Sweden
2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Sweden.

Sweden was among the first to falter in the great recession. The downturn was mitigated by aggressive stabilization policies, led by a sharp relaxation of monetary policy, a slew of emergency financial sector support measures, and actions raising bank capital. The policy actions taken were effective because they occurred against the background of Sweden’s credible inflation targeting, freely floating exchange rate, and budgetary frameworks. The intention to keep policies supportive are appropriate. Fiscal policy anchors this effort, and the monetary stance is highly accommodative.

Abstract

Sweden was among the first to falter in the great recession. The downturn was mitigated by aggressive stabilization policies, led by a sharp relaxation of monetary policy, a slew of emergency financial sector support measures, and actions raising bank capital. The policy actions taken were effective because they occurred against the background of Sweden’s credible inflation targeting, freely floating exchange rate, and budgetary frameworks. The intention to keep policies supportive are appropriate. Fiscal policy anchors this effort, and the monetary stance is highly accommodative.

I. Background 1

Sweden was hard hit by the great recession

1. After a long boom, Sweden was amongst the first to falter in the great recession. Output peaked at end-2007, and has fallen by over 6 percent from peak to trough (Text Figure, Figure 1). Exports and gross fixed capital formation fell by 12 and 16 percent respectively in 2009; permanent and temporary employment fell by 2 and 7 percent respectively in 2009 while unemployment rose from 6 to 9½ percent by 2010 Q1; equity values halved from peak to trough, money markets froze, corporate financial positions—notably of manufacturing exporters—deteriorated, and credit growth of non-financial corporations stopped abruptly (Figure 2).

Figure 1.
Figure 1.

Sweden: The Long View, 1996–2009

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Haver Analytics, Konjunkturinstitutet, Statistics Sweden, and IMF staff calculations.1/ In thousands.
Figure 2.
Figure 2.

Sweden: Into the Downturn, 2007–10

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Haver, Statistics Sweden, and IMF staff calculations.1/ OMX Stockholm Price Index (1995=100); bond yield and STIBOR in percentage points.
uA01fig01

Cumulative Declines of Real Output 1/

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: OECD and IMF staff estimates.1/ Cumulative declines measured as the fall in real output from peak to trough between Q1 2007 and Q1 2010.

In line with staff advice, the impact was attenuated by aggressive stabilization policies

2. The Riksbank cut the policy rate from 4¾ to ¼ percent and signaled its intent to maintain low interest rates for an extended period (Figure 3). This was accompanied by a sweep of new liquidity measures, such as the expansion of eligible collateral and counterparties, longer term repo operations with a fixed interest rate, and the provision of dollar liquidity, as well as establishment of a new credit facility to accept commercial paper as collateral to support credit growth. (Figure 3 and Box 3). While the Riksbank did not apply discretionary intervention in foreign exchange markets, thereby accommodating krona depreciation, the National Debt Office borrowed externally SEK 100 billion (US dollars 15 billion) to boost international reserves and the Riksbank tapped U.S. Federal Reserve and ECB’s currency swap arrangements.

Figure 3.
Figure 3.

Monetary Policy Measures, 2007–10

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Thomson Financial/Datastream, Bloomberg, Haver, and Riksbank.
uA01fig02

International Reserves

(In billions of US dollars)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Source: Riksbank.

3. On the fiscal side, the budget balance swung from a surplus of 2½ percent of GDP in 2008 to a deficit of 0.8 percent of GDP in 2009, delivering 3.3 percentage points of GDP in support to demand (Text chart, Figure 4). Of this, 1.6 percentage points of GDP comprised discretionary measures for 2009, focused on the tax side, including permanent cuts in personal, social contributions and corporate income tax. Cautious estimates on revenue and spending meant that the overall headline balance outturn was some 2 percentage points of GDP stronger than the authorities had budgeted (¶49–50), though the impact of this on output was limited by the small size of the multipliers. But fiscal support for demand was appropriate given uniquely strong fiscal fundamentals (See Box 2). And to confirm commitment to sustaining those fiscal credentials, the 2010 Budget Bill tightened the 2012 expenditure ceiling by SEK 10 billion (0.3 percentage points of GDP) from its earlier announced level, as staff had suggested.

Figure 4.
Figure 4.

Fiscal Policies in the Crisis

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Ministry of Finance, Eurostat, and IMF staff calculations.

Sweden: Fiscal Measures 2009–10

(In percent of GDP)

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Sources: 2009 Budget Bill and 2009 Spring Fiscal Policy Bill

Includes lower contributions to the unemployment insurance fund, changes in under-pricing rules, changes in interest deductibility, and widening of the CIT tax base.

4. As elsewhere, discretionary measures to avert a significant rise in unemployment were also put in place, albeit on a smaller scale than elsewhere. Active labor market policies were strengthened and upgraded through job search assistance and training (Text chart).

Table. Crisis Measures on Labor Market Policies

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Source: OECD

Seasonal Adjustment of Real Output

Tracking quarterly output developments during the downturn has been difficult. Distinguishing outliers from new information about seasonality that is contained in each new data round has proved challenging for statisticians, compounded in Sweden’s case by rebasing the reference year to the chained-volume method—to 2008 with the May 6 data release and to 2009 with the May 28 data release. As a result, the reported quarterly shape of the downturn and the timing of recovery have changed significantly across data releases (Text chart).

Table. Seasonally Adjusted GDP growth rate, quarter-on-quarter, across releases

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Source: Statistics Sweden.

Highligted numbers were classified as outliers in estimation of seasonal factors.

uA01fig03

Seasonally Adjusted GDP across Releases

(Constant Prices)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Statistics Sweden and IMF staff calculations.1/ Calculations are made to rebase the earlier release with reference year 2008 (May 6th, 2010) for comparison purpose with the latest release. The axis on the right hand side corresponds to the actual GDP (in SEK millions) with reference year 2009.

To assess the latest release of quarterly data for the years to 2010Q1, staff re-estimated seasonally adjusted GDP data using fixed seasonal factors, based on the estimated seasonality up to 2006Q3—the last period for which estimation using Statistics Sweden’s 2-year ahead and 2-year behind method of estimating seasonality is unaffected by the global downturn in 2008 (Text chart). This confirms the broad shape of the recession as reported in the latest release of data, but suggests that it started a little later.

uA01fig04
Sources: Statistics Sweden and IMF staff estimates.1/ Adjusted seasonal factors are calculated as the ratio between nonseasonally adjusted series and the seasonally adjusted series up to and including 2006Q3. The calculated seasonal factors are then applied to the subsequent output numbers after 2006Q4.

The Strength of the Swedish Sovereign

Since 1993, a successful fiscal consolidation—expenditure has been reduced by about 19 percentage points of GDP, to 50 percent of GDP in 2007, and the general government debt to GDP has fallen from 70 to 40 percent of GDP—has taken place. This has underpinned and reflected the credibility of its framework of fiscal rules, which has included an independent fiscal policy council since 2007.

uA01fig06

Projected increase in total age-related spending

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Source: Commission Aging Report 2009.

Projections for public debt in the next 5 years remain below 45 percent of GDP, even in relatively adverse macroeconomic circumstances and further out, the burden of age-related spending is low (resulting from a radical pension reform in the late 1990s). And even under the most pessimistic estimates of such costs, the discounted net worth of the government remains positive. (See, 2008 Article IV Consultation Report).

Moreover, whereas public finances deteriorated sharply elsewhere, the budget outcome in Sweden in 2009 was strong, and was also considerably stronger-than-anticipated—especially given the large contraction in output. This mainly reflects better-than-anticipated labor market developments—which, including their effects on consumption taxes, are estimated by staff to account for half of the over performance on the budget balance, compounded by larger than expected returns on reforms of various entitlement programs. Labor market reforms to increase participation rates (such as the earned income tax credit) coupled with reform of the unemployment insurance and sick benefits schemes have led to a sharp decline in the number of people supported by benefit schemes as well as the level of benefits paid out. Lower payouts under these schemes improved the fiscal balance by roughly ½ of 1 percentage point of GDP.

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Sources: Ministry of Finance and IMF staff calculations.

The cumulative structural fiscal stimulus to 2010, net of savings in sick leave and entitlements benefits, has been some 1.8 percent of GDP. Absent further announced measures, it appears on staff estimates set to increase further in 2011. But consistency with the balance-over-the cycle target remains underpinned by the reductions in medium-term spending ceilings.

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Source: Ministry of Finance; IMF staff calculations

Authorities’ estimates;

Staff estimates

The Status of Crisis Intervention Measures

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5. On the financial stability side, the deposit guarantee was doubled and extended to all types of deposits, new bank recapitalization and debt guarantee schemes were introduced, supervisory liaison with those in the region was intensified, while several banks, including those with the largest Baltic exposures, made rights issues and stopped dividend payments to raise capital positions well above prudential requirements (Text Figure). The authorities also launched a review of their framework for bank regulation and supervision. A modest bank stability charge, levied on banks non-equity liabilities has been introduced (¶55). This will eventually form a fund of 2 percent of GDP available to finance bank rescues.

6. In this context, the krona depreciated by 15 percent in real effective terms from mid-2008 to early 2009, further supporting net exports and activity, as reflected in significant rises in manufacturing export and import prices. But more recently, it appreciated again, in part reflecting Sweden’s strong fiscal fundamentals as market concerns about sustainability in Europe have risen (See text figure). In that context, export and import prices have fallen back. Since early 2009, the krona has appreciated by 10 percent in real effective terms, and is still probably modestly undervalued at prevailing rates (Box 4 and Figure 5).

Figure 5.
Figure 5.

Sweden: External Competitiveness Remains Firm, 1996–2009

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: International Finance Statistics, Konjunkturinstitutet, Statistics Sweden, and IMF staff calculations.
uA01fig07

Sensitivity of sovereign bond yields to daily changes in the Greek Sovereign bond yield 1/

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Bloomberg; and IMF staff estimates.1/ Data refer to 10-year sovereign bonds from Nov 1, 2009 to Apr 30, 2010.

These measures have yielded fruit

7. Financial sector strains have eased (Figure 6). As elsewhere, interbank spreads over expected policy rates have returned to pre crisis levels, and bank capital ratios have strengthened by all standard measures, while liquidity ratios are broadly unchanged (See Text chart). This has supported continued growth of credit to households.

Figure 6.
Figure 6.

Sweden: Selected Financial Markets Indicators, 2005–09

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Thomson Financial/Datastream, Bloomberg, and Haver.

Summary of the Performance and Operation of Swedish Four Major Banks

(In percent; unless otherwise indicated; end period)

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Sources: Banks’ annual reports; and IMF staff estimates.

With Basel II transition rule.

For Nordea and Handelsbanken, excludes loans to credit institutions; for SEB, includes all credit portfolios (such as commitment and guarantees); and for Swedbank, includes credit institutions.

Competitiveness and the Equilibrium Real Exchange Rate

On standard measures, the krona has long appeared undervalued, and still does so, even after its 10 percent real effective appreciation from its mid-2009 trough (Text chart).

Four factors qualify these standard measures in this case:

Current CGER Estimates 1/

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Source: CGER

April 2010

  • Population ageing calls for a medium-term strengthening of the net external position. So the external stability measure may overstate competitiveness, and the need for appreciation implied by the equilibrium RER estimate would also be inconsistent with this.

  • Measures of competitiveness which compare prices directly (as opposed to tracking relative inflation rates over time) suggest that the equilibrium rate for the krona is weaker than RER measures imply. The gap arises because while periodic reweighting of baskets of comparator countries broadly tracks trade shifts, this practice overlooks price level differentials which generally motivate these shifts in the first place. Comparing absolute measures of relative prices based on purchasing power parities with RER measures suggests a gap between them of 11 percent—implying that the CPI-REER may overstate competitiveness by that margin.

  • Sweden produces consumer durables and investment goods, the long run global demand for which has likely fallen as a result of the recent crisis. Thus, an equilibrating depreciation is likely needed as a result of the global crisis. While the MB and ES measures should reflect this via medium-term trade projections, the latter are subject to considerable uncertainties in the current global context.

  • Alongside other indicators, notably the moderate level of inflation expectations and weak exports, the staff assessment is that the currency is probably not very significantly undervalued.

uA01fig08

Sweden. International Relative Prices vs. Real Effective Exchange Rate Index

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: IMF Information Notice System; and IMF staff calculations.

8. Output began to rise from mid-2009, although it still remains well below capacity. Personal consumption also held up, in part due to the buoyant housing market, growing through 2009 after the modest fall in 2008—a major stabilizing factor. Personal savings rates fell slightly, after a long secular upward trend in recent years which reflected earlier pension reform, while personal incomes remained buoyed by the moderate declines of employment and wages, and supplements to income from budget transfers.

9. Firms hoarded labor to a far greater extent (without extensive government support) than in the 1990s—temporary jobs (one-sixth of total) fell 10 percent but have already risen significantly since late-2009, while permanent jobs fell only moderately—albeit at the expense of labor productivity. The Spring 2010 round of multi-year wage settlements—covering most of the private and public sector labor force—have settled on rises of some 2½ percent, easing prospective cost pressures.

10. The export sector, including exports of manufacturing goods that were severely hit during the recession, has rebounded since late-2009. New orders for industry and exports have strengthened in recent months, supporting the strong growth recorded in 2010Q1.

11. Concerns that downturn might prompt a deflationary cycle have receded (Figure 7). Measures of underlying inflation remained in positive territory even as the headline measure (reflecting interest rate cuts and falling global energy prices) went negative for a time. Measures of inflation expectations—over all horizons—have remained anchored within the inflation target range.

Figure 7.
Figure 7.

Monetary Policy Measures, 2003–10

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Thomson Financial/Datastream; Bloomberg; Haver, and Riksbank.

12. And house prices rebounded significantly. The drop of some 10 percent—which by some measures still left houses moderately overvalued—ended in early 2009 and then reversed.2 This reflected the stimulus of low interest rates—which also produced a marked increase in the share of new variable rate mortgages—the resilience of credit to households, and constraints on new housing supply.

uA01fig09

Cross-country Comparison of House Prices

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: OECD and Loungani (2010).1/ Long-term average represents 1970–2000. Current ratios as of end-2009.

Sweden: Near Term Economic Developments, 2008–10

(percent change, quarter-over-quarter, seasonally-adjusted)

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Sources: Statistics Sweden and IMF staff calculations.

II. Outlook and Risks

The external environment remains highly uncertain

13. As a small open economy, with deep external financial sector linkages, Sweden is highly exposed. External trade comprises over 90 percent of GDP, and direct foreign exposures, including to the Baltics, comprise half of its major banking group’s assets—which itself is 350 percent of GDP.

14. In this context, economic growth projections in the recent World Economic Outlook (WEO) for the European Union remain low relative to market consensus, at 1 percent and 1.3 percent for 2010 and 2011, respectively, and they note downside risks. Although the outlook in the Baltics has improved, the ultimate fallout on credit impairment there remains unclear.

Latest WEO Projection on Economic Growth

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Sources: WEO projections (Apr-2010) and staff estimates.

15. And the global outlook, in which the European outlook is nested, remains subject to high uncertainties. The 90 percent confidence interval around central-case WEO projections remains very wide, with the lower bound even falling in 2011 (Text chart). Accordingly, the lower bound of staff’s growth projections declines in 2011 before picking up in the medium term.

16. As contracting demand for consumer durables, and investment and intermediate goods led the global recession, Sweden was particularly exposed as these are goods in which it specializes (Text charts). As noted in the 2009 Article IV consultation for Sweden, these output composition factors will also affect the outlook: if the global demand for these goods lags the global recovery—as may be anticipated given large global output gaps and balance sheet and fiscal adjustments in advanced economies—demand for Swedish exports may disappoint relative to its peers in the medium-term. And the short term growth momentum abroad and in Sweden is also qualified somewhat because a significant part of the upturn reflects firms rebuilding inventories.

Sweden: Key Export Sectors, 1990–present

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Sources: Eurostat, Statistics Sweden; and IMF staff calculations.

Sweden: Geographical Composition of Exports, 1995–present

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Sources: Direction of Trade Statistics; and IMF staff calculations.

Notes: Excluding the Baltic countries (Estonia, Latvia, and Lithuania).

17. Uncertainties about export prospects are compounded by the termination of various global stimulus measures with particular impact on durables and investment-related spending.3 If global “self sustaining” aggregate demand has not resumed by the time these measures expire, Sweden is particularly exposed.

uA01fig10

Tier 1 capital ratios

(In percent, based on Basel II transition rules)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Banks annual reports, and staff calculation.

18. Sweden’s flexible exchange rate could provide a buffer, supporting activity even if some of these adverse risks materialize, but the market stress in Europe has prompted a “search for strong sovereigns” that potentially increases capital inflows into Sweden, reversing much of the earlier krona depreciation. If this continues, prospects for net exports and growth will be dented.

19. These uncertainties are reflected in the authorities’ output projections (¶48). The Riksbank projects output growth of 2.2 percent, but with a 90 percent confidence interval ranging from a fall of 1 percent to growth of 5 percent.

20. In the staff central case, supported by global conditions, export volumes are expected to grow by some 5 percent in 2010 and 4 percent in 2011 (Text chart). But given considerable excess domestic capacity, fixed investment will remain weak even if export growth is strong, and household consumption is not likely to drive growth strongly, with permanent employment projected to grow slowly. And the impetus to growth may be attenuated if the krona continues to appreciate. Thus, output could grow by about 3 percent in 2010, slowing down to 1.9 percent in 2011—higher than Riksbank projections as of April of 2.2 percent for 2010 but lower than 3.7 percent projected by Riksbank for 2011.

Sweden: Near Term Economic Developments, 2010–11

(percent change, quarter-over-quarter, seasonally-adjusted)

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Sources: Statistics Sweden and IMF staff projections.

21. If so, the output gap will remain large for 2010. According to estimates based on aggregate production function and filtering techniques, the gap is likely to narrow only a little in 2010, to somewhere between 3 and 6 percent of potential output.

uA01fig11

Output gap

(in percent of estimated potential output)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Riksbank and IMF staff estimates.

22. But, as noted, risks around these projections are considerable. And aside from short-run uncertainties, the outlook for potential output growth over the medium-term is similarly clouded. It has been dented by the contraction in gross domestic fixed investment and may be compounded if hysteresis effects appear in labor markets.

III. Implications for Policies and Policy Frameworks: 2010–11

23. In this environment, the central outlook is for moderate growth for Sweden but with significant downside risks. Thus, policy should remain strongly supportive, while standing ready to tighten rapidly if upside scenarios emerge.

24. These challenges—with echoes elsewhere—have a particular character in Sweden.

  • While, for other advanced economies, renewed growth alongside fiscal sustainability concerns calls for measured withdrawal of fiscal stimulus soon, external demand may lag for Sweden, fiscal fundamentals are uniquely robust, and monetary policy nominal rates are already close to their floors. Thus, need and scope for fiscal stimulus in 2010–11 remains, even in the central case.

  • Others also face capital inflows, but these are mainly rapidly growing competitive economies with inflows that are expected to ease once the major countries pick up. Sweden’s growth is less secure and the “safe haven” inflows could endure-particularly if fiscal sustainability concerns in the Euro Area prove to be protracted.

  • Likewise, many countries have to rebuild their financial sectors, but policy in Sweden has also to address the large size of the sector and its particular regional exposures-with inward and outward spillover risks still primary concerns.

  • And if global demand for investment goods and consumer durables lags over the medium-term, Swedish employment may need to shift into services. Thus, while aspirations to raise employment will require appropriate support for aggregate demand, it will also require labor market structures which facilitate these shifts.

A. Fiscal Policy and Framework

Fiscal support to demand appropriately continues

25. With nominal monetary policy rates close to effective floors, and fiscal balance outturns in 2009 significantly stronger than planned, growth has resumed but the output gap remains large. So a further 2.3 percentage points of GDP of stimulus is planned for 2010—2.0 percentage points of which comprise new measures outlined in the Fall 2009 and Spring Bills 2010—and a further 1.6 percentage points of GDP of discretionary stimulus is planned for 2011 (¶51). The recently announced nominal expenditure ceilings rise by SEK 10 billion in both 2013 and 2014 (1 percent) from the lowered 2012 ceiling, accommodating some resumption of public spending growth as economic growth normalizes.

Sweden: Fiscal Measures 2010–11

(In percent of GDP)

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Source: 2009, 2010 Budget Bills and 2009, 2010 Spring Bills.

Active labor market policies

26. Thus, on the authorities’ current plans, fiscal stimulus across the global crisis has been spread out (¶49–51). And given sizeable automatic stabilizers, discretionary stimulus has given greater emphasis to supporting long-run supply side efficiencies, as opposed to immediate support for aggregate demand. Most of the discretionary stimulus over 2009–11 is accounted for by tax measures, including permanent cuts in corporate tax, social security contributions and personal income tax—with an expansion of the earned income tax credit—though temporary spending measures to support active labor market policies and stem the fall in employment at the local government level are also included. The estimated multiplier of such tax cuts is 0.35 percent, compared with a 0.7 percent from equivalent expenditure measures. Their contribution to addressing the structural shifts needed in employment is discussed below.

27. This is broadly appropriate. While the overall fiscal support for demand was smaller than was planned in 2009 and is on the lower end of EU countries even including 2010 plans (Text chart), the envisaged discretionary stimulus planned for 2010–11 appropriately balances the risks. Given strong fiscal fundamentals, the size of the output gap (however estimated), doubts about the strength of prospective growth, and constraints on monetary policy, a presumption of further stimulus is appropriate. Under the fiscal authorities’ central case assumptions of growth of 2½ percent in 2010, the fiscal balance will deteriorate from a deficit of 0.8 percent of GDP in 2009 to 2.1 percent of GDP in 2010.

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EU Countries: Change in the Fiscal Balance 2008–10

(percentage points of GDP)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: World Economic Outlook; and Swedish Ministry of Finance.

28. These plans remain consistent with continued observance of the authorities’ nominal expenditure ceilings, even on staff assumptions. The picture on the balance target is less clear, however, as estimates of the structural fiscal balance have become particularly hazardous—with both the output gap and estimates of the stabilizers highly uncertain at present. This is reflected in the differences between staff and the authorities’ estimates, and discrepancies of both from estimates of the cumulative structural impact of fiscal initiatives since 2008 (Box 2). On balance, the strains with respect to observance of the balance target appear likely to rise, especially if the stimulus measures already announced for 2011 are not offset by other actions. In that context, if by the fall of 2010 the medium-term outlook for growth is stronger than is now anticipated, some policy tightening will be necessary, and a balance will need to be struck between monetary and fiscal action. To the extent that the stronger outlook is accompanied by further appreciation of the exchange rate, then offsets to the planned structural fiscal stimulus for 2011—perhaps going as far as implying overall consolidation if competitiveness concerns mount considerably--should support monetary tightening.

29. The current fiscal framework has anchored policies well including during the recent downturn (see Attachment 1). However, the increasing number of indicators to assess compliance with the balance target risks is raising concerns in some quarters about its credibility. This raises further the premium on the Swedish Council for Fiscal Policy in preparing detailed assessments and conclusions for the general public regarding the consistency of policy with the rules.

Sweden: Comparison of Fiscal Outlook

(Percent of GDP)

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Source: 2010 Spring Fiscal Policy Bill and staff projections.

As a percent of potential output.

Budgetary Impact of a 1 Percent Change in GDP

(In percent of GDP)

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Source: OECD (2005), using 2003 weight.
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Multiplers in Sweden Using GIMF

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Source: IMF staff estimates.

B. Monetary Policy and Framework

30. The authorities have successfully headed off earlier considerable concerns with the possibility of disinflation. Inflation excluding mortgage interest rates has consistently remained within the target range (notwithstanding negative headline inflation rates for a period), nominal wage growth remains moderately positive, and inflation expectations remain well anchored. Alongside concerns that house prices have been quickly recovering, supported by bank lending to the household continuing to grow at 10 percent (year-on-year), the authorities have indicated that a tightening cycle will begin in summer 2010.

31. Inflation pressures are not expected to rise for now. Even with fiscal policy tending to err on the side of stimulus for 2010, export and growth prospects remain uncertain and in any event the output gap remains large. Moreover, since early 2010, capital inflows have intensified upward pressures on the krona, providing additional disinflationary impetus and compounding concerns for the growth outlook. And while house price inflation is notable, it may be spurred in part by the earlier preannouncement of the recent termination of a tax stimulus. And even if that played a minor role, appreciation of asset prices is intended as a key means of stimulating demand, so house price appreciation might more appropriately be viewed as further evidence of the success of efforts to avert a deeper downturn. Nevertheless, risks of a sharp correction and possible macroeconomic disturbances remain, so close surveillance remains appropriate, alongside cautions to individual borrowers (¶56).

32. Accordingly, the tightening cycle should be gradual and cautious. In particular, if market turmoil in Europe continues, this could provide grounds to delay it. But in any event, the stance of monetary policy will remain highly accommodative, without threatening the inflation target.

33. The flexible inflation targeting regime has proved its worth during the crisis. It accommodated focus of the initial overall policy response to global crisis on monetary relaxation, including via a significant depreciation. This outturn also underscores that in the case of small open economies such as Sweden, monetary instruments remain effective even when policy rates reach their nominal floors. This is because such economies have the option to relax the effective monetary stance through exchange rate channels to head off risk of deflation through direct intervention in foreign exchange markets. Thus, concerns to the effect that risk of ineffectiveness of monetary instruments warrants more elevated inflation targets do not apply in such cases.

34. In June, the Riksbank abolished +/-1 percent tolerance interval around the inflation target rate to strengthen its communication—particularly, to avoid unnecessary misunderstanding by the public when inflation falls outside the range (¶57). This remains consistent with accountability, as the general principles guiding policymaking—including how actual and projected deviations from target are treated—are laid out occasionally and formally in issues of “Monetary Policy in Sweden”.

C. Financial Sector Policy and Framework

35. The specter of global financial collapse after Lehman’s has been contained (Figures 8 and 9). Swedish bank capital has been raised, non-banks solvency ratios have recovered along with global stock prices, and exit from extraordinary financial sector support measures has begun—the Riksbank has begun tightening conditions for its term repo operations. In this context, challenges arise from uncertain regional—including Euro Area—growth, Baltic exposures, continued dependence on non-deposit funding, and uncertainties ahead of regulatory reforms expected from the global consultative process underway. Most recently, the authorities decided to maintain the debt guarantee scheme until end-2010, which was scheduled to be terminated effective end April 2010, along with other EU members (¶57).

Figure 8.
Figure 8.

Performance of the Swedish Banking System, 2003–10

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Thomson Financial/Data Stream; Bloomberg; Banks’ Annual Reports; and WEO.
Figure 9.
Figure 9.

Sweden: Non Bank Financial Sector, 1990–2010

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Sources: Riksbank, Statistics Sweden, and Haver.

36. Stress tests provide comfort on immediate vulnerabilities. The Riksbank’s main scenario projects credit losses in 2010 of ½ percent of total loans, down from 1½ percent a year ago, reflecting better outturns than expected and the improved GDP growth outlook in the Nordic and Baltic regions. The stress scenario assumes prolonged domestic and regional recession and associated declines in employment and rises in borrowers’ financial distress. It shows credit losses rising to a total of 4 percent in 2010–12. But even so all major banks are projected to maintain core Tier 1 capital ratios well above 8 percent and so well above the 4 percent ratios secured in the adverse scenario in the stress test a year ago.

37. Nevertheless, uncertainties remain, notably regarding the corporate sectors’ financial position. Market indicators suggest that banks continue to face a heightened credit risks there, particularly in non-durable consumer goods and services sector and construction and real estate sectors (Text chart).

uA01fig14

Swedish corporate sector expected default frequency

(In percent)

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Source: Moody’s KMV.

38. Furthermore, significant banking operations abroad—encompassing jurisdictions with varied supervisory quality—give rise to credit and reputational risks from subsidiaries to parents, and to euro and/or dollar liquidity risks in the event of market strains. These idiosyncratic elements should be reflected in Swedish capital and liquidity requirements. And where operations potentially generate liquidity needs in foreign currency, liquidity requirements should take into account that the Riksbank resources available to satisfy them are limited. And cross- border resolution frameworks should be developed further in line with EU proposals.

39. More broadly, with confidence broadly restored, bank regulatory arrangements should aim to wean the financial sector off of the extensive contingent public support it now enjoys, including for too-big-to-fail banks and including their dependence on Riksbank liquidity. But steps to do this—including tightening liquidity and capital requirements—should be taken in light of their impact via credit conditions on the monetary stance (and vice versa). In scenarios in which monetary tightening is appropriate, such measures should accompany (if not preceded) actions to raise central policy rates. In other scenarios, such steps should be taken only in so far as—and in ways that—they do not indirectly tighten the monetary stance. And any such steps should be taken on the basis that further adjustments may be needed in light of prospective international agreement on banking regulations.

40. Ability to manage tail risks also remains a concern. In particular, while direct exposures to Euro Area peripherals are minimal, strains there could deepen or widen, affecting third countries to which Swedish financial firms are exposed directly or indirectly. Indeed, these spillover effects are apparent in market data for the large Swedish banks (See Attachment II). Thus, a priority is to verify the adequacy of contingency plans, including the assessment of liquidity risks in the financial system, supervisory and crisis management readiness, and the level of international reserves, not least given continued reliance of Swedish banks on substantial wholesale funding (Attachment II). Even given the legal framework for nationalization of banks in case of emergency, the option to extend this toolkit to include a special resolution framework for financial institutions is encouraged (Box 6; ¶55).

41. The most fundamental need however is to strengthen micro and macro supervisory capacity and to review the crisis management framework, including the authorities’ capacity to deal with possible strains in the financial sector. A reform initiative has just begun, with reviews by a government commission expected to be completed within two years. The key issues include: (i) the division of labor on micro and macro prudential regulations among the Ministry of Finance, the Riksbank, the Financial Supervisory Authority, and the National Debt Office; (ii) macro prudential tools; (iii) a bank resolution framework and a deposit insurance scheme; (iv) international reserve management; and (v) supervisory capacity building. Any reforms to the architecture of macroprudential institutions should maintain effective communication and coordination between all authorities, with appropriate accountability, and retain the independence of monetary policymaking.

42. The 2006 FATF assessment report suggested some weaknesses in Sweden’s AML/CFT framework. Among several measures to address such concerns, Sweden implemented the third EU Money Laundering Directive on March 15, 2009, and the FSA issued new regulations and guidelines governing measures against money laundering and terrorist financing on May 15, 2009.

Proposals to Strengthen Sweden’s Financial Stability Framework

Some elements of the financial stability framework could usefully be strengthened.

  • Bank resolution framework. In October 2008, the government enacted “Government Support to Credit Institutions Act” which gives the National Debt Office power to grant credit guarantees, and if there is a serious systemic risk and bank capital falls below 25 percent of the regulatory requirement, take over a troubled bank (¶55). This scheme was first applied in resolving the Carnegie Investment Bank failure in late 2008.

  • A Prompt Corrective Action style ladder is needed, covering all banks and fully empowering the FSA to take the full range of supervisory corrective actions.

  • Supervisory capacity. The FSA remains constrained by high staff turnover, and it would benefit from greater funding, including to allow more thorough on-site inspections.

  • Deposit insurance scheme. Under the current legal framework, deposit insurance funds can only be disbursed after a failed bank is placed into bankruptcy. The insolvency process can be initiated by the petition of an unpaid creditor or by the failed bank itself, but not by the FSA. Thus, the process could be lengthy. Furthermore, the ability of the authorities to obtain relevant information about the balance sheet of a troubled bank at an early stage should be clarified.

  • Cross border coordination. There are major uncertainties in how a cross-border crisis would be resolved in a coordinated way. Memoranda of Understanding on crisis management were signed at the EU level and with three Baltic countries. New MOUs between the Nordic and Baltic economies are under active preparation.

  • Non-bank financial institution supervision. A number of non-bank financial institutions raise deposits, but they are neither subject to FSA supervision nor reporting requirements.

Why Is a Special Resolution Framework for Banks Needed?

Sweden does not have a special resolution framework for financial institutions. Currently, the authorities have two broad sets of resolution tools: public fund injections (including partial to full nationalization) and corporate bankruptcy. The nationalization approach proved effective in solving the Swedish banking crisis in the early 1990s and the Carnegie Investment bank failure in late 2008. However, reliance on corporate bankruptcy has as elsewhere proved challenging, as evidenced by the case of Custodia (a credit market institution). In particular, lengthy judicial reviews after the revocation of its license by the FSA led to higher costs to the government and public. 1

Experience during the current global crisis proves the need for a special resolution framework, separate from corporate bankruptcy, to enhance the toolkit for effective and least-cost crisis management. The FSA—rather than creditors or shareholders—should have the sole power to put the institution into resolution procedure immediately at a predetermined capital level after revoking its license. A resolution law should also ensure that a receiver or liquidator appointed by a public body should have the right to use all resolution methods, such as acquisition by a private sector purchaser, bridge bank, and partial transfer of deposits and assets to a good bank. The law should also ensure appropriate creditor safeguards so that no creditor of a resolved bank is left any worse off than the situations without the special resolution framework.

This would follow practice elsewhere. In Canada, Japan, the United Kingdom, and the United States, special regime laws provide for special rules for bank insolvency, with the administration the supervisor or the deposit protection agency.

1In January 2006, the FSA attempted to revoke Custodia’s license but was unable to place it into bankruptcy. While the case is reviewed by the court, Custodia continued to accept deposits from the public for a while. In August 2006, the shareholders finally placed the institution into bankruptcy. During this period, the value of assets declined significantly, resulting in an increase in losses covered by the government’s deposit insurance.

D. Labor Market Policies

43. The labor market has held up much stronger than expected—showing much greater resilience than was apparent during the downturn in the early 1990s (Text chart and Attachment III). But youth unemployment remains close to 30 percent.

uA01fig15

Sweden: Real GDP Growth and Unemployment Rate, percent

Citation: IMF Staff Country Reports 2010, 220; 10.5089/9781455204601.002.A001

Source: OECD.

44. Two sets of actions have been taken to address the labor market challenges. First, the Reform Program for Growth and Employment in recent years has increased resources available for preparatory and vocationally-oriented training, and improved information for job seekers regarding vacancies, through the Public Employment Services (Text chart). Second, the reductions in direct taxation which dominated the stimulus packages in 2009–10 (¶49, 58) will help by supporting growth of new sectors. This will help to avoid hysteresis effects in unemployment and support the structural shifts needed in coming years.

Table. Labor Market Policies—Structural Reforms

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Sources: OECD, Swedish authorities.

45. Such efforts could be taken further. The difference between employment protection between regular and temporary workers could be rebalanced to avoid impeding the shift of workers in over-invested sectors to more productive uses, and the increase in the proportion of temporary workers in the total is symptomatic of this challenge. Furthermore, with 70 percent of workers unionized, future wage setting mechanisms need to maintain flexibility. However, further expansion of direct measures (e.g., tax incentives or discretionary subsidies for firms to hoard labor) may only contribute marginally as public spending on active measures is already high, and is already well focused on those elements of these policies which have generally been found to be most effective (See Attachment III).

IV. The Authorities’ Views 4

46. The authorities agreed with the overall staff assessment.

47. Following global crisis and Baltic difficulties, decisive macroeconomic and financial sector stabilization policies and eased regional and global conditions had secured a rebound in exports and output from mid-2009, which had reportedly accelerated significantly in the first quarter of 2010. Household consumption and the service sectors remained buoyant throughout, working hours had adjusted flexibly in the most adversely affected sectors, and recently employment had begun rising. Core inflation and inflation expectations have held close to target, despite the shocks and volatility in the krona, and financial sector resilience has been strengthened significantly (¶2–11).

48. But the output gap remains large and, as underscored by ongoing strains in Europe, Sweden remains vulnerable to global shocks. So even as a return to “normal” macroeconomic policy settings is signaled—by reaffirmation of the commitment to the fiscal rules and by advancing the anticipated commencement of the monetary tightening cycle—the policy stance will remain highly accommodative in the near term. But policies will tighten prudently over time given current expectations (¶13, 21, 23).

Fiscal policy and framework

49. Aversion to budget deficits—which dates back to the early 1990s—remains strong among the general public and all parties, even in the context of downturns. However, discretionary stimulus of some 1½ percent of GDP in 2009, was needed to address both immediate uncertainties and to continue to support long term productive efficiencies in the economy. Both objectives were reflected in the composition of the stimulus measures—including reductions in personal and corporate taxes, increased allocations to various active labor market and business support initiatives, and added transfers to municipalities (¶3).

50. Nevertheless, the 2009 budget balance outturn was unexpectedly strong. While the buoyancy of employment and household incomes played key roles in this, further factors include continued additional savings from earlier initiatives to tighten eligibility for various entitlement programs, low take up rates for some of the discretionary support initiatives, and reductions in the size of the automatic stabilizers following reforms to labor markets and tax structures (Box 2). These matters remain under review.

51. Given strong public finances, output well below capacity, and need to reinforce structural flexibility in the economy still further, additional discretionary fiscal stimulus of 2¼ percentage points of GDP has been provided in 2010, balanced across further income tax reductions and spending on municipalities. The timing and nature of further action to strengthen flexibility will be considered in light of macroeconomic developments in Sweden and abroad, and be consistent with continued adherence to the framework of fiscal rules (¶25–27).

52. Those fiscal rules anticipated and weathered global crisis well and remain the central anchor for budget policy. The unusual nature of the recent downturn has, as elsewhere, complicated measurement of compliance with the surplus target. To improve monitoring, a ten-year average of net lending is now used to assess past savings, while the average surplus from 2000 has been dropped. However, the role of the Swedish Fiscal Policy Council remains central in making overall and final assessments of these matters, and it indicates that policies for 2010 remain appropriate under the rules and given the strains in markets in Europe at present (¶28–29).

Monetary policy and framework

53. The strong showing of the Swedish economy from late-2009, as reflected in a variety of indicators, as well as some concern with the housing market, was reflected in the Riksbank’s Executive Board’s decision in February 2010 to advance its anticipated commencement of the tightening cycle to the summer of 2010. While the timing and extent of this action remains under review, and developments in Europe will be taken into account, domestic developments suggest that this indication remains appropriate as a first step towards returning monetary policy back to “normal” settings. In any case, the stance of monetary policy will remain highly accommodative in the near term (¶30–32).

54. The monetary framework remains appropriate. The recent decision to remove the tolerance interval around the inflation target was taken because no operational consequences necessarily follow from outturns outside the interval, and full assessments of policy and prospects are provided by the Executive Board in all cases (¶33–34).

Financial sector policy and framework

55. As reflected in the latest Financial Stability Report, published in June 2010, vulnerabilities have receded following stabilization in the domestic and regional economies, and multiple steps taken to reinforce bank capital. Capacity to manage trouble institutions has been confirmed in practice, and the bank resolution law of 2008 provides a secure framework for crisis management via nationalization. The guiding principle is that in such cases, former shareholders should bear their full burden, and this is reflected in adoption in October 2008 of the “bank stability fee” of 0.0018 percent on bank non-equity liabilities (doubling in 2011) to prefund any interventions in future. Options to extend the range of instruments available to manage weak institutions will be reviewed by a government commission which will report to the government within two years (¶5, 40).

56. The housing market remains a concern for consumer and macroeconomic stability reasons, rather than financial stability reasons. Preemptive steps taken to cool the market. include repeated reminders by Executive Board members that new borrowers taking variable rate mortgages should be aware that rates will rise, and proposals for penalties on new mortgages with loan-to-value ratios above 85 percent have been presented by the FSA board ((¶31).

57. In light of recent market stresses in Europe, the debt guarantee scheme was extended to end-2010—with its duration now governed by EU agreement on such schemes. Furthermore, tests of contingency planning continue, and the level of international reserves will be assessed in this context (¶35, 40).

Labor market policies and framework

58. Unemployment remains a key concern, notwithstanding stronger employment outturns than anticipated. Active labor market initiatives will therefore remain extensive, supported by further reductions in income taxation to raise incentives to work. But with a “realistic” attitude from both sides of industry evident in the “local crisis” wage agreements and in the recent multi-year settlements, reduced employment protection is not needed in order to strengthen broader economic performance (¶44–45).

V. Staff Appraisal

After a long boom, Sweden was amongst the first to falter in the great recession

59. Output peaked at end-2007, and fell 5 percent in 2009. Unemployment has risen to over 9 percent, corporate financial positions—notably of manufacturing exporters—have deteriorated, and output may be some 4 to 6 percent below capacity.

The downturn was resisted by aggressive stabilization policies

60. These were led by a sharp relaxation of monetary policy, a slew of emergency financial sector support measures, and actions raising bank capital. Alongside, a fiscal relaxation of 3 percentage points of GDP to a deficit of 0.8 percent of GDP in 2009 supported demand. All these actions were accompanied by a 15 percent real effective depreciation of the krona, from levels that on some measures were already competitive.

These policies have yielded fruit

61. As globally, earlier financial strains have eased and exit from emergency financial sector support measures has begun. Credit to households remained buoyant, and concerns with a deflationary spiral have been erased—with core inflation and inflation expectations remaining close to target throughout. Moreover, personal consumption held up firmly, and firms hoarded labor to a far greater extent than in the 1990s. In this context, output began to rise from mid-2009.

62. The policy actions taken were effective because they occurred against the background of Sweden’s credible inflation targeting, freely floating exchange rate, and budgetary frameworks—with public debt sustainably below 45 percent of GDP.

Nevertheless, prospects for growth in 2010–11 remain uncertain

63. While the global growth outlook is better than earlier anticipated, risks remain elevated, and global demand for consumer durables and investment and intermediate goods—in which Sweden specializes—lags the global recovery. Moreover, market stress in Europe has prompted a market “search for strong sovereigns” which has reversed much of the earlier krona depreciation, denting prospects for net exports and growth. All this is appropriately reflected in the Riksbank’s assessment growth in Sweden in 2010 could be as high as 5 percent or as low as -1 percent.

Accordingly, the authorities’ intentions to keep policies supportive are appropriate Fiscal policy anchors this effort

64. The budget anticipates a further increase in the deficit to over 2 percent of GDP in 2010. This includes tax reductions and increased transfers to municipalities, summing to 2¼ percent of GDP. As this responds to concerns with output prospects, and, as indicated by the Swedish Fiscal Policy Council, is fully consistent with fiscal stability and the framework of fiscal rules, it is appropriate. If economic growth and employment turn out to be stronger than anticipated, the budget balance will do likewise. And the tax reductions in the 2009–10 budgets will help to boost structural flexibility.

65. As the current fiscal rules—targeting a surplus of 1 percent of GDP across the cycle, supported by medium-term expenditure ceilings—remain well suited for Sweden, the critical element in any changes will be to reinforce the central role of the Swedish Fiscal Policy Council in assessing compliance.

Alongside, the monetary stance is set to remain highly accommodative

66. The rekindling of growth optimism and some concerns with house prices has underpinned recent Riksbank announcements that the anticipated tightening cycle would be brought forward to mid-2010. Nonetheless, inflationary pressures remain well contained. Given the large output gap and recent krona strength, the immediate outlook is for core inflation to continue to fall. Accordingly, the tightening cycle should be gradual and cautious. And continued uncertainty over the implications of market strains in Europe could provide grounds to consider the appropriate time for its start.

67. The decision to retire the tolerance interval around the inflation target avoids raising unnecessary concern when headline inflation falls outside the range. Accountability under the adjustment is retained by the occasional publication of the principles guiding how policymakers use their discretion within the inflation targeting framework.

And financial stability remains under close surveillance

68. The Riksbank Financial Stability Report indicates that core Tier 1 capital ratios for all large banks will remain above 8 percent even in a stress scenario. This is stronger than previous assessments, partly reflecting the improved outlook for the Baltics. And the Financial Supervisory Authority’s proposal to penalize loan-to-value ratios above 85 percent will help to address vulnerabilities. Nevertheless, risks remain, including those from banking operations abroad and from liquidity risks in euro and dollar markets. These elements should continue to be reflected in Swedish capital and liquidity requirements in line with forthcoming global agreements on such arrangements. And cross-border resolution frameworks should be developed further, in line with EU proposals.

Ability to manage tail risks should also remain under active review

69. While direct exposures to Euro Area peripherals are minimal, Sweden is exposed indirectly. Thus, a priority is to update “war games” to verify contingency plans. These would also provide a useful opportunity to confirm that international reserves are at appropriate levels. And steps to establish a special resolution regime to manage troubled financial institutions and to further raise resources for banking supervision are welcome. Any reforms to the architecture of macroprudential institutions should maintain effective communication and coordination between all authorities, with appropriate accountability, and retain the independence of monetary policymaking.

70. Sweden should remain on the standard 12-month consultation cycle.

Table 1.

Sweden: Selected Economic and Social Indicators

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Sources: OECD; World Development Indicators; Statistics Sweden; Riksbank; Ministry of Finance; Datastream; INS; and IMF staff estimates

Based on relative unit labor costs in manufacturing.

Table 2.

Sweden: Medium-term Scenario, 2007–14

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Source: IMF staff projections.

Contribution to real GDP growth.

In percent of nominal GDP.

HICP annual average, in percent.

In percent of potential GDP.