DBRS Morningstar Confirms Swiss Confederation at AAA, Stable Trend

DBRS Ratings Limited (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 CREDIT RATING CONSIDERATIONS
The confirmation of the Stable trend reflects DBRS Morningstar’s view that the risks to Switzerland’s ratings remain limited despite the recent challenges in the Swiss banking sector and uncertainty in the global macroeconomic environment. The crisis at Credit Suisse AG (CS) resulted in a state facilitated takeover of CS by UBS AG (UBS), with a package of measures taken by the government, the Swiss National Bank (SNB) and the Swiss Financial Market Supervisory Authority. While this helped stabilize the financial system, it could lead to concentration risks for the Swiss banking sector. Authorities are currently reviewing liquidity requirements and the too big to fail (TBTF) regulations, which are likely to be presented within the next 12 months.

Switzerland’s solid public finances and strong economic recovery after the pandemic have helped mitigate risks posed by the weaker external environment. Following a post pandemic recovery of 3.9% in 2021, real GDP growth slowed to 2.0% in 2022, largely due to sharp interest rate increases in Switzerland’s main trading partners that have curbed demand. Against this backdrop, the Swiss authorities project growth to come in at 1.1% in 2023. After posting fiscal deficits in 2020 and 2021 as a result of the pandemic, the Federal Council has adopted a debt-brake compliant budget in 2024. Switzerland continues to have one of the lowest government debt ratios among sovereigns in the AAA category estimated at 39.1% of GDP in 2022. At the same time, inflation in Switzerland reached its peak in August 2022 at 3.5% and has been gradually easing, remaining considerably lower than in other advanced economies due to the country’s low dependence on fossil fuels. That said, the SNB raised its policy interest rate by a further 25bps to 1.75% in its June 2023 meeting.

Switzerland’s AAA ratings are underpinned by its wealthy and diversified economy, sound public finances, and solid external position. Strong institutions, predictable policies, and historical neutrality have long made Switzerland a safe haven for investors. Switzerland benefits from a highly productive workforce, high levels of educational attainment and labor force participation. These credit strengths counterbalance the challenges associated with Switzerland’s high mortgage debt and recent financial market developments. Additionally, the May 2021 decision not to sign the institutional framework agreement with the EU could gradually lead to increased barriers to trade between Switzerland and the EU. That said, Switzerland has already begun to enact appropriate policies in response to these challenges. Ongoing exploratory talks between the Swiss and the EU authorities in order to facilitate a mutually beneficial balance of interests could result in a new negotiation mandate in the coming months.

CREDIT RATING DRIVERS

DBRS Morningstar considers the likelihood of a downgrade of Switzerland’s ratings to be low. Nonetheless, the ratings could be downgraded if severe external shocks or a sustained deterioration in growth prospects materially affect Switzerland’s financial stability and fiscal position. Moreover, a materialization of substantial contingent liabilities stemming from the financial sector could put negative pressure on the ratings.

CREDIT RATING RATIONALE

Swiss Authorities Facilitate Merger of CS with UBS to Protect Financial Stability While Also Dealing With Inflation

Over the past few months, the financial position of the Swiss banking sector has been challenging, largely dominated by the crisis at Credit Suisse – Switzerland’s second largest bank. Switzerland’s historical status as a financial center is an important source of growth for the country. The financial sector contributes 10.3% of GDP supporting 219,000 full time employment positions equivalent to 5.5% of the total workforce. However, given the size of its banking sector, which is nearly 520% of GDP, shocks to banks especially if systemically important, can have an impact on financial stability. In March this year, the mounting issues at Credit Suisse – a result of long-standing breaches of legal and supervisory obligations and shortcomings in risk management – resulted in temporary financial market instability eventually leading to a state-facilitated merger with UBS, Switzerland’s largest bank. The transaction which was completed on June 12, 2023 involves a package of measures by the government, the SNB and the Swiss Financial Market Supervisory Authority (FINMA). The acquisition of CS by UBS will most likely result in output and job losses and there could be secondary effects as well. If UBS does not spin off CS, the resulting larger financial institution will materially increase the concentration risks in the Swiss banking system. It will have a combined mortgage market share of 26% and a combined deposit market share of 26%. That said, Switzerland's wealthy economy and strong fiscal position provide a degree of resilience to withstand a substantial shock.

A further concern for the SNB is the banking sector’s exposure to the real estate sector. While real estate prices have cooled down, with single family home price growing by 4.1% in 1Q 2023 down from 8.5% in 1Q 2022, Switzerland’s mortgage-to-GDP ratio remains high at 148% in 1Q 2023 up from 135% in 1Q 2015. The CS takeover by UBS could result in a concentration of the mortgage portfolio, albeit lower than other large domestic banks in other jurisdictions. While details of the combined entity are still being worked out, UBS has sound capital, funding and liquidity positions. Following a transition period starting 2025, the combined bank would have to comply with capital requirements that reflect the change in its systemic importance. In addition to UBS, now Switzerland’s sole global systemically important bank, the Swiss banking system has domestically focused banks (DFBs) and other banks mainly comprising domestic banks and branches and subsidiaries of foreign banks. As per the latest financial stability report, in the current rate environment, DFBs continue to see an increase in profitability levels. However, in the event of a further significant rise in interest rates, these banks could be affected through their exposure to the mortgage and real estate markets and to interest rate risks from maturity transformation. According to the IMF, household mortgages are three times EU-levels and make up 85% of total loans and half of bank assets. Pension funds and insurers have also investment amounts of 23% and of 12% of their funds in the real estate sector.

That said, the SNB’s stress scenario analysis suggests that most domestically-focused banks’ capital buffers remain sufficient to cover the potential loss stemming from a deterioration of Swiss mortgage and real estate markets and in a scenario involving a severe recession. While the domestically focused banks would suffer losses, the reactivation of the sectoral countercyclical buffer ensures that capital would not fall below their regulatory minimum. Furthermore, the SNB continues to monitor mortgage and real estate market developments closely and has reactivated the countercyclical capital buffer which aims to enhance the resiliency of the financial system.

In addition to playing an important role in dealing with the crisis at CS and its takeover by UBS, the SNB has been addressing inflationary pressures. Inflation in Switzerland exceeded its 0% to 2.0% price stability range in February 2022, peaking at 3.5% in August 2022. Since then, inflation has eased with the latest June 2023 reading coming in at 1.7%. In response to the uptick in inflation, the SNB started tightening its monetary policy in June 2022, by raising interest rates and selling foreign currency. In its latest meeting in June 2023, the SNB raised policy rates by a further 25bps to 1.75%, its fifth consecutive hike from -0.75%. Incorporating its new conditional forecasts for average annual inflation at 2.2% for 2023 and 2024, which takes into account second round effects of higher electricity prices and rents, the SNB indicated that to ensure price stability over the medium term, further rate hikes are possible. The SNB also stated that it would continue to be active in the foreign exchange market, focusing on selling foreign currency to maintain appropriate monetary conditions.

Another recent headwind for the SNB were record losses of CHF 132.5 billion in 2022. Consequently, it was not able to make any transfers to the government. The SNB is responsible for managing the country’s foreign exchange currency reserves which are allocated in a 75:25 ratio between bonds and equities. The unprecedented loss is attributed to interest rate hikes across the world resulting in a correction in both equity and bond markets. The record loss is also a consequence of the size of the SNB’s balance sheet.

Swiss Fundamentals Remain Strong Despite a Challenging External Environment and Turbulence in the Financial Sector

Switzerland’s ratings are underpinned by its wealthy and diversified economy, and solid economic performance. GDP per capita currently stands at USD 92,365, one of the highest in the world and its global competitiveness ranking is consistently one of the highest in Europe. This reflects Switzerland’s highly productive workforce, which is characterized by high levels of educational attainment and high labor force participation (83.5% as of Q4 2022) and internationally competitive industries and companies.

Following a 2.5% pandemic-induced recession in 2020, the Swiss economy rebounded strongly posting a growth of 3.9% in 2021 before slowing to 2.0% in 2022. The slowdown is largely attributed to the challenging external environment, primarily the sharp interest rate increases in Switzerland’s main trading partners and the war in Ukraine. Although Switzerland’s direct exposure to Russia and Ukraine is small, the repercussions of Russia’s invasion of Ukraine have increased the economic headwinds as a result of supply side energy issues that have led to higher inflation. Average HICP in Switzerland is forecast at 2.2% in 2023, significantly below the euro area average of 5.8%. Price growth is relatively contained in Switzerland compared to other advanced economies primarily due to the relatively lower reliance on fossil fuels for electricity generation, low energy intensity in Swiss manufacturing and the strengthening of the Swiss franc. High inflationary pressures in Switzerland’s main trading partners have led to more restrictive financial conditions. This has curbed demand resulting in adverse effects on export sectors of the Swiss economy. Nonetheless, domestic demand in Switzerland remains strong led by the service sector. Against this backdrop, the Swiss Federal Government’s expert group on economic forecasts (SECO) projects growth to come in below average at 1.1% in 2023, rising to 1.5% in 2024 (GDP is adjusted for sporting events).

Switzerland’s Creditworthiness is Underpinned by Its Strong Public Finances and Solid Fiscal Framework

Switzerland’s prudent fiscal policy, underpinned by its debt brake rule, constitutes a key credit strength. Since the introduction of the debt brake rule, the federal budget – with the exception of 2022- has no longer shown any structural deficits. The debt brake mandates a balanced budget over the business cycle. Higher expenditures has to be financed by increased revenues or corresponding expenditure cuts. Following the pandemic-related fiscal deficits of 3.0% of GDP in 2020 and 0.5% in 2021, Swiss public finances have improved to a near balanced position of 0.2% in 2022. The IMF expects the fiscal balance to average 0.2% through its forecast horizon (2023-2028).

Switzerland’s public debt levels remain low relative to other AAA-rated peers. The pandemic resulted in the general government gross debt ratio rising from 39.6% in 2019 to 43.3% in 2020. Since then, the economic recovery and the withdrawal of stimulus have resulted in the debt ratio declining to 39.1% in 2022. The Maastricht debt ratio, which excludes pensions and healthcare, rose from 25.2% in 2019 to 28.3% in 2020 due to the pandemic has now stabilized at marginally lower levels of 27.6% of GDP. Switzerland’s low public debt levels combined with substantial financial flexibility, help the country to stand out among other highly-rated sovereigns. The government’s debt maturity structure remains favorable, with average maturity of marketable debt (bonds and T-bills) at 10.2 years. All debt has been issued in Swiss francs. Interest expenditures for the general government, as estimated by the IMF, were less than 0.4% of GDP in 2022. Recently increase concentration risks in the Swiss financial sector due to the takeover of CS by UBS could ultimately increase contingent liability risks attached to a single bank. That said, the liquidity lines with preferential rights in bankruptcy proceedings coupled with risk premium on loans paid, provide some assurances against potential losses for the sovereign. Moreover, the loss if any would be treated as an extraordinary item. With highly transparent public finances and consistent efforts to address medium- and long-term fiscal challenges, DBRS Morningstar views Swiss fiscal management and policy to be very strong.

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. Switzerland’s persistent current account surpluses averaging nearly 8% of GDP over the last two decades reflect its role as a financial center, an attractive location for corporations, high per-capita income levels, and high savings rate. Switzerland’s positive net international investment position (NIIP) of 96.5% of GDP in 2022 reflects the substantial accumulated net wealth of Swiss residents and official foreign exchange reserves. Switzerland’s overall foreign exchange reserves rose from USD 340 billion in 2011 to USD 1111 billion in 2021 and are currently at USD 925 billion. Due to its foreign exchange intervention as part of its monetary policy mandate, the SNB’s balance sheet has grown to 122% of GDP as of March 2023.

Switzerland’s Ratings Are Supported by Its Strong Institutions

Supporting Switzerland AAA ratings is its political environment, characterized by its federal democratic system, high institutional capacity and low level of corruption as reflected in the World Governance Indicators. The stable political system combined with neutrality in international conflicts have long made Switzerland a safe haven for investors. Despite the fact that the Swiss constitution prohibits Switzerland being a member of any defense union such as NATO and disallows any military engagement, Switzerland has implemented all the economic sanctions on Russia which include financing restrictions and asset freezes, travel bans, and prohibition of sale/transfer of key technologies.

Switzerland is not part of the EU and its unique relationship is based on bilateral agreements (two packages known as Bilaterals I & II) and several other agreements ensuring, among other things, access to the EU’s single market for several sectors. Between 2014 and 2021 Switzerland and the EU negotiated on a common institutional framework to streamline Switzerland’s market access to the EU. The future of Swiss-EU relations remains uncertain after the Swiss Federal Council halted the discussions due to substantial disagreements mainly on the Citizens’ Rights Directive and wage protection in May 2021.(See Swiss-EU Relations At An Impasse). In February 2022, the Swiss government proposed a broad package approach in order to facilitate a mutually beneficial balance of interests. Since then, the Swiss and the EU have held nearly 40 exploratory talks, which could eventually lead to preparations for a new negotiating mandate. The EU is Switzerland’s largest trading partner and the failure of talks could ultimately result in an increase in trade barriers with its EU partners. DBRS Morningstar nonetheless expects that Switzerland will continue to maintain strong relationships with its EU counterparts in the foreseeable future.

There were no Environmental/ Social/ Governance factors that had a significant or relevant effect on the credit analysis.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (July 4, 2023)

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/417480.

Notes:
All figures are in 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 https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this credit rating include the Federal Council, State Secretariat of Economic Affairs (Economic Forecasts May 2023), Federal Department of Finance (Federal Finances at a glance, March 2023 ), Swiss National Bank (Quarterly Bulletin 1/2023, Financial Stability Report 2023); Federal Department of Foreign Affairs (Switzerland’s European Policy, September 2022), European Central Bank (ECB), Eurostat, OECD, IMF (WEO April 2023), World Bank, BIS, Our World in Data, the Social Progress Imperative, the 2019 and 2020 Global Competitiveness Reports from the World Economic Forum, UNHRC, and Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this credit rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, 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

DBRS Morningstar does not audit the information it receives in connection with the credit rating process, and it does not and cannot independently verify that information in every instance.

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 credit ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication/. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key credit rating assumptions can be found at: https://www.dbrsmorningstar.com/research/417470.

This credit rating is endorsed by DBRS Ratings GmbH for use in the European Union.

Lead Analyst: Spyridoula Tzima, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: July 14, 2011
Last Rating Date: January 22, 2023

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