Country Report Switzerland
The Swiss economy has outperformed its Eurozone peers during 2012 and will probably continue to do so through 2013. GDP growth will continue to be driven primarily by domestic demand, being bolstered by low unemployment, strong consumer confidence and being unhindered by (the need for) an austerity drive. The peg versus the euro (CHF/EUR 1.20) has continued to shield the Swiss economy from currency appreciation during the intensification of the euro crisis in the Summer of 2012. That said, the past currency appreciation still generates deflationary pressures, meaning that the headline consumer price inflation is likely to stay in negative territory through 2013. The prime medium-term risk that the Swiss economy faces is the collateral damage of its safe haven status, namely overvalued house prices. House prices in certain hot spots already exhibit signs of bubble dynamics.
The Swiss economy has outperformed its Eurozone peers during 2012 and will probably continue to do so through 2013. GDP growth in 2012 came in at 1% y-o-y. With half of Swiss exports destined for Eurozone countries, that is no small feat, given also the lagged effects of past exchange rate appreciation that is feeding into a loss of price competitiveness. The currency peg versus the euro (CHF/EUR 1.20) introduced by the Swiss National bank (SNB) in September 2011, combined with continued deflation implies an underlying improvement in the real effective exchange rate going forward. That said, export growth will likely remain sluggish amid weak external demand (especially in the Eurozone). A re-ignition of the euro crisis will pose a substantial downward risk to this already downbeat outlook.
GDP growth will continue to be driven primarily by domestic demand, being bolstered by low unemployment, strong consumer confidence and unhindered by (the need for) an austerity drive. Low (mortgage) interest rates and the resulting housing market boom (further discussed below) are an important ingredient in this development. As the low-interest rate environment is unlikely to reverse anytime soon and house prices will remain high at least over the medium term, this situation will likely continue to underpin domestic demand in 2013-14.
Monetary and exchange rate policy
On the monetary policy front, we still deem the introduction of the exchange rate floor by the SNB as an appropriate policy response to the safe haven capital inflows that threatened to choke Swiss exports. With the policy rate stuck at the zero bound, the currency peg was the next line of monetary defense and it has continued to shield the Swiss economy from extreme currency overvaluation during the intensification of the euro crisis in the Summer of 2012. However, the strong Franc (prior to the installment of the floor) continues to feed into deflationary pressures, meaning that the headline consumer price inflation is likely to stay in negative territory through 2013.
When deflationary pressures subside and capital starts leaving Switzerland in search of higher yield, the SNB may in the medium-term face a delicate balancing act of running down its accumulated foreign currency reserves while needing to tighten the policy stance to contain inflationary risks. If the SNB were to unwind its foreign exchange interventions too fast, the resulting Franc appreciation would generate losses on its remaining foreign currency holdings, while unwinding too slow may jeopardize price stability. With the euro crisis lingering and SNB forecasting inflation well below its target through 2015 (inflation forecast at 0.7% vis-à-vis its 2% target), this is no near-term dilemma.
Housing market and macro-prudential supervision
The prime medium-term risk that the Swiss economy faces is the collateral damage of its safe haven status, namely overvalued house prices. In its Financial Stability Report, the SNB states that continued house price dynamics risk generating general overvaluation of residential property, fueled by the persistence of historically low interest rates and strong competition in the banking sector. Already it flags a number of worrying developments, among which a continued strong growth in mortgage production, specifically in areas already showing signs of overvaluation, a general rise in loan-to-value ratios and a concomitant decline in the affordability of new mortgages, and narrowing of mortgage interest rate margins.
Substantial policy action is being taken in an attempt to cool down the housing market in a controlled manner. Note that Switzerland had already added a 'Swiss Finish' to the Basel III principles, requiring its two largest banks (USB and Credit Suisse) to meet much stricter capital requirements (total capital ratios of 19% compared to 10.5% under Basel III). On top of that, the regulators have since increased capital requirements on mortgages portfolios, installed stricter repayment criteria and prohibited the use of (occupational, or Pillar II) pension fund savings to finance minimum down payments. In February 2013, they activated the newly-created counter-cyclical capital buffer (CCB), requiring banks to hold yet more capital against residential mortgages from September 2013 onwards. Swiss bank commentaries, for instance by Credit Suisse, suggest that the impact on house price inflation may be limited though, as the impact on the cost of mortgages is too limited. Barring a sharp rise in interest rates, authorities should consider phasing out the mortgage interest rate deductibility in a further attempt to cool down the housing market. And beyond this immediate need, it would remove household incentives to carry more mortgage debt than warranted (the ratio of residential mortgages to Swiss GDP already being among the highest in the world) and thus improve financial stability.