Reputation is gold. One can live off it. Switzerland does. The country is renowned for discretion, rule of law and stable institutions. Ten years ago, this was true. Today, it is not anymore. But not all is lost. The Swiss Bankers’ Association, a rather official, even officious, group of technocrats is worried. According to their most recent benchmarking study, Switzerland’s private banking lost its competitive edge. Comparable financial places, for example the US, Hong Kong, Bahamas or Luxemburg are faring better.

Examining 10 different competitiveness factors, the benchmarking study found out that Switzerland leads in only three – rule of law, digitisation and the labour market. The country is best case average in matters of information exchange and data protection. Regarding access to external markets as well as taxation, Switzerland holds the last place. But there is more: The Confederation is over-compliant in its capital and liquidity regimes for banks, in anti-money laundering and in corporate governance. Over-compliance equals cost, complication and loss of competitiveness.

Costly regulations …

This picture is not restricted to banks. Switzerland seems to be losing its competitiveness across the board. The domestic economy has been stagnating in terms of productivity. Export-oriented sectors like machine-manufacturing, the production of plastics, and tinting are struggling. Retailing is feeling the heat. Logistics, shipping and the trade in commodities are not what they used to be. Luckily, the science-industries, tourism and information technologies are flourishing.

Granted, some of the actual problems arise due structural change of the economy. These are quite natural and are traced back to digitisation, new sectors displacing old and young skillsets competing with old. But there is a significant group of problems that is self-inflicted – mainly by regulations. For example: In the last decade, Switzerland introduced all Basel III provisions to all banks. It did not use any of the rooms of manoeuvre foreseen by that framework. The country willingly became over-compliant in all matters related to international taxation and anti-money laundering introducing a lot of Swiss finish. On top of that, the alpine Confederation abolished bank secrecy. Similarly, the real economy is affected by the regulatory burden. Switzerland has the world’s strictest law on climate change with the steepest all-economy carbon-tax. It showcases the planet’s most rigid anti-trust regime, which is notorious for its application on small firms. Switzerland diminished tax incentives for multinational holdings and is in the process of increasing taxes on corporations and small and medium enterprises.

The total amount of regulation-induced costs makes around 10% of the country’s gross domestic product GDP, or, over US$70 billion per year. In addition to that, there is taxation; not to mention the many mandatory administrative fees, duties and charges: pension insurance, health insurance, highway due, public television levy and the carbon tax are just some of the many examples.

… but good macro-data

As dire as this on-the-ground reality is, the macroeconomic data tells a different story. In the year 2018, the Swiss economy grew by 2.5%. For 2019, the Federal Expert Group for economic forecast expects an expansion of the economy by 1.5%. The Swiss GDP has been expanding between 1% and 3% yearly for nearly a decade. The world’s 20th largest economy with a nominal value-add of $678.57 billion (2018, according to the World Economic Forum) has a record-low rate of unemployment of just around 2.5%. Inflation is non-existent.

How can these two findings – rapid microeconomic decline and good macroeconomic outcome – be reconciled? Two complementary explanations come to mind. First, Switzerland is a highly diversified economy. Weaknesses in some sectors can be compensated by growth in others. And second, economic agents react well to the increasing regulatory burden.

To the first: Switzerland is commonly associated with its banks and watches. Facts, however, tell a different story. Just around 9% of Swiss GDP goes back to financial services. Manufacturing makes around 18%, retail almost 15%; the largest part of GDP, some 31%, is generated in other services. While it is also true that every year more than 25 million watches and clocks are produced in Switzerland, they only account for 9% of Swiss exports.

Chemical and pharmaceutical products make more than 44% of the country’s total exports, machinery and electronics more than 14%. By the way, Switzerland manufactures and exports around twice as much in coffee- and tobacco-based products than chocolate and cheese.

To the second: 99% of all companies in Switzerland employ fewer than 250 people. This tissue of small and medium-sized agents makes the economy flexible and resilient at the same time. Small and medium enterprises can adapt more easily to changing environments, including the regulatory environment. The symmetry of responsibility – entrepreneurs carrying the risks of their decisions personally – allows these enterprises to counteract intervention and regulatory barriers in imaginative ways.

This does not mean that regulation makes these enterprises better. It only explains how the Swiss economy absorbs regulation. In other words, almost all productivity gains of the Swiss companies are used for offsetting increased regulatory costs. Imagine what these enterprises could do if their regulatory burden was reduced and they were free to use their productivity for value creation?

There is yet another, additional, factor working to Switzerland’s advantage. It is a safe haven for many investors and companies worried by the situation in the European Union. It is consensus that the EU’s economy is imbalanced. Brexit, the Mediterranean countries and signs of economic weakness in Germany, paired with erratic anti-technology regulation and ultra-expansive monetary policy drive agents to safe havens – Switzerland among them.

At least the Swiss economy is playing this card right now. So, while it is true that Switzerland is losing its competitive edge, especially to Asian and North American economies, it remains attractive when compared to the EU. Additionally, Switzerland has maintained a fair profile navigating what can be called the struggle for hegemony among the US, the EU, Russia and China. Its political neutrality certainly helped in engaging these agents participating in their projects or initiatives without exclusively committing to any of them. The Swiss government strives to diversify the country’s economic partnerships. With more than 30 free trade agreements across the globe, Switzerland is the only country in the European continental mass to have such an agreement with China, Japan and South Korea. Also, Switzerland seems better positioned than its competitor EU to reach a free trade deal with the US. The idea is to diversify economic partnership away from the EU, consequentially easing the EU’s regulatory pressure on Switzerland.

Relationship with the European Union

Switzerland diversifying away from the EU is important. Both are linked together via a series of free-trade agreements commonly referred to as ‘bilaterals’. They go far beyond classic free trade establishing a deep link. An example for this in the free circulation of people: a Swiss citizen might work anywhere in the EU, and a citizen of the EU might freely and without visa or permit migrate to Switzerland and take a job there. Another example is the visa- and passport-free travel within Europe, as well the cooperation in questions of inner security established by the Schengen/Dublin agreements.

It is difficult to deny that the Swiss economy has benefitted from this link. Not only because the EU makes roughly half of the Swiss international trade, but also because the inflow of people from the EU made the economy grow. Additionally, this inflow contributed to increasing the productivity of the Swiss workforce.

On the other hand, these rather short-term benefits might be outweighed by long-term costs. Switzerland is factually forced to adapt its legal framework to that of the EU. The bulk of the previously mentioned regulation-induced costs arise from Swiss laws being changed to fit the EU’s demands. More importantly, the increase in the workforce’s productivity is more than offset by the inefficient regulations being imported from the EU. Most importantly, the EU wishes to extend its direct jurisdiction to Switzerland. If this happens, much of what makes Switzerland will be lost. If Switzerland becomes EU, it loses its peculiarities. Since its peculiarities give rise to its competitive advantage, if Switzerland becomes EU, it loses its last lever in global competition.

Negative interest rates

A final complication is created domestically. After years of outright currency manipulation, the country’s central bank, Swiss National Bank, introduced negative interest rates in 2015. Ever since, capital in Switzerland is yielding negative, pension funds are losing money and mortgage and other debts are piling up. Real estate is still one of the most important sources of welfare for private households and funding for private enterprises. In most cases, private pension systems allow people to incur debt, indirectly collateralising it. If pension funds yields are negative, the pression for reducing debt, if not foreclosing, rises. At least according to some experts, Switzerland is reaching a tipping point in this regard. Some speak of the bubble bursting.

While this scenario might be overly pessimistic, it at least points in the right direction. With negative interest rates, there is no increase in the productivity of capital. The households’ and small enterprises’ traditional sources of welfare and funding, be them real estate or pension funds, are at risk. The regulation of financial markets being increasingly tightened does not help. Often, Swiss regulators simply forbid new sources of returns, for example alternative investments. Zealous overcompliance led the Swiss financial market to shrink by almost one third in ten years.

Switzerland has a good reputation. Macro-data as well as diplomatic manoeuvring contribute to it. However, the reality on the ground is less rosy than the country’s reputation allows for.

Regulation-induced cost is an important burden for domestically and exports-oriented sectors. It takes almost all productivity gains away from the value-add. The most important risk for Switzerland, at present, is its relationship to the EU. The Union wanting to engulf the Confederation would take Switzerland’s competitive edge. This risk, however, also is the most pressing, because some sectors of the Swiss economy refer the short-term benefits from the country’s relationship with the EU and disregard its long-term costs.

Also, financial regulation and negative interest-rates belong to the grim reality of Switzerland. Since 2015, its toll has been accumulating for example, as mounting losses for pension funds or the reality of a financial market that does not produce positive yields.

But while the Swiss reality is severely different from the myths of its reputation, not all is bad news. The diversity of the Swiss economy as well as the flexibility of its small and medium-sized enterprises handle the actual challenges well – at least, well enough to maintain the country well-off and its reputation shiny.