Sweden
2003 Article IV Consultation-Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Sweden
Author: International Monetary Fund
Publication Date:
05 Aug 2003
eISBN:
9781451835908
Language:
English
Keywords:
ISCR; CR; Stockholm All share index; narrowing interest rate differential; lower-than-expected inflation; Riksbank; share index; statistics Sweden; GDP deflator; monetary policy; nominal interest rate; current account; Inflation; Global; inflation targeting
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The Swedish economy recovered from the crisis, assisted by a sizable fiscal stimulus. Executive Directors commended the fiscal and monetary frameworks, skillful and proactive management of monetary policy of the Riksbank, the soundness of the financial system, and stressed the need to accelerate structural reforms. They welcomed the steps to strengthen the financial system, according to the Financial Sector Assessment Program recommendations. They appreciated the authorities for exemplary efforts to promote open trade policies, and for the high level of official development assistance.

Abstract

The Swedish economy recovered from the crisis, assisted by a sizable fiscal stimulus. Executive Directors commended the fiscal and monetary frameworks, skillful and proactive management of monetary policy of the Riksbank, the soundness of the financial system, and stressed the need to accelerate structural reforms. They welcomed the steps to strengthen the financial system, according to the Financial Sector Assessment Program recommendations. They appreciated the authorities for exemplary efforts to promote open trade policies, and for the high level of official development assistance.

I. Economic Background

1. Supported by a sizeable fiscal stimulus, the Swedish economy recovered from the 2001 slowdown, substantially outperforming the euro area in 2002 (Figure 1). Despite the continued weakness in the telecom sector1 and depressed business investment on account of persisting excess capacity, household consumption strengthened as tax cuts and government transfers boosted disposable income. After a strong first half, external demand weakened rapidly in the second half of the year with the worsening global outlook and GDP growth slowed sharply. Although economic activity picked up in early 2003, driven by net exports, industrial production and manufacturing orders remained weak and consumer confidence depressed.

Figure 1.
Figure 1.

Sweden: Output Developments and Prospects

(Annual percentage change)

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Sources: Statistics Sweden; and staff projections.

Sweden: GDP by Expenditure Category, 2000–2004

(percentage changes)

article image
Sources: Statistics Sweden, Riksbank, Ministry of Finance, and staff estimates.

Includes statistical discrepancy.

2. Persistent weakness in the labor market restrained wage increases while their impact on costs was offset by strong productivity gains.2 With the manufacturing sector continuing to shed labor, employment stagnated despite increased demand from the construction and the public sectors, and the rate of unemployment remained virtually unchanged in 2002 (Figures 2 and 3). However, rising sickness absenteeism, and a cyclical contraction of overtime led to a fall in the number of hours worked, while indicators of vacancies declined. Nominal wages rose somewhat less rapidly than a year earlier. Wage pressures in the local government sector continued to be strong, as evidenced by a protracted nationwide strike by the municipal service workers in April–May 2003.

Figure 2.
Figure 2.

Sweden: Labor Market Developments

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Sources: Statistics Sweden and OECD.1/ Open unemployment plus participants in active labor market programs that are excluded from open unemployment (e.g., retraining, and youth employment schemes).
Figure 3.
Figure 3.

Sweden: Inflation Developments

(Percent change from a year ago)

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Source: Statistics Sweden; and Riksbank1/ UNDIX = CPI excluding changes in indirect taxes and subsidies and interest costs for owner-occupied housing; UNDINHX also excludes changes in import prices; the horizontal lines indicate a 1 percent range around the 2 percent inflation target.2/ Inflation expected one year ahead.

Sweden: Labor Market Indicators, 2001–04

(Annual change in percent)

article image

In percent of labor force.

Including participants in labor market programs.

3. Inflation, after a temporary rise in early 2003 driven by energy prices, has receded below the 2 percent target. With high demand—reflecting the unusually cold winter—and exceptionally low reservoir levels in Nordic hydroelectric power plants pushing up energy prices, headline inflation reached 3.4 percent in February 2003, before falling back to 1.9 percent in May as energy prices began to decline.3 Underlying inflation excluding energy prices remained well under 2 percent. Inflation expectations, despite edging up slightly following the recent spike in headline inflation, remain around the 2 percent target. Equity prices have fallen substantially in the last two years, while property prices have started weakening after a steady rise since 1997 (Figure 5).

Figure 4.
Figure 4.

Sweden: Exchange Rate Developments

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Source: IMF, International Financial Statistics
Figure 5.
Figure 5.

Sweden: Asset Price and Interest Rate Developments

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Sources: Statistics Sweden; Riksbank; IMF, International Financial Statistics, and INS.1/ Repo rate was 63 percent in September 1992.

4. Despite the appreciating krona, competitiveness remained strong and large current account surpluses persisted. The krona appreciated by more than 5 percent in effective terms in 2002, gradually reversing some of the sharp decline of the previous two years (Figure 4). Helped by improved relative growth prospects, rising interest rate differentials (Figure 5), and a slowdown in portfolio outflows, the krona appreciated vis à vis the euro in the first part of 2002 and remained stable thereafter, while appreciation vis à vis the U.S. dollar continued well into this year. The unit labor cost-based real exchange rate appreciated almost 6½ percent in 2002. However, the current account surplus rose further to 4.2 percent of GDP as the lagged effects of the 2001–02 depreciation boosted exports—mainly in the first part of the year—and imports fell. As the portfolio reallocation following the crisis of the technology sector is likely coming to an end, the slowdown in outflows is expected to continue, giving additional support to the currency. Markets expect the krona to appreciate by another 5 percent vis à vis the euro in 2003.

d29864855e1072
Source; Riksbank, Inflation Report 2003:2

II. The Policy Setting and The Short-Term Outlook

5. Monetary policy has been implemented proactively, consistent with the Riksbank’s credible inflation targeting framework. After tightening in the first part of 2002, monetary policy eased on signs of weakness in the economy and heightened risks to the global outlook. With accelerating inflation in 2001 and early 2002, the Riksbank raised interest rates by 50 basis points in March–April. However, disappointing growth prospects in the euro area and increasing geopolitical uncertainties led to a reassessment of the outlook for inflation. Judging the spike in inflation fueled by energy prices as temporary, the Riksbank reversed course toward year-end, restoring the policy rate to its level of early 2002. With the rapidly worsening external outlook, these cuts were followed by a 25 basis point reduction in March 2003, and a further easing of 50 basis points in early June to a level of 3 percent. (See below).

6. The exceptional strength of the public finances—especially in a comparative EU context—has begun to erode, primarily due to a rising trend of discretionary spending (Figure 6). The overall surplus this year is expected to be 3 percentage points of GDP lower than in 2000, half of which is due to expenditure increases. Mainly reflecting the discretionary loosening, the structural balance is projected to be 2¾ percentage points of GDP weaker over this same period. A marked decline in the revenue ratio—due partly to the first three stages of the phased income tax reduction that the Fund supported—masks an upward trend in local taxation. Local government consumption rose by more than 1 ½ percent of GDP over three years.4 This accounted for most of the ratcheting up of expenditure (Figure 7), as increases in both sickness related transfers and investment (0.6 percent of GDP each) are largely offset by the decline in interest payments.

Figure 6.
Figure 6.

Sweden: Fiscal Developments and Prospects

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Sources: Statistics Sweden and Ministry of Finance.1/ Excluding interest expenditure and income.
Figure 7.
Figure 7.

Sweden: Expenditure Forecasts, 2001–2004

Citation: IMF Staff Country Reports 2003, 230; 10.5089/9781451835908.002.A001

Source: Budget Bill: Swedish Economy, various issues

Sweden: General Government Financial Accounts, 2000–03

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Source: Ministry of Finance

7. Fiscal policy remains anchored to the medium-term framework, centered on the target of a surplus of 2 percent of GDP over the cycle. The fiscal policy stance in 2003 is expected to be moderately contractionary. The structural surplus is projected to rise to almost 1½ percent of GDP, despite further discretionary spending increases of ½ percent of GDP, reflecting increases in net capital income and local government taxes—the latter rising by almost ½ percent of GDP. Faced with budgetary pressures, the authorities have postponed the fourth and final phase of the income tax reduction. In line with the fiscal rule specifying a 2 percent surplus over the cycle, the structural surplus is now projected to return to this level by 2005 as the output gap narrows, and the public debt-to-GDP ratio is projected to continue declining.

8. On the backdrop of fragile prospects for a robust global recovery, Sweden faces subdued economic growth and rising unemployment in the near term. The external sector is expected to contribute little, if anything, to growth in 2003 as weak external demand holds back exports, and imports recover from recent unusually depressed levels. Public consumption is projected to slow sharply after the high growth of last year, and an upturn in business investment will be hampered by the continued weakness of the telecom sector. With high house prices and low interest burden providing ample support to household financial positions despite losses in stock market wealth, and the sharp rise in household saving rate over the past two years, private consumption is likely to hold up well, barring any unexpected shocks to confidence. All in all, economic growth is likely to remain significantly below potential, with continued unutilized resources. The risks to the outlook are mainly on the downside, stemming primarily from a weaker-than-expected global recovery. Inflation is expected to remain well below target over the next year as energy prices return to normal levels and wage demands in the autumn bargaining round remain moderate.

III. The Policy Discussions

9. The authorities’ strategy in recent years has focused on consolidating their strong macroeconomic policy framework and preserving Sweden’s generous welfare state. The Fund has viewed the medium-term fiscal and monetary frameworks as consistent with best practices. In the years of high growth, the staff and the Executive Board have consistently urged using the room for maneuver provided by strong public finances to reduce the high tax burden, especially on labor, and to carry forward the process of streamlining the welfare state. The authorities have implemented a phased program of tax cuts, but have disagreed on the need for a reduction in the size of the public sector. While agreeing on the desirability of improving the incentive structure to encourage greater work effort and promoting competition, the authorities have preferred to follow a gradualist course.

10. The discussions centered on the following key themes:

  • The implications of the slowdown in economic growth for the macroeconomic policy stance;

  • The reasons behind the erosion of the recent strength of the public finances and the risks to the framework of fiscal rules;

  • The necessity of addressing the emerging tensions between the rising demand for public services and generous welfare provisions through a bolder approach to streamlining the social insurance regime;5

  • The consequences of a possible euro entry for competitiveness, stabilization policy and the framework of fiscal rules;

  • Reinvigorating the structural policy agenda, particularly in the areas of tax, product, and labor market reform.

A. Monetary Policy and the Financial Sector

11. The Riksbank saw a subdued economic outlook this year and a decline in medium-term inflation pressures. Although the cessation of the Iraq war had reduced uncertainty, and stock prices had risen since the beginning of the year, consumer confidence had deteriorated and other indicators, such as manufacturing growth and capacity utilization, remained weak. The Riksbank marked down its outlook for growth since its March inflation report, and officials noted that the growth outlook in trading partners, particularly in the euro area, continued to worsen. The spike in electricity prices had already reversed, eliminating the main source of upward inflation pressure. Moreover, headline inflation for April was significantly below expectations. The authorities were hopeful that the recent labor unrest in the local government sector would not trigger higher wage demands in the autumn bargaining round. Rather, wages were expected to be moderate given a likely pickup in unemployment and subdued economic conditions. With continued economic slack suggested by many indicators, underlying inflation forecast to be below the symmetric target of 2 percent,6 and downside risks to the global outlook, the mission saw scope for a further reduction in interest rates.

12. The Riksbank agreed that room for monetary easing was emerging, as evident in its decision to cut interest rates by 50 basis points in early June and shift to a downward bias. In its June inflation report, the Riksbank pointed to a continued deterioration in international economic activity, which was expected to have a dampening effect on the Swedish economy. The forecast for growth in 2003 was revised down by ½ percentage point to 1.2 percent, due to the weak external conditions and a delay in the expected investment upturn. Forecasts for underlying inflation have also been revised down—the 12-month rate two years ahead is projected below target, at 1.6 percent—given the postponement of the economic recovery and a downward revision to import prices after the unexpected rapid fall in oil prices. The Riksbank judges the downside risks stemming from the external sector to outweigh any lingering upside risks from wages or electricity prices.

13. The financial system remains sound and stable. Banks have responded quickly to a decline in profitability—from 13 percent return on equity to 10.7 percent—with cost-cutting measures. Loan losses have increased only marginally, and capital adequacy remains at sound levels. Although the recent decline of commercial property prices has reduced bank loan collateral values, and depressed equity prices have adversely affected the balance sheets of pension institutions and insurance companies, risks in the financial sector remain limited. Bankruptcies of non-financial companies and loan losses have been rising, but the levels are still low and credit to this sector has been stagnant. Household indebtedness has risen in recent years, but its impact on credit risk has been mitigated by low interest expenses and higher home values, the latter viewed as reflecting fundamentals. Strict personal bankruptcy laws and extensive social insurance schemes further limit credit risks from the household sector. Steps to improve regulation and enhance supervisory capacities are under way, in line with the Fund’s FSAP recommendations (IMF Country Report No. 02/161). Improvements of the interbank settlement system are expected by year end. The division of responsibilities between the Financial Supervisory Authority and the Riksbank has been clarified, and cooperation continues with other Nordic supervisory authorities for enhancing cross-border supervision and delineating emergency liquidity arrangements for large regional financial groups.

B. Fiscal Policy and the Fiscal Framework

14. The authorities’ overriding priority is to preserve the generous welfare state and provide quality public services rather than to reduce the tax burden.7 The mission noted that the room for implementing the fourth stage of the income tax reform had been used to raise expenditures, while the increase in local government taxes had undercut the central government’s income tax reductions. Officials observed that the rise in spending on public services such as healthcare, childcare and education was in response to growing demands for such services and reflected the government’s policy priorities. Within the constraints set by these priorities, tax cuts would be considered if they can be afforded, but there was no commitment to cut income taxes on any given time scale. They would, however, curb some of the generosity of the transfer system to pay for needed public services, if that became necessary.

15. Pressures on local government expenditure show no signs of abating, foreshadowing unrelenting pressures on the public finances. The authorities conceded that, given that more than 70 percent of local government services depend on the size and age structure of the population, the rising costs of elderly care over the upcoming decade will strain expenditures further. Furthermore, it is becoming increasingly difficult to retain well qualified staff in social service provision, as wages are perceived to be too low. In response, local government wages grew around ½ percent faster than the economy-wide average over the past few years. The authorities recognized that the cost of the social insurance system was beginning to strain their ability to provide quality public services while simultaneously keeping the public finances healthy.

16. Acknowledging the procyclicality of local government finances, the authorities were nevertheless reluctant to modify the system. The mission was concerned that the balanced budget requirement without expenditure ceilings and the constitutional right of local governments to tax had resulted in both an upward trend and procyclicality in public spending (Box 1). In response, the authorities made several points. Most importantly, the Swedish public understood that a higher tax burden was the price that had to be paid for quality public services. While accepting that local governments expanded too rapidly, officials stressed that there was large pent-up demand for public services after the retrenchment of the mid-1990s. They also conceded the problem of local government procyclicality but argued that the effect of the cycle on local government finances was mild, partly because benefits were taxable. They did not favor moving to a less cyclically sensitive tax base, such as one relying on property taxes, as this would increase regional revenue disparities and require more drastic redistribution. However, they noted that a government appointed committee to discuss stabilization options in the event of Sweden joining EMU had recommended that local government revenue be stabilized over the cycle, by averaging it over a number of years. This could prove sensitive, however, as the constitution enshrined the right of local governments to tax their citizens. Despite its evident disincentive effects, the authorities were also not keen to alter the revenue equalization scheme between local governments, as they felt it served a valid redistribution function. Moreover, it is a complex system which has evolved over time and is not easily amenable to change.

Will Sweden’s Fiscal Rules Remain Effective? 1/

Sweden’s medium-term fiscal framework is anchored to three separate fiscal rules. In 1997, the authorities announced a target of a general government surplus of 2 percent of GDP over the cycle while simultaneously establishing comprehensive central government nominal expenditure ceilings set three years in advance. The surplus target was viewed as consistent with the expected long-term cost associated with an aging population. The framework was enhanced in 2000, when a balanced budget requirement for local governments was introduced, with the understanding that any deficits must be cleared within two years.

A revenue boom allowed the fiscal framework to be compatible with a steadily rising primary expenditure path. The early years of the fiscal framework coincided with high economic growth and a revenue boom, so that the rules were never seriously tested. The government also continued to ratchet up spending in every budget over the past few years (Figure 7), mainly, on local government consumption. As the estimates of the surplus in 2000 and 2001 continued to increase with each revision, the government responded by raising spending plans, especially for 2002 onwards. The room under the ceilings engendered by favorable cyclical conditions made this discretionary expansion possible. Moreover, buoyant local revenue meant that the balanced budget rule could be respected while increasing spending at this level of government.

The fiscal framework is coming under increasing pressure. The recent downturn exposed some of the strains within the system, especially as expenditure rose rapidly in 2002. The local government sector ran a deficit of almost ½ percent of GDP and was forced to recoup it losses by raising taxes by this amount in 2003. Central government is also feeling the pinch, as the Spring budget implemented a number of cutbacks to prevent an outright breach of the expenditure ceiling. Even so, the strains persist as there is practically no margin left under the ceilings. At the same time, the last budget bill postponed setting expenditure ceilings for these years.

Well designed fiscal rules should limit procyclicality, especially in good times. The political economy literature stresses that politically induced deficit or expenditure biases are often characterized by profligacy in good times, followed by difficulty tightening in bad times. Some commentators argue that fiscal frameworks often work best when they include a rule specifying how to respond to shocks, especially positive ones. For Sweden, this would at a minimum require that cyclical margins not be used for discretionary increases in spending. Going a step further, it could specify how higher than expected revenue could be divided between saving and cutting taxes.

There are particular problems with the balanced budget rule for local governments. The large size of the local government sector combined with the cyclical nature of its revenues—based, unlike in many countries, on income taxes—means that the balanced budget rule fosters procyclicality. There is nothing in the framework to prevent local governments from spending any extra revenue. When the revenue boom peters out, the inability to cut spending means that taxes have to be raised, as in 2003. The incentives inherent in the revenue equalization scheme among local governments add to the problem, as the benefits of broadening the tax base are dissipated to other regions, while higher revenues from raising tax rates are retained.

1/See Selected Issues paper.

17. The authorities remain firmly committed to the expenditure ceilings. The authorities viewed the ceilings on central government expenditure as having played a key role in restraining the growth of spending over the past few years, and as central to maintaining credibility. The 2003 Spring budget announced a series of expenditure cuts and postponements, totaling 0.2 percent of GDP in 2003 and 0.4 percent of GDP in 2004, to prevent a breach of the expenditure ceilings. The authorities have shifted expenditure between years and made increasing use of tax expenditures to provide subsidies to local governments outside the purview of the ceilings. Even so, the room for maneuver is limited as the cyclical margins under the ceilings have been effectively exhausted. The authorities cited a number of key risks in the upcoming months: higher unemployment, a greater influx of refugees, and most importantly, a less than anticipated decline in sick leave costs. Further cuts later in the year could not be ruled out. The authorities recognized the importance of maintaining a sufficient margin under the expenditure ceiling to allow for cyclical variations of expenditure. The mission also argued that the expenditure ceilings should be linked more explicitly to the surplus target.

18. The authorities were optimistic that the measures taken in the recent Spring budget would curb the growth in sickness payments. Around a third of the estimated expenditure savings for 2003 and 2004 come from reaping the benefits of these sick leave measures. For the first time, the authorities had recognized that incentives were a part of the problem. The measures included lowering the benefit (by reducing the replacement ratio marginally from 80 percent to 77.6 percent), preventing the unemployed from resorting to higher sickness benefits when they become sick, and passing on a third week of costs to employers. The mission welcomed these steps, but argued that stronger measures might be called for making a decisive dent on the issue and to ensure that the expenditure ceilings are not breached.

C. The Debate on EMU Membership

19. The deterioration in the public finances has taken a back seat to a debate on the adequacy of stabilization instruments in the event of Sweden joining the EMU. The debate is focused on whether fiscal policy will be able to stabilize the economy in the face of asymmetric shocks in the absence of an independent monetary policy. Some have also advocated raising the fiscal surplus target.8 The main labor union federation (LO) had proposed establishing buffer funds financed by social security contributions to be used as a cushion in a downturn. The authorities have rejected this proposal and view the emphasis on the possibility of asymmetric shocks as excessive and somewhat misguided. They would prefer to see the debate focus on the tangible economic benefits of joining the EMU, such as exchange rate stability, associated gains through enhanced trade and investment, and greater financial integration. Recognizing that many voters are concerned with the stabilization issue, however, the government has not ruled out compensatory measures, and is giving some thought to the idea of varying the VAT rates over the cycle as a stabilization instrument. The mission argued that the concerns about the lack of adequate stabilization policy tools was misplaced, and that Sweden’s strong automatic stabilizers—given the large size of public consumption and transfers relative to the economy, and the taxation of benefits, stabilizers are among the largest in the EU—would be sufficient to enable adjustment to most adverse shocks without additional discretionary measures.9

20. The implications of EMU for wage formation and the Swedish welfare state are also under debate. There is a widespread conviction that the Riksbank’s inflation targeting regime has provided an indispensable discipline to wage formation. Nevertheless, proponents of EMU are optimistic that competitive pressures in a monetary union would ultimately prompt a strong awareness of the need for wage moderation, especially since the use of devaluation to restore competitiveness would be precluded. While euro skeptics argue that the market discipline of a floating exchange rate would provide better incentives for sound public finances than would transpire in a monetary union, proponents of EMU counter that the Stability and Growth Pact would subject fiscal policy to greater international scrutiny. The Swedish position on tax policy in the EU has been to support tax autonomy to a great extent, except where tax competition introduces distortions. Proponents of EMU argue that membership in the monetary union would contribute to growth and strong public finances that would further support the Swedish welfare system. However, groups that would stand to lose from a reduction in the welfare state tend to have the most serious misgivings about joining. The effect of EMU on the rest of the structural policy agenda is generally not considered to be large.

21. There was agreement that Sweden’s competitive position remained strong. While model-based estimates of equilibrium exchange rates are highly uncertain, most estimates from the Riksbank, the IMF, and other institutions indicate that the krona has some room for real appreciation (Box 2). In choosing an entry rate, the Riksbank underlines the need to weigh the risk of economic stimulus from an unduly weak rate, which would require contractionary fiscal policy, against the risk of an overly strong rate, which could entail a costly adjustment associated with restoring competitiveness.

EMU Membership and the Krona

If the EMU referendum results in a decision to join, Sweden could enter ERM2 as early as January 1, 2004. Sweden’s output and unemployment have followed similar trends (Figures 1 and 2) to the EU. Its business cycle has been relatively well synchronized with the euro area in the last decade, especially in recent years. Based on this synchronization and current economic forecasts, an early entry into ERM2 would not pose difficulties on cyclical grounds. In the event of a “No” vote, markets do not anticipate any lasting effects on interest rates or the exchange rate.

The Riksbank considers the risk of conflict between the inflation and exchange rate criteria in ERM2 to be limited. 1/ Once Sweden and the euro area countries agree to a central rate that is viewed as a credible entry rate, the scope for exchange rate speculation would be small, especially given the expected short duration of the ERM2 transition. Only shocks large enough to bring the central rate into question would likely undermine even a narrow band. The risk of currency speculation would be further reduced by maintaining strong economic policy fundamentals. The Riksbank has also simulated the scope for independent short-term interest rate policy in ERM2 and the ability to achieve both inflation and exchange rate criteria in the event of an unexpected shock. Preliminary results have suggested that a moderate wage shock would be compatible with the convergence criteria. However, very large wage and fiscal shocks, such as those experienced in the 1980s due to policy mistakes after financial liberalization, could potentially undermine the band or inflation criteria. Historically, other countries have experienced a variety of interest rate convergence speeds on the path toward adopting the euro, suggesting that Sweden would have some scope for interest rate policy directed at low and stable inflation. (See “Swedish Monetary Policy and EMU”, Riksbank brochure, www.riksbank.com)

Most econometric models estimate that the krona has been weaker than its equilibrium exchange rate. The Riksbank published analytical work in the December 2002 Inflation Report that could provide the basis for an assessment of a reasonable central rate in ERM2. Projections of the real exchange rate through 2006 were presented based on three models that considered fundamentals such as relative GDP versus the euro area, terms of trade, net foreign assets as a percent of GDP, ratio of consumer to producer prices, relative demographics, budget deficits, and a regime shift in 1993. The three models predicted that the real exchange rate would appreciate by between 1.5 percent and 11.3 percent by the end of 2006. Given expectations for broadly similar inflation rates, the Riksbank estimated that the nominal exchange rate would be in the range of about 8.2 and 9.0 krona per euro in 2006. The staff has estimated the equilibrium exchange rate based on a multilaterally-consistent macroeconomic balance approach as well as panel estimation of purchasing power parity adjusted for some fundamental factors such as changes in relative productivity between traded and non-traded sectors, relative output in manufacturing, income flows on net foreign assets, and commodity terms of trade. The krona was estimated to be 11 percent and 12 percent weaker than its equilibrium level relative to the euro at the end of January on the basis of the macroeconomic balance approach and PPP approach, respectively. Actual exchange rate changes in recent years have also been affected by capital account factors, such as equity outflows responding to the shifting prospects of the telecom sector, outward portfolio investment, and repayments on the government’s foreign debt.

1/See the November 13, 2002 speech by the Riksbank Governor Lars Heikensten (www.riksbank.com).

D. Structural Policies and Other Issues

22. The authorities see the need to contain the erosion of labor supply due to rising absenteeism. The growing adverse impact of the escalating use of sickness leave—as well as of early and disability retirement—on public finances, labor supply, and, ultimately, growth is being increasingly acknowledged in the public debate. The negative impact of this trend on labor costs could also jeopardize the authorities’ ambitious employment objective. The authorities believe that the phenomenon of absenteeism is driven by complex socio-economic forces, most notably the ageing workforce, as suggested by the rising share of workers on long-term sick leave. This aspect of the problem is best addressed by measures to improve rehabilitation and new opportunities for part-time work. While stressing the importance of their objective to protect those in need, the authorities recognize that the generosity of sickness benefits may give rise to incentives for excessive use of the system, particularly if eligibility criteria are too broad and controls too loose. However, while some reduction in sick leave is expected in the near term from the spring budget measures, the number of people on disability pensions is likely to increase further, as there is likely to be some shift from long-term sick leave to disability.

23. The authorities agree that the lack of competition in some sectors is harmful to consumers. They noted that competition in all sectors of the economy had increased substantially in the past decade. Following EU entry in 1995, Sweden has been quick to adopt most internal market directives and has now reached, together with Denmark, the highest rate of implementation in the EU. However, the price level remained about 20 percent above the EU average, with half of the differential attributed to lack of competition. After initial progress, price convergence to the EU has in fact stalled. Lack of competition is evident in sectors such as retail trade, pharmaceuticals and construction. However, the authorities believe that there is no obvious barrier to entry in these sectors and that competition will increase with further integration in the EU. The authorities have continued to strengthen the conditions for competition, making available new resources for the Competition Authority, issuing new legislation against cartels, and improving the complaint procedures to ensure fair treatment in public procurement. The large public ownership of housing, particularly in the rental sector, has led to depressed housing investment and impeded labor mobility. The authorities were trying to address the problem through the provision of loans and grants to certain categories (e.g., students), but were not in favor of significant deregulation of rental housing.

24. The Swedish government is strongly committed to free trade, particularly with poorer countries. In the recent EU discussion on the reform of the Common Agricultural Policy, the authorities have reiterated their position that advanced countries should take the initiative to reduce tariffs on agricultural goods and substantially cut down agricultural support in the medium term. The government is working with EU partners to advance the objective of phasing out tariffs on goods imported from poorer countries, with particular emphasis on textile, clothing, and footwear. In the current Doha Round, Sweden supports the US proposal for the total elimination of tariffs on industrial goods within ten years.

IV. Staff Appraisal

25. The Swedish economy was able to ride out the global slowdown in 2002, comfortably outpacing growth in the euro area. This resilience in the face of a continuing slump in the telecom sector was made possible by a strong stimulus from fiscal policy and substantial support from external trade, sustained in part by the weak krona. While the well-designed fiscal and monetary frameworks continued to ensure policy credibility, the exceptional strength of public finances built up over the boom years enabled the authorities to implement the third consecutive step of income tax reduction, helping to dampen the downturn. Looking ahead, as the room for policy maneuver shrinks rapidly in the face of slower growth, the challenge facing the authorities will be to preserve the credibility of the fiscal policy framework.

26. The inflation targeting framework has gained considerable credibility in recent years. The Riksbank’s clear and transparent communication of its inflation forecast and policy reaction has increasingly guided expectations, thereby providing a strong anchor to wage formation. Over the past year, monetary policy has responded with agility to changes in economic conditions and assessment of inflation prospects.

27. With a hesitant global recovery and the inflation forecast below target, the Riksbank appropriately cut the policy rate further. With most indicators pointing to continued economic slack and wage demands in the autumn bargaining round expected to be moderate, there appears to be some room for additional easing, if that becomes necessary. However, excessive wage demands in the autumn round will leave monetary policy little room to respond to a deterioration in the economic outlook.

28. The financial system remains fundamentally sound. Despite a decline in profitability and a marginal increase in loan losses, bank profitability and capital adequacy remain at sound levels. While credit risks have been well contained, those associated with a significant decline in property values or a rise in unemployment bear continued monitoring. The authorities have taken welcome steps to improve the settlement system, to clarify the division of responsibilities between supervisory institutions, and to meet the Basle II requirements and new EU directives.

29. In the event of a decision to join the EMU, Sweden’s sound macroeconomic fundamentals position it well for a smooth transition. Public finances are fully consistent with entry requirements, and indeed, are on a firmer footing than in many euro area countries. Strong automatic fiscal stabilizers should be sufficient to enable adjustment to most negative shocks, without additional fiscal stabilization instruments or a higher fiscal surplus target. The government’s decision not to adopt the proposal for a buffer fund is therefore appropriate. Moreover, Sweden’s competitive position has strengthened following several years of high productivity growth and moderate wage increases, helping keep unemployment low and underpinning export growth despite the decline in the telecom sector. Indeed, sizeable current account surpluses would be expected in the medium term even if the real exchange rate were to appreciate moderately. Low inflation is also in line with criteria for EMU entry and would facilitate smooth monetary management during a transition period.

30. The marked deterioration in the public finances in 2002, albeit partly cyclical, reflected a continued ratcheting up of public spending. Much of this increase is taking the form of higher local government spending, and to a lesser extent, higher payments for sickness leave. Indeed, the path of primary spending has shifted up in each new budget bill since autumn 2000.

31. The trend of higher public spending has stalled the long-overdue process of lowering Sweden’s high tax burden. The delay in the implementation of the fourth and final stage of the income tax reform, and the local authorities’ increasing resort to raising tax rates to meet the unabated pressures on local spending point to the risks of a reversal of direction. As demographic forces increase pressures on age-related spending over the coming years, the prospect of a reduction in the tax burden is becoming increasingly elusive. Indeed, there is a risk of a steadily rising tax burden, with all its attendant efficiency costs.

32. A reform of the local government financing arrangements would strengthen the fiscal framework. Given the large size of the local government sector and the balanced budget rule, the cyclicality of local government revenue sources risks undermining the objectives of the overall fiscal framework and prompting a general upward trend in tax burden. Moreover, such policy responses risk leading to a procyclical fiscal policy behavior, similar to that observed in parts of the euro area. Therefore, it is essential to restructure the local government tax base to reduce its current sensitivity to the economic cycle. Given their perverse incentive effects, reform of the revenue sharing arrangements is becoming imperative to provide incentives to maintain the quality of services, which will be all the more important through the upcoming demographic transition.

33. The credibility of the expenditure ceilings should be preserved. The ceilings have restrained spending growth and contributed to healthier public finances. Maintaining the ceilings depends on the authorities’ ambitious goal of significant savings in sick leave expenses. The proposals in the Spring budget, such as marginally reducing the generosity of the sickness benefit and restricting the unemployed from receiving higher benefits when they become sick, are necessary and welcome. However, these measures are unlikely to be sufficient to curtail the steep rise in sickness payments. Stronger measures to affect incentives may well be needed, such as reducing the replacement ratio significantly and shifting a portion of the cost of long-term sick leave to the employer.

34. The design of the expenditure ceilings within the fiscal framework could be improved. Cyclical margins under the ceilings have repeatedly been used up by discretionary spending increases. Moreover, the ceilings have yet to be tested in a serious downturn. The decision to postpone setting a ceiling for 2005 until the autumn budget is also unhelpful. Going forward, margins under the ceiling should only be used for cyclical spending. In addition, expenditure ceilings should be linked explicitly to the surplus target and a consistent fiscal strategy incorporating spending and tax plans should be devised to ensure that the surplus target remains credible.

35. The recent strains on public finances have brought into sharp relief the urgency of renewed efforts to streamline the generous welfare state. Over the medium and longer term, demographic pressures will intensify age-related spending and make it impossible to meet the rising demands for public services without straining the framework of fiscal rules to a breaking point. A choice needs to be made between generous social insurance benefits and provision of adequate public services, if the tax burden is not to be raised to unsustainable levels. An early commitment to trim back the generous welfare provisions to strengthen incentives would help avoid future strains on the fiscal framework.

36. The current policy setup discourages work effort in the short run and risks lowering further the effective supply of labor in the long run. In particular, the high level of taxation on labor income and the high replacement ratios for social benefits discourage labor force participation and work effort. Similar disincentive effects flow from the generosity of the sickness and early retirement schemes, while the compressed wage structure serves to discourage acquisition of skills. A concerted effort to address these issues is necessary to raise sustainable long-term growth.

37. Strengthening competition and opening up markets would help enhance economic growth. Despite the progress made since participation in the EU internal market, significant barriers to competition remain in areas like pharmaceuticals, retail trade, and construction. Measures to encourage competition and liberalize the housing market should be accelerated.

38. The authorities’ efforts to champion more open trade policies overseas aptly complement their generous development assistance, which at 0.74 percent of GNP, remains among the highest in the world.

39. Sweden is expected to remain on the standard 12-month consultation cycle.

Table 1.

Sweden; Selected Economic Indicators

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Sources: Statistics Sweden; Riksbank; IMF, International Financial Statistics; INS; and staff estimates.

Staff projections, unless otherwise indicated.

In percent of potential GDP, also adjusted for timing of tax revenues.

April.

Based on relative normalized unit labor cost in manufacturing.

Table 2.

Sweden; General Government Financial Accounts, 1997–2006

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Sources: National authorities; and Fund staff calculations.
Table 3.

Sweden: Balance of Payments, 1997–2008

(In billions of dollars)

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Sources: Riksbank, and staff projections.
Table 4.

Sweden; Indicators of External and Financial Vulnerability

(In percent of GDP, unless otherwise indicated)

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Sources: Riksbank; Statistics Sweden; National Debt Office; and staff calculations.

Staff projections, unless otherwise indicated.

Table 5.

Sweden: Public Sector Debt Sustainability Framework, 1997–2007

(In percent of GDP, unless otherwise indicated)

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Indicate coverage of public sector, e.g., general government or nonfinancial public sector Also whether net or gross debt is used.

The primary balance is calculated as revenue minus primary expenditure This differs from Table 2, where the primary balance is defined as primary revenue minus primary expenditure.

Derived as [(r − π(1+g) − g + π∊(1+r)]/(1+g + π+gπ)) times previous period debt ratio with r = interest rate; π − growth rate of GUP deflator; g = real GDP growth rate, α = share of foreign-currency denominated debt: and ∊ = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The rate interest rate contribution is derived from the denominator in footnote 2/ as r − π (1+g) and the real growth contribution as −g.

The exchange rate contribution is derived from the numerator in footnote 2/ as α∊(1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt; stock.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (bused on GDP deflator).

Table 6.

Sweden External Debt Sustainability Framework, 1997–2017

(In percent of GDP, unless otherwise indicated)

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Derived as [r−g−ρ(1+g)+εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock, with r = nominal effective internal rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real CDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [−ρ(1+g)+εα(1+r)]/(l+g+ρ+gρ) times previous period debt stock ρ increases with an appreciating domestic currency (∊> 0) and rising inflation (based en GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.