Switzerland -- 2005 Article IV Consultation, IMF Concluding Statement
March 7, 2005
1. The Swiss economy returned to moderate output growth in 2004, after several years of stagnation, but structural concerns remain. Exports rebounded and, with supportive policies, corporations invested in machinery and equipment, and households boosted residential construction and purchased furniture and other consumer durables. These developments improved the fiscal balance and allowed a gradual turn in monetary policy toward neutrality. Some progress was made in structural reforms, but much remains to be done. On this basis, it is unclear that a significant increase of potential output growth is in sight. Nevertheless, strengthening output growth is important because the long-run fiscal outlook appears inconsistent with promised entitlements in an aging society.
2. The economic expansion is expected to continue, notwithstanding a soft patch at end-2004. Growth was more balanced than in some partner countries, with an expansion in all demand components. Nevertheless, weaker demand in the euro area, the U.S. dollar depreciation, and higher oil prices dented the upswing. The external factors are projected to improve again as the year unfolds, and the SNB decision in December to place monetary policy on hold was correct. The mission expects growth in 2005 to pick up in the second half of the year, but on average to be lower than in 2004. Risks to the outlook are a slump in the U.S. dollar, a drop in financial markets, persistent euro-area softness, or a spike in oil prices.
3. Inflation is expected to remain low, with a temporary uptick as higher oil costs pass through the price system. Wage settlements are appropriately moderate in today's labor markets, and are not seen as pushing up inflation. Moreover, the output gap leaves room for noninflationary growth, and the liquidity overhang has largely dissipated. There is some strength in housing prices in one or two localities, but it is not a general phenomenon.
4. Monetary policy continues to be expansionary and patience is appropriate before making another move. With stronger economic activity, the step-wise lifting of the policy rate in June and September 2004 by a cumulative 50 basis points was opportune. This did not inhibit the upswing as the policy rate remained negative in real terms. Moreover, it provided a signal of leaning against the wind of oil prices—thus providing an anchor for expectations—while creating room for policy maneuver downward. Looking forward, the question is not whether monetary policy should move to a more neutral rate, but at what pace. For now, monetary policy should be on hold until the recovery has firmed up again.
5. The monetary policy framework is working well and the communications strategy has been fine-tuned. The shift from semi-annual to quarterly monetary reporting, including a rolling three-year inflation forecast, and the release of additional information on money market operations, increased transparency and was well received. However, one aspect of the monetary transmission mechanism deserves attention. Housing rents are linked by law to interest rates. This generates perverse signals of core inflation, and consideration should be given to cutting the automatic link between rents and interest rates.
6. The public finances were stronger than expected in 2004, and need to continue improving in 2005. The fiscal impulse is projected to be slightly contractionary in 2005, with monetary policy on hold. This policy mix is appropriate: as fiscal policies are being adjusted, monetary policy makers can afford to be patient.
7. The debt brake mechanism has proven very valuable to keeping the federal finances under control. The 2005 budget contains an expenditure level that is consistent with the debt brake, and automatic stabilizers should be allowed to operate. The complementary adjustment program (Entlastungsprogramm 2004-EP 2004), now before parliament, needs to be approved as well. The EP 2004 seeks to eliminate the federal government structural deficit by 2007. The mission supports this objective as a minimum for the medium-run. Low average real GDP growth and pressure on social security place added emphasis on fiscal prudence. Indeed, the authorities need to undertake an analysis of the key public sector tasks, focusing resources on priority activities and aiming at lasting structural adjustment, lest repeated short-run EPs lead to fatigue and undermine the debt brake.
8. The new constitutional structure for fiscal federalism (Neuer Finanzausgleich-NFA) is welcome. The NFA clarifies and improves the assignment of tasks between the federal and lower level governments with a focus on subsidiarity; and modifies the financing mechanism to improve efficiency. Limiting incentives to spend and increasing inter-regional equity are especially valuable goals. The debt brake does not encompass the lower level governments, which could leave the federal government too isolated in its task of fiscal management—therefore, the NFA needs to be implemented also with a view to strengthening the overall coherence of fiscal policy.
9. The proceeds from SNB gold sales are one-time flows and should be used to reduce debt. The sales are not a permanent source of income, and thus should not be used for expenditure. This would postpone reforms and make future corrections more painful.
10. The key challenge for fiscal policy is to establish intertemporal consistency. The impending demographic shift is gradually leading to large pressures on social security (including first-pillar pensions, disability, and health care). Although the existence of a large second-pillar pension system leaves Switzerland better prepared than some peers, this does not diminish the difficulties in the public finances. These issues, which by no means are unique to Switzerland, must be addressed before the political economy of aging makes it more difficult to agree on adjustment steps—by 2010, more than half of the voters will exceed 50 years of age. A significant effort will have to be made to bring the need for a long-run fiscal strategy to the public. In our view, this requires putting the analytical issues in the public debate: the proximate size of the intertemporal fiscal gap; a well-rounded and quantified set of policy options to close this gap over time; and a discussion of burden sharing. Options include different mixes of revenue increases, expenditure cuts, and structural reforms to increase growth, keeping in mind the need to protect the most vulnerable members of society. As is done in some countries, Switzerland could prepare annual long-run fiscal sustainability reports bringing together demographic and growth scenarios, and an assessment of the unfunded fiscal obligations that an aging population could create. This will also help to show that waiting makes the solution more costly.
11. Structural reforms are proceeding too slowly. The public is increasingly aware that prices and living costs are substantially higher in Switzerland than in surrounding countries. Some valuable progress is underway as part of the 17-point growth agenda, in addition to the bilateral agreements with the EU, increased efforts at challenging cartels, and lower long-distance telephone costs, but significant impediments to higher growth remain, for example:
• Domestic trade in goods and services is heavily burdened by market segmentation and red-tape,
• High import tariffs and price support for agriculture keep food prices significantly higher than abroad,
• Much remains to be done in network industries for electricity and gas, telecom, postal, and rail services,
• And not least, the potential is great to raise efficiencies by harmonizing and simplifying regulations across jurisdictions, and by seeking economies of scale in health care delivery.
In short, the lack of a common market and competition inside Switzerland drives up nontradables prices and undermines dynamism—hence keeping output and jobs growth low. Removing distortions and boosting growth can alleviate pressures on the social security system. In the end, neither monetary nor fiscal policies can substitute for these needed structural reforms.
12. Results in the banking sector have improved. 2004 was a good year, with sharply higher profits, significant increases of assets under management, and a strengthening in balance sheets. Progress appears to have been made in the whole sector, assisted by reductions in operating costs and higher growth. Domestic mortgage lending in particular was buoyant, and care must now be taken to avoid repeating the real estate euphoria of the late 1980s. Also, while banks are better capitalized than proposed under the Basle II capital adequacy guidelines, risks must be carefully monitored by management and supervisors. The authorities' proactive attitude in strengthening banking supervision is commendable, and in this context efforts should continue to bolster the quality of external audits and in facilitating uniform assessments of debtors. On July 1, 2004, the revised Banking Act was put into force, harmonizing under the sole responsibility of the Swiss Federal Banking Commission the supervision, reorganization and liquidation of banks. Switzerland is preparing amendments regarding the application of its Money Laundering Act to individual nonfinancial areas, and the increase of transparency concerning the owners of bearer shares. Switzerland is also undergoing in 2005 a third round of mutual evaluation by the member states of the FATF.
13. Insurance companies have also recovered but there remain elements of weakness, and several second-pillar pension funds continue to be underfunded. Profits in insurance companies have improved with the recovery of asset markets and better underwriting results, but the very low interest rate environment continues to pressure the life segment and the second pillar pension funds. For the insurance industry, we welcome the move toward risk-based supervision. Regarding the old-age saving plans, some regulatory issues deserve attention. Minimum interest rates were slightly increased, even though effective market returns on invested assets remained low. Conversion rates that determine the annual benefit upon retirement and the accounting rate used to determine the present value of contractual pension liabilities have been reduced but in the mandatory segment remain too high—thereby underestimating the amount of underfunding in the second pillar. Greater weight should be given to analytical formulas in parameter setting, alongside the needs to protect the beneficiaries, while supervision should be strengthened by introducing harmonized standards across cantons and by shifting from regulatory to actuarial assessments. At a minimum, the long lags in pension fund data need to be remedied, and lower discount rates should be employed to calculate funding adequacy. In such cases, provisions already exist to allow a reduction in benefits or to raise contribution rates, which should be employed to restore the reserves.
14. Additional resources need to be allocated to the improvement of economic statistics to strengthen the basis for sound economic analysis and policy. The upgrading of the quarterly national accounts, the launching of a survey on the cost of borrowing, and progress in compiling annual financial accounts are welcome. Cash fiscal data are of high quality but suffer from lags for lower levels of government; those on an accrual basis will be prepared for 2007. We also encourage the compilation of a timely monetary survey with detailed sectorization.
15. Despite a challenging fiscal task, we urge Switzerland to meet its target for official development assistance of 0.4 percent of GDP by 2010. Moreover, the poorest countries would be greatly assisted by efforts to eliminate trade barriers, including in the WTO trade round that favors lower levels of agricultural tariff and nontariff protection.
The mission is grateful for the generous hospitality it received, and for the frank and stimulating discussions it enjoyed with all interlocutors.