One can expect Switzerland to be highly exposed to the ongoing global turmoil, as it is a small economy with extensive linkages to the rest of the world through trade and financial channels. Indeed, its growth performance has weakened substantially, with GDP contracting by 1.2% on an annualised basis in the fourth quarter. This column argues that further weaknesses could be in store from trade, asset earnings, and banking channels.
While Switzerland’s growth performance appears respectable at a glance, compared to the situations in the US and Japan for instance, a closer look paints a darker picture. Net exports and investment were down sharply in the fourth quarter, and only a substantial build-up of inventories sustained growth. This will likely prove short-lived – as firms realise that demand will not rebound any time soon, production will be cut and there will likely be a large inventory payback.
In addition to trade flows, Switzerland is tightly connected to the rest of the world through dividend and interest streams on international financial holdings. With Swiss net foreign assets amounting to 133% of GDP, such earnings play a substantial role. In 2006, before the onset of the crisis, net earnings posted a surplus of 11% of GDP that exceeded the trade surplus. The financial turmoil has driven this surplus to zero, sharply curtailing Swiss national income. This abrupt turnaround primarily reflects lower earnings on Swiss FDI holdings abroad. While the data do not provide any sectoral breakdown, this most likely reflects losses on the foreign activities of Swiss banks. Further losses on these foreign operations would further reduce Swiss national income.
Switzerland’s foreign risks
The biggest risk facing the Swiss economy remains its large financial sector with substantial international exposure. The total assets of Swiss banks amount to 6 times annual GDP, up from 4 times ten years ago. The picture is dominated by two large banks, UBS and Credit Suisse, whose assets are equivalent to four times GDP. Several vulnerabilities are notable. First, the sector remains highly leveraged, even though Swiss banks are well capitalised on a risk-adjusted basis. While the risk-weighted capital ratios of Swiss banks exceed 10%, capital only represents 4% of the banks’ balance sheets on an unweighted basis. The high leverage is concentrated in the two large banks, which have a ratio of 2.5%, while the rest of the sector is on sound footing.
A second concern is that foreign currencies account for nearly two-thirds of banks’ balance sheets, an amount equivalent to 4 times annual GDP (the split between domestic and foreign activities closely parallels the currency composition of balance sheets). While the currency composition of assets and liabilities is well matched, this situation raises the risk of liquidity issues that could not easily been addressed by the Swiss National Bank, as it is not a lender of last resort in foreign currencies. Although swap facilities with foreign central banks alleviate this problem to some extent, the sheer size of foreign currency holdings remains an issue. The situation is again highly contrasted. The two large banks stand out, with foreign currencies representing 80% of their assets, compared to 35% for the other banks, and only 10% if we focus on the states’ “cantonal” banks and local banks that account for nearly half of the domestic market.
The concentrated composition of the Swiss banking sector with the dominant position of two large banks is a risk factor. While domestic activities only represent one-fifth of their balance sheets, they still account for one-third of all domestic bank activities due to their sheer size. The two big banks are thus essentially global operations, with a side business in the domestic market, while the other banks are primarily focused on the domestic market, which accounts for two-thirds of their activities (90% for the cantonal and local banks). Losses on the big banks’ foreign operations then have systemic implications for the Swiss domestic financial sector, an aspect clearly illustrated by Swiss authorities’ intervention to support UBS in September. Looking forward, building a firewall between foreign operations and the domestic financial system represents one of the major challenges faced by Swiss authorities. To provide some concluding food for thought, a solution could be to split the two large banks between domestic and foreign operations, so that losses on the latter would not jeopardise the domestic financial system.
Professor of Economics, Graduate Institute, Geneva and CEPR Research Fellow