DBRS Morningstar Confirms Swiss Confederation at AAA, Stable Trend

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

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS Morningstar’s view that Switzerland’s credit fundamentals remain solid, despite the severe economic shock from the Coronavirus Disease (COVID-19). The coronavirus pandemic and the measures implemented to contain it have led to a severe downturn in economic activity both in Switzerland and abroad. The fiscal costs of fighting the pandemic and its economic implications will result in a substantial, but temporary increase in the deficit, which will still be felt in 2021. However, Switzerland entered the current crisis with sound public finances, including a low level of debt and interest costs, which provide the government with valuable fiscal headroom to mitigate the severe impact from the pandemic without compromising fiscal sustainability.

Switzerland’s AAA ratings are underpinned by its wealthy and diversified economy, sound public finances, consistent external surpluses, and institutional strength. Switzerland benefits from a highly productive workforce, and high levels of both educational attainment and labor force participation. Strong institutions, predictable policies, and historical neutrality have long made Switzerland a safe haven for investors. Switzerland’s low levels of indebtedness combined with substantial financial flexibility, help the country to stand out among other highly-rated sovereigns.

Looking ahead, Switzerland faces some medium-term challenges. Uncertainty surrounding Swiss-EU relations, due to the negotiations on the institutional agreement with the EU and the upcoming popular vote on the free movement of persons agreement, scheduled for the 27th of September, could adversely affect the open Swiss economy. In addition, low interest rates and the consequent search for yield are fueling increased borrowing by domestic investors in the real estate market, thereby moderately increasing risks to financial stability. That said, Switzerland is expected to provide appropriate responses to these challenges, and is firmly placed in the AAA category.

RATING DRIVERS

DBRS Morningstar considers the likelihood of a downgrade of Switzerland’s ratings to be low. Nonetheless, external shocks or a sustained deterioration in growth prospects that are severe enough to materially affect Switzerland’s financial stability and fiscal position could put downward pressure on the ratings.

RATING RATIONALE

The Pandemic Will Result in a Deep Transitory Contraction, But Swiss Economic Fundamentals Remain Solid

Switzerland has been effective in containing the spread of the coronavirus pandemic, recording 33,883 confirmed infections and 1,693 deaths related to the outbreak as of July 22, 2020. The number of new infections have fallen from a peak of almost 1,500 cases per day in late March to around 100 new cases by mid-July. That said, the pandemic and the measures to contain it have led to a severe downturn in economic activity. The Swiss authorities expect GDP to contract 6.2% in 2020, the most severe downturn since the oil crisis in the 1970s, with unemployment to average 3.8% for the year. For comparison however, the IMF’s interim World Economic Outlook released in June expects the Euro Area to contract 10.2%. Unlike previous recessions, the service sector has been heavily affected, particularly in the hospitality industry, passenger transport, the entertainment industry and parts of retail trade.

The lockdown, imposed from March 17 until April 26 to limit the spread of the virus, together with disruptions in external trade and global supply chains, resulted in Q1 2020 GDP declining 2.6% QoQ. While Q2 2020GDP will undoubtedly show a deeper decline, the loosening of restrictive measures coupled with the government’s stimulus measures are likely to contribute to a modest rebound from the third quarter. Provided that Europe avoids further significant outbreaks, growth is expected to recover to 4.9% in 2021. The government’s base case assumes no renewed intensification of lockdown measures and that the second-round economic effects in the form of lay-offs and corporate bankruptcies remain limited.

To deal with the economic fallout, the Federal Council announced a series of federal-level support packages amounting to CHF 73 billion (10.4% of 2019 GDP) to support affected businesses and households. While DBRS Morningstar expects the support measures to be effective, the near-term outlook is clouded by considerable uncertainty. While further waves of infection or trade tensions could additionally impair economic activity, the unprecedented global monetary and fiscal policy measures could support the recovery more strongly than expected.

While the near-term global economic outlook is severely challenging, Switzerland’s ratings are underpinned by its wealthy and diversified economy and its medium-term economic outlook remains strong, underpinned by solid real income growth and continued rising net wealth. The Swiss economy repeatedly ranks highly in international comparisons; GDP per capita currently stands at USD 82,341 and its global competitiveness ranking is consistently one of the highest in Europe. This reflects Switzerland’s highly productive workforce, high levels of educational attainment, and high levels of labor force participation. Swiss economic growth has historically outperformed the euro area average due to sustained consumption and investments growth. However, as a safe haven currency, the Swiss franc remains vulnerable to appreciation pressures arising from risk aversion. This coupled with uncertainty on the EU-Switzerland institutional agreement and the search for yield, could increase financial stability risks.

Switzerland’s Low Public Debt Provides Sufficient Space For Stimulus Measures to Support the Economy

Switzerland entered the current crisis with sound public finances, providing the government with valuable fiscal headroom to mitigate the severe impact from the pandemic without compromising fiscal sustainability. The Swiss authorities have maintained pragmatic and disciplined fiscal policies for more than a decade, which is reflected in modest structural surpluses since 2006 and a declining debt-to-GDP ratio which stood at 26.9% in 2019. Moreover, Switzerland’s debt break rule helps ensure that fiscal policy is balanced over the business cycle by linking spending to cyclically-adjusted revenues and saving any surplus.

Nonetheless, the pandemic has had a profound impact on federal finances. The Federal Council announced a series of federal-level support packages amounting to CHF 73 billion (10.4% of 2019 GDP). Direct fiscal stimulus measures amount to CHF 31 billion, and include the short-time unemployment scheme (Kurzarbeit), while guarantees to SMEs and corporates amount to CHF 42 billion. The initial focus of the package was largely through expenditures and guaranteed loans to avoid layoffs, safeguard wages, support the self-employed and prevent insolvencies due to liquidity bottlenecks. The focus of the government has now shifted from providing emergency lifeline to the economy to fine-tuning various support measures and ensuring policy continuity as the country transitions back to a more normalized situation.

The policy measures to support the economy, coupled with the contraction in growth, will take a toll on revenues and result in a sharp deterioration in fiscal performance in 2020. Following a fiscal surplus of 0.9% in 2019, the IMF in its April 2020 Fiscal Monitor projects a fiscal deficit of -5.1% of GDP in 2020 and of -1.9% of GDP in 2021. The relatively quick reduction in the deficit in 2021 reflects the temporary nature of the measures as well as the economic recovery. To finance the package and compensate for lower-than-expected tax revenues, the Federal Council has already passed various supplementary credits and late registrations for the 2020 budget for the attention of the Parliament.

Thanks to its low level of public debt, Switzerland is in good financial position to adopt a comprehensive and substantial package of measures to support the economy. The debt brake is flexible and contains an exception for non-controllable contingencies such as severe recessions, natural disasters, and other shocks. This exemption ensures that the federal government can react flexibly, as evidenced by the response to the COVID-19 pandemic. Nonetheless, the large fiscal deficit and sharp drop in nominal GDP will result in a sizeable increase in Switzerland’s public debt ratio in 2020. Furthermore, some of the liquidity support measures, such as tax deferrals, will transitorily increase short-term funding needs. Consequently, the IMF definition of public debt which takes into account pensions and healthcare expects the public debt ratio to increase from 39.3% in 2019 to 46.4% of GDP in 2020, where it will stabilize.

Despite the increase in public debt in 2020, Switzerland’s low level of public indebtedness, combined with substantial financial flexibility, helps the country to stand out among other highly-rated sovereigns. The government’s debt maturity structure is favorable, with average maturity at 9.8 years and all debt has been issued in Swiss francs. Nominal yields on government debt are negative over all outstanding bonds up to 45-year maturities. Interest expenditures for the general government, as estimated by the IMF, were less than 0.2% of GDP in 2019. Consequently, DBRS Morningstar does not expect the current macroeconomic and fiscal shocks to exert downward pressure on the ratings. With highly transparent public finances and consistent efforts to analyze and address medium- and long-term fiscal challenges, DBRS Morningstar views Swiss fiscal management and policy to be very strong.

The Swiss National Bank Remains Highly Accommodative and Supportive to the Economy

The coronavirus pandemic and the measures implemented to contain it have led to a severe downturn in economic activity. This coupled with lower oil prices prompted the Swiss National Bank (SNB) to further revise its inflation estimates downwards to -0.7% in 2020, -0.2% in 2021 and 0.2% in 2022. In response to the pandemic, the SNB said that it would maintain its accommodative stance, keeping its policy rate and interest on sight deposits at the SNB at -0.75%. However, in light of the appreciation pressure on the Swiss franc, the SNB said it would be willing to intervene more strongly in the foreign exchange market, despite the U.S. Treasury putting Switzerland back on its ‘watch list’ as a potential currency manipulator.

To ensure liquidity shortages do not turn into solvency issues, the SNB launched extraordinary lending facilities under its COVID-19 refinancing facility (CRF) and activated swap agreements with the Federal Reserve. The CRF loans are guaranteed by the federal government thus enabling companies to obtain credit simply and at favorable terms. This coupled with the raising of the negative interest exemption threshold (i.e. the amounts on which banks do not pay negative interest rates), and the deactivation of the countercyclical capital buffer have made it easier for banks to lend at favorable conditions. SNB’s proactive measures have resulted in an upward adjustment in the “Monetary Policy and Financial Stability” Building Block.

Financial Stability Risks have Risen, But Banks are Well Positioned to Meet These Challenges

Switzerland’s historical position as a financial center is an important source of growth and prosperity for the country but can also leave Switzerland exposed to external shocks. The COVID-19 pandemic has led to a marked deterioration in financial market conditions around the world. However, Swiss banks are well positioned to deal with these challenges. They have a solid capital base for managing the heightened risks caused by the pandemic-triggered economic downturn.

That said, the Swiss financial sector is concentrated, with two global systemically important banks (G-SIBs) domiciled domestically, each holding total assets which exceed domestic GDP. In addition, the search for yield in a low growth and low inflation environment have intensified financial stability risks for the domestically-focused banking sector. Several years of strong growth in both bank credit and real estate prices have resulted in the build-up of imbalances on the mortgage and residential real estate markets. With mortgage growth outpacing income growth, Switzerland’s mortgage-to-GDP ratio has risen to 128.7% of GDP – the highest among the OECD countries. The IMF notes that with yields on residential investment above those on government bonds, pension funds and insurance funds have invested more than 25% of their resources in the real estate sector. Thus, between property ownership, pension and insurance savings, and real estate-related equity holdings, Swiss households are highly exposed to real estate market developments through both direct and indirect channels.

However, DBRS Morningstar considers risks stemming from the financial sector to be contained with both the G-SIBs meeting the resilience and resolution requirements – the two pillars of the ‘too big to fail’ regulations. Both Credit Suisse and UBS have sound buffers over minimum capital requirements. The SNB’s scenario analysis indicates that, thanks to these capital buffers, the two banks are able to cope with significantly worse developments in the economic environment than under the baseline scenario.

Domestically-focused banks remain the greater concern. In addition to a potential increase in provisions and write-downs on outstanding loans to Swiss corporations, these banks could come under greater strain due to existing imbalances on the mortgage and real estate markets. Banks’ mortgage portfolios could be negatively impacted if the downturn led to a worse-than-expected decline in income at both the households and corporate level and prompts questions about affordability risks. However, SNB’s scenario analysis indicates that domestically focused banks’ resilience is adequate and that the available capital buffers ensure that the lending and loss-absorbing capacity of the banking sector are sufficient even if the economic impact of the COVID-19 pandemic should turn out to be worse than currently expected.

Switzerland’s External Accounts Remain a Key Credit Strength

Swiss external accounts are characterized by a structural current account surplus and a positive net creditor position. The persistent current account surpluses averaging 10% of GDP over the last two decades reflect its role as a financial center, an attractive location for corporations, Switzerland’s high per-capita income levels, and high savings rate. Over the last decade, the Swiss National Bank (SNB) reserves have risen from USD 340 billion in 2011 to USD 851 billion currently due to its foreign exchange intervention, and its balance sheet now stands at 130% of GDP. Accumulation of net savings and official foreign exchange reserves have resulted in a positive net creditor position of 143% of GDP as of March 2020.

Strong Institutions and Stable Politics But Uncertainty Around Swiss-EU Relations Remains Elevated

Switzerland’s political environment is characterized by its federal democratic system, high institutional capacity, and low level of corruption. Stable politics, along with neutrality in international conflicts, have long made Switzerland a financial safe haven for investors. However, negotiations on the institutional agreement with the EU and the upcoming popular vote on the free movement of persons agreement is likely to keep uncertainty on the Swiss-EU relations elevated.

Switzerland currently enjoys a unique relationship with the EU. It is not part of the EU and unlike Norway, Iceland and Liechtenstein, it is not a member of the European Economic Area (EEA). Relations with the EU are based on a network of agreements made up of around 20 main agreements and a large number of secondary agreements ensuring, among other things, access to the EU’s single market for several sectors. Unlike the other members of the EEA, it enjoys partial access to the EU’s single market while being under no legal obligation to adopt new relevant EU legislation.

However, since 2014, Switzerland and the EU have been negotiating an institutional agreement, aimed at ensuring a more uniform and efficient application of existing and future market access agreements. After consultations on this draft were held in Switzerland, Switzerland identified three points of concern in 2019 that need to be clarified. These include maintaining the current level of wage protection in Switzerland, certain aspects of state subsidies and the EU citizen’s rights directive, which goes beyond free movement of workers. Because of these open questions concerning the institutional agreement, Brussels followed through with its threat of letting the stock market ‘equivalence’ regime lapse on June 30, 2019. With this, EU investment firms are no longer able to trade directly on Swiss stock exchanges if the shares concerned are admitted to trading on an EU regulated market or are traded on an EU trading venue. In order to protect the Swiss stock exchange infrastructure, the Federal Department of Finance and the Swiss Federal Council activated on July 1st, 2019 the Federal Council’s ordinance, that prevents financial centers in the EU from trading shares of companies based in Switzerland.

Furthermore, DBRS Morningstar will monitor the results of a popular vote that was initially scheduled for May 17 but postponed to September 27, 2020 due to the pandemic. This popular vote could potentially change the Swiss Constitution and terminate the free movement of persons agreement between Switzerland and the EU/EEA, effective a year after the vote. The vote could negatively affect the relationship between Switzerland and the EU. DBRS Morningstar will also closely monitor the progress in the discussions concerning the upcoming EU-UK trade deal, expected to conclude by the end of 2020, as the stance taken by the EU could affect the future relationship between Switzerland and the EU.

ESG CONSIDERATIONS

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/364480.

Notes:
All figures are in Swiss Franc (CHF) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments, September 17, 2019.
See: https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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 Morningstar considers the information available to it for the purposes of providing this rating was 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 Morningstar 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 (DBRS Morningstar) 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 24, 2020.

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.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

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

For further information on DBRS Morningstar 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: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: July 14, 2011

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

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