Switzerland -- 2007 Article IV Consultation Mission, Concluding Statement
March 5, 2007
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 is performing well as the expansion enters its fourth year. Growth is balanced, inflation is low, and employment is strong. These developments reflect cautious monetary and fiscal policies and structural reforms, in a favorable global environment. The key challenges are to avoid complacency and to consolidate the good performance by continuing with structural reforms.
2. Prospects for 2007 remain positive and risks appear balanced. Growth likely peaked in 2006, and in 2007 is expected to ease to 2 percent. Consumer spending is supported by strong employment growth, while high capacity utilization is stimulating equipment investment. Exports are benefiting from weakness in the franc, strong sales in pharmaceuticals and precision instruments, and high earnings from financial services. Downside risks would emerge if external growth were to slow significantly or global imbalances unwind abruptly—thereby appreciating the exchange rate while slowing financial service exports. Upside risks would emerge if the exchange rate were to remain weak or employment accelerate further.
3. Potential growth may have increased. The labor market opening to EU citizens has generated a positive supply shock, while entry by foreign firms in retail and other sectors is strengthening domestic competition. This suggests that potential growth may have shifted up in the 1½-2 percent range, and that the output gap may be small or nonexistent.
4. Inflation is expected to remain low. Lower oil prices slowed headline inflation to ½ percent (core inflation is 1 percent), while globalization and stronger domestic competition limited the pass-through from the exchange rate and wholesale prices to the CPI. Nevertheless, higher import and wholesale prices could still filter through to consumers, which needs to be monitored. Wage data are deficient, but indicators suggest that wages are rising around 2 percent a year, which would not threaten price stability.
Monetary and exchange rate policies, and competitiveness
5. The normalization of policy interest rates is close to ending. The SNB has a strong reputation for delivering price stability, which has firmly anchored inflation expectations. A slight further tightening appears appropriate and has been priced in by markets.
6. Further policy steps are surrounded by larger uncertainty. Judging the appropriate monetary stance becomes more difficult around turning points and growth appears at its cyclical peak. Concurrently, monetary policy needs to take into account structural changes in the economy. If labor supply and productivity have improved, Switzerland could enjoy more buoyant activity than in the last decade without generating undue price pressures. But the exchange rate has been weak, which could yet affect costs. Therefore, monetary policy needs to remain flexible.
7. The monetary policy framework and communications strategy are working well. Quarterly monetary reporting with a rolling three-year inflation forecast are assisting expectations' formation. Nevertheless, one area where the mission continues to feel unease is the link between interest rates and housing rents. As noted on previous occasions, this link introduces a perverse signal of inflation—without rents, CPI inflation is even lower. A second distortion is that publicly owned banks apparently are under pressure not to increase their mortgage rates as this would cause rent increases.
8. The exchange rate regime is a free float and should continue to serve the country well. Recent exchange rate behavior is a conundrum. Switzerland's large current account surplus, strong international investment position, and improved growth rate suggest that the currency should strengthen. However, the emergence of the euro as a safe haven currency and structural reforms that reduce domestic prices would be consistent with a lower real exchange rate. Carry trades have been associated with currency weakness, which might be temporary. A market determined exchange rate is best equipped to handle this uncertainty.
9. External competitiveness is strong and the current account surplus is very large. The mission recommends that the authorities analyze further the factors generating this surplus. Currency weakness, Switzerland's large stock of net foreign assets, and its position as an international financial center and provider of wealth management services, could be playing a role. Nevertheless, deeper structural reform in the internal market, such as adopting the "Cassis de Dijon" principle, could further energize domestic demand and make a contribution, appropriate for Switzerland's size, to the reduction of global imbalances.
Financial sector policies
10. The financial sector is performing well. The Financial Sector Assessment Program update mission found that the system is strong and prospects positive. The main downside risks are external, and related to a possible increase in volatility. Stress testing suggests that the banking sector is resilient to a variety of shocks, while some insurers remain vulnerable to equity and real estate price adjustments. Occupational pension funds are improving their funding, but aggregate coverage is not yet adequate, especially in some public sector funds.
11. Switzerland is upgrading its regulatory and supervisory arrangements in recognition of evolving risks and international best practices. There remain some opportunities for enhancement.
• FINMA. Establishing a unified and independent financial regulator, the Financial Market Authority, is welcome. The draft proposals could be strengthened by providing the regulator with increased sanctioning power, while avoiding conditions that might limit its operational and prudential capacity. It is critical that the supervisor be equipped with adequate staffing and financial resources.
• Large bank supervision. Banking supervision has been strengthened. One area that requires further attention is overseeing liquidity. Given the complex nature of the banks and their systemic importance, continuing efforts should be made to evaluate regularly their evolving risk exposures and complex operating models. Advanced capital and liquidity regimes and stress testing should be implemented proactively.
• Insurance sector. The Swiss Solvency Test (SST) is at the forefront of risk-based liability management. Preparations for the SST have identified some high-risk insurers. These should receive focused inspections and, if needed, be required to increase their capital and reserves or reduce risk exposures.
• Pension funds. Pension sector supervision across cantons remains fragmented and uneven, and should be upgraded. Moving toward a centralized approach to regulation and supervision could provide benefits, including economies of scale and uniform supervision and enforcement. The authorities should consider introducing risk-based funding requirements and strengthening integrity regulations.
• Cantonal banks. Governance of cantonal banks could be bolstered by giving them the overriding goal of profit maximization while dedicating part of their profits through the fiscal process to achieve social objectives.
12. Fiscal performance has generated a surplus one year ahead of target. The public finances have benefited from cyclical revenue gains resulting in small surpluses at all levels of government except the social security accounts. The fiscal stance in 2006 appears about neutral. In the Confederation, the debt brake has worked well, and the authorities have been steadfast in their implementation of two sizeable expenditure reduction programs. Together with asset sales and the GDP upswing, the debt ratio has declined for the third year in a row.
13. The main risk is procyclical behavior, which needs to be avoided.
• Confederation. The 2007 budget and medium-term financing plan foresee smaller budgetary surpluses than in 2006, even though the economy is expected to be buoyant. Moreover, the authorities are contemplating large extraordinary expenditure (including a new off-budget infrastructure fund in 2008) and settlement of overdue pension liabilities outside the debt brake. Offsetting measures should be precisely defined. The authorities should compensate for these extraordinary expenditures inside the debt brake in the medium term to preserve the integrity of the fiscal framework and its objective of balance over the cycle.
• Cantons. While cantons have used most of the proceeds from SNB gold sales for debt reduction, they are also taking advantage of the buoyant economy to cut tax rates. In part, the tax reductions reflect improvements in the New Financial Equalization Mechanism, which provides incentives to lower the tax burden rather than maximize it as in the previous system. Thus, while lower taxes partly reflect the transition to the new equalization system, and contain many positive aspects, they also reflect Switzerland's competitive federalism which generates tax cuts during an upswing, without taking account of deficits in social security that need to be addressed.
14. Measures beyond the debt brake are needed to solve long-run fiscal pressures. The debt brake covers the Confederation budget but not the growth in social security entitlements. In this regard, we welcome the settlement of obligations in the civil service pension fund; its move to a defined contribution plan; and the increase of the female retirement age to 65 by 2009. In due course, the retirement age for men and women should be raised further in view of increased life expectancy. Other measures will still be needed.
15. We welcome the preparation of a long run fiscal sustainability report. The report needs to provide a view on expected fiscal pressures over the long run under current policies. This will offer insight into structural fiscal dynamics, and can be used for monitoring and scenario analysis to illuminate the impact of measures in safeguarding social security. Switzerland's public finances are feeling the effects from population aging, and delaying decisions will eventually require more severe adjustment.
16. Fiscal data. The Confederation is commended for its decision to implement an accrual accounting system, including the development of a public sector balance sheet. The cantonal and local governments still provide fiscal data with long lags.
We thank the authorities and others for interesting and open discussions, and generous hospitality.