On April 30, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Switzerland as well as the country’s 2014 Financial System Stability Assessment (FSSA).

The growth of the Swiss economy has gathered pace, but inflation nevertheless remains close to zero. The recovery is expected to continue and inflation should rise gradually while the output gap will progressively close. The fiscal position is healthy, with a broadly neutral stance projected for 2014, and government debt is low.

There has been no new foreign exchange intervention to support the exchange rate floor, but past safe haven inflows have not yet reversed and the balance sheet of the Swiss National Bank (SNB) remains large. Despite improved market confidence toward the euro area and tapering in the United States, the exchange rate has remained close to the floor. For 2013, the SNB reported a large valuation loss on gold holdings, triggering the first suspension of profit transfers to the Confederation and cantons in recent memory.

Expansionary monetary policy and ample liquidity have contributed to push real estate prices and mortgage debt to historic heights, with prices of owner occupied apartments rising by 6 percent per year on average since 2008. Mortgage lending has grown by about 5 percent per year since 2009, and mortgage debt recently reached an all-time high of over 140 percent of GDP. The authorities have taken several measures to contain risks, including raising the countercyclical capital buffer and adopting prudential measures to tighten lending standards and conditions.

The financial sector has continued to restructure to adapt to the more stringent regulatory environment. The 2014 Financial Sectro Assessment Program (FSAP) Update finds that the position of the financial sector has improved markedly since the Global Financial Crisis, but gaps remain in the regulatory framework, prudential oversight, and safety net.

The current economic model faces some medium-term challenges. International initiatives to address tax evasion and money laundering are eroding bank secrecy. The tax treatment of corporate income on foreign activities is coming under international scrutiny. A recent popular vote approved curbs on immigration, which has been an important contributing factor to the acceleration in Swiss economic growth in the 2000s.

Executive Board Assessment²

Executive Directors noted that the Swiss economy has regained momentum and growth is healthy, but monetary and exchange rate conditions have not yet normalized, and risks relating to deflation, the domestic housing market, and spillovers from external developments remain. In the medium term, some aspects of the current economic model might be challenged.

Directors noted that domestic macroeconomic conditions do not call for a monetary tightening yet and that the risk of a resumption of safe haven inflows remains considerable. They generally agreed that the exchange rate floor remains necessary to guard against deflationary risks. Directors underscored that an appropriate strategy going forward should seek to keep inflation expectations well anchored while avoiding an excessive tightening of monetary conditions. When conditions permit, a return to a flexible exchange rate would be desirable.

While recognizing the need for caution in calibrating unconventional policy instruments, Directors recommended contemplating alternative measures. In particular they encouraged the authorities to consider introducing negative interest rates on excess bank reserves in case of deflationary pressures resulting from appreciation. However, it would be important to carefully monitor their economic impact and reinforce macroprudential measures as needed. In an upside scenario, the authorities should also gradually reduce their holdings of foreign exchange reserves. More broadly, Directors noted that the SNB balance sheet would likely remain extended for a prolonged period, and encouraged the authorities to step up SNB’s provisions.

Directors welcomed the steps taken to contain risks in the mortgage and real estate markets, including the increase in counter-cyclical capital buffers. They advised the authorities to continue to monitor price developments in the housing sector, and to lay the groundwork for stronger policy actions to curb the demand for mortgages, potentially including tax reforms, and direct regulatory measures targeting affordability and loan-to-value ratios.

Directors welcomed the implementation of considerable regulatory reforms. Noting remaining gaps, they encouraged the authorities to follow up on the FSAP update recommendations. In particular, they advised the authorities to encourage the large banks to achieve leverage ratios tighter than international standards. Directors also underscored the need to reach cooperation agreements with key foreign supervisors to make the large banks resolvable. They generally called for reforms to the deposit insurance system, including to make it more transparent and universal across all banks. In general, they also considered it important to increase resources for prudential bank supervision, provide closer oversight and guidance to auditors performing supervisory audits, and seek to improve the governance of the cantonal banks.

In light of the recent popular vote, Directors agreed that a rapid resolution of uncertainty related to future immigration policy will be important to support economic recovery. They welcomed the new legislative pension reform proposal as well as plans to reform aspects of the corporate income tax. On the latter, Directors encouraged putting in place a new regime taking into account international efforts to counter base erosion and profit shifting.