“Senator John Kerry released his plan today to eliminate the deficit. He said all we have to do is find a really rich country like Switzerland and marry it.”
~ Jay Leno; the approach of courting the Swiss has since turned out to be a little less amicable…
The presidential debates are deservedly receiving a lot of attention these days. Over the past few weeks, to the great surprise of many, Mitt Romney has taken the lead in the polls. That is particularly intriguing in light of the fact that the mainstream media seems to have generally favored the incumbent. In the midst of the presidential debates and campaigning, it has gone somewhat unnoticed that several indicators in Europe have started turning negative again. Moreover, the US keeps heading towards a fiscal cliff that, no matter who takes the wheel in the upcoming elections, cannot be avoided without incurring considerable economic pain.
In my view, the somewhat optimistic and hopeful pattern that financial markets have taken over the past few months is rapidly coming to an end. I am concerned that you may have to buckle up for what comes after the elections. We will discuss our expectations and scenarios for the global economy in more depth next week. Today, I would like to focus on Switzerland and its future.
Lately, I´ve been getting quite a few questions about my expectations on Switzerland´s future. Some of our clients at BFI and several Mountaineers wondered whether Switzerland still has what it takes to be a successful and strong economy in the future. Will Switzerland remain independent? Is Swiss private banking and wealth management doomed? Is the Swiss franc still that number one safe haven currency that it used to be?
These questions are reasonable and understandable. Over the past few years, most of the mainstream news on Switzerland has normally been subject to a very negative spin. And there is no doubt that a number of developments have given rise to concern and even frustration for me as well. Most of all, I am not very happy with the compromises and rule-bending that occurred in the context of the UBS case. In my view, a big mistake – a mistake loaded with multiple layers of moral hazards – was made when UBS was safeguarded by the Swiss government, i.e. with Swiss taxpayer´s money.
However, I do not want to spend time reiterating matters that have been discussed at length here in our Mountain Vision and elsewhere already. Instead, I want to explain, as concisely as possibly, why I have the highest of expectations for Switzerland – in terms of its economy, its financial center, and its currency.
A Country´s Fundamental ‘Health´ is Reflected in the Strength of its Currency
Let´s start with currency. We live in a time of historical transition, a period during which global dominance by the historic great powers is giving way to something new. This transition of power not only impacts geopolitics and economics, but it also impacts that ultimate indicator of economic power and health: the strength of each nation´s currency.
Safeguarding capital from the unknown consequences of aggressive and experimental central bank policies is of paramount importance to today´s investors. In the aftermath of the financial crisis, determining which currencies will hold their value for the longer term and which will fall has become harder to do more so than ever before.
The same old approaches to currency investing do not seem comprehensive enough to address today´s challenges. For example, interest rate parity and purchasing power parity are useful constructs, but they do not offer the guidance needed today to help us more fully determine relative currency strength. What process can we use to separate winners from losers in the pursuit of currency diversification?
The following ‘STRONG´ variables can be employed to determine the fundamental economic strength of a nation:
• S: Sustainability – Sustainable balance sheets, healthy fiscal trends
• T: Transparency – Readily available statistics, reliable information
• R: Rule of Law – Reliable legal framework, regulatory quality
• O: Openness – Freedom of travel, free exchange rates, etc.
• N: National Fundamentals – Healthy economy, competitiveness, education, history, culture, etc.
• G: Governance – Time-tested political system, democratic mechanisms
Historically, currency markets have rewarded countries with strong fundamentals. The more positive the aforementioned STRONG valuables are in aggregate, the stronger a nation´s economy and its currency will be in the medium- to long-term. Switzerland has been and continues to be a beacon of strength along all of these dimensions.
I will not bore you with a lot of statistics, but I will share a few with you which reflect on the above factors of strength.
Strong ‘National Fundamentals´ and ‘Sustainability´
The following factors afford an indication of a country´s fundamental strength and fiscal sustainability:
• Fiscal management: Quality and proven track record of fiscal management and discipline. Based on the Swiss “debt brake”, a law invoked and ratified by the Swiss people in 2001, Switzerland has written budget surpluses continuously, even during these difficult recent years.
• National competitiveness: Economic competitiveness can be measured in many ways. The most prestigious ranking is provided annually in form of the Global Competitiveness Index. Switzerland leads that ranking as the most competitive economy in the world.
• Fundamental macroeconomic variables: A number of macroeconomic variables can be used as indicators of strength in the dimensions of ‘Sustainability´ and ‘National Fundamentals´. The following are arguably the most critical: Low national debt to GDP ratio, high surplus to GDP ratio, and positive current account position. Again, in all of these variables Switzerland comes out on top.
The following chart compares currency returns versus the US dollar to the Debt / GDP ratio from 2000 to 2010. Clearly, stable to falling debt to GDP ratios have tended to correlate with positive currency performance. The Swiss franc has outperformed all other (paper) currencies.
Source: OECD as of 12/31/10
Strength Regarding ‘Openness and Freedom´
Switzerland is widely considered to be one of (if not) the freest and most open countries in the world. This is primarily based on the Swiss system of direct democracy and its long history of independence and neutrality, combined with its high level of diversity and international interrelations.
Currency markets have a history of rewarding countries that are free. Why is that?
Freer countries have the tendency to avoid over-taxation, over-regulation, and support policies that promote freedom and innovation. Freer floating currency regimes allow market forces to play a role in determining value. Market forces and (truly) democratic systems, and particularly the Swiss system of direct democracy, create feedback mechanisms to help keep the excesses of government in check.
Obviously, the measurement of freedom and openness is one prone to subjective nuances and arbitration. Nevertheless, a generally accepted measure you might consider taking a look at is the Index of Economic Freedom by the Heritage Foundation, or the Economic Freedom of the World Index by the Fraser Institute.
Countries with more economic freedom also have the tendency to have strong currency performance vs. the dollar. The following diagram displays the currency returns (vs. USD) of international currencies from 2000 to 2010, in comparison to the Index of Economic Freedom by the Heritage Foundation.
Source: Heritage Foundation as of 12/31/10
Strength Regarding ‘Rule of Law´
Switzerland is a safe jurisdiction with solid rule of law. Investors and businesses, both internally and internationally, value the solidity and dependability of Switzerland´s legal system.
It is not by chance that Switzerland is home to some of the world´s largest global corporations and organizations. You will probably recognize some of the names, including Nestle, ABB, Roche, Novartis, Google, FIFA, Swatch, UBS, Credit Suisse, UNESCO, WHO, WTO, United Nations, International Red Cross, the World Intellectual Property Organization, the Universal Postal Union, etc…
The fundamental rights bestowed on Swiss businesses, citizens, and residents are reflected well in the country´s high level of trust in the law and the quality of regulations. As an example, you can look at the interaction of Swiss citizens with the Swiss tax authorities. In most countries, any attention by the tax authorities tends to be one of those items in life you try to avoid at all cost. In Switzerland, personal meetings and negotiations with tax authorities, particularly at the Cantonal level, are an avenue sought regularly by taxpayers. Frequently, tax payers are able to exploit the tax competition between different Cantons. It is, in my view, that kind of tax competition that contributes most to the fact that taxes are still comparatively low in Switzerland.
A generally accepted measure of “Rule of Law” is the Worldwide Governance Indicators by The World Bank. Again, as depicted by the following chart, currency markets have favored the fundamentally strong countries with solid rule of law.
Source: World Bank as of 12/31/10
It is based on some of these considerations that, first of all, we continue to favor the Swiss franc as a currency of safety in our portfolio management. Secondly, it is based on the fact that a country´s currency reflects its economic fundamental strength that we are optimistic about Switzerland´s future as a free nation and strong economy.
Is Swiss Private Banking Dead?
Many have been quick to predict the end of Swiss private banking if not the end of Switzerland as a reputable financial center altogether. Such conclusions are based on the two bubbles that have burst.
First of all, the business with non-declared assets has come to an end. World-wide, citizen transparency is moving in as the “commonly accepted standard”. Based on the assumption that Swiss private banking could only be successful in a world that tolerates tax evasion and banking secrecy, many concluded that investors would seek shelter elsewhere and Swiss banking would dwindle into oblivion.
Secondly, the global credit machine is stuttering. Investors, particularly in Europe and the U.S., are hesitant to invest, and certainly hesitant to employ leverage in their investments. This of course is bad news for banks and brokers that have profited from transaction turnover and volume. Switzerland would surely feel this painfully as well.
On both accounts, these concerns have been justified, but they are proving to be wrong. Yes, a large number of investors – for example Germans with non-declared accounts – have transferred their assets out of Switzerland, frequently to jurisdictions like Hong Kong or Singapore. Based on the media´s focus on Switzerland, a somewhat skewed impression was created that Switzerland has completely given up on banking secrecy and sold out on its banking clients.
However, this has not happened. The Swiss government is working hard to retain and protect Swiss banking secrecy via a series of double taxation treaties, with Germany, the UK, Austria, Greece, and others, that aim at protecting privacy in exchange of withholding taxes on the accounts. In other words, investors from countries with such tax treaties in place will continue to enjoy the absolutely legitimate benefit of privacy – banking secrecy was NOT erected for the purpose of tax evasion but for personal safety in the context of Germany´s Nazi regime – but, they will be taxed on their gains according to the rates defined in the respective treaties.
Therefore, Switzerland has not “folded”. On the contrary, investors that transferred their funds to Singapore, for instance, are awakening to the fact that they are not better off. Such jurisdictions are not equal in terms of service, privacy or regulatory safety. Furthermore, the regulatory framework there has changed much more drastically and rapidly.
Singapore, just like Switzerland, has come under increasing pressure. And, as it appears, they have indeed folded lock, stock, and barrel. Just last week, Singapore signed a tax information exchange agreement with Germany. Others, including the US and UK, are expected to follow soon. The Monetary Authority of Singapore has actually announced plans to penalize banks that open accounts with untaxed money.
Furthermore, as reported in last week´s Update, the Monetary Authority of Singapore (“MAS”) has announced a law on October 9th that includes tax offenses as a predicate offense for money laundering in Singapore. This law will take effect on July 1st of 2013. This means that tax offenders will be treated equally to drug dealers, smugglers or members of organized crime. They will be reported and prosecuted accordingly.
Switzerland, still the World Leader in International Private Banking
Switzerland, a small country, rich, healthy, economically competitive, smack dab in the middle of Europe: of course it is under pressure from its not so fortunate neighbors and bankrupt “allies”. The trend toward more transparency and tax compliance will hardly seize, not in a world of growing debt and deficits. The Swiss have recognized this. They are adjusting their private banking business model, painfully, but pragmatically and steadily. Most Swiss want to retain banking secrecy, for as long as possible, thus the aforementioned double taxation treaties.
There will be more downsizing and firing, particularly in the large banks. And, most Swiss banks will continue to be hesitant of accepting US clients, at least for as long as the tax treaty with the US is still in the making. However, I believe that to conclude that Swiss private banking has come to a standstill is false.
Contrary to the impression created in the press, and against all odds, Switzerland continues to be the leader in cross-border private banking. In terms of market share, and based on a study conducted by Boston Consulting, Switzerland makes up more than 27% of the global cross-border private banking market.
Cross-border private banking, market share in percentage
Source: Boston Consulting Group; SBVg Research
Furthermore, in an age of increasing fiscal and monetary imbalance, one prone to financial repression and intrusive government policies, wealthy investors around the world are still looking for a safe haven to keep their assets. Most Swiss private banks continue to see net inflows of funds.
From the Euro zone, America, and the UK, after-tax, or so-called “white” funds, are flowing to Zurich and Geneva. And now, these are by nature after-tax, declared assets. Considerable growth is reported from other regions, primarily Asia, Latin America and Russia. A growing number of new millionaires and high net-worth investors are looking for a solid and dependable jurisdiction, with good service and a long tradition of private banking. Switzerland fits the bill.
Will Switzerland stay unaffected by the global economic weakness? Is the floor versus the Euro not a problem? Will private banks and wealth managers have to adjust their business models? Of course, the answer to all of these questions is yes. The Swiss economy, including its financial sector, is facing a very challenging environment.
However, in the end, as with any competition, the winner does not have to be perfect. The winner just has to be a little faster and better than the rest. If I had to bet, Switzerland would certainly be high up on my list.