Switzerland: 2008 Article IV Consultation, Concluding Statement of the IMF Mission
March 17, 2008
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 Swiss economy performed impressively during the recent global upswing. Although Switzerland's international preeminence has eroded in some respects, performance in the recent cycle has been strong. Indeed, Switzerland rode the global expansion with much success, and growth exceeded the euro area average in the past four years. High-value added manufacturing gained in strength. Switzerland's position as a major global financial center was reinforced. And a broader emphasis on services delivery has opened up new growth possibilities. Building on long-standing strengths—advanced infrastructure, a skilled and flexible workforce, openness to the flow across its borders of trade, capital, and people, low tax rates, and a small government—these developments augur well for the future.
2. But the risks to its financial service industry threaten to dent the gains achieved. The very strengths of the Swiss economy, its openness and its dynamic financial sector, also expose it to adverse developments overseas. As such, the Swiss economy experiences sharper swings than most advanced nations. In turn, the risk-management strategies of Swiss banks can generate negative spillovers for the global financial system and the world economy. Swiss public policy, therefore, has international consequences.
3. The policy priority is to pay due attention to securing greater domestic financial stability. The task is challenging and the lessons from the ongoing financial tensions can only slowly be incorporated into regulatory and supervisory practice. Nevertheless, the proactive approach of the Swiss authorities to increase buffers in the financial system is welcome. Monetary and fiscal policies must play supportive roles within their well-defined frameworks. In this regard, the tendency of monetary policy to be accommodative and impart a modest stimulus while the fiscal stance remains conservative appears to strike the right balance for now. As events unfold, these choices may need to be revisited.
The Near-Term Outlook
4. A significant slowdown in growth is projected. The current global environment is characterized by a high degree of uncertainty and, hence, projections are subject to more than the usual imprecision. The momentum from buoyant growth in much of Europe during 2007 is still evident. Industrial capacity utilization and order books suggest continued strength, and sentiment indicators are moderating only gradually. Yet, financial markets are signaling a more serious growth deceleration. From 3.1 percent in 2007, we expect GDP will grow by just under 1½ percent in 2008 and stay in the same range in 2009. While outcomes could be better, even lower growth is a real possibility as global financial imbalances unwind.
5. The slowdown stems from several sources, which will likely emerge sequentially. Exports of goods and services will slow at first, as U.S. and European imports decelerate. While the stronger Swiss Franc has not reached levels that would significantly hurt exports, continued appreciation could have a material effect, especially in combination with a further slowdown in world growth. GDP growth may initially be held up by consumption growth, given the recent strength in employment. However, slowing exports, the inflationary effects of the oil price increase and, in particular, the global financial tensions can all be expected to dent consumer confidence, leading to weaker consumption expenditures in the later part of 2008 and early 2009. This projected weakness in consumption explains our somewhat lower GDP growth estimate than that of the authorities.
6. The current account surplus, to a large degree, reflects structural and cyclical factors. The surplus, which we project will decline from 17 percent of GDP in 2007 to 15½ percent in 2008, is generated by substantial service exports and net investment income. After adjusting for structural and cyclical factors (and the asymmetrical accounting treatment of retained earnings between direct and portfolio investments), the size of the current account is about 4 percentage points greater than the norm based on Switzerland's economic fundamentals. The reduction of the double taxation of dividend income could lead Swiss firms to reduce their retained earnings and hence reduce the excess over the norm.
Maintaining Financial Stability
7. The Swiss authorities have responded vigorously to limit the knock-on effects of the current financial tensions. They have injected liquidity into the banking system, often in coordination with other major central banks, maintained an enhanced oversight of the major banks and insurance companies, and worked actively with other regulators to share information, coordinate supervisory activities, and draw lessons for the future.
8. Further policy actions must reflect the realities of an intensely competitive global banking environment. Global banks operated in a manner that proved to have adverse systemic implications. They engaged worldwide in activities with low margins but also with apparently low risk. Partly because of the limited regulatory capital requirements for these perceived low risk activities, returns to shareholders were high. But this strategy also generated high leverage (nominal assets in relation to capital). Within this general approach, some took on more risk than others. As such, when their assets were revealed to be much riskier than earlier thought, and had to be written down, the banks concerned were faced with the prospect of inadequate capitalization and loss of confidence, and had to move rapidly to raise fresh capital in increasingly difficult markets. Looking ahead, therefore, the Swiss authorities, along with their counterparts elsewhere, are rightly focused on increasing the buffers in the financial system.
9. More realistic risk measurement is crucial. It is widely agreed that the current financial distress would have been mitigated had the Basel II framework been fully implemented. Compared with Basel I, the new framework captures off-balance-sheet assets better and takes a more sophisticated approach to measuring risks. In addition to implementing Basel II, the Swiss authorities are also revisiting their risk-based capital framework, drawing on the recently revealed outcomes and correlations across asset classes. These assessments will, in turn, lead to typically higher capital requirements.
10. However, given the limits of any risk-based framework, consideration of additional capital is merited to cushion against unanticipated risks. Using a leverage ratio for large banks to supplement existing capital requirements is under discussion. Such an approach would add a transparent capital buffer. It also has its limitations, not least the possibility that banks will have an increased incentive to "hide" their assets by moving them off-balance-sheet. However, implemented with appropriate flexibility and safeguards, a leverage ratio approach could serve as a useful complement to the existing regime, while helping to strengthen the supervisory response to future increased risk-taking by the banks.
11. While additional capital will also mitigate liquidity risks, further development of liquidity risk management in response to recent events is a priority. In line with the recommendations in the Financial Sector Assessment Program (FSAP) update in May 2007, the authorities are developing a stress testing framework to improve global liquidity risk management by the major banks and are more actively reviewing banks' contingency plans and liquidity management policies. They are also collaborating with other regulators internationally to enhance global practices. In contrast to this proactive approach for capital and liquidity requirements, the authorities are pursuing the options for enhanced disclosure norms within the context of international discussions and developments.
12. The ambitious insurance regulation agenda needs continued prioritization and attention to overall resources. Market events have had a less severe impact on insurance companies than on the banks. Risk management in the sector has been improving, spurred by continuing implementation of the innovative Swiss Solvency Test (SST). The recent application of the SST to reinsurance companies is welcome, as is the commitment to thorough reviews of companies' SST results. In line with the FSAP recommendations, the regulator is enhancing qualitative requirements such as internal controls and there are plans to develop onsite supervision further and to strengthen international supervisory cooperation on the major groups. This extensive work program requires careful management within the resource envelop.
13. Regulatory refinements, however, will be insufficient without efforts to boost supervisory capabilities and resources. The Swiss Banking Commission faces the special challenge of keeping pace with two large, sophisticated, global banks. Similar challenges arise in regulating insurance and reinsurance groups with global reach. The current regulators-and their successors in the integrated FINMA that takes over on January 1, 2009-need the requisite independence and resources to meet their responsibilities. In this regard, the law constituting FINMA helpfully provides flexibility in budgeting, staff compensation, and strategic planning. It would be appropriate to use this flexibility to retain supervisors skilled in modern financial practices and to attract still more as Switzerland's advanced regulatory approach develops further in response to current market events.
14. Since FINMA will remain at a resource disadvantage relative to the groups it deals with, it deserves to be bolstered in various ways. Early decisions to complete the appointment of the board and senior management of FINMA would reinforce the vision for FINMA as a force in domestic and international initiatives to improve financial regulation. In addition, the traditional approach of close supervision may need to be supplemented by rules that specify transparent benchmark performance measures and supervisory responses. In this context, also of value would be a further shift to onsite activities by supervisors, with appropriate reliance on external auditors to monitor regulatory compliance. So too would be efforts to build on existing cross-border supervisory arrangements for global groups, to secure even more active support of host supervisors in maintaining the stability of global operations.
15. The current conjuncture also poses special challenges for monetary policy. Fueled by oil and food prices, inflation reached 2.4 percent in February. For 2008, the average inflation rate is projected at 2.0 percent, falling to 1.4 percent in 2009, as also assessed by the Swiss National Bank (SNB) in the context of its March policy decision. Despite the projected decline in the inflation rate to below 2 percent, the risk is that the current high rates may persist. The greater inflation risk has unfortunately coincided with worsening growth prospects. At successive policy decision points, this polarization has increased, heightening the trade-offs involved. Moreover, the consideration of safeguarding against a particularly adverse outcome has added to the complexity of decision making.
16. In this complex and uncertain environment, the SNB has steered a carefully calibrated policy course. In September, the Governing Board of the SNB raised the target range for the 3-month Libor by 25 basis points to 2.25-3.25 percent, guided in part by the inflationary concerns. The ongoing market turmoil had pushed the Libor rate to above the mid-point of the existing range, where it is typically steered. In response to this market-driven tightening of monetary conditions, the SNB lowered the 1-week repo rate to bring the 3-month Libor to 2.75 percent, the mid-point of the range, in effect creating a useful accommodation. Since then, the target range has remained unchanged as slower expected growth and the insurance motive have balanced the inflation risks. However, maintaining the 3-month Libor at or close to 2.75 percent—and in practice, preventing it from rising—has sometimes implied an easing stance achieved through lowering the shorter-term repo rates.
17. While the monetary policy stance has, thus, been appropriate, the operational framework by which this has been achieved deserves, in due course, further consideration. The September decision—when the target range for the 3-month Libor and the operational 1-week repo rate were moved in opposite directions—occurred at an unusual moment in financial history, when short-term credit spreads increased sharply within a few weeks. The likelihood is that the target range and the 1-week repo rate will only rarely move in opposing directions. And, indeed, the SNB has maintained its target range steady since September, providing monetary accommodation when necessary by adjusting the 1-week repo rate. This has imparted some flexibility to the conduct of monetary policy in this stressful period. However, the implication is that the monetary policy stance of the SNB cannot always be inferred from its announced target range in the same way as that for other central banks. These issues deserve further analysis.
18. The state of public finances continued to improve in 2007. A substantial general government surplus of over 2 percent of GDP reflected, in large part, buoyancy in revenues associated with the strong growth but also moderation of expenditures beyond that required by the discipline of the "debt brake," which helps achieve budget balance over the medium-term. Surpluses were recorded at all levels of government, and their debt-to-GDP ratios continued to decline.
19. The authorities remain committed to a conservative fiscal approach. The Confederation budget shows a swing to a deficit in 2008. However, a part of that deficit represents extraordinary expenditures; and because these largely reflect accounting changes and one-time transfers, they do not add to a significant expenditure stimulus. With cantonal and communal surpluses expected to hold, the general government fiscal balance is projected to remain relatively unchanged in structural terms, implying limited fiscal stimulus. From a policy perspective, the authorities rightly do not see the need for a stimulus at this time. Besides the inherent timing lags, past experience indicates that loosening the fiscal stance has had, at best, little expansionary effect as additional expenditures have added more to imports than to domestic production.
20. Long-term fiscal sustainability requires continued structural reforms. The Long-Term Sustainability report due to be published in May marks an important step in recognizing the tasks ahead and raising awareness of needed actions. In particular, the projected rise of health care expenditures and other long-term pressures require new actions. This may include: (i) an increase in the VAT rate to finance disability insurance; (ii) an orderly reform of social benefits; and (iii) containment of health care expenditures. The savings to be achieved through the Task Evaluation Program (Aufgabenüberprüfung) are necessary to prevent aging-related expenditures from crowding out other social expenditures. A useful tool for planning and communication would be an inter-temporal government balance sheet.
21. The proposal to enhance the debt-brake rule is welcome. The rule has provided valuable fiscal discipline thus far. However, there is the risk that the rule could be undermined through so-called "extraordinary" expenditures, which are not subject to that rule. While the need to allow for one-time large extraordinary expenditures clearly exists, the current proposal to place boundaries on such expenditures and to amortize them in a predictable manner and in a reasonable time frame deserves to be actively pursued.
Switzerland's high standard of living and recent dynamism are, in no small measure, due to consistent and forward-looking policies. Rapidly moving events have placed on policymakers a heavy burden, with the immediate task of maintaining financial stability. Vigilant navigation through these challenging times should permit a return to economic buoyancy. We thank the authorities for their hospitality, and to all interlocutors for the candid and fruitful discussions. We wish them the very best in achieving their goals.