Sweden
2006 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Sweden

This 2006 Article IV Consultation highlights that a broad-based economic upturn is under way in Sweden, spurred by strong global growth and supportive fiscal and monetary policies. Private consumption has served as the engine of expansion, supported by resurgence in investment and buoyant exports. The momentum of the current recovery is expected to continue, although to ease back in 2007–08 in the face of capacity constraints and fading policy stimulus. Growth is also expected to ease back in 2007–08.

Abstract

This 2006 Article IV Consultation highlights that a broad-based economic upturn is under way in Sweden, spurred by strong global growth and supportive fiscal and monetary policies. Private consumption has served as the engine of expansion, supported by resurgence in investment and buoyant exports. The momentum of the current recovery is expected to continue, although to ease back in 2007–08 in the face of capacity constraints and fading policy stimulus. Growth is also expected to ease back in 2007–08.

I. Background and Outlook1

1. A new center-right coalition government has launched an ambitious economic reform program, aimed at addressing widespread exclusion from the labor market. The exclusion is underlined by the fact that despite strong growth in recent years, set to reach almost 5 percent in 2006, over a fifth of the working-age population remains economically inactive—unemployed, underemployed, or dependent on social benefits. The government's first budget, unveiled soon after it took office in October 2006, is centered on proposals to cut taxation for low and average income earners, reduce generous unemployment and sickness benefits, and redefine the scope of labor market policies. The broad contours of this program are in tune with the IMF's advice in recent years to streamline Sweden's extensive welfare state (see Table 1).

Table 1.

Sweden : Fund Policy Advice

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Staff's extensive work on the analysis and rationale for reform of the Swedish model is set out in “Sweden's Welfare State: Can the Bumblebee Keep Flying?” by Subhash Thakur, Michael Keen, Balazs Horvath, and Valerie Cerra, 2003, IMF. See also “Fiscal Policy in a Decentralized Economy” by Stephan Danninger, “Sickness Absence: Sweden in an International Perspective” by Leo Bonato and Lusine Lusinyan in IMF Country Report No. 04/245 and “The Swedish Fiscal Framework: Towards Gradual Erosion?” by Fabrizio Balassone, “The Tax-Benefit System and Labor Supply in Sweden” by Evridiki Tsounta and Leo Bonato in IMF Country Report No. 05/344.

2. The reform is initiated against the backdrop of a broad-based economic upturn, far outpacing the euro area. Spurred by strong global growth and supportive fiscal and monetary policies, the momentum of the current recovery is expected to continue, although easing back in 2007–08 in the face of capacity constraints and fading policy stimulus. With continued robust gains in household wealth and disposable income, private consumption has served as the engine of expansion, supported by a resurgence in investment and buoyant exports.

uA01fig01

Real GDP Growth, 1995–2007

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

Sweden: Output and Demand, 2002–2008

(percent change)

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Sources: Statistics Sweden and staff calculations.

Contributions to Growth

3. Strong growth has yet to translate into a durable revival in employment. While employment has recently begun to rise, the boom has also encouraged new entrants to the labor market. The headline unemployment rate has thus declined only gradually. Total unemployment has edged up, as participation in active labor market programs has continued to rise, boosted in part by pre-election public spending. Employment is expected to continue rising in 2007–08, reflecting the normal lag behind activity, and as policy reforms put in place create incentives for firms to hire new workers. Headline unemployment may rise initially before declining over the medium term, as participants in labor market programs are gradually drawn into gainful work.

Sweden: Labor Market Indicators, 2002–2008

(percent change)

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Sources: Statistics Sweden, Riksbank, and staff calculations.

As a percent of the labor force

As a percent of the working-age population

4. Inflation is edging up toward the Riksbank's target of 2 percent. During 2005–06, wage inflation has remained moderate and coupled with unexpectedly strong productivity gains, especially in manufacturing, has helped contain labor costs (Figure 1). However, cost pressures have begun to emerge in recent months, reflecting the pass-through of higher energy prices and incipient wage pressures. With capacity utilization at an all-time high and a sizeable positive output gap projected to open, measures of expected inflation have been rising toward the inflation target (Figure 2).

Figure 1.
Figure 1.

Sweden: Labor Market Developments, 2000–06

(percent change)

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

Source: Statistics Sweden and staff calculations.
Figure 2.
Figure 2.

Sweden: Inflation Developments

(Percent change from a year ago)

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

Sources: Statistics Sweden; the Riksbank and NIER.1/ UND1X = 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.

5. The Riksbank has begun to gradually withdraw the strong monetary stimulus in place for the past two years. In response to rising underlying inflation and higher expected inflation over the policy horizon, the key policy rate was raised in steps from a historic low of 1.5 percent in January 2006 to 3 percent in December. Markets expect continued further tightening—of about 100 basis points—in 2007.

uA01fig02

Sweden, Euro Area and US Interest Rates

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

6. Sweden's competitive position remains strong despite the appreciating krona (Figure 3). The krona has remained broadly unchanged against the euro in recent years; however, it has appreciated 5 percent in effective terms over the past year and about 14 percent since late 2001. With low inflation and strong productivity gains over the past five years, real appreciation has been less, at around 8 to 10 percent. Large actual and projected current account surpluses are expected to lead to a positive international investment position by 2009 (Table 5).

Figure 3.
Figure 3.

Sweden: Exchange Rate Developments

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

Sources: IMF, International Financial Statistics.
Table 5.

Sweden: Balance of Payments Accounts, 2002–11

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Includes investments in financial derivatives (not shown).

Positive number indicates an accumulation of foreign assets.

7. Fiscal policy is strongly pro-cyclical in 2006–07. The structural surplus is likely to fall below the 2 percent target in 2006, as buoyant tax revenues are offset by pre-election spending on job-creation programs by the previous government. The tax cuts in the budget for 2007, including those in income, wealth and property taxes, amount to around 2 percent of GDP and would be financed partially by lowering welfare benefits, raising unemployment insurance contributions, and reducing spending on labor market programs. However, the net fiscal impact is expansionary, with the structural surplus projected to weaken substantially in 2006–07.

Sweden: General Government Balances, 2004–2009

(as a percentage of GDP)

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Sources: Fall Budget 2006 and staff estimates.

8. Growth is expected to ease back in 2007–08 (Table 3). As the stimulative effects of monetary and fiscal policy fade, domestic demand is expected to slow and the positive output gap will start to close. With continued solid gains in disposable incomes and wealth, consumption is projected to support activity. Investment, growing much faster than potential GDP during the recovery, is likely to decelerate sharply. Net exports will continue to make a small positive contribution to growth, sustained by a strong competitive position. The risks are broadly balanced, with a possible slowdown in world growth offset by the likelihood of stronger-than-projected domestic demand.

Table 3.

Sweden: Medium-Term Scenario, 2002–11

(percent change)

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Sources: Statistics Sweden and staff calculations.

Contributions to Growth

9. Over the medium term, potential growth is expected to slow markedly, primarily reflecting the coming demographic transition. Potential growth has been boosted over the past several years by a rise in total factor productivity growth and increased labor participation. However, in the absence of further changes to the institutional and incentive structures, adverse demographics are set to soon offset these positive influences. With working age population expected to begin shrinking by the end of the decade, despite significant immigration, potential growth is projected to fall from recent rates of around 2¾ percent to barely 2 percent by the end of the decade.

II. The Policy Debate

10. The pace and sequencing of reforms are at the center of the debate. The staff and the authorities see eye-to-eye on the broad philosophy underlying the reform agenda and the importance of sustaining a consensus behind the new policy paradigm (Box 1). Looking ahead over a four-year electoral horizon and beyond, considerations of timing and tactics are equally important elements in the authorities' thinking. The opportunity to shape the longer-term design of the Swedish model—indeed influence the broader debate on the European social model—makes the change of policy direction in Sweden of particular interest to the international community.2

Sweden: The New Government's Program

Taxation

  • A ‘job deduction’ from income taxes for low and middle income earners will reduce marginal tax rates. The income tax deduction, amounting to about 1½ percent of GDP, is intended to be raised in a second stage of tax cuts in 2008.

  • Introduction of “New Start Jobs” in the form of a subsidy to the employer, with a view to returning those outside the labor market to work.

  • Employers' social security contributions for young and older workers will be reduced so as to make it more attractive for employers to recruit and retain them. Employer contributions are also to be lowered in selected service sectors. This may not be feasible until 2008, inter alia due to EU rules on state aid.

  • Tax reductions for purchase of household-related services are proposed.

  • Wealth tax rates will be halved to 0.75 percent as a prelude to their elimination.

Welfare and Labor Market

  • Unemployment benefits will be reduced, with the replacement ratio falling to 70 percent from 80 percent after 200 days.

  • Sickness benefits will be cut and subject to stricter enforcement to reduce their overuse and eliminate fraud.

  • Labor market programs will be substantially reduced and made more efficient, abolishing programs such as sabbaticals that run counter to the “work-first” principle.

Privatization

  • Government stake in state-owned companies will be reduced. Sales are expected to total around 7 percent of GDP over the next 3 years.

A. Toward a More Inclusive Labor Market

11. The government's labor market strategy is well designed to promote sustainable growth. The authorities stress that the package is aimed at addressing simultaneously unemployment and poverty traps. The decision to cut taxes for low and average earners is intended to make employment more attractive for those now outside the labor market. Reductions in unemployment and sickness benefits are intended to underline the dual role of social insurance as a safety net and as a support to facilitate the transition back to work. A scheme to lower social security contributions for young and older workers should encourage employers to recruit and retain these groups. Programs will focus on matching jobseekers with vacancies and raising competition in employment services.

12. The authorities do not underestimate the challenge of changing entrenched behavior patterns. Officials acknowledge that the implementation of measures to stimulate labor demand, such as the planned cuts in social security contributions for selected sectors, such as services, face challenges (related, for instance, to EU rules on state aid). The time lag before the policy changes will start affecting behavior also remains uncertain. The authorities, nevertheless, express confidence that employment will rise substantially over the next few years.

13. The authorities plan further cuts in taxation, subject to the overriding constraint of maintaining a healthy fiscal surplus. In the staff's view, the high tax burden—among the highest in the world—suggests ample scope for reducing taxation. The government's expectation is that future tax reforms would be financed partly from the dynamic economic gains arising from the first wave of cuts. In the staff's view, cutbacks in either public consumption or transfers will be necessary to create room for further strategic tax cuts. The authorities have ruled out cuts in public services, limiting their room for maneuver. While the intention to increase competition in health care and social services is welcome, potential exists for using private suppliers to deliver the same quality of services at lower cost, for instance in childcare, healthcare, and eldercare. The government may, nevertheless, need to seek cuts in public consumption as well.

14. In a departure from past policies, the new government plans to privatize some state-owned enterprises. It intends to sell a sizeable share of its stake in state enterprises—around 7 percent of GDP—with the proceeds to be used to repay foreign debt. Due to the sheer size of the divestment, it is expected that a substantial portion will be taken up by foreign investors, raising foreign interest in Swedish capital markets. The privatization could enhance competition in sectors where the state currently plays a major role, such as real estate, mortgage finance, and alcoholic beverages.

B. Fiscal Policy and Framework

15. The recent trend of pro-cyclical fiscal policy is set to continue in 2007 (Table 4). Staff estimates that the general government structural surplus will fall well below the 2 percent target, mainly reflecting the tax cuts. While conceding that the fiscal stance might be procyclical in the short term, the authorities view the fiscal outcome for 2007 in the broader context of their agenda to streamline the welfare state and raise sustainable growth and employment.

Table 4.

Sweden: General Government Financial Accounts, 2001–09

(as a percentage of GDP)

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Sources: Spring Budget 2006 and staff estimates.

16. The government intends to refine the fiscal framework while preserving the target of a surplus of 2 percent of GDP over the cycle. Staff and the authorities view the target as appropriate to ensure fiscal sustainability in the face of the demographic challenges. In line with past Fund advice, the 2007 budget has reduced reliance on tax expenditures and restored a three-year horizon for expenditure ceilings. The authorities hope to embed the fiscal framework within their wider policy agenda of raising employment. They see merit in the staff's view that an independent economic agency could derive the annual structural surplus target in a macroeconomic context and translate it into a headline budget target. Such a setup would eliminate ambiguous targets that can lead to lax policies in good times and to a procyclical correction in bad times, thereby undermining public confidence in the framework. The authorities intend to move in this direction in the Spring 2007 Budget.

C. Monetary Policy and Framework

17. With inflation expected to rise over the next two years, the Riksbank is expected to tighten monetary policy further. Real interest rates remain close to zero and the monetary stance remains quite accommodative. Riksbank officials do not contest the staff's view that a neutral policy rate—consistent with an inflation target of 2 percent—would be about 4 percent. In their view, the degree of slack in the labor market would also have a bearing on the pace of tightening. As for the level of the krona, officials concur that conventional model-based indicators suggest that the krona is undervalued. They note that the Riksbank has not intervened in exchange markets with a view to influencing the exchange rate in recent years.

uA01fig03

Benchmarks for Monetary Policy, 2000–06

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

18. Recent changes to the inflation targeting framework have improved the clarity of monetary policy communication. The changes also provide a more internally consistent forecast and enrich the policymaking debate. The Riksbank is considering switching to using its own forecasts for interest rates that are consistent with achieving the inflation target. The staff welcomes this as another step that would keep the Riksbank at the forefront of international best practice. A recent evaluation of the Riksbank's inflation targeting framework commissioned by the parliament arrives at a similar conclusion and should contribute to the further evolution of the framework.3

D. The Financial Sector

19. The financial sector remains stable. Bank profitability is high, and capital levels are adequate to absorb moderate economic shocks.4 Asset quality has improved significantly, as household and corporate balance sheets have strengthened in recent years. While household debt has risen sharply, the authorities view the debt service burden as manageable, and estimate that it will remain so even if interest rates rise beyond current market expectations. Equity markets have recovered from their slump earlier this year, and house price inflation is showing signs of slowing to a more moderate pace (Figure 4). Nevertheless, financial supervisors acknowledge that asset prices, especially those for real estate, need to be monitored closely, along with banks' exposure to highly leveraged transactions. Regional cross border supervisory cooperation is well-established and continues to be enhanced.

Figure 4.
Figure 4.

Sweden: Asset Price and Interest Rate Developments

Citation: IMF Staff Country Reports 2007, 052; 10.5089/9781451836004.002.A001

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

20. The 2002 FSAP had noted certain weaknesses in the supervisory regime. Recent difficulties in revoking licenses of two small deposit-taking institutions in a timely fashion underscore the need to improve the legislative framework for bank resolution. While neither institution posed a systemic risk, the authorities are addressing this deficiency by drafting legislation to create an integrated framework for managing and unwinding troubled institutions.5

III. Staff Appraisal

21. The new government's ambitious reform agenda is timely and welcome. The economy is on course for another year of strong growth, despite some slowing as output approaches capacity limits. The incipient recovery in employment is expected to strengthen, supported by the new policy initiatives, and total unemployment, including persons in labor market programs, should begin to fall as well. Both monetary and fiscal policies are set to remain supportive of demand.

22. The reform program is rightly centered on restructuring the extensive tax and benefit systems to steer more people toward gainful employment. The tax cut aimed at low and average income earners, together with the reduction in unemployment and sickness benefits, and a revamping of the extensive labor market programs should boost employment. Although the magnitude and timing of the impact of these complementary initiatives are uncertain, they are expected to alleviate the adverse effects of the compressed wage structure on the employment prospects of low-skilled workers.

23. The high tax wedge needs to be reduced to raise incentives to work, but room for further tax cuts will need to be found within the constraints of the fiscal framework. The new government's strong political commitment to sound public finances is welcome and reinforces the credibility of its economic program with the markets and the public. Expenditure restraint will be critical to create room for additional tax cuts over the medium term.

24. The fiscal framework could be refined further to improve its transparency and accountability and to reduce procyclical policy bias. The framework has served Sweden well in ensuring fiscal discipline, and the new government has rightly decided to preserve it. However, the fiscal surplus target lends itself to different interpretations, compromising the effectiveness of the framework. The government's intention to refine and clarify the framework is therefore welcome, as are the decisions to restore the three-year horizon of spending ceilings and reduce reliance on tax expenditures.

25. With inflation expected to rise over the next two years, the Riksbank will need to tighten monetary policy further. With inflation rising toward the target, output at or above capacity, and a substantial fiscal stimulus in 2006–07, there is scope for continued tightening, broadly in line with current market expectations. As for the real exchange rate, conventional model-based indicators suggest that the krona remains undervalued.

26. Recent changes to the framework have helped improve the clarity and transparency of monetary policy communication. Further modifications to the framework—using its own forecasts for interest rates that are consistent with achieving the inflation target, for example—would keep the Riksbank at the forefront of international best practice. An evolution of the framework in this direction can be expected, as already signaled by the Riksbank.

27. The financial system has strengthened further and remains stable. Asset prices, especially those for real estate, need to be monitored closely. The recent difficulties in revoking the license of two small deposit-taking institutions on a timely basis suggest a need for improving the legislative framework for bank resolution. The authorities' plans to do so are therefore welcome.

28. The pay-off from labor market reforms could be enhanced by initiatives to promote competition and reduce the burden of regulation. Although Sweden ranks well on many international indicators of business climate, evidence of informal barriers to entry in sectors such as construction suggests scope for improving competition and encouraging entrepreneurship. The government's plans to sell some of its holdings in state-owned enterprises are welcome in this context. Deregulation in the housing market would make an important contribution to raising efficiency and promoting labor mobility.

29. The government has embarked on a course that is both courageous and necessary. Its success will help ensure that the much admired Swedish model of an inclusive society thrives in the face of the challenges of demographics and globalization. The international community will be watching the progress of this endeavor with keen interest.

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

Table 2.

Sweden: Selected Economic Indicators

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Sources: Statistics Sweden; Riksbank; Ministry of Finance; Datastream; INS; and staff estimates.

Staff projections.

In percent of potential GDP, also adjusted for one-off effects.

Based on relative normalized unit labor cost in manufacturing.

Table 6.

Sweden: Indicators of External and Financial Vulnerability, 2000–2006

(In percent of GDP, unless otherwise indicated)

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Sources: Statistics Sweden; Riksbank; Ministry of Finance; Datastream; INS; and staff calculations.

Staff projections unless otherwise indicated.

Appendix I. Sweden: Fund Relations

(As of November 30, 2006)

I. Membership Status: Joined 08/31/51; Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund:

(SDR Million; based on existing use of resources and present holdings of SDRs):

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1/ When a member has overdue financial obligations outstanding for more than three months, the amount of such arrears will be shown in this section.

VII. Exchange Arrangements: The Krona has been floating since November 19, 1992. Sweden has accepted the obligations of Article VIII (Sections 2(a), 3, and 4) and maintains an exchange system that is free of restrictions on the making of payments and transfers for current international transactions, apart from those imposed for security reasons, which have been duly notified to the Fund by the Riksbank on June 1, 2006 (EBD/06/79, June 23, 2006) in accordance with Executive Board Decision No. 144-(52/51).

VIII. Article IV Consultation: Discussions for the 2005 Article IV consultation were held in Stockholm, May 16–25, 2005 and the staff report (IMF Country Report 05/343) was issued on September 15, 2005. The consultation was concluded by the Executive Board on September 2, 2005.

IX. Technical Assistance: None

X. Resident Representative: None

1

A staff team comprising Messrs. Thakur (Head), Brunner, and Gray (all EUR), joined by Ms. Roos Isaksson, Senior Advisor for the Nordic Baltic Executive Director, visited Stockholm during November 7–14, 2006 to conduct a streamlined consultation. The mission met Finance Minister Anders Borg, Riksbank Governor Stefan Ingves and other senior economic officials, as well as representatives of labor and business, the private financial sector, and the academic community. Sweden is on a 12-month consultation cycle. It has accepted the obligations of Article VIII and maintains an exchange system free of restrictions on current international payments and transfers. However, it maintains exchange restrictions solely for security reasons, which have been notified to the Fund.

2

See, for example, “Globalisation and the Reform of European Social Models” by Andre Sapir, 2005, http://www.bruegel.org/Files/media/PDF/Publications/Papers/EN_SapirPaper080905.pdf).

3

The report reviews the Riksbank's experience of inflation targeting over the past decade and makes a number of recommendations. Francesco Giavazzi and Fredric Mishkin “An Evaluation of Monetary Policy Between 1995 and 2005”, November 2006, www.riksdagen.se/upload/Dokument/utskotteunamnd/200607/FiU/200607_RFR1_eng.pdf.

4

Recent stress tests by the Riksbank indicate that Swedish banks are well positioned to absorb either adverse domestic economic shocks or a significant deterioration in their foreign loan portfolios.

5

A staff mission from the Monetary and Capital Markets Department will visit Stockholm in January 2007 to explore this issue in depth and make recommendations.

Sweden: 2006 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Sweden
Author: International Monetary Fund