Sweden
2008 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Sweden

This 2008 Article IV Consultation highlights that Sweden’s economy has performed well, but is sensitive to global demand. The activity is now moderating. Exports have benefited from sound competitiveness, but euro area and U.S. slowing is causing them to decelerate. Private consumption growth has been relatively smooth, as employment and wages have picked up, and disposable income further benefited from tax cuts. Employment growth reached 2 percent, and the unemployment rate declined from 8 percent in 2005 to 6 percent in early 2008.

Abstract

This 2008 Article IV Consultation highlights that Sweden’s economy has performed well, but is sensitive to global demand. The activity is now moderating. Exports have benefited from sound competitiveness, but euro area and U.S. slowing is causing them to decelerate. Private consumption growth has been relatively smooth, as employment and wages have picked up, and disposable income further benefited from tax cuts. Employment growth reached 2 percent, and the unemployment rate declined from 8 percent in 2005 to 6 percent in early 2008.

I. Context

1. The economy has performed well, reaching the peak of two recoveries—the business cycle and a decade-long structural recovery following the banking crisis and sharp downturn in the early 1990s. A structural recovery extending far beyond the business cycle has also been observed in other industrial countries following a crisis—the Netherlands after its “Dutch disease” in 1980–82; Germany after the unification cost blowout in 1991–95; Finland after its banking crisis in the 1990s. Activity is now slowing with the two recoveries easing, and demographics reducing potential growth.

2. A center-right government took office in 2006, following three terms of the labor party. The government is boosting labor participation and reducing reliance on the welfare state. The reforms are politically sensitive, and support in the polls has declined somewhat.

3. Swedish banks have been resilient to global financial turmoil, but risks are rising. Share prices have dropped compared to Nordic indices, and average CDS spreads have risen, reflecting repricing of risk and weakening growth in the Baltics. Vulnerabilities have been mitigated by strong domestic economic conditions so far.

II. Recent developments

4. Activity is moderating. Industrial production is slowing (Figure 1) (Table 1). The manufacturing PMI declined from 60 pts in 2006 to 50. Construction is also softening, after strong growth. Exports benefited from sound competitiveness and strong foreign demand, but euro-area and US slowing is causing a deceleration.

Figure 1.
Figure 1.

Sweden--Cyclical Indicators suggest growth is slowing

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Source: IMF staff projections based on data provided by the authorities.1/ National Institute of Economic Research synthetic indicator of economic ativity.2/ Peak in late 2006 reflects law change (end of subsidy) effective 1/2007.
Table 1.

Sweden: Selected Economic Indicators

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

Based on relative unit labor costs in manufacturing.

5. Private consumption growth has been relatively smooth. Employment and wages have picked up, and disposable income has benefited from tax cuts. However, recent global financial turmoil has hit confidence and consumption slowed into 2008 (Figure 2).

Figure 2.
Figure 2.

Sweden--Quarterly National Accounts show that the Economy has been performing well

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Source: IMF staff projections based on data provided by the authorities.

6. Investment expanded rapidly in 2004–07. Besides construction, Sweden has invested to meet global demand for high value-added products in telecom, biomedicine, and machinery. The competitive krona supported investment. Capacity use was high.

7. The labor market performed well. Employment growth reached 2 percent a year (Figure 3). Supply increased with a larger working-age population, immigration, and higher participation. Unemployment declined from 8 percent in 2005 to 6 percent in early 2008.

Figure 3.
Figure 3.

Sweden--Labor Market Indicators have Improved in Recent Years

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

8. Tight capacity boosted prices and wages. Inflation increased from ½ percent in 2005 to 4 percent in May 2008. Energy and food prices boosted the headline, but the core rate also rose to 2.9 percent. Wages firmed up, and the Riksbank is monitoring second round effects. ULCs increased when labor productivity fell at the peak of the labor cycle (Figure 4).

Figure 4.
Figure 4.

Sweden--Wages and Labor Costs are Rising

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Source: Statistics Sweden

9. Fiscal policy remained strong. Sweden continues its exemplary fiscal recovery since the crisis in the 1990s when the deficit reached 10 percent of GDP. The turnaround has been expenditure-led, but recent performance also experienced buoyant revenues. Debt is falling below 40 percent of GDP (Figure 5).

Figure 5.
Figure 5.

Sweden--Fiscal Policies are Sound

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

10. With the strong fiscal adjustment and high private saving, the external current account surplus reached 8 percent of GDP. Sweden’s open economy is sensitive to global activity, which has been buoyant. The trade surplus is 7 percent of GDP. Growing net external assets and favorable returns contributed net factor payments of 2 percent of GDP. Foreign aid exceeds 1 percent of GDP (Figure 6).

Figure 6.
Figure 6.

Sweden--Balance of Payments and International Investment Position Indicators

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

III. Outlook

11. Following global financial turbulence, the economy is projected to slow below potential in 2008 and begin to turn up in 2009. Consumer confidence has weakened, reducing retail spending. Business confidence has dropped less (Figure 7). The authorities and staff project growth of 2 percent in 2008 and 1¾ percent in 2009 (Table 2). Consensus growth forecasts are trending toward this outlook from above.

Figure 7.
Figure 7.

Sweden--Consumer and Business Confidence Indicators are Dropping

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

1/ Scaled to zero on average.
Table 2.

Sweden: Medium Term Scenario, 2006–13

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Sources: Statistics Sweden and IMF staff calculations.

Contributions to growth

Sweden: Medium-Term Outlook 1/

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Source: Fund staff projections.

Percent.

Contribution to growth.

12. Sweden is well positioned to absorb some slowing. Softer growth has a silver lining in view of the high capacity utilization, consumer prices, and tight housing markets. At the same time, the strong fiscal position, the repo rate at 4¼ percent, and the external current account surplus provide Sweden with policy room to respond. However, the banking system is showing growing risks, requiring close monitoring.

13. Risks to growth for 2008 are balanced; those for 2009 depend on developments in the banks. If funding costs normalize and the Baltics achieve a soft landing, stable credit expansion should support growth. If turmoil persists, Swedish housing prices fall, and/or Baltic exposures sour, a credit crunch could slow growth below forecast.

14. Sweden’s long-run outlook appears sound. Long-run potential growth likely ranges from 2–2¼ percent. Sweden’s population is projected to slow but not decline—the dependency ratio will rise (Figure 8). The working-age population is expected to slow with cohorts retiring. Further, TFP growth has been above average recently, which staff attributes to the structural recovery from the 1990s. It is assumed to level off at 1.1 percent a year going forward, akin to other high-income countries.

Figure 8.
Figure 8.

Sweden--Demographic Indicators and Assumptions

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Source: IMF staff projections based on data provided by the authorities.

Sweden: Long-Run Potential Real GDP 1/

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Source: Statistics Sweden; and Staff projections.

In percent.

IV. Policy Discussions

15. With the economy in good shape, discussions focused on managing risks to banks and the real economy. Financial sector surveillance focused on bank risks, and how to strengthen Sweden’s deficient remedial and resolution framework. Exchange rate surveillance focused on external and domestic stability as linked to the policy mix. Monetary policy risks have increased with inflation expectations drifting above the inflation target. Fiscal policy is strong, subject to monitoring contingent risks.

A. Financial Sector Surveillance

Bank soundness

16. Swedish banks have performed well so far (Tables 35). Four dominant banks (Nordea, SEB, Swedbank, and Handelsbanken) have significant cross-border exposures. They enjoyed record profits while expanding aggressively abroad. Return on equity increased as return on assets remained unchanged, signaling rising leverage. Tier 1 capital adequacy is 7 percent and overall risk-weighted CARs are 10 percent—adequate but not spectacular.

Table 3.

Sweden: Financial System Structure, 2002–07

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Sources: Riksbank, Financial Supevisory Authority, and IMF staff estimates.

Including foreign branches.

Not including minor local companies

Market value of funds

Number of institutions is computed on unconsolidated basis.

Table 4.

Sweden: Financial Soundness Indicators: Banks, 2003–07

(end-period, in percentage)

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Sources: Financial Supervisory Authority, Riksbank, and IMF staff estimates.

From 2007, under Basel II, actual reported above/below capital requirement (8 percent); computed here in percent of risk-weighted assets for consistency purposes.

On consolidated basis

Table 5.

Sweden: Financial Soundness Indicators: Non-Banks, 2003–07

(end-period, in percentage)

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Sources: Financial Supervisory Authority, Riksbank, and IMF staff estimates.

Sweden: Selected Financial Soundness Indicators. 1/2/

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Source: Riksbank and Fund staff estimates.

End-period, in percent.

Total banking system; for the four large banks see Table 4.

17. Sweden has little direct exposure to US subprime paper—instead exposure to the Baltics is significant. Swedbank and SEB are dominant players in the Baltics, with up to two-thirds lending market share (Figures 9 & 10). Each earns about a third of operating profits in the Baltics with 11 percent of their total lending there (in euros and local currency). Rising concerns over credit risks have led banks to cut loan growth. This is delicate, because too fast a retrenchment could undermine the profits and assets the banks are trying to protect. On the funding side (in euros, krona, and local currency), the global risk repricing has increased liquidity risk, as wholesale and securities-related borrowing represent an important source of the banks’ total funding. Funding has tightened up and become more costly. Banks have responded in part by switching to covered mortgage bonds, which carry double collateral (of the underlying mortgages and the bank guarantee) and permit longer average maturities.

Figure 9.
Figure 9.

Sweden: Key Financial System Indicators

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Figure 10.
Figure 10.

Sweden: Key Financial Sector Indicators

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Sources: Riksbank, MKMV CreditEdgePlus, Bloomberg LLP, BIS, and IMF staff estimates.

18. Market signals indicate heightened risks. Stock prices have dropped and credit default swap spreads have increased, notably for banks active in the Baltics (Figure 11). Staff discussed its background work on banks’ default dependencies, using the latest nonlinear techniques (Box 1).1 The Riksbank has drawn increased attention in its Financial Sector Stability Reports to the risks from the Baltics, as well as from the elevated Swedish house prices. The banks, in turn, signaled their enhanced focus on credit quality in the Baltics. Staff recommends that banks do not lower capital/asset ratios further (i.e. increase leverage), even though having moved to Basel II may allow them to do so, given their high share of mortgage lending that tends to have lower risk-weighting.

Figure 11.
Figure 11.

Sweden: Financial Market Indicators

Citation: IMF Staff Country Reports 2008, 278; 10.5089/9781451836028.002.A001

Source: Thomson Financial/DataStream and Bloomberg.

Default Dependencies and Bank Stability

The soundness of one bank depends on overall system stability. As seen in a staff application for Sweden, the probability of default of one bank is linked to that of others, directly through interbank deposits and syndication, and indirectly through lending to common sectors and exposure to capital markets and proprietary trades. This default dependency can be non-linear when the financial system experiences stress. Looking at bank risk individually and ignoring this interdependency overestimates financial sector resilience.

Staff analyzed the default dependency between the four Swedish banks with nonparametric models with the following results:

  • The Swedish banking system remains stable but with a higher tail risk than six months ago. The joint probability of default (JPoD) or tail risk that all four banks default simultaneously has risen significantly, but less than the average probability of default (PoD) of individual banks. This indicates a buffer of resilience. For comparison, at the height of the global financial distress, the JPoD of 15 major international banks increased faster than their average PoDs, indicating that weaknesses in one or several institutions magnified risks for the entire system.

  • Banks exposed to the Baltics have higher risk. Banks with high Baltics’ exposure have seen their JPoD increase faster and their resilience depend increasingly on the soundness of the entire Swedish financial system. This calls for vigilance regarding their shock absorption capacity.

19. The authorities’ and banks’ own analyses suggest that the banks are prepared to cope with significant adverse events, should they come. For instance, the banks have sufficient buffers to cover loan losses up to 20 percent of total Baltic exposure while still meeting minimum CARs. Staff encouraged that stress-test assumptions also contemplate “tail” risks that combine effects from concurrent shocks (e.g., long stagnation in the Baltics with maintenance of the currency pegs, or a recovery with valuation effects if a peg were to be adjusted). Baseline scenarios posit soft landings in the Baltics, but banks cannot ignore the possibility of tougher times. Indeed, spillovers from credit to liquidity risks would be problematic given the substantial reliance by banks on capital market funding and since a drying up of this funding could also cause a credit crunch in Sweden itself.

Bank supervision and resolution

20. Against this background, the Financial Supervisory Authority (FSA) is working to enhance cross-border supervisory cooperation with Scandinavian and Baltic partners. The FSA is moving toward replicating the supervisory colleges among Scandinavian countries in the Baltics. Banks and the FSA are also proceeding with the implementation of Basel II. Eight banks have permission to use internal risk-based models. Staff sees room to use Pillar II and stress testing to bolster capital adequacy, even in the absence of a coordinated effort at the European level. The FSA needs adequate resources to address high staff turnover, and assess the quality of banks’ balance sheets with more on-site inspections of credit policies and portfolios, and less reliance on auditors’ reports.

21. Staff’s core recommendations centered on beefing up Sweden’s bank remedial and resolution framework. The 1990s crisis was addressed with facilities that are no longer in place. It would be risky to rely on a similar approach if new bank stress were to hit because the banks are much larger today, operate cross-border, and rely more on capital markets. Bank resolution in Sweden falls under regular corporate law, which is too slow for prompt remedial action and to meet the special needs of the payments system.2 The responsibilities between the FSA, Riksbank, Deposit Insurance Agency, and fiscal authorities are not clear, which could lead to costly problems.

22. The Ministry of Finance is drafting a new bank resolution framework. Staff discussed key features:

  • The FSA needs the authority and tools to implement strict prudential measures in a coherent, comprehensive, step-by-step, graduated framework. It should range from provisions for special consultations for early stress assessment, to firmer measures in a remedial context, all the way to decisive bank resolution measures.

  • It needs to be based on written code that defers to specialized courts to ensure timeliness of judicial oversight, while preventing appeals from blocking the implementation of supervisory decisions.

  • It would need to include all banks, as special treatment for systemic banks accentuates moral hazard and adds legal complexity.

  • Immediately after a bank license is revoked, authorities should take effective control, replace management, and trigger the deposit guarantee. The authorities should have a wide range of tools to wind up a failing institution, from the partial sale of its assets to arranging its acquisition or merger with another bank.

  • To minimize moral hazard, the owners of a failing bank should take the first hit. To minimize the cost to the Treasury, authorities should have the legal option to facilitate a merger into a stronger institution, or redeem shares of a failing institution at a price corresponding to its value in the absence of state aid, subject to administrative procedures.

  • Legislation needs to prescribe a clear and credible priority of claims on bank assets, with potential losses for some creditors to discourage excessive risk taking.

23. The authorities were in broad agreement, but were investigating several details. They noted that the legislation would need to remain under corporate law, but agreed that specialized courts should be established for quick resolution. They were considering to invoke the new framework only for systemic banks. And they were assessing the legal possibilities for resolving a failing bank without contravening European law. An FSAP update could further elaborate on these and other financial sector issues.3

B. Exchange Rate Surveillance

24. The Swedish krona is freely floating as determined by market forces. At constant REER, the external surplus would remain high, and the IIP turn positive, bolstering net factor earnings. However, the REER should increase in future as fiscal tightening ends and policy interest rates are higher on average than in the past—supporting the krona and reducing over time the large current account surplus (Tables 67). The velocity of this adjustment is difficult to predict because it also depends on the behavior of trading partners.

Table 6.

Sweden: Balance of Payments Accounts, 2006–13

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Includes investments in financial derivatives.

Positive number indicates an accumulation of foreign assets.

Table 7.

Sweden: International Investment Position, 2006–13

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Includes investments in financial derivatives.