DBRS Confirms Switzerland at AAA, Stable Trend

DBRS, Inc. (DBRS) confirmed the Swiss Confederation’s Long-Term Foreign and Local Currency – Issuer Ratings at AAA and its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The Stable trend reflects the strong fundamentals of the Swiss economy, its soundly-managed public finances, its consistent external surpluses, and its institutional strength. Due to robust external demand, the Swiss economy grew above trend at 2.5% in 2018. However, weaker global trade since late 2018 has resulted in growth slowing to 1.4% in 1Q 2019. Nonetheless, Switzerland’s open and productive economy benefits from a large pool of domestic savings and the safe-haven status of the Swiss franc. The federal government’s fiscal policy framework remains conservative with the general government posting a surplus of 0.6% of GDP and the debt ratio declining to 27.7% of GDP in 2018. While the implementation of the tax reforms will likely result in the Swiss Confederation incurring a short-term reduction in receipts, these reforms should ensure that Switzerland’s international competitiveness is maintained.

In DBRS’s assessment, Switzerland’s strong credit fundamentals are underpinned by its economic resilience, high levels of productivity, and wealth. Strong institutions, predictable policies, and historical neutrality have long made Switzerland a safe haven for investors. Sound fiscal management remains another key credit strength as fiscal policy remains highly disciplined and general government debt continues to shrink relative to GDP. Despite these strengths, Switzerland faces some medium-term challenges. Low interest rates and the consequent search for yield are fueling increased borrowing in the real estate market and could result in financial stability risks in the event of a shock to domestic housing prices. The outcome of negotiations with the EU to establish an institutional agreement, aimed at ensuring a more uniform and efficient application of existing and future market access agreements, is surrounded by uncertainty. Similar to other advanced economies, demographics could hold back potential growth and affect fiscal dynamics in the medium term.

RATING DRIVERS

DBRS considers the likelihood of downward pressure on Switzerland’s ratings to be low. Nonetheless, a significant decline in domestic real estate prices could potentially expose the sovereign balance sheet to increased contingent liability risks. Alternatively, external shocks or a sustained deterioration in growth prospects combined with a substantial weakening of the country’s fiscal performance could put downward pressure on the ratings.

RATING RATIONALE

Tax Reforms Build on Switzerland’s Strong Fundamentals and Preserve Switzerland as an Investment Destination

Switzerland’s ratings are underpinned by its wealthy and diversified economy, its strong public institutions, and the country’s financing flexibility. The Swiss economy consistently ranks highly in international comparisons; GDP per capita currently stands at US$83,583 and its global competitiveness ranking is consistently one of the highest in Europe. This reflects Switzerland’s high levels of educational attainment and the almost 80% labor force participation rate. Swiss economic growth has historically outperformed the euro area and did so again in 2018 with growth coming in at 2.5% due to sustained consumption growth and net exports. Biennial sporting events provided a modest additional impetus to growth. The declining momentum in the global economy is likely to result in Switzerland’s GDP growth slowing to 1.2% in 2019 before recovering to 1.7% in 2020. Growth is underpinned by low unemployment (2.6%) and rising net wealth, which help offset the impact of weaker global trade.

Two key issues taking centerstage in 2019 include corporate tax reforms and Switzerland’s relations with the EU. Following the passage of the Federal Act on Tax Reform and AHV Financing (AHV is the German acronym for Old Age and Survivors Insurance) by the Swiss Parliament, 66.4% of Swiss voters approved the government’s proposal to overhaul corporate tax rules in a referendum on corporate tax reforms on May 19, 2019. The new law will enter into force on January 1, 2020 and largely eliminates preferential income tax rules benefiting multinational corporations at the canton level, satisfying EU and OECD concerns while preserving Switzerland’s attractiveness as an investment destination. As the outcome of a political compromise, the Act also incorporates pension reforms which accounts for supplementary AHV financing through a 0.3% increase in social security contributions. Further, to ensure that the reform burden will be distributed equally between the levels of government, the reform raises the cantons' share of direct federal tax revenue to 21.2% from 17%. Overall fiscal balances could deteriorate marginally as the law enters into force on January 1, 2020. However, the reform would likely be supportive of medium-term growth prospects and DBRS believes the compensating revenue and expenditure adjustments will be manageable for the confederation, cantons and municipalities.

A Low and Declining Public Debt Ratio and Solid Fiscal Framework Underpin Switzerland’s Creditworthiness

Switzerland’s strong fiscal position is reflected in consistent modest surpluses and a declining debt-GDP ratio. The country benefits from a robust and transparent federal fiscal framework and continues to demonstrate a commitment to structurally balanced budgets. The debt brake, introduced in 2003, ensures that expenditures and receipts are balanced over the business cycle in the federal budget. The federal budget has consistently achieved structural surpluses since 2006. While much of government spending is executed at the sub-sovereign level (federal spending accounts for only 32% of general government expenditure), cantons also have a demonstrated track record of prudence. Despite corporate tax reforms, Switzerland is likely to run a modest fiscal surplus (0.3% of GDP) through the government’s budget forecast horizon may result in a further declining public debt to GDP ratio.

Switzerland features low levels of indebtedness combined with substantial financial flexibility, helping the country to stand out among other highly rated sovereigns. The IMF projects general government debt to fall from 40.5% of GDP currently to 35.7% by 2022 (from 27.7% of GDP to 24.5%, per Maastricht rules) Federal government debt, currently at 19.3% of GDP, is expected to fall to 16.4%. The government’s debt maturity structure is favorable, and debt is issued in local currency. Nominal yields on government debt are negative out to 13 years, enabling the government to enjoy projected negative real yields on its entire debt stock. Interest expenditures for the general government, as estimated by the IMF, were less than 0.5% of GDP in 2018 and at very low fixed interest rates. Because of these favorable debt dynamics and the strong commitment to fiscal discipline, the downward trend in Switzerland’s general government debt ratio is resilient to a variety of negative shocks.

Institutions Are Well Capitalized, But Financial Vulnerabilities Are Deepening

Switzerland’s highly open economy and historical status as a financial center are important sources of growth and prosperity for the country. Monetary policy is focused on price stability (defined as a rise in the price index of less than 2% per year), a medium-term inflation forecast, and a policy interest rate. Since abandoning the exchange-rate ceiling at 1.2 vis-à-vis the euro in January 2015, the Swiss National Bank (SNB) lowered deposit rates into negative territory to - 0.75% and reduced the target range for the three-month Libor to -1.25% and -0.25%. In its June 2019 policy assessment, given the uncertainty around the future of Libor, SNB replaced the target range for the three-month Libor with a new SNB policy rate, which stands at -0.75%. Short-term Swiss franc money market rates are expected to be close to the SNB policy rate. The SNB also said that given the appreciation pressure on the franc, monetary policy would remain expansionary, reflected in its negative interest rates and willingness to intervene in the foreign exchange markets. SNB also marginally revised its conditional inflation forecasts to 0.6% in 2019, 0.7% in 2020, and 1.1% in 2021 as compared to 0.3%, 0.6%, and 1.2% expected in the same time in the last quarterly forecasts.

The search for yield in a low growth and low inflation environment have intensified financial stability risks. The Swiss financial sector is a potential source of vulnerability due to its size and level of concentration, though DBRS believes risks stemming from the financial sector are contained. Property prices and mortgage lending, which had stabilized following the introduction of macro-prudential measures during 2012-2014, have risen since 2017. Household leverage at 130% of GDP is among the highest in the OECD. Household and commercial mortgages make up 85% of bank loans and more than 200% of GDP. The IMF notes that with yields on residential investment above those on government bonds, pension and insurance funds have invested more than 25% of their resources in the real estate sector. Consequently, the direct and indirect exposure of households to the real estate sector is high through ownership of property and savings held in pension and insurance funds, and holdings of real estate-related equities.

While the increase in capital and liquidity buffers (particularly the increase in the countercyclical capital buffer to 2%) have helped to reduce risks in the housing market, the imbalances in the mortgage and real estate market persist. Rising prices in recent years coupled with growing vacancy rates have raised risks of a correction. However, strong population growth coupled with SNB’s continuous monitoring of real estate developments to reassess the need for an adjustment of the countercyclical capital buffer are positive. Consequently, DBRS views risks stemming from potential housing market stresses as contained and the sovereign ratings are unlikely to come under pressure.

Persistent Current Account Surpluses and Net Creditor Position Reflect Strong External Accounts
Switzerland’s external accounts is characterized by a structural current account surplus and a positive net creditor position and remain a key source of strength. The size and composition of its external accounts reflect its role as a financial center, an attractive location for corporations and Switzerland’s high per-capita prime saver population. Switzerland’s persistent current account surpluses averaging 10% of GDP are increasingly driven by its trade balance and profits from merchanting. A positive net international investment position of 116% of GDP in 2019 (as of Q1) reflects the substantial accumulated wealth of Swiss residents and official foreign exchange reserves. This net position can be volatile, given Switzerland’s role as a financial center, but has averaged over 100% of GDP for the past decade. Much of the recent growth in gross external assets has stemmed from the SNB’s accumulation of official foreign exchange reserves. Over the last decade, the Swiss National Bank accumulated over CHF810 billion (US$806 billion) in foreign exchange reserves, which have reached approximately 116% of GDP as of 1Q 2019.

Uncertainty Around EU Relations Grows but Switzerland’s Strong Institutions and Stable Politics Are a Key Strength

Switzerland’s political environment is characterized by its federal democratic system, high institutional capacity and low level of corruption. Stable politics combined with neutrality in international conflicts have long made Switzerland a safe haven for investors. The Federal Council, Switzerland’s executive body, is made up of seven members, each of which heads a government department. Decisions are made jointly. Combined with a bicameral legislature and multiparty system, political decisions require a broad degree of consensus. The system is highly deliberative and allows for frequent popular referenda on important issues. Thus far however, Swiss voters have displayed pragmatism by rejecting some of the most radical policy proposals. Furthermore, Switzerland has found ways to implement the results of some potentially problematic popular initiatives while preserving sound policies and meeting key international commitments.

Switzerland is not a member of the European Economic Area. Its unique relationship with the EU is based on a network of agreements made up of two packages of bilateral agreements (Bilaterals I and II) and around 100 other agreements that ensure its access to the Single Market. (For more details, please see DBRS commentary entitled “3-Years on from the Brexit Referendum, do the Swiss and Norwegian Models Provide Lessons?, available at www.dbrs.com). This access does not include electricity and most financial services, but until recently, the EU allowed a permit called ‘stock market equivalence’ which enabled EU investment firms to trade certain Swiss shares not only on EU stock exchanges but also on Swiss stock exchanges. However, the stock market equivalence expired on June 30, 2019, resulting in the Swiss Federal Department of Finance (FDF) activating measures to protect the Swiss stock exchange infrastructure as of July 1, 2019 and thereby also safeguarding the access of EU investment firms to trade Swiss shares on Swiss stock exchanges.

Switzerland’s relations with the EU have been affected by concerns over its corporate tax regimes, and immigration quotas. Since 2014, Switzerland and the EU have been negotiating an agreement on institutional matters, aimed at ensuring a more uniform and efficient application of existing and future market access agreements. This is important as 53% of Switzerland’s exports go the EU and about 71% of all its imports come from the EU. The draft institutional agreement unveiled in December 2018 has gone through consultations with the main stake holders including cantonal governments and political parties. While the EU was hoping for a positive signal from Switzerland to sign the agreement as quickly as possible, this could potentially be delayed due to the demand of the Swiss government for clarifications on certain areas of the draft institutional agreement. Furthermore, the recent elections in the EU, upcoming elections in Switzerland, and uncertainty around Brexit may play a role as well.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the Rating Committee include the potential implications of tax policy changes, Switzerland’s relations with the EU, economic outlook; inflation; housing prices and financial stability risks.

KEY INDICATORS

Fiscal Balance (% GDP): 0.2 (2018); 0.1 (2019E); 0.1 (2020F)
Gross Debt (% GDP): 27.7 (2018); 26.8 (2019E); 26.0 (2020F)
Nominal GDP (CHF billions): 689.9 (2018); 704.4 (2019E); 724.4 (2020F)
GDP per Capita (CHF): 80,729 (2018); 81,529 (2019E); 82,941 (2020F)
Real GDP Growth (%): 2.5 (2018); 1.5 (2019E); 2.0 (2020F)
Consumer Price Inflation (%): 0.9 (2018); 0.8 (2018); 0.9 (2020F)
Domestic Credit (% GDP): 258.5 (2017)
Current Account (% GDP): 9.8 (2018); 9.0 (2019E); 9.0 (2020F)
International Investment Position (% GDP): 128.2 (2018); 116.8 (Mar-2019)
Gross External Debt (% GDP): 265.0 (2018); 264.8 (Mar-2019)
Governance Indicator (percentile rank): 99.5 (2017)
Human Development Index: 0.94 (2017)

Notes:

All figures are in Swiss Franc (CHF) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The primary sources of information used for this rating include Federal Department of Finance, Swiss National Bank, Swiss Federal Statistical Office, State Secretariat for Economic Affairs, OECD, IMF, European Commission, UNDP, World Bank and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This rating was not initiated at the request of the rated entity.
The rated entity or its related entities did participate in the rating process for this rating action. DBRS did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is an unsolicited credit rating.

This rating is endorsed by DBRS Ratings Limited for use in the European Union. The following additional regulatory disclosures apply to endorsed ratings:

The last rating action on this issuer took place on January 31, 2019.

Solely with respect to ESMA regulations in the European Union, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party

Generally, the conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS’s outlooks and ratings are monitored.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see: http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Lead Analyst: Rohini Malkani, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Thomas R. Torgerson, Co-Head of Global Sovereign Ratings
Initial Rating Date: July 14, 2011

For more information on this credit or on this industry, visit www.dbrs.com.

DBRS, Inc.
140 Broadway, 43rd Floor
New York, NY 10005 USA