative than the marginal rate, bringing it close to the current ECB policy rate. The SNB’s balance sheet has expanded to 110 percent of GDP, a 90 percentage point increase since the beginning of the GFC.

A01ufig2

Interest Rate Gap

(3-Month Rate)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Haver; and IMF staff calculations.
A01ufig3

Total Assets of Major Central Banks

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Source: Haver.

Negative Policy Interest Rates

article image
Sources: Bloomberg and Haver Analytics.Note: As of October 2016.
Staff’s views

14. The SNB’s two-pronged policy approach and accommodative stance are appropriate to the challenges facing the Swiss economy, and have helped avert a prolonged slowdown and sustained deflation:

  • The negative interest differential against major currencies is consistent with the Swiss franc’s role as a safe haven currency, which constrains policy independence. Relying on a negative marginal rate helps to deter new inflows by encouraging banks to transmit negative rates to large investors, while shielding their retail depositors. This also helped preserve banks’ profits, which depend on the effective policy rate.3 However, the move to negative rates has not been sufficient to preserve the interest rate differential with major central banks, contributing to persistent inflow pressures.

  • Foreign exchange purchases are warranted to address Switzerland’s below-potential output, overvalued REER and sub-par inflation that is largely exchange rate driven. Moreover, FX purchases were effective in preventing a sharp appreciation following the Brexit vote, despite a large jump in inflows, although smaller, higher-frequency purchases are also expanding the SNB’s balance sheet.

15. Some refinements could improve the assignment of policy tools and simplify communications. The negative interest rate differential should be calibrated so as to discourage persistent inflows that can cause prolonged deflation and weaken activity. On the other hand, exchange rate purchases should be reserved primarily to respond to episodic inflow surges to prevent sudden, large exchange rate appreciations. Some widening of the current effective interest rate differential—either by lowering the marginal policy rate or the exemption threshold—should therefore be considered to reduce the need for frequent small-scale interventions. This would also slow the increase in the SNB’s already-large balance sheet, which continues to trend upward relative to GDP and is subject to valuation changes that can affect public finances.

16. However, operational and stability considerations could at some point limit the room for maneuver. Competition between banks and other lenders could over time bid down bank lending rates, thereby increasing risk taking while also pushing a wider set of deposit rates into negative territory. This could raise incentives for cash hoarding and erode a key source of bank funding. In addition, portfolio diversification can reduce but not eliminate valuation risks on the SNB’s balance sheet. Over the longer term, accommodating some gradual appreciation, as was the case prior to the GFC, should be considered. Beyond monetary policy, structural reforms should be considered to narrow the large domestic saving-investment gap and reduce savers’ home bias.

Authorities’ views

17. The SNB’s expansionary two-pronged monetary policy is working well. With credit continuing to grow at a moderate pace, and the Swiss franc still significantly overvalued, the exchange rate is the primary transmission channel for monetary policy. The negative policy rate has worked well in Switzerland, with the parallel decline in key market rates signaling the effectiveness and credibility of the policy tool. Tiering has helped limit the impact of negative rates on banks’ profits, thereby avoiding the need for banks to pass along these rates to smaller depositors. There is little indication of cash hoarding. FX purchases are an important complement to negative policy rates, facilitating the absorption of large safe haven inflows and also avoiding the need to further widen the interest differential vis a vis other major central banks. Utilization of these two instruments is appropriately balanced at present.

18. Room is available to ease further, but monetary policy alone cannot support the real economy for an extended period. Keeping interest rates at very negative levels for a long time could eventually encourage cash hoarding and excessive risk taking. Moreover, while there is no upper limit to the size of the SNB’s balance sheet, and portfolio diversification has safeguarded its value, currency exposure is a risk. Nonetheless, there is room to lower the policy rate further, if needed. However, addressing the economy’s structural shortcomings is beyond the scope of monetary policy.

Fiscal Policy

Background

19. Switzerland’s long-standing fiscal rule has led to a decline in public debt. The “debt brake” rule, introduced in 2003, requires a balanced cyclically-adjusted federal budget on an ex ante basis, and in case of ex post spending overruns, offsetting structural surpluses are expected in subsequent years. The rule, together with conservative frameworks at other levels of government, has delivered a significant reduction in general government debt, which stood at 46 percent of GDP at end 2015 (Annex III). Moreover, outturns have tended to exceed the targeted balanced structural position.

20. Several fiscal reform initiatives are in the pipeline. Options for meeting the fiscal costs of aging—including equalizing the retirement age for men and women and raising VAT rates (currently among the lowest in Europe)—are being discussed by parliament. Eliminating preferential tax treatment of foreign companies currently offered by several cantons is underway by unifying rates for all firms within a canton. The new corporate tax rates are expected to average 14–15 percent, and would likely lead to some revenue loss.

Staff’s views

21. Switzerland has ample fiscal space in view of its negative borrowing costs, moderate and declining public debt and broadly balanced general government finances. The current federal-level debt brake rule allows automatic stabilizers to dampen the business cycle and provides flexibility for extraordinary spending in the event of “exceptional financial circumstances.”4 With about 70 percent of general government spending occurring outside the boundaries of the rule, the rule may not in practice significantly impede the use of fiscal space.

22. Despite a goal of structural balance, the rule is implemented in a somewhat tighter manner and could benefit from some refinements in its application. A tendency to not fully spend budget appropriations and a conservative approach to estimating potential output have led to systematic ex post structural surpluses that have accumulated to 4 percent of GDP since 2003. With some two-thirds of the budget pre-committed as transfers to other levels of government, spending compression is focused on the remaining relatively narrow set of categories, including education, which can have implications for longer-term growth and competitiveness. With fiscal policy providing less support than envisaged under the rule, additional pressure is also placed on monetary policy. Reducing within-year underspending or permitting underspent amounts to be used the following year by allowing symmetric operation of the rule’s ex post provision would alleviate this issue. On the other hand, increased transfers to the cantons to partially compensate them for CIT reform-related revenue loss will further squeeze other federal spending.

23. In the event of a prolonged downturn or deep recession, a discretionary fiscal stimulus would provide essential support to economic activity. Moderate public debt, negative borrowing costs and broadly balanced budgets suggest the presence of ample fiscal space to respond with a discretionary stimulus in the event of a sizable negative output gap. Supporting the economy by temporarily setting aside the rule is permitted under the “exceptional financial circumstances” clause, and would avoid overburdening monetary policy.

24. The authorities’ proactive approach will help address challenges to pension system sustainability. With average life expectancy of 83 years, raising retirement ages for men and women (currently 65 and 64, respectively), together with increasing VAT rates, is essential to generate new resources to help fill the expected deficit in the first pillar, pay-as-you-go pension system. Additional pressure is being felt in the private second pillar scheme where the legally-mandated minimum conversion rate used to translate accumulated savings into an annuity is too high relative to long-term interest rates and life expectancy. In addition, despite a reduction last year, the guaranteed interest rate used to compound contributions remains too high. Lowering both the mandated conversion rate and the compounding rate—by indexing them to a long-term sovereign bond—would reduce the risk of contingent fiscal liabilities and help ensure the sustainability of the social safety net.

Authorities’ views

25. Fiscal policy in Switzerland follows a prudent approach that simultaneously delivers debt reduction and economic stabilization. Since the GFC, fiscal policy has supported growth through a healthy pace of infrastructure investment and solid growth in education spending, while also providing temporary targeted support to employment following the 2015 appreciation. As a result, the domestic-oriented economy is performing well. This situation contrasts with that of several other countries where, owing to high public debt, governments have pursued fiscal austerity that necessitated unconventional monetary easing to compensate for weak government demand. The debt brake rule, which enjoys broad popular support, has led to a significant reduction of nominal debt, annual underspending is a modest 0.3 percent of GDP, and there is no need at present for higher fiscal spending.

26. The debt brake rule has flexibility in extraordinary times to provide additional stimulus, which the authorities have shown a readiness to use under appropriate conditions. The “exceptional circumstances” clause has been previously invoked and will be used again in 2017 for migration-related spending. In general, fiscal stimulus is most effective when domestic absorption is weak, while monetary policy is best suited to respond to external shocks or when the export sector is under pressure.

27. Medium-term fiscal challenges can be addressed without an undue increase in taxes. To stabilize pension system finances, Parliament is expected to agree by early 2017 a combination of a higher retirement age for women and an increase in the range of 1–1½ percentage points in the VAT rate, which will be earmarked for the Old-Age and Survivors’ Insurance. Following full phase-in of the corporate tax reform in 2019, corporate tax rates are likely to be reduced in the majority of the cantons, and while rates levied on foreign companies will increase marginally, other factors will continue to ensure Switzerland remains an attractive foreign investment destination.

C. Preserving Financial Stability in a Low Interest Rate Setting

Background

28. Exposure to real estate by lenders and borrowers is high, notwithstanding a relatively low home ownership rate of 45 percent. After 10 successive years of increases that raised house prices by a cumulative 40 percent, prices stabilized in Q2:2016 and the pace of mortgage lending has gradually eased to around 3 percent. This reflects a series of macroprudential measures introduced during 2012–14, including “self regulatory” measures by banks that were adopted in response to moral suasion by the authorities.5 The increase in the countercyclical capital buffer on mortgages from one to two percent in 2014, a temporary increase in mortgage interest rates in 2015 and some slowdown in population growth also helped to stabilize house prices. More than 80 percent of banks’ domestic loans are mortgages (including to corporates), and among new mortgages, about a third have loan to value (LtV) ratios of 75 percent or more. Insurance companies and pension funds have shifted asset allocations toward real estate in search of higher returns. Non-mortgage credit is declining. At about twice disposable income, household debt is one of the highest among OECD countries, although financial assets are several times larger and the total rate of nonperforming loans is a very low 3 percent.

A01ufig4

Switzerland: Domestic Bank Loans, 2016

(Billions of CHF - total equals 166 percent of GDP)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Haver Analytics; and IMF staff calculations.
A01ufig5

Household Debt in Selected OECD Countries

(Percent of gross disposable income;2015 or latest)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Source: Haver Analytics.

29. The Swiss systemically-important global banks (G-SIBs) (Credit Suisse and UBS) continue to increase capital buffers. In response to the evolving business and regulatory landscape, in recent years these banks have reduced leverage by shrinking their balance sheets (from a combined 6½ times to 2¾ times GDP) and raising capital, and have shifted toward wealth and asset management where profits have been resilient. However, the operating environment for banking remains challenging. As with other G-SIBs, share prices of the large Swiss banks have fallen sharply in recent years, although some recovery has occurred since mid-2016. In July 2016, the Swiss authorities began implementing stricter too-big-to-fail (TBTF2) regulations for their G-SIBs, and which are more conservative than Basel minima, requiring them to have sufficient capital to absorb operating losses and adequate debt capital to fund an orderly resolution.6

Staff’s views

30. Elevated household debt and banks’ concentrated exposure to mortgages could amplify macroeconomic shocks, and new measures should be readied and supervision further strengthened. House prices relative to income have grown significantly since the great recession, and while prices have recently stabilized, price to income ratios remain stretched. Average debt per borrower is very high given the relatively low rate of home ownership. A prompt response will be needed if greater competition in credit markets further bids down interest rates and spurs a resurgence of mortgage lending or an acceleration of house prices. The response should target the build-to-rent segment where activity is currently brisk and where larger risk weights and/or faster amortization relative to owner-occupied properties is appropriate to reflect the international tendency for higher default and loss rates on these loans. Greater recourse to legally-binding regulation in preference to banks’ self-regulation could ensure any needed changes are implemented in timely manner and that uniform standards apply to all mortgage providers. The stepped up frequency of on-site inspections by the supervisor, FINMA, across all types of banks—including cantonal banks, as recommended by the 2014 FSAP—is welcome. Further progress is warranted to refine supervisory arrangements for external bank audits, including to ensure arm’s length financial relations between banks and auditors providing supervisory services on behalf of FINMA.7

A01ufig6

Switzerland: House Price to Income and House Price to Rent Ratios

(deviations from period averages, in percent)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources:OECD; and IMF staff calculations.
A01ufig7

OECD Countries: House Price to Rent Ratio and House Price to Income Ratio

(deviations from period averages, in percent)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: OECD, Haver Analytics; and IMF staff calculations.Note: Calculated as deviation of the latest observation from the average for the respective period.

31. The new Swiss G-SIB regulations appropriately reflect the systemic risk characteristics of these banks. The establishment of Swiss holding company structures for the Swiss G-SIBs will help ensure the survivability of core operations critical to the Swiss financial system. The large size of these banks relative to the Swiss economy and their potential role in global risk propagation warrant the requirements on leverage ratios and too-big-too-fail regulations that are more stringent than minimum international standards. This will also help safeguard the Swiss economy from inward spillovers. Attention should also be given to risk weights used in internal ratings-based models and greater disclosure of weights as part of the forthcoming revision to Basel requirements could help to strengthen credibility.

Authorities’ views

32. Downward pressure on mortgage lending rates could encourage excess supply of investment properties. The revision of the self-regulation rules for mortgage lending (approved by FINMA), the activation and increase of the sectoral CCB targeting risks in the domestic mortgage and real estate markets and the permanent adjustment of risk-weights for high loan-to-value mortgage loans have all helped to stabilize house prices. Tax incentives favor high mortgage debt, but at the same time lead to large financial assets for the same individuals, thereby mitigating financial stability risks. Mandatory amortization and the 20 percent own-funds down payment requirement also partly offset financial stability risks. Moreover, the widespread application of conservative mortgage affordability tests (using an interest rate of 5 percent plus an additional 2 percentage points for taxes and maintenance) and comfortable LtV margins provide buffers in case interest rates rise or house prices decline. However, institutional and private investors—in search of higher yielding assets—have increased activity in build-to-let properties, where prices are vulnerable to higher interest rates or slower immigration. A significant premium on risk weights for investment property mortgages relative to owner-occupied mortgages would be appropriate under new Basel guidelines.

33. FSAP recommendations on onsite bank supervision and auditing are constructive. While continuing to pursue a risk-based supervision model, FINMA has increased the frequency of onsite inspections across all supervised entities by 10 percent, in line with FSAP recommendations. On the FSAP recommendation regarding the use of audit firms as extended arms of the supervisory authority, measures to improve the efficiency and effectiveness of the regulatory audit framework are being assessed, inter alia by introducing the direct mandating of audit firms by FINMA.

34. New regulatory measures solidify the position of the Swiss G-SIBs, but the systemically important domestic banks (D-SIBs) and transparency of risk weights require further attention. The recently implemented stricter capital standards are crucial to reduce the likelihood of spillovers among G-SIBs and from the G-SIBs to the domestic economy thereby increasing financial stability. Reflecting the long phase-in periods, it will take several years to bring the gone-concern capital buffers to the prescribed regulatory levels. To further reduce systemic risks, gone-concern capital requirements for D-SIBs are necessary. Discussions about the implementation of such regulations are currently taking place. Finally, greater transparency on risk weights, expected to be required by the new Basel standards, would be an important improvement.

D. Structural Issues

Background

35. In recent years, Switzerland’s GDP growth has been boosted by brisk labor force expansion, while the investment-to-GDP ratio has remained modest. Immigration has brought significant benefits for growth and pension system sustainability by helping to offset the decrease in the Swiss working-age population. However, the investment ratio has remained at about 23 percent, well below the saving rate. As a result, labor productivity has grown relatively slowly and has been outpaced by real wages.

A01ufig8

Labor Productivity: GDP per Hour Worked

(USD constant prices, 2010 PPP)

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: OECD and IMF staff calculations.

36. Switzerland continues to make progress with implementing international standards for cooperation and information sharing in the financial sector. A comprehensive AML/CFT risk assessment has been published last year and strengthened due diligence requirements for financial intermediaries became effective in 2016. An assessment of the implementation of Financial Action Task Force (FATF) recommendations and of their effectiveness has been adopted by the FATF in October and is scheduled for publication shortly. The legal basis for the automatic exchange of information on tax matters was adopted in 2015, and Switzerland agreed with the EU and several other states and territories that it will begin collecting data in 2017, with data exchange commencing in 2018. Corporate tax reform by the cantons will align the corporate tax code with international initiatives to counter base erosion and profit shifting.

Staff’s views

37. Strengthening productivity would help mitigate possible appreciation shocks while also allowing firms to adapt in the event of a slowdown in labor force growth. Preserving close economic ties with the EU by reaching pragmatic solutions is crucial given sizable trade and economic linkages. Continuing to welcome foreign workers and adequately funding education are also essential to secure long-run growth, especially in frontier technologies. However, increasing the rate of investment would rebalance the capital-labor ratio, and help ensure that Swiss wages remain aligned with productivity levels. The planned harmonization of tax rates on domestic and foreign firms, to be achieved by sharply reducing the upper rate and modestly raising the lower rate, will increase incentives for domestic firms to invest, enabling them to improve efficiency, become more flexible and better cope any future strengthening of the exchange rate.

38. Increasing transparency and cooperation in the financial sector helps to level the playing field among participating countries while also protecting Switzerland’s integrity as an international financial center. Building on recent progress, the authorities are encouraged to further strengthen the enforcement of FATF and OECD standards. In particular, it is key to ensure private banks and wealth managers comply with customer due diligence requirements, to promote entity transparency, and to sustain effective international cooperation.

Authorities’ views

39. The economy demonstrated resilience and flexibility in response to the large exchange rate appreciation and should continue to build on these achievements. Switzerland strongly supports open markets, and maintaining bilateral agreements with the EU is essential. Structural reforms are needed to increase competitiveness, and continuing to adequately fund research universities is a priority to remain a world leader in innovation and to create private sector spin-offs. However, large capital inflows that result from globally loose monetary policies, remain an ongoing challenge for the economy.

40. Switzerland has been an early adopter of numerous international initiatives, and related laws are strictly enforced. However, given Swiss banks’ major role in global wealth management, these banks tend to be more exposed than others to money laundering concerns, especially in emerging markets. FINMA has repeatedly warned banks to be vigilant for these risks and has stepped up its efforts by more intensive and proactive supervision. FINMA pursues suspect cases and, imposes administrative sanctions (disgorgement of profits, ban to enter new business relations with PEP) initiates enforcement proceedings against individuals, and forwards cases to the criminal authorities where appropriate.

Staff Appraisal

41. The Swiss economy adapted well to the sharp appreciation that followed the exit from the exchange rate floor in early 2015. Flexibility by firms and the labor market, together with an effective monetary and fiscal policy response, helped to cushion the impact and facilitate adjustment. As a result, growth remained positive, the current account surplus was resilient, and consumers’ real purchasing power was boosted by the drop in prices. Nonetheless, segments of the economy remain pressured by the moderately overvalued real exchange rate.

42. The economy is forecast to return to moderate growth, although downside risks could cloud this outlook. GDP is expected to grow by 1½ percent in 2016, and to stabilize at 1¾ percent over the medium term. This trajectory is consistent with gradually closing the output gap and unwinding the real overvaluation. However, important external and domestic risks could affect this outlook, including renewed capital inflow surges, further weakening of global growth, sharp domestic property price movements, concerns about the health of large global banks and changes to Swiss-EU economic relations.

43. Monetary policy should remain accommodative by discouraging inflow pressures. The SNB’s two-pronged approach, which combines a negative interest rate and foreign exchange purchases, has helped avert a prolonged slowdown and sustained deflation. This has been achieved notwithstanding the Swiss franc’s role as a safe haven currency, which limits policy independence. Notably, a sharp appreciation following the Brexit vote was avoided despite a jump in inflows.

44. While room for maneuver is ultimately limited, some rebalancing of policy tools would improve policy effectiveness and simplify communications. Scope further remains to widen the negative policy rate differential relative to other major currencies in order to reduce the need for frequent small-scale interventions. This would reserve foreign currency purchases for responding primarily to large episodic inflow surges. However, both tools are subject to increasing costs—risks of cash hoarding and financial instability in the case of negative interest rates, and the potential for valuation losses on the SNB’s expanding balance sheet in the case of intervention—which warrants a cautious approach. Given these constraints, over the longer term, some additional upward flexibility for the Swiss franc should be a policy option.

45. Within the existing debt brake framework, fiscal policy could provide additional support to the economy. The rule’s automatic stabilizers help to dampen the business cycle. However, a tendency to underspend approved allocations and a conservative approach to estimating the output gap results in a tendency to overshoot the structural balance objective that, at the margin, places additional pressure on monetary policy. Moreover, the success of the rule at lowering public debt and keeping budgets broadly balanced, together with the current negative borrowing costs, suggests ample fiscal space exists for a discretionary stimulus in the event a sizable output gap were to open. This flexibility, which is permitted under the rule’s “exceptional circumstances” clause, would avoid overburdening monetary policy.

46. Elevated exposure to real estate by borrowers and lenders could amplify shocks, calling for timely preparation of new property-related measures and strengthened supervision. Credit and house price dynamics have slowed in response to previous macroprudential policies and higher lending rates by banks. However, competition among banks and also from nonbank lenders could drive down rates, triggering a renewed upswing in the mortgage credit-and-house price cycle. Pre-emptively preparing new tightening measures is warranted, with a focus on the build-to-let segment and relying on legally-binding regulation. Further progress is needed to align incentives for external auditors tasked with performing supervisory functions.

47. The too-big-to-fail regulations governing the Swiss G-SIBs reflect their systemic risk characteristics and their large size relative to the Swiss economy. These regulations are appropriately more stringent than the Basel minimum requirements. In addition, risk weights used in banks’ internal ratings-based models should be reviewed, and in the context of the ongoing Basel review, require banks to provide more information on their weights, which would strengthen the credibility of their financial reporting.

48. Early adjustment of pension system parameters will help protect the long-term viability of the social safety net. Rapid population aging will increase future fiscal obligations. Raising retirement ages for women and men and increasing VAT rates with revenue earmarked for pensions will help to narrow the gap in the publicly-funded first pillar pension. Lowering the conversion rate used to calculate annuity payments to better reflect expected interest rates and life expectancy and aligning the rate for compounding premiums with market interest rates would strengthen the stability of the second-pillar, defined-contribution scheme.

49. Continuing to meet international standards is essential to preserve Switzerland as a prime destination for foreign investment and protect the integrity of its banks. Widespread international cooperation is needed to achieve a level playing field across jurisdictions, and Swiss legal standards should continue to adapt to evolving AML/CFT and tax transparency standards. Identified lapses, including in those that could arise the context of the recent FATF evaluation, should be vigorously pursued.

50. Strengthening productivity would protect the economy from future exchange rate shocks and a possible slowing of the labor force, while keeping it at the technology forefront. Preserving close economic ties with the EU while continuing to welcome foreign workers is essential to safeguard Switzerland’s high standard of living. The corporate income tax reform may help raise investment rates by small and medium-sized firms, allowing them to boost productivity, underpin wages and build resilience in the event of an appreciation.

51. It is recommended that the next Article IV consultation take place on the standard 12-month cycle.

Possible Implications for EU Relations of the 2014 Referendum Restricting Immigration

An initiative to limit immigration narrowly won a Swiss referendum vote in 2014. A binding referendum in February 2014 to introduce quotas for immigration won the popular vote with a slim majority (50.3 percent), and was also approved by a majority of cantons, thereby satisfying the double-majority requirement to amend the constitution. In line with the new constitutional article, a law to limit immigration should be put in place by February 2017.

Impeding the free flow of labor from the EU could breach bilateral treaties and impede Switzerland’s access to the single market. Since voting down membership to the European Economic Area in the early 1990s, Switzerland secured access to EU markets through some 120 bilateral accords. A series of core agreements, including a requirement to allow EU citizens to work within Switzerland without restriction, contain a “guillotine clause” that would invalidate all accords if any individual one were terminated. Switzerland is also a member of the Schengen area of border-free travel. Cancellation of these arrangements has the potential to severely constrain Swiss companies’ access to EU markets, which absorb more than half of Switzerland’s exports and are the source for three-quarters of its imports. It could also impede trade in financial services.

Moreover, the Swiss labor market relies heavily on foreign workers, including highly skilled ones. Foreigners account for more than half the increase in the labor force, which has grown by 13½ percent since 2002. Many are cross-border commuters from neighboring EU countries, facilitated by Switzerland’s inclusion in the Schengen area. At present, there is a significant share of foreign nationals in the working-age population, many of whom are highly skilled and fill critical positions in hi-tech industries. Foreigners also contribute importantly to the Swiss old age pension system. Limits on foreign workers would dampen confidence and investment, as well as impeding output growth.

No compromise has been reached with the EU, but talks are continuing. The lower house of parliament has proposed a measure that provides some advance notice of job openings to people residing in Switzerland. The upper house has yet to vote, and any approved measure would need to be discussed with the EU. The Brexit vote could have a bearing on the Swiss-EU discussions, which could extend to broader issues including an institutional framework to allow Swiss laws to adjust swiftly to changes in EU rules.

External Sector Assessment

Staff sees the Swiss external position as moderately weaker (and the real exchange rate as moderately stronger) than implied by medium-term fundamentals and desirable policies. The EBA analysis points to a positive current account gap of around 5 percent of GDP in 2015, however, idiosyncratic factors (large exchange rate and other valuation losses on the net international investment position (NIIP), as well as non-traditional inflows; see Annex I) reduce the gap to -4 to +2 percent of GDP. In view of the large valuation losses in recent years, which depend in part on the size of gross foreign assets and liabilities, the realized current account surplus has been insufficient to stabilize the NIIP.1 Moreover, the EBA REER models suggest the REER was 16–23 percent overvalued on average during 2015, although this reflects in part the implicit mean reversion in the model. Taking into consideration the EBA estimates from both the current account and REER models, as well as staff’s broader analysis, staff assesses the franc to have been moderately (10 percent) above the level consistent with fundamentals and desirable policy settings on average during 2015. However, this assessment is subject to considerable uncertainty, in part reflecting inconsistent findings across the EBA models. Subsequent developments (a lower NEER and more negative inflation in Switzerland than in its trading partners) suggest that the extent of overvaluation for 2016 may have decreased.

2016 External Balance Assessment for Switzerland (for the year 2015)

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Source: IMF staff calculations.

The figure reported is based on the estimated current account gap and an assumed elasticity with respect to the REER. The elasticity used is a common elasticity assumption of 0.71 for exports and 0.92 for imports, adjusted by the size of exports and imports in GDP. Note that closure of a current account gap generally would require a shift in saving or investment rates as well as a movement in the REER. Negative value denotes undervaluation.

After multilateral consistency adjustment.

1 Changes in the NIIP can arise from three sources: (a) acquisition of foreign assets and incurrence of foreign liabilities (the corollary of the current account); (b) changes in the measurement and sampling of data; and (c) changes in the value of assets and liabilities. In the case of Switzerland, valuation effects are likely to be significant in view of (i) the large size of gross foreign assets and liabilities, (ii) large shifts in bilateral exchange rates, (iii) the large imbalance between foreign currency-denominated assets and liabilities owing to the higher share of foreign assets denominated in foreign currency as compared with foreign (and foreign currency denominated) liabilities; and (iv) the larger share of foreign liabilities than foreign assets in the form of equities. Because of (iii) and (iv), the effect of exchange rate and equity price movements on the NIIP is not symmetric. See the Swiss National Bank’s “Swiss Balance of Payments and International Investment Position, 2015.”
Figure 1.
Figure 1.

Switzerland: The Long View, 2000–15

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

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

Switzerland: Selected Monetary Indicators, 2007–16

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Haver Analytics; Swiss Federal Statistics Office; and Swiss National Bank.1/ Nominal rate minus inflation.
Figure 3.
Figure 3.

Switzerland: Monetary Policy, 2000–16

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Swiss National Bank; Swiss Federal Statistical Office; State Secretariat for Economic Affairs; JP Morgan; Bloomberg; and IMF Staff calculations.1/ SARON (Swiss Average Rate Overnight) is an overnight average rate referencing the Swiss Franc interbank repo market.
Figure 4.
Figure 4.

Switzerland: Selected Financial Indicators, 2007–16

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

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

Switzerland: Indicators for Global Systemic Banks, 2006–16 1/

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Bankscope; Bloomberg; Haver; 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.
Figure 6.
Figure 6.

Switzerland: External Accounts and Exchange Rates, 2000–16

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: Swiss National Bank; and Haver Analytics.
Figure 7.
Figure 7.

Switzerland: Housing Markets, 1985–2015

Citation: IMF Staff Country Reports 2016, 381; 10.5089/9781475560398.002.A001

Sources: State Secretariat for Economic Affairs; Swiss National Bank; IMF Global House Price Index; Haver Analytics; and Wuest and Partner./1 Rental prices in these segments.
Table 1.

Switzerland: Selected Economic Indicators, 2014–21

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

Contribution to growth. Inventory accumulation includes also statistical discrepancies and net acquisitions of valuables.

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.

Table 2.

Switzerland: Balance of Payments, 2014–21

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Sources: Haver Analytics; Swiss National Bank; and IMF staff estimates.
Table 3.

Switzerland: SNB Balance Sheet, 2010–15

(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.

Table 4.

Switzerland: General Government Finances, 2014–21

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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, 2006–15

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Source: Federal Ministry of Finance.
Table 6.

Switzerland: Financial Soundness Indicators, 2007–15

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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.

From 2007 onwards broader criteria pursuant to national accounting regulations (FINMA-RS 08/2 Art. 228b) has been applied for defining non-performing loans.

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.

In 2015, the indicator was redefined in line with Basel III regulations, leading to a series break. The 2015 value under the new definition is not yet available.

The indicator “liquid assets as percent of short-term liabilities” has been replaced by the ratio of hiqh quality liquid assets to net cash outflows. This leads to a break between 2014 and 2015.

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