Mission Concluding Statements
Switzerland and the IMF
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INTERNATIONAL MONETARY FUND
Bern, February 24, 2003
1. In the face of lackluster external demand, the Swiss economy is continuing to mark time. Contrary to expectations this time last year, the world economy did not pick up with the hoped-for strength, leaving Switzerland mired in stagnation. However, it would be wrong to over-dramatize the situation. Despite a steep fall in investment, weak exports, and rising unemployment, consumption has continued to grow. And although some sectors have contracted sharply-notably the financial sector and tourism-much of the economy has shown a degree of resilience. The challenge for the period ahead is to foster the conditions for a recovery in demand. Looking longer term, more competitive domestic markets will be required to support higher productivity and output growth.
2. There is good reason to expect growth to strengthen during this year, but major uncertainties need to be recognized. The IMF and most forecasters expect global growth to strengthen. Domestically, monetary conditions have been eased considerably and there is still stimulus in the pipeline. Against this background, the mission projects growth of about ¾ percent in 2003. But the possibility of armed conflict in the Middle East is a major drain on confidence, a factor behind high oil prices, and a potential trigger for a safe-haven appreciation of the Swiss franc. While a swift resolution could dissipate uncertainty and high oil prices-and thereby present upside potential for the forecast-less benign outcomes are clearly possible. In addition, the assumed recovery in Europe, Switzerland's main trading partner, is not yet established and financial markets remain depressed.
3. Monetary policy has been conducted flexibly as evidence of more persistent demand weakness has accumulated. A clear focus on medium-term price stability-and an impressive track record of delivering in this regard-has enabled the Swiss National Bank (SNB) to respond promptly to the evolving economic situation and to upward pressure on the Swiss franc; short-term interest rates have appropriately been reduced to almost zero. On current prospects, and given the absence of inflationary pressures, very low interest rates can probably be maintained for some time-indeed, taking rates down their final notch could be considered. At the same time, intervention in foreign exchange markets would be warranted if strong upward pressure on the Swiss franc resumed. Although we would not see the Swiss franc as over-valued from a longer-term perspective, it has appreciated relatively rapidly in effective terms over the past couple of years and this is difficult for the economy to absorb in the short term.
4. While the monetary policy framework has proved to have sufficient degrees of freedom, policymakers could yet be challenged if the upturn were further delayed. Essentially, the SNB has run out of room to counteract a rising output gap through lowering interest rates. Absent an exchange rate appreciation, there would be no clear trigger when to move to less conventional policy instruments such as foreign exchange intervention. Meanwhile, delay could risk the economy slipping into a prolonged slump: with inflation already below 1 percent, prices could begin to fall and exacerbate weak demand through rising real interest rates. The SNB will thus need to continue to monitor the situation carefully: a short period of mild price declines would not of itself be a major concern, but could be the first step on a risky path. At a more general level, the difficult choices that low inflation and interest rates could force on the SNB argue for inflation over the medium term to be on average in the upper half of the 0-2 percent price stability range.
5. Although the federal budget is under strain, the overall fiscal situation is relatively sound from a macroeconomic perspective. The general government deficit was small in 2002. It is likely to widen in 2003, but this will broadly reflect the operation of the automatic stabilizers, which is appropriate at this stage of the business cycle.
6. The federal budget is heading for a showdown with the new debt brake mechanism, which calls for balanced budgets over the economic cycle. The debt brake was introduced at a time when the structural deficit was larger than expected. On current spending plans, we project a deficit of just over SwF 3 billion (0.8 percent of GDP) in 2003 and, including the cost of the family tax package, about SwF 5 billion (1.1 percent of GDP) in 2006. The debt brake rule does not require further action this year, but would call for a considerable reduction of the deficit in 2004. The required adjustment is inflated somewhat by the methodology used to calculate the cyclical component of the deficit, but ultimately there is a sizable structural component to correct.
7. The authorities will need to reduce the structural deficit in a manner that credibly preserves the debt brake objectives. Balancing the budget over the cycle is a sensible rule as it will be important to avoid a repeat of the run-up in public debt of the 1990s, especially given the longer-term fiscal strains that will arise from an aging population. The ground for fiscal consolidation should thus be prepared this year by enhancing expenditure restraint: supplementary budget requests should be kept well below last year's level, for example. The expenditure growth built into the financial plan for 2004 and beyond is no longer viable and the budget and the revised financial plan will need to be much more austere. However, in the end, a degree of pragmatism will be needed. Given the small base of spending that the federal government controls directly, front-loading expenditure adjustment in 2004 could be disruptive. If plans and the measures underpinning them-including perhaps tax increases-are transparent, realistic, and binding, the credibility of the debt brake objectives can be preserved even if the letter of the rule is not observed in the short term.
8. The financial sector could face an extended period of consolidation and will thus need to be watched carefully by the supervisors. After having accounted for about half of the growth in the entire economy in the past decade, the sector is bearing the brunt of sharp declines in financial markets. Banks are making considerable adjustments and white collar unemployment has been a novel feature of this downturn. Since last year's FSAP exercise, there has not been a serious deterioration in credit quality or banks' capital adequacy. But strains can be expected to persist, especially if recovery is further delayed and financial markets remain depressed. For the large international banks and banks that rely heavily on fee income related to the performance of financial markets, global competition will likely intensify thereby placing a premium on prudent risk management, good reputation, and cost containment.
9. Supervision remains strong and is continuing to adapt to the changing world. The authorities are acting on the FSAP recommendations and their own initiatives. In this context, we encourage fast enactment of a revised law on bank rehabilitation, liquidation and deposit insurance, as well as plans to integrate banking and insurance supervision. We also support increased resources for the supervisory authorities and their ongoing efforts to strengthen oversight of bank auditors. The new anti-money laundering ordinances that should come into effect in June are a further welcome development that should provide an important additional reputational safeguard for Switzerland's financial sector.
10. Strains in the pension and insurance sectors also raise important public policy questions. A strong, multi-pillar pension system puts Switzerland well ahead of most nations in managing demographic aging. This said, the fully-funded second pillar has been hard hit by large stock market losses. Although systemic implications may not be overly worrying, the strains in the sector could have significant macroeconomic spillovers, especially if asset prices were to fall further. In this context, the reduction in the minimum interest rate on pensions to 3¼ percent was a sensible first move-particularly bearing in mind that contributors benefited from the earlier stock market boom-as it will help institutions to rebalance long-term assets and liabilities. But with government bond yields barely above 2 percent, a further reduction will almost certainly be needed this year. From the supervisory perspective, accelerated efforts are needed to improve standards by passing a new insurance law in line with EU insurance legislation and to strengthen oversight of pension schemes so that interventions remain timely and the consumer is protected.
11. With the financial sector likely to continue consolidating for some time, other sectors will have to contribute more to growth if the recovery is to be robust and sustained. The prospects for this happening will remain uncertain as long as important market inefficiencies are allowed to persist. Switzerland offers many attractive features to investors, not least a flexible labor market with well-educated workers. But the prevalence of sheltered sectors and a poorly functioning internal market not only hamper growth in the affected sectors but also keep prices and business costs high across the entire economy.
12. In this context, the slow momentum of product market reform remains disappointing. The broad problems have long been diagnosed: the Internal Market Act lacks effectiveness; cartels and price fixing arrangements inhibit competition; heavy subsidization of agriculture misallocates resources; public procurement practices are complex and often restrictive; and unliberalized network sectors deny consumers and producers the benefits of lower prices and competitive opportunities. With the passage of the new Competition Law now in sight, there will be a better framework to combat cartels, barriers to entry, and price fixing. In the network sectors, postal liberalization is starting to catch up with the rest of Europe, but the long-awaited unbundling of the last mile in telecommunications remains stalled and public rejection of the authorities' proposals for the electricity sector was a major setback. Elsewhere, solutions remain on a slow track. At a time of highly publicized corporate scandals at home and abroad, there is an understandable lack of trust in market solutions. But the issues need to be separated, with corporate governance problems addressed through strengthening the new governance code and improving the transparency of company accounts. Meanwhile, political leadership is needed to revive the reform momentum. A more systematic sectoral approach that exposes the reasons for high prices might be a more effective way to build support for dismantling market distortions.
13. We hope that official development assistance (ODA) will be spared from further budget cuts and urge the government to keep to its target of raising ODA to 0.4 percent of GDP by 2010. Help to the poorest nations will also come from the authorities' initiative to eliminate trade barriers. We encourage the government to leverage this welcome move by working within the new Doha trade round to significantly reduce protection of agriculture.
14. A modest additional allocation of spending would significantly improve economic statistics. Plans to upgrade the national accounts later this year are welcome, but many gaps and quality deficiencies will remain in the flow of funds, the production accounts, and the quarterly estimates, as well as in many other statistical areas. This will continue to hamper the analysis carried out by both policymakers and the private sector.
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The mission would like to thank the authorities for their hospitality and stimulating and open discussions.
IMF EXTERNAL RELATIONS DEPARTMENT