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IMF
Calls for Greater Domestic Financial
Stability to Reduce Risks
The International Monetary Fund
(IMF) has made an assessment of
the Swiss economy and issued a statement
recently in Berne. It has said that
while the Swiss economy has done
fairly well taking advantage of
the recent global upswing, the risks
to its financial services industry
can dent the gains achieved. Following
are the salient features of the
IMF assessment.
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.
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.
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
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.
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.
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
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.
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.
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.
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.
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.
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.
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.
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.
Monetary Policy
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.
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.
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.
Public Finances
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.
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.
Long-term fiscal sustainability
requires continued structural reforms.
The Long-Term Sustainability report
due to be published 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.
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.
Production index
Periodicity flexibility: Switzerland
is taking a flexibility option for
the periodicity of the data and
will continue to disseminate the
production index on a quarterly
basis.
The Swiss economy has an extremely
large number of small and medium
size enterprises (99.8% of all Swiss
enterprises employ less than 500
employees) operating in a great
variety of activities. Because of
this structure, the compilation
of monthly indices would be very
difficult and time-consuming. Moreover,
the indices would not provide representative
data or evident results about the
business cycle. For these reasons
Switzerland is taking a flexibility
option for the periodicity and timeliness
of the data and will continue to
disseminate the production index
on a quarterly basis with a timeliness
of one quarter.
Timeliness flexibility: Switzerland
is taking a flexibility option for
the timeliness of the data and will
continue to disseminate the production
index with a timeliness of one quarter.
The Swiss economy has an extremely
large number of small and medium
size enterprises (99.8% of all Swiss
enterprises employ less than 500
employees) operating in a great
variety of activities. Because of
this structure, the compilation
of monthly indices would be very
difficult and time-consuming. Moreover,
the indices would not provide representative
data or evident results about the
business cycle. For these reasons
Switzerland is taking a flexibility
option for the periodicity and timeliness
of the data and will continue to
disseminate the production index
on a quarterly basis with a timeliness
of one quarter. |
