Switzerland -- 2006 Article IV Consultation Concluding Statement of the IMF Mission
March 6, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. The economy strengthened in 2005. Growth was balanced with broad-based contributions from domestic demand and exports. These developments took place in a favorable external environment combined with a slight weakening of the Swiss franc vis-à-vis the U.S. dollar, sustained support from monetary policy, and welcome stirrings of structural reform. The recovery provides opportunities to advance structural reforms further and review entitlement programs to prepare the economy for population aging.
2. Growth prospects for 2006 are positive and risks appear contained. The economy emerged from 2005 with some momentum, and the mission projects growth of about 2¼ percent—thereby closing the output gap sometime in the year. The gradual recovery in the euro area provides a favorable backdrop for Switzerland. Business capacity indicators have increased, which should support investment. The labor markets still show some slack, but the unemployment rate is expected to ease. These developments suggest that the recovery benefited from higher labor productivity growth, with employment gains lagging somewhat the business cycle. This shows the importance of preserving labor market flexibility, a well-known asset of the Swiss economy. At the same time, there are some risks from yet higher and volatile oil prices, geopolitical turbulence, and the eventuality of an avian flu pandemic and of a disorderly unwinding of global imbalances.
3. Headline inflation, at slightly over 1 percent, remains remarkably low, despite the rise in oil costs and sustained supportive monetary conditions. Wage increases were moderate and complemented with increased use of bonus payments, which enhanced wage flexibility and therefore reduced the risk of inflation. Moreover, Switzerland, as a small open economy, has benefited substantially from the globalization supply shock, which tightened competition in the domestic economy through lower cost imports. And last but not least, structural reforms are beginning to have some moderating effect on prices. The entry of large foreign retailers further catalyzed competition and made consumers more sensitive to price differentials. Housing prices, with some exceptions, have increased moderately.
4. Monetary policy needs to move gradually to a neutral stance. This should not undermine the expansion; the policy rate needs to be raised to prevent the underlying monetary policy stance from actually easing. The key task of the Swiss National Bank is to assure that inflation expectations remain firmly anchored, while allowing benefits from reforms and increased productivity, as they occur, to lift growth. This requires flexibility, already shown by the SNB's patience in recent years, but also a willingness to act promptly and decisively, in symmetrical fashion, if signs emerge of price pressures, or if exchange rate volatility disturbs monetary conditions (e.g. a safe-haven shock to the franc).
5. The monetary policy framework and the communications strategy continue to work well. Quarterly monetary reporting, including a rolling three-year inflation forecast, and increased transparency are assisting expectations' formation. However, as noted last year, the linking of housing rents to mortgage rates generates perverse signals of inflation, and with policy rates rising to the neutral level, this distortion will gain relevance. The link between rents and interest rates should be reconsidered. Connecting social security funding to SNB profits might be seen as compromising the independence of the SNB, and undermine confidence in monetary policy.
6. Fiscal performance was stronger than expected in 2005, and should improve further in 2006. The fiscal impulse was slightly contractionary in 2005, while monetary policy was on hold for most of the year. This policy mix was appropriate. As the economy returns to potential output, the fiscal structural deficit needs to be eliminated.
7. The debt brake mechanism has proven valuable in keeping the federal finances under control, but is becoming exposed to structural expenditure pressures. The budgeted expenditure of the confederation in 2006 is consistent with the debt brake and the authorities are on track to eliminate the federal government structural deficit by 2007. This objective should be a minimum for the medium run in view of some erosion in the tax base (stamp duty) and to allow tax reform (lowering the marriage penalty). Moreover, while structural reforms have started, potential real GDP growth is still moderate and pressures on entitlement programs continue to accumulate. The authorities are aware that the room for discretionary expenditure cuts is limited. Therefore, to preserve the credibility of the debt brake, structural fiscal reforms will be needed. These should not be delayed, because forging consensus for their approval will become increasingly difficult as the population ages.
8. Thus, the key challenge for fiscal policy remains to secure long-run fiscal sustainability. The authorities are contemplating a host of reforms. While the projects are in their early stages, the mission welcomes them as a strong signal of commitment to address the aging question:
• Review of federal tasks and administrative reforms. The authorities are reviewing systematically the main government tasks, with completion of the reports aimed for late 2006. An administrative reform is also underway to improve efficiency, including reducing personnel expenditure. Lastly, a subsidy review will be finalized toward year-end. These projects can help lower structural costs and are welcome.
• Social programs. These are the most important areas for reform. One modality that could be considered is to disentangle financial flows between the federal government and the social security system.
Disability insurance. The authorities are seeking more timely intervention for disabled workers and faster reintegration, and a small increase in the payroll contributions. This is only a first step, and additional revenues will have to be found in the next few years.
Health Care. The tasks of financing and providing health care is shared between the confederation and the cantons, which creates a need for coordination. One cause of the accelerating health care expenses is that neither consumers nor medical providers directly confront the costs of services, so that incentives are poorly aligned. Moreover, the autonomous nature of cantons has resulted in large duplication of hospital infrastructure. The mission supports efforts to rationalize clinics, establish hospital benchmarking, and to strengthen performance pay. More freedom to contract health services and insurance will sharpen competition. There may also be a need for higher copayments on the path to a long-run solution.
First pillar pensions. Increasing the female retirement age from 64 to 65, planned for 2009, is warranted in view of increased life expectancy. Further measures may be needed to extend working life. Indexation can be moderated subject to safeguards for the needy, as has been done in several countries. Inevitably, this program, too, will require higher funding in future.
• Civil service pensions (Publica, second pillar). This reform seeks to establish two entities. One for existing retirees (with grandfathering), and one for workers (a defined contribution scheme). This limits the risk of unfunded liabilities.
9. The mission welcomes the authorities' commitment to preparing a Long-Run Fiscal Sustainability Report. It should contain a fiscal baseline projection (on current policies, with cautious assumptions), a set of policy options with preliminary quantification of their impact, and a tentative time table for their approval and implementation.
10. This Report could usefully include a preliminary public sector balance sheet that incorporates an estimate of the net present value of projected future deficits. This information could help assess what public assets are vital for the functioning of the state, as well as provide an indication of the benefits from structural reforms.
11. There has been progress on structural reform, but much remains to be done. Some valuable progress is underway as part of the 17-point growth agenda, and the bilateral agreements with the EU have supported a well-functioning labor market. However, the reform agenda remains large:
• Further to strengthen competition, Switzerland would benefit from the early adoption of the "Cassis de Dijon" principle on a broad basis.
• Farm multifunctionality could be supported by less distortive instruments than high import tariffs and internal support that keep food costs higher than elsewhere.
• Reforms in network industries should be accelerated and the regulatory and supervisory framework strengthened. Switzerland is among the least reformed countries in these industries.
• Harmonizing and simplifying regulations across jurisdictions would boost efficiency.
12. The financial sector had a good year and prospects for 2006 are favorable.
• Results in the banking sector were strong. Banks benefited from the economic expansion, high returns in equity markets, and from cost cutting and improved risk assessment and management. Banks are well capitalized, liquid, and profitable, and stress tests indicate substantial resilience to shocks. Retail banking has become more competitive, with significant growth in mortgage lending and asset management. Mortgage loan-to-value ratios appear moderate and clients' debt service ratios are reasonable. Lending standards, interest rate and credit risks, and risk transfer, must be carefully monitored because banks have gone through a long period of low interest rates that are now beginning to rise. In addition, risks could arise from an abrupt unwinding of global imbalances. The ability of the authorities to assess systemic risk has improved through stronger banking supervision. Moreover, they continue to complement their standard analysis with other qualitative and quantitative assessments to capture structural changes in the banking system and new instruments. The authorities' assessments could further benefit from additional stress tests by the large banks using scenarios specified by the SNB in collaboration with the Banking Commission.
• Insurance companies also have made progress in 2005. Their corporate health improved based on restructuring, strengthened supervision, improved risk management, and strong performance in the equity markets. The catastrophic natural events in the United States affected the profitability of the reinsurance industry, but its overall performance remains good.
• The financial position of the second pillar pension funds has improved, but underfunding remains. There are several issues in this sector that warrant further analysis in the FSAP update.
Published data are likely to understate underfunding because future liabilities are discounted with an average technical interest rate of around 4 percent, while the long-run market interest rates are barely above 2 percent. Moreover, life expectancy appears underestimated as well.
The system is inadequately and unevenly supervised by cantons. Supervision is fragmented and some cantons may not have the technical expertise or resources to conduct thorough supervision, or to follow up on reporting. The mission recommends a more centralized and harmonized supervisory system, authorized to regulate and enforce compliance. In the longer-run, the funded pension system should also be oriented toward risk-based regulation and supervision.
In the pension segment, supervision is different from that of life insurance, which creates distortions. Also, the portability framework for life-insurance plans could produce stress under circumstances of interest rate volatility.
The system should be governed by market-based parameters.
13. Economic statistics should be improved to strengthen the basis for sound economic analysis and policy. The upgrading of the quarterly national accounts and the compilation of annual financial accounts are welcome, but there is scope for further improvement. 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 encourage the compilation of a monthly monetary survey with detailed sectorization.
14. We urge Switzerland to continue to meet its target for official development assistance of 0.4 percent of GNI. Moreover, the poorest countries would be greatly assisted by efforts, including in the WTO trade round, that favor 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.