Swiss economy slumps, shows reliance on franc cap

ZURICH (Reuters) - The Swiss economy unexpectedly shrank in the second quarter as the impact of the euro zone crisis weighed on the country's exports, providing further justification for the central bank's cap on the strong franc.

The Swiss National Bank imposed a 1.20 per euro limit on the franc a year ago to ward off a recession and deflation as investors exiting the euro zone sought a sanctuary in the currency.

But the economy contracted for the first time in nine months, falling 0.1 percent compared with the first quarter. The figure was below analyst forecasts for a growth rate of 0.2 percent and compared with a first quarter expansion that was revised down to 0.5 percent.

Exports of services contracted 0.9 percent in the second quarter even as private and public consumption stayed relatively healthy.

"An unexpected shrinking," said Julius Baer Chief Economist Janwillem Acket. "The SNB has no other option but to continue with its policy, no matter how costly it is. It would have been even more costly not to do anything at all."

Until now, the Swiss economy's relatively solid performance had prompted questions about the continued need for the SNB's cap on the franc, which it has had to defend by selling hundreds of billions of francs, pushing its foreign exchange reserves to nearly 70 percent of annual output in July.

But evidence that headwinds were gathering came on Monday with a purchasing managers' index reading that showed a manufacturing slump deepened last month.

"The Swiss economy successfully bucked the difficult trend in the euro zone for a long time," said Bernd Hartmann, VP Bank head of investment research. "But the slight contraction in the second quarter shows that the Swiss economy cannot completely decouple itself. The linkages within Europe are too great."

ING economist Julien Manceaux contrasted the Swiss contraction with the 0.3 percent quarterly growth recorded in neighbouring Germany.

"Weaker external demand, even if the floor below the CHF is now holding for a year, is to blame," he said.

SNB Chairman Thomas Jordan confirmed his commitment on Monday to defend the 1.20 limit, saying any new rise in the franc would pose a major threat to the economy.

HEADWINDS

The SNB has predicted the economy will slow significantly in the second half, forecasting growth of about 1.5 percent for the year. It will update that forecast at its quarterly monetary policy meeting on September 13.

Year-on-year, second quarter GDP rose 0.5 percent, again well below average forecasts - which were for a rise of 1.6 percent - and slowing from a revised 1.2 percent growth in the first three months.

"The picture is in line with what leading indicators like the PMI showed," said Credit Suisse economist Maxime Botteron. "Growth in Switzerland is not as strong as one thought. It shows that the minimum exchange rate remains necessary."

Growth in private consumption, considered the backbone of the economy, slowed in the quarter to 0.3 percent compared with the first three months, from 0.9 percent in the previous quarter.

"Private consumption is still an important support of economic growth. However, consumption growth has already slowed significantly. Falling job security is already showing itself in consumer confidence," said VP Bank's Hartmann.

(Additional reporting by Emma Thomasson; Editing by John Stonestreet)