Public Information Notice No. 05/74

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Switzerland

June 10, 2005

On June 6, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Switzerland.¹

Background

The Swiss economy has returned to growth with supportive external demand and domestic policies. However, the recovery has been fragile and business indicators suggest that activity is currently experiencing a soft patch. Unemployment has crept up to 3.9 percent, which is low by international standards. Despite the increase in oil prices, inflation remains well under control and the current account is running a large surplus.

With inflation projected to remain inside the 0-2 percent range of price stability, and the recovery still fragile, the Swiss National Bank (SNB) has maintained an accommodative posture. Since raising the three-month policy rate to 0.75 percent in mid-2004, the SNB has put on hold the return of interest rates toward a neutral level. Indeed, the strengthening of the Swiss franc has already withdrawn some monetary stimulus. The general government deficit is estimated to have narrowed to 1 percent in 2004, and the federal government is taking further steps under the debt-brake rule to eliminate its structural deficit.

Growth is projected to continue, albeit at a lower pace. The staff projects growth of 1¼ percent in 2005, from1.7 percent in 2004, with some risks on the downside if demand from partner countries were to falter. Potential growth is estimated at 1½ percent and is projected to decline in the medium term to ¾ percent as a result of population aging.

Executive Board Assessment

Executive Directors commended Switzerland's sound macroeconomic management and flexible labor markets, which have secured low inflation and unemployment and a high standard of living. External demand conditions and accommodative domestic policies have led to a rebound of economic activity. Also, the country's external position remains strong, in part reflecting investment income from Switzerland's large net foreign assets. At the same time, Directors noted the existence of downside risks to the economic recovery, stemming from possible softening of demand in major trading partner countries, higher oil prices, and further appreciation of the franc.

Directors observed that raising the economic growth rate and tackling the fiscal pressures associated with population aging continue to be Switzerland's main challenges. They attributed the weak growth performance to the strong segmentation of internal product markets, substantial non-tariff import barriers, and lack of domestic competition. They stressed the importance of opening up sheltered sectors, intensifying competition in product markets, and eliminating non-tariff barriers, and welcomed the authorities' adoption last year of a growth package of reforms in these areas. Directors underscored that higher growth will make it easier to absorb the costs of population aging. They acknowledged the consensus-based nature of economic policy-making in Switzerland, and in this context stressed the need for a public education campaign to garner support for structural reforms.

Directors observed that the monetary policy framework has allowed the Swiss National Bank (SNB) to respond flexibly to economic developments and deliver low inflation. They considered that the current accommodative monetary stance remains appropriate. With inflation risks low, output below potential, and the economic recovery still fragile, the current low level of interest rates should be maintained for the time being. However, Directors noted that, with a narrowing output gap, some monetary tightening will be needed sooner or later. They welcomed the SNB's intention to remain vigilant for signs of price pressures, and to be prepared to return to more neutral interest rates as the recovery firms up, taking into account the lags in the effectiveness of monetary policy in Switzerland. Directors commended the SNB's effective communications strategy, and welcomed the steps taken to increase transparency through the quarterly publication of the three-year-ahead inflation forecast and the assessment of monetary policy conditions.

Directors welcomed the improvement in the public finances in 2004. They supported the authorities' plans to phase out the federal structural deficit while allowing the full play of automatic stabilizers around this path. They considered that the debt-brake rule provides a solid anchor for fiscal policy over the business cycle, and reduces the procyclicality of such policy. However, Directors stressed that the mounting pressure on the social security system and the possibility of loss of financial tax revenue due to competition from other financial centers require fiscal prudence and cooperation with cantonal governments. In this regard, they called for a comprehensive evaluation of public sector activities, with a view to focusing resources on priority activities and reducing expenditure, particularly expenditure on transfers and subsidies. Directors welcomed the agreement for a new structure of fiscal federalism, which should enhance coordination between the various levels of government, improve transparency, and reduce incentives for spending on non-priority projects. They supported the intention of the federal government to use the proceeds of gold sales exclusively for debt reduction, and strongly encouraged cantons to do likewise.

Directors underscored the importance of early and decisive action to address aging-related fiscal pressures and avoid an excessive burden on future generations. They encouraged the authorities to monitor regularly the underpinnings of first-pillar pension entitlements, and to recalibrate parameters such as the retirement age and the replacement rate. They underscored the need to resolve the problem of underfunding of second-pillar pensions, and welcomed plans to harmonize supervisory standards across cantons. Directors also emphasized the need to check the rise of health care costs by exploiting economies of scale and encouraging competition among providers, and welcomed the reforms that were sent to Parliament.

Directors encouraged the authorities to develop a multi-year fiscal framework encompassing all levels of government and social security, and to determine a path for the public debt-to-GDP ratio consistent with long-term fiscal sustainability. They acknowledged that this is a challenging task given the high degree of autonomy of the cantons and the small size of the federal government relative to the general government. In this context, Directors considered that the publication of periodic fiscal sustainability reports could raise public awareness of the need for a comprehensive long-run fiscal strategy in the context of Switzerland's moderate long-term growth prospects.

Directors noted that the financial system appears to be healthy and dynamic. They commended the efforts to strengthen further the supervisory framework, and stressed the importance of continued vigilance in monitoring financial sector risks. They welcomed steps to strengthen insurance supervision, including a switch to risk-based supervision. Directors also welcomed the significant progress that has been made in recent years to bring Switzerland's anti-money-laundering and anti-terrorism-financing regimes in line with the recommendations of the Financial Action Task Force, including the extension of the application of the Money Laundering Act to professions and activities outside the financial sector.

Directors welcomed the agreement with the European Union on a package of bilateral treaties, which could help advance the pace of reform and achieve greater integration with European economies, thereby increasing economic efficiency. They also welcomed the planned amendment of the internal market law and the liberalization of the electricity market to stimulate competition. They noted the high level of protection and subsidization of agriculture, and urged an accelerated pace of dismantling these distortions. Directors commended the authorities for the effectiveness of their official development assistance, and encouraged them to move closer to the United Nations target of 0.7 percent of gross national income.

Directors noted that available economic statistics are generally adequate for surveillance purposes. However, they urged the authorities to correct the remaining data gaps, weaknesses, and delays so as to improve the quality of economic analysis and policy implementation.