Switzerland: 2009 Article IV Consultation - Conclusions of the Mission
March 9, 2009
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. Despite strong economic fundamentals, Switzerland cannot escape the impact of the global crisis. In recent years, the Swiss economy has experienced high growth, low unemployment and modest inflation, with strong fiscal and external positions. However, its openness, both in trade and financial relations, means that the domestic economy cannot be isolated from foreign shocks. The transmission runs through two main channels: a financial channel, including the impact of the crisis on the balance sheets of financial institutions and business models looking forward; and a trade channel, through which the global slowdown affects demand for exports. Both the financial and real shocks associated with the crisis have a major impact on the outlook for the Swiss economy.
2. The mission expects a significant economic decline. The economy entered a recession in the second half of 2008, as the global financial crisis intensified and world trade fell sharply. Looking ahead, there are clear signs that the decline will accelerate as a result of a further weakening of global demand. Along with a sharp contraction in exports, investments are now being postponed. Consumption has held up well so far, but as unemployment rises, household spending will lose momentum. Growth is expected to pick up gradually in 2010, in line with an expected global recovery. As elsewhere, inflation is projected to decline further in 2009, with a few quarters of negative rates due to temporary factors. The external position is expected to weaken, because of lower financial sector inflows, but the current account will continue to register large surpluses; the exchange rate is broadly in equilibrium.
3. The authorities have taken a proactive approach in reducing the impact of the crisis on the economy, but more may be needed. They have taken wide-ranging measures to address risks to the stability of the banking system. In addition, the monetary policy stance has been relaxed aggressively, and a fiscal expansion is underway. However, uncertainty about future economic and financial sector developments—internationally as well as in relation to Switzerland—remains, and further policy action may be required if the turmoil continues. Determining the optimal policy mix to address both further economic weakening and continuing financial sector vulnerabilities is the key challenge looking ahead.
Explore options for timely, targeted, and temporary fiscal stimulus
4. The fiscal position is robust, but will be affected by the current downturn. Supported by recent years of strong growth and the impact of the debt brake rule, fiscal consolidation has resulted in general government surpluses and a declining stock of public debt. In 2008, although the debt stock rose as a result of large one-off expenditures, the federal government’s structural surplus increased again. Over the current year, however, the fiscal situation is expected to deteriorate rapidly as the recession deepens. Despite the absence this year of large extraordinary expenditures, a federal government deficit is projected for 2009, which will widen over the forecast horizon. At other levels of general government, surpluses in 2008 will turn into deficits in 2009-10. If this process were to coincide with an overly mechanical application of fiscal rules—e.g. not using the option of greater flexibility in bad times, where appropriate—it would carry the risk of triggering procyclical tightening in 2010.
5. The federal and cantonal fiscal stabilization programs are welcome, and further stimulus should be considered. The planned and approved cantonal and federal measures amount to some ¾ percent of GDP in 2009. Approval of the second federal stabilization package is important, and, in light of the deteriorating outlook, a third package should be considered to help support domestic demand in 2010. These measures contribute to the international fiscal policy response to the global crisis. The automatic stabilizers are allowed to work fully, and are particularly strong in unemployment insurance. Additional stimulus—to be closely coordinated between federal and cantonal governments—could consist of public investment and transfers targeted to low-income households, including to subsidize health care contributions. Stimulus plans should preserve sufficient fiscal room to allow additional public sector support for the financial sector, if needed.
6. Fiscal stimulus should not put at risk the sustainability of public finances in the long run. The Long-Term Sustainability Report 2008 projects a need for structural fiscal consolidation to offset rising expenditures due to an aging population. Additional pressures relate to the persistent deficits in the disability insurance system. Therefore, short-term fiscal stimulus must be designed to be temporary so as to avoid undermining long-term sustainability—a consideration to which financial markets have also become more sensitive.
Limited room for further loosening of monetary policy
7. The SNB has used monetary policy to good effect in a difficult environment. With inflation rates elevated in the first three quarters of 2008, the SNB kept the monetary stance unchanged, offsetting the increase in risk premiums through lower repo rates. Concurrently, timely infusions of SFr liquidity in interbank markets, use of repos with maturities up to one year, foreign exchange swaps, and new refinancing facilities lowered risk premiums and eased appreciation pressures on the currency. With the economy starting to slow, inflationary expectations rapidly falling and the currency appreciating, the SNB moved forcefully, relaxing the monetary policy stance by 225 basis points over a period of about two months at the end of 2008. The policy rate is now near zero.
8. There are currently no signs of a credit crunch. The decline in economic activity has influenced the demand for loans, and lending conditions have tightened in line with the deterioration of the cycle. However, the deleveraging of the two big banks has not affected domestic lending. Demand for mortgages remains high, reflecting long term rates that are at historically low levels as well as still strong employment. Ample liquidity in the banking system, high credit standards and the absence of a housing bubble have supported mortgage credit.
9. There is still room for some further conventional monetary easing, if needed. The recent rate cuts will take time to fully affect demand. The SNB has signalled its intention to keep policy rates close to zero for a prolonged period. Should more easing be needed, the Bank has room for further monetary measures: bringing the policy rate even closer to zero, expanding the collateral used in regular monetary operations, and introducing repos with maturities longer than one year in order to influence long term interest rates. Under the current circumstances, direct foreign exchange intervention should be aimed only at countering disruptive short-term pressures on the currency.
10. Unconventional measures could be considered in exceptional circumstances. Should economic activity deteriorate faster than expected and threaten price stability or the normal functioning of credit markets, the SNB may need to contemplate unconventional policy measures. They include quantitative easing, i.e. operations to increase bank reserves in return for public or private assets. There are, however, constraints associated with such policies in Switzerland. In particular, the depth of corporate and confederation bond markets is limited, and selecting private sector paper may be complicated. In addition, there is little evidence of distortions in credit markets as supply of mortgage financing—the dominant form of domestic credit—has remained stable. In any case, these measures need to be chosen so as to avoid putting stress on the SNB’s balance sheet and contributing to distortions in the markets.
Focus on financial stability
11. The scale of the financial sector and its importance to the wider economy call for a clear focus by the authorities on ensuring financial stability. Safeguarding stability is essential for a return to growth and will also contribute to restoring international financial stability. The size of the Swiss economy and limited public sector and central bank resources constrain what the authorities can do to support the financial sector without incurring unsustainable liabilities. In addition, the high degree of concentration in the financial sector hampers the creation of effective market-based support mechanisms for times of stress, such as industry-funded deposit insurance schemes. All this puts a high premium on strong, effective regulation and supervision, with a particular focus on close monitoring of vulnerabilities, early identification and response to risks, and contingency planning to deal with possible stresses.
12. Faced with severe financial sector pressures last autumn, the authorities responded with timely and broad stabilization measures. The creation of a fund to acquire distressed assets from UBS (the StabFund) and the injection of government capital eased market concerns about the bank’s solvency. Enhancing the deposit protection scheme addressed the risk of a wider loss of confidence in the banking sector. The government made clear its readiness to take other measures including guarantees, if necessary, for bank borrowing. At the same time, new capital adequacy targets were introduced to encourage further reduction in the largest banks’ risks over time. This will in particular constrain investment banking, where most of the recent losses arose. Action by the authorities has been accompanied by measures taken by banks themselves to reduce balance sheet size and build up liquidity buffers.
13. There remain risks to the major banks, however, particularly as the global downturn continues. While most distressed assets have been written down, hedged or transferred from the balance sheet, the banks have not removed all such assets. There are risks associated with some off-balance sheet activities and cross-border exposures, in particular to vulnerable emerging market countries. As a result of the downturn, the banks are also suffering from an erosion of earnings on their large private banking and wealth management businesses, as assets under management and credit demand decline. Despite a reduction, leverage remains high on measures (such as tangible common equity) now focused on by markets.
14. The financial crisis is also generating stress in other parts of the diverse Swiss financial sector. Life insurance companies have been affected by declining asset values, which will make it harder to meet guaranteed returns to policyholders while maintaining required solvency ratios. There are similar effects on the private pension funds, although they also have more flexibility for dealing with such pressures. Non-life insurance is less exposed to the financial crisis, although the reinsurance sector has been affected by diversification into investment banking and resulting losses. Private banks are now being affected by the same forces affecting the major banks’ wealth management business. While many smaller and medium-sized banks have benefited from cash outflows from larger banks, strong liquidity at these firms also creates some risk of less prudent and riskier lending practices.
15. Additional measures to address future financial sector pressures may be needed. Stress tests may help to indicate potential needs for additional (core) capital and liquidity support. Before direct government and central bank support is considered, facilitating private sector solutions can contribute to building confidence and enhancing liquidity in the system: in this context, the SNB’s initiative to encourage the channeling of funds from small to large banks through the covered bond market is welcome. Further declines in asset values may yet create a need for new government capital injections, while potential funding constraints due to deleveraging in international capital markets may call for government guarantees.
16. The authorities should further develop the regulatory framework. Last year they introduced an innovative reform of capital regulation for the large banks—introducing both a minimum leverage ratio and higher risk-based capital adequacy requirements that adjust to downturns—while acknowledging the need to avoid enhancing the current downturn by tightening capital and other rules too early. New liquidity regulations to be introduced this year for the large banks will respond to the weaknesses in international bank liquidity standards highlighted by the crisis. Switzerland has a developed bank resolution framework, but the recently extended deposit insurance regime should be revised to ensure timely payout and adequate protection of depositors in case of failure, regardless of the size of bank. This requires, amongst other measures, the introduction of ex ante funding. The authorities are addressing these issues and will bring forward plans later in the year.
17. The establishment of a new integrated supervisor (FINMA) at the beginning of 2009 provides a good opportunity to strengthen financial supervision further. An independent and well-resourced supervisory authority capable of responding effectively to the lessons of the financial crisis is essential to maintaining financial stability. FINMA should continue its progress in enhancing skills and resources, integrating sectoral regulatory approaches and strengthening its forward-looking systemic surveillance. It needs to develop a strong supervisory style, deepening cooperation with the SNB and foreign regulators. It should continue its intensive oversight of the large banks, including their overseas operations. But with stress spreading to other parts of the financial sector, there is also a need for close supervisory focus on the large (re)insurance sector and on medium and small banks. With respect to the supervision of the smaller banks, this may require further development of the dual approach (with auditors) with increased on-site examination by FINMA staff and close attention to potential weaknesses in work delegated to auditors. In addition, there is a need to continue strengthening pension fund supervision (by cantons) in line with earlier recommendations.
We thank the authorities and all our other counterparts for their hospitality and the open and fruitful discussions.