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ZURICH (Reuters) - The Swiss economy unexpectedly shrank in the second quarter as the euro zone crisis caught up with a country that had seemed relatively immune to its neighbors' woes, providing further justification for the central bank's cap on the strong franc.
The surprise 0.1 percent contraction mirrors emerging evidence in Sweden, another euro outsider whose currency is attracting unwelcome strength, that the euro bloc's problems are beginning to hurt previously resilient neighbors.
Up to now the Swiss National Bank appeared to have succeeded in warding off the risks of recession and deflation by capping the value of the franc last September at 1.20 per euro, helping to keep the country's high-value export industries competitive.
"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."
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 for euros, pushing its foreign exchange reserves to nearly 70 percent of annual output in July.
But evidence that loss of economic confidence within the euro zone is hurting other economies mounted on Monday when purchasing managers' indexes around the world showed widespread contraction in manufacturing activity.
That included Sweden, where manufacturing activity plumbed a three-year low in August and unemployment rose. Sweden is home to global exporters such as SKF, which makes bearings, Volvo, the world's second-largest truck maker, and Ericsson, which makes gear for mobile telephone networks.
Chemicals is the biggest Swiss export industry, including Clariant and Lonza. High tech machines and drugs produced by Novartis are also major exports.
The Swiss blue-chip equity index .SSMI was among the worst-performing major European stock markets on Tuesday, down 0.4 percent at 6,409 points at 0824 GMT.
The Swiss economic contraction was the first in nine months and wrong-footed most analysts, whose forecasts centered on a quarter-on-quarter growth rate of 0.2 percent. The first quarter expansion was revised down to 0.5 percent. Second quarter exports of services fell 0.9 percent.
"The SNB has no other option but to continue with its (franc) policy, no matter how costly it is," said Julius Baer Chief Economist Janwillem Acket. "It would have been even more costly not to do anything at all."
ING economist Julien Manceaux contrasted the Swiss contraction with the 0.3 percent quarterly growth recorded in neighboring Germany.
"Weaker external demand, even if the floor below the franc 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.
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.
"For the remainder of the year, we expect growth to remain subdued. Although Switzerland should avoid a recession, GDP should barely expand," said Credit Suisse economist Maxime Botteron.
Year-on-year, second quarter GDP grew 0.5 percent, again well below average forecasts - which were for 1.6 percent growth - and slowing from a revised 1.2 percent growth in the first three months.
Growth in private consumption, long considered the backbone of the economy, slowed on to a quarterly 0.3 percent, from 0.9 percent in the previous quarter.
"Private consumption is still an important support of economic growth. However ... falling job security is already showing itself in consumer confidence," said VP Bank's Hartmann.
Additional reporting by Emma Thomasson; Editing by Ruth Pitchford