EMU, Switzerland? Marie-Christine Luijckx and Luke Threinen Public Policy 542 April 10, 2006
Introduction While Switzerland is the EU s closest geographic, cultural, and economic ally, it is not a member state. Since applying for membership in 1992 led to two negative referenda in the country, the idea of joining has been put on hold indefinitely. However, by all economic measures it seems that Switzerland now more than ever should be ready to reconsider its stance on participation in the European Monetary Union (EMU). As trade has liberalized and the work force has become more mobile, the benefits to integration have increased. In addition, as the movements of the Swiss economy have begun to mirror those of the Euro area, the costs of joining have also decreased. This paper will analyze the economic costs and benefits of Switzerland joining the EMU. In particular, it will look at how Switzerland stands relative to the four criteria for currency integration: regional interdependency, industrial diversification, factor mobility, and symmetric shocks. It will end with a policy recommendation on whether Switzerland should peg based on its performance on each of these criteria. Switzerland vs. EMU Switzerland is historically a neutral and independent country with stable growth, low unemployment, and a highly skilled labor force. While the country is small, the national currency, the Swiss Franc (SFr), is strong and liquid due mainly to the size of the banking sector. As the currency freely floats, Swiss policymakers have full access to monetary and fiscal policy to stabilize the economy. In contrast, the countries of the EMU have forsaken independent monetary policy to use the Euro as their currency. There are currently 12 countries in the EMU: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. In addition, there is a handful of EU and non-eu countries that peg their respective currencies to the Euro 1. As Switzerland is a stable and prosperous country, it would potentially be a good candidate to join the ranks of the EMU, but for years it has been resistant to give up any of its autonomy. As a consequence, it has also missed out on the opportunity to join the unified market and enjoy the subsequent monetary efficiency gains. Regional Interdependency One of the most important factors in deciding whether a country should join a currency union is how well integrated the economy of that country is with the area it would join. The more integrated they are, the more magnified are the monetary efficiency gains. The best way to measure this is to look at trade flows between Switzerland and the Euro zone. While Switzerland remains outside the EU, there are no substantial barriers to trade between the two. The Swiss government has negotiated a number of bilateral agreements to ensure open access to European markets. Switzerland s economy is dependent on these economic ties as the 1 Wikipedia: Eurozone See http://en.wikipedia.org/wiki/eurozone
EU is its most important partner. The strong relationship between Switzerland and the EU dates back to 1972 when the Free Trade Agreement was signed allowing for free trade of industrial products. In 1999, seven more bilateral agreements were signed, which included measures to free the movement of persons and lower other technical barriers to trade. More recently, in 2004, a second set of bilateral agreements addressed agricultural products and other controversial issues 2. As a small country, Switzerland is very dependent on trade. The trade to GDP ratio from 2002 to 2004 was as high as 88.2% with an incredible trade per capita of 38,205 US$. Switzerland is the 21 st biggest merchandise exporter and 18 th largest merchandise importer in the world 3. Switzerland s biggest exports are machinery, chemicals, metals, watches, and agricultural products. In terms of imports, Switzerland is a net importer of food and has to buy almost all of its energy and industrial raw materials abroad. It is no surprise that the majority of Switzerland s trade is with its geographical neighbor, the EU- 25. In fact, 62.1% of its exports are destined for the EU-25 and 82.8% of its imports originate there 4. Within the EU, Germany, France, and Italy are Switzerland s largest trading partners accounting for 32.9, 11.7, and 10.2 percent of imports respectively (see Figure 1). Though not part of the EMU, Switzerland is already strongly regionally dependent on European trade for the health of its economy. This reflects the general trend in Europe towards intraregional trade over inter-regional trade 5. Even for the much larger EU, Switzerland is the second biggest trading partner after the United States. In addition, as Switzerland has moved its domestic regulations in line with that of the EU, it has lowered the potential future costs of adopting the Euro. Industrial Diversification In an optimum currency area, industrial diversification is important to buffer shocks. In a developed and prosperous country like Switzerland, the economy is already fairly well diversified. In addition to the insurance companies and banks it is well known for, Switzerland has a comparative advantage in customized engineering products. These products include precision instruments and watches, pharmaceutical goods, and vehicles and other machines 6. Thus, with a variety of high value-added products and a strong banking sector Switzerland is able to protect its economy from sector-specific shocks. Joining the EMU would only help to further diversify Switzerland s industry and portfolio, but it is not among the largest benefits it would receive. Symmetry of Economic Shocks In assessing possible monetary union with the Euro area, another consideration for the Swiss is whether their economy tends to face shocks which are similar in quality, magnitude, and timing to the Euro area s economy. If the Swiss economy faces shocks which tend to be different in some important way from the shocks faced by the Euro area, the costs to Switzerland of surrendering monetary autonomy would increase greatly. This is because the monetary policy called for by the 2 Bilateral Agreements I & II See http://www.europa.admin.ch/e/ 3 WTO Statistics Database: Country Profile Switzerland 4 Ibid 5 WTO Statistics Database: Intra- and Inter- Regional Merchandise Trade, 2004 6 Economist Intelligence Unit: Country Profile Switzerland
shock facing the Swiss might differ greatly from the policy called for by conditions in the Euro area. This could even result in the Swiss facing, say, a monetary contraction just when conditions in Switzerland call for a monetary expansion, and an exacerbation of the Swiss problems. It is difficult to determine, let alone quantify, the shocks that an economy faces at any given time. However, some useful proxies are available which shed a great deal of light on the Swiss-Euro Zone comparison. The most obvious and broadest indicator of economic shocks is a change in Gross Domestic Product. In comparing the percent change in Switzerland s GDP growth to GDP growth changes in the Euro area from 1995 to the present, a high degree of symmetry is apparent. In fact, from 1996 to 2006, the changes in Swiss GDP growth moved in the same direction as changes in Euro area GDP growth every year (see Figure 2). Note that this is not to say that when the Euro area GDP grew, so did the Swiss GDP rather, it shows that changes to the rate of growth were in the same direction. For instance, in 2001, Euro area GDP growth fell from +3.70% to +1.80%, while Swiss GDP growth fell from +3.61% to +1.05%, with both economies continuing to grow, but at a slower rate. Another helpful proxy for economic shocks is the unemployment rate over time. Specifically, we would expect a negative economic shock to increase the unemployment rate, with all else held equal. While all else is not be held equal in reality, a look at the unemployment rates in Switzerland and the Euro zone from 1995 to 2005 is instructive. As with changes in GDP growth, we see the unemployment rates moving virtually in parallel over this period (see Figure 3), although the Swiss unemployment rate stays about 6 to 8 percentage points below that of the Euro area. As noted, unemployment is not a perfect indicator of symmetric shocks because other factors are changing at the same time. One of the factors which might force unemployment rates to move in parallel even under asymmetric shocks is monetary policy. For example, if the Swiss economy faced a negative external shock which, if left alone, would raise the unemployment level, the Swiss National Bank (SNB) may be able to avert the unemployment rise by expanding the money supply and thereby lowering interest rates. However, if the Euro area was not subject to the same shock, the European Central Bank (ECB) would be unlikely to follow the same monetary policy as the SNB. It is therefore useful to examine movements in the Swiss interest rate compared with those of the Euro area to see whether, in fact, the SNB s monetary policy has strayed far from the ECB s. Figure 4 suggests that this was not the case for the period 1995 to 2005. Using changes in the money market interest rate as a proxy for changes in the national interest rate, we see again that the SNB quite obviously followed the ECB s lead over this period. This in turn suggests either that the two banks were responding to similar conditions or that one of them followed the other s monetary policy for some other reason (of course the SNB would have followed the ECB, not the other way around). For instance, the interest rate changes in the two areas would be correlated if the SNB was implementing a de facto peg of the SFr to the Euro. In actuality, the truth may be that the SNB was not forced to choose. If the SNB s policy was to peg the SFr to the Euro while simultaneously responding to asymmetric shocks to the Swiss economy, one would expect to see some kind of divergence between the macro indicators of the two areas or some slippage in the exchange rate. For instance, if the SNB anticipated an upturn in the economy which would not be felt in the Euro area and wanted to raise interest rates, it would have to intervene in the foreign exchange market to keep the SFr from appreciating. This could show up as a divergence of Swiss-Euro area interest rates. Similarly, if the SNB kept the interest
rates and exchange rates on par while the Swiss economy turned up, we might expect to see GDP, unemployment, or inflation figures diverge. We have seen that GDP and unemployment have moved together; Figure 5 shows that moves in consumer prices also match closely from 1995 to 2005 across Switzerland and the EMU. Finally, Figure 6 shows moves in the Euro:US$ and SFR:US$ exchange rates from 1995 to 2005. Once again, the Swiss and Euro area figures move in lockstep. Figure 7 shows the calculated Euro:SFr exchange rate implied using the data from Figure 6 in the past ten years, the exchange rate has moved between the band of 0.61 and 0.68 Euro:SFr, with the rates since the official adoption of the Euro occupying an even narrower band. It is difficult to see this as a coincidence, especially in light of the degree to which Switzerland s economy relies on streams of imports and exports. Factor Mobility Even for countries whose macroeconomies tend to face similar conditions, there will be times when the shocks they experience diverge. In this case, participation in the currency union is less costly when there is high geographic factor mobility across the union, particularly for labor. Switzerland and the Euro area exhibit a relatively high degree of labor mobility. Inasmuch as they were, legal barriers are no longer an obstacle in Switzerland to EU migration. Since 2002, all Swiss citizens have been eligible to live and work in any EU country. 7 Additionally, Swiss voters accepted a proposal last summer to join the passport-free Schengen travel zone. 8 This allows free travel between all member countries, which include some of the largest Euro zone countries, such as Germany, France, Italy, as well as some of the other Euro zone countries which have strong Swiss economic ties, such as Austria, Spain, and the Netherlands. Another commonly mentioned barrier to labor mobility in Europe is language. This does not apply in the same way to Switzerland, however, which lacks a unique language. Instead, Switzerland has three official languages German, French, and Italian 9 each of which originates in a country bordering Switzerland. Indeed, these three bordering countries, all Euro zone members, are Switzerland s three largest European trading partners. 10 Additionally, Germans and Italians compose two of the top four populations of foreign nationals living in Switzerland. (The largest group, former Yugoslavian nationals, is also the newest.) In all, Switzerland hosts a wide variety of foreign-born permanent residents and temporary workers from around the Euro zone. Over half of Switzerland s 1.5 million foreign residents in 2000 were from Europe, 11 making up over 10% of the population. Policy Recommendation 7 Free movement of persons Switzerland-EU15, Swiss Federal Office for Migration 8 One country says yes, The Economist, June 9, 2005. 9 CIA, Switzerland, The World Factbook, 2005 10 Switzerland, Country Profile, EIU, 2005. 11 Switzerland Faces Common European Challenges, Country Profiles, February, 2005. See http://www.migrationinformation.org/feature/display.cfm?id=284
Switzerland and the Euro zone meet each of the criteria for economic success of a currency union presented above. Factor mobility is high between Switzerland and the EMU, particularly in the critical area of labor. Switzerland lacks many of the legal and cultural barriers to mobility present elsewhere in Europe. Our analysis of the economic shocks experienced by Switzerland and the EMU has revealed a strong symmetry between macroeconomic indicators between the two from 1995 to 2005. The Euro:SFr exchange rate has been remarkably stable during this period as well, and especially since 1999. Finally, Switzerland s economy is strongly dependant on trade flows both to and from the Euro zone countries, with well over half of its imports and exports traded with these countries. To a lesser extent, the Euro zone is also dependant on trade with Switzerland. Our conclusion is that the gains arising from Swiss adoption of the Euro would outweigh the costs for each party. On strictly economic grounds, we recommend Swiss adoption of the Euro. Conclusion We have more or less limited our discussion to whether the Swiss will benefit from joining the EMU, not the other way around. Taking the other perspective, we believe the EMU would also benefit from having Switzerland as a member. As noted above, little Switzerland accounts for a rather large percentage of the Euro area s external trade. Switzerland has easily met the constraints of the Stability and Growth Pact for the past ten years (see Figures 8 and 9), something which even some much larger EMU members cannot claim. Also, Switzerland is a rich, stable country with a highly developed financial sector. Lastly, while on economic grounds we have made the case that Switzerland should join the EMU, we have not discussed the political ramifications and complications. Joining the EMU would mean amending the Constitution in a number of areas. First, it would mean easing Switzerland s substantial commitment to neutrality and sovereignty. Second, it would require a change to Swiss bank secrecy legislation to allow for direct taxation. This would impair one of the country s biggest service sectors, the banking system. Third, it would require Swiss citizens to give up some of their voting rights to the common good of the European Union. For a country that is focused on people s initiatives, this is a large departure from the status quo 12. For these amendments to be made to the Constitution there would have to be referendum in Switzerland with a majority in favor which, given historical voting patterns, is very unlikely. Thus, while it may economically justifiable to join the EMU, politically Switzerland would not be able to achieve such integration at this time. It might instead opt for declared currency peg, or it may continue down what is, by all appearances, a de facto peg to the Euro. 12 Economist Intelligence Unit: Country Profile Switzerland
Bibliography * CH-EU Integration Office, Bilateral Agreements I & II, April, 2006. See http://www.europa.admin.ch/e/index.htm. CIA, Switzerland, The World Factbook, 2005. Economist Intelligence Unit, Switzerland, Country Profile, 2005. The Economist, One country says yes, June 9, 2005. Migration Information Source, Switzerland Faces Common European Challenges, Country Profiles, February, 2005. See http://www.migrationinformation.org/feature/display.cfm?id=284. Swiss Federal Office for Migration, Free movement of persons Switzerland-EU15, April, 2006. See http://www.swissemigration.ch/elias/en/schweizeu/index.html Swiss National Bank, Währungsreserven der Schweiz, Daten und Statistiken, 2005. Wikipedia, Eurozone, April, 2006. See http://en.wikipedia.org/wiki/eurozone. World Trade Organization, Switzerland, Country Profile, 2005. World Trade Organization, Trade by Region, International Trade Statistics, 2005. * All data in Figures 2-7 are from the Economist Intelligence Unit online.
Figure 1