Public Information Notice No. 01/49

Public Information Notice: IMF Concludes Article IV Consultation with Switzerland

May 21, 2001

On May 9, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Switzerland.¹

Background

The Swiss economy had its best performance in a decade in 2000. Jolted by an upswing in exports and buoyant domestic demand, GDP growth rose to 4 percent in early 2000 before receding to a more sustainable pace in subsequent quarters. This has largely eliminated the earlier output gap and has pushed the unemployment rate below 2 percent. During the 1990s, Switzerland had experienced persistent low growth and the unemployment rate had risen to over 5 percent.

Despite indications of increasing shortages of skilled labor, inflation remains subdued. During 2000, increased competition and deregulation in telecommunications helped to offset steep oil price increases, keeping inflation below 2 percent. With the partial reversal of oil price hikes, headline inflation dipped below 1 percent in early 2001. Core inflation remains about 1 percent and the tightening in the labor market has bolstered wage demands only moderately.

The external current account surplus reached almost 13 percent of GDP in 2000. The record level mainly reflects the high net investment income (11½ percent of GDP) on Switzerland's large net foreign asset position (143 percent of GDP at end-1999).

Amidst evidence in early 2000 that the economy was growing at an unsustainable rate, monetary policy was adjusted promptly to head off inflation pressures. The Swiss National Bank (SNB) raised the mid-point of its key operational interest rate target (three-month LIBOR) from 1 percent in September 1999 to 3½ percent in June 2000. Interest rates were subsequently kept unchanged until March 2001 when signs of a weakening external environment and benign inflation prospects prompted the SNB to reduce its interest rate target by ¼ percentage point. At the beginning of 2000, the SNB abandoned formal monetary targeting in favor of a new monetary policy framework that aims at keeping inflation below 2 percent in the medium term.

The Swiss franc has appreciated by about 4 percent against the euro since March 2000, after having shadowed it closely for more than a year. However, due to the weakness of the euro, mainly against the dollar, the Swiss franc is still slightly weaker in nominal and real effective terms than it was prior to the advent of the euro.

Windfall revenues and the strong economy helped to generate a general government surplus of 1.8 percent of GDP in 2000 compared to a deficit of 0.4 percent of GDP in 1999. However, about 1½ percentage points of the swing reflected one-time revenues from the interest withholding tax and stamp duties on securities transactions. In 2001, the general government surplus is expected to shrink to 0.3 percent of GDP as withholding tax and stamp duties revert to normal levels.

In the past few years, fiscal policy has been guided by a constitutional requirement to balance the federal budget by 2001. Cantons and communes have also been trying to reduce high debt levels accumulated during the low growth 1990s. The fiscal framework has already helped to reduce the general government debt/GDP ratio from a peak of over 54 percent in 1998 to under 49 percent at end-2000. Recently, the Council of States approved a proposal to allow the federal budget to vary with the economic cycle—whilst remaining balanced on average—although approval by the National Council and a referendum are required before the proposal can be implemented.

Real GDP growth is projected to slow from 3½ percent in 2000 to about 2 percent in 2001-02. Although buoyant consumer confidence and investment in machinery and equipment are expected to underpin solid domestic demand growth, the weakening external environment should dampen export growth. Inflation is projected to remain at or below 1½ percent.

Executive Board Assessment

Executive Directors commended the Swiss authorities for maintaining sound macroeconomic policies, which have facilitated a strong recovery in economic activity and reduced unemployment to a very low level without rekindling inflation. Looking forward, Directors considered that the main challenge is to pursue more vigorously the structural reforms that are needed to improve Switzerland's long-term growth prospects.

Directors considered that the current expansion is likely to continue in 2001, albeit at a more sustainable pace, but viewed the growth projection as subject to downside risks from the weakened global economy. Noting that inflation remains subdued, and that the external current account is strong and the currency is appreciating, Directors welcomed the recent interest rate cut. They considered that the Swiss National Bank (SNB) has scope to ease interest rates further should the slowdown in economic activity become more pronounced.

Directors considered that the new monetary policy framework, with its explicit inflation forecast, has improved the effectiveness of monetary management since its introduction in January 2000. Within this framework, the SNB has been able to accommodate the first round effects of the oil price rise without a noticeable effect on inflation expectations. Directors noted that the SNB's credibility is high because of its tradition of independence and stability-oriented policymaking. Looking forward, they considered ways in which the policy framework could be even made more effective over time. In this regard, they welcomed the SNB's intentions to enhance its communication strategy, including the articulation of the assumptions underlying the inflation forecast and rationale for policy decisions.

Directors welcomed the elimination of the federal budget deficit ahead of schedule. In present circumstances, they did not see the projected sharp decline in last year's surplus of the general government as problematic from a cyclical point of view, especially as last year's surplus mainly reflected transitory revenue gains. However, they cautioned against the temptation to use the temporary revenue gains to finance tax cuts or new expenditures.

Directors welcomed the innovative rules-based approach to fiscal policy formulation adopted by the Swiss authorities and endorsed the government's proposal to balance the federal budget over the cycle, as this would help lower the public debt ratio and provide more room for automatic fiscal stabilizers to operate. Nevertheless, they expressed concern that the degree of cyclical flexibility of the budget is limited. In this context, they generally supported the exclusion of net lending to the unemployment insurance fund from the definition of the budget balance, and the plans to shore up the reserves of the fund to prevent procyclical changes in contribution rates as a way to further strengthen the automatic stabilizers. Directors considered that there remains scope for stronger mechanisms to ensure that unanticipated budget surpluses are put toward debt reduction. They also took note with interest of the proposals under consideration regarding the project to reform fiscal relations among different levels of government, which are intended to lead to improved fiscal redistribution among cantons, allowing them to compete on a more level playing field.

Directors underscored that ongoing public expenditure restraint will be needed to accommodate planned tax cuts and the rising strains on social security from population aging. They encouraged the authorities to review the sustainability of pension and health benefits, and take early action as needed.

Directors welcomed progress in opening up sheltered sectors to competition, but noted that more needs to be done to raise the relatively low trend rate of real growth in Switzerland. They stressed in particular the importance of completing liberalization in the telecommunications sector, accelerating plans to open up the electricity sector, making anti-cartel legislation more effective, and strengthening the Competition Commission.

Directors had a wide-ranging discussion on the links between competitiveness, openness, and exchange rate developments. They observed that Switzerland's external current account surplus has risen further owing to substantial earnings on foreign investments. Directors noted that the opening up of sheltered sectors could improve productivity and raise investment, allowing over time for a reduction of the current account surplus and for continued moderate real appreciation of the Swiss franc.

Directors noted that, while the financial sector appears to be in good health, supervisors will need to remain vigilant in light of the turbulence in stock markets and the weakening of the economic environment. They welcomed the authorities' review of the financial supervisory framework and their decision to undertake a Financial Sector Assessment Program (FSAP), which will provide a timely opportunity to review reform plans and assess vulnerabilities, particularly as globalization and changing technology provide new opportunities and risks. Directors encouraged the authorities to give adequate priority and resources to combat money laundering.

Directors commended Switzerland's commitment to liberal trade. They encouraged the authorities to accelerate the dismantling of high protection in agriculture and to consider providing more favorable access to Swiss markets for the least developed countries.

Directors commended the authorities for the effectiveness of their official development assistance (ODA) and welcomed their plan to raise ODA to 0.4 percent of GDP within the next decade. A few Directors expressed the hope that Switzerland would be able to raise its contribution further toward the UN target of 0.7 percent of GDP.

Directors noted that, while the statistical data are adequate for purposes of Article IV surveillance, further efforts are needed to improve the quality and comprehensiveness of the data so as to strengthen the basis for economic analysis and management.