Staff Report for the 2012 Article IV Consultation

Sweden’s recovery from the global crisis was swift reflecting its strong position at the onset of the crisis. The 2012 Article IV Consultation reports that the economic outlook remains clouded. Executive Directors have commended Sweden’s sustained strong macroeconomic performance, which has been underpinned by prudent policies and effective institutions. They have also welcomed efforts to strengthen the macroprudential framework and financial sector oversight through tighter capital and liquidity requirements, and have encouraged the authorities to further their cross-border collaboration with regional banking regulators.


Sweden’s recovery from the global crisis was swift reflecting its strong position at the onset of the crisis. The 2012 Article IV Consultation reports that the economic outlook remains clouded. Executive Directors have commended Sweden’s sustained strong macroeconomic performance, which has been underpinned by prudent policies and effective institutions. They have also welcomed efforts to strengthen the macroprudential framework and financial sector oversight through tighter capital and liquidity requirements, and have encouraged the authorities to further their cross-border collaboration with regional banking regulators.

The Setting

1. Sweden’s macro financial performance over two decades has been strong: robust growth, low inflation, declining trend unemployment, and rising incomes, low government bond yields, and strong external positions. But there are vulnerabilities and concerns looking ahead.

2. In particular, growth prospects in coming years in its major trading partners Germany, Norway, the United Kingdom, the United States and Denmark—are in question. In Advanced Europe, cyclical recovery appears to have already run its course and estimates of trend growth have been lowered from pre-crisis. And in the United States, the cyclical recovery is weaker than usual after recessions. And while there are upside risks associated with these global projections—notably progress towards a durable resolution in the Euro Area (EA)—the risks are largely to the downside: a possible sharp resurgence of strains in the EA; or/and a « lost decade » of growth there; and in either context, possible further oil supply shocks. And despite some improvement, the global financial system remains vulnerable (See the Risk Assessment Matrix). In this light, can Sweden’s strong performance continue?

Sweden: Risk Assessment Matrix

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Note: L, M, H denote low, medium and high.

There are reasons for concern

3. Sweden’s record has largely been achieved in the context of a buoyant global economy. Sweden is small and open, and so is highly exposed to its trading partners, notably Europe, which purchases some 70 percent of its exports of goods and services. Furthermore, the particular composition of Swedish exports—dominated by investment and intermediate goods—exposes it to the most cyclical components of demand in the European and global economies, which up to 2008, were in upswing. But trend and cyclical external prospects have weakened (Box 1). Furthermore, as an oil importer, global oil supply shocks matter (despite being an European Union leader on renewable energy), directly and—if oil shocks compound global weakness—indirectly.

4. And Sweden features an outsized financial sector, some 5½ times GDP. Though direct exposure to the EA periphery is low, Sweden’s assets are dominated by claims on core EA and the Nordic-Baltic region, both of which are vulnerable to tail risk strains in the EA. And well over half of banking liabilities are wholesale, exposing Sweden directly to liquidity shocks in global financial markets (Box 1).

5. Furthermore, even the strength of Sweden’s sovereign may be proving to be a mixed blessing—by causing appreciation of the krona. The fiscal rules targeting a 1 percent of GDP surplus across the cycle alongside multi-year nominal expenditure ceilings, all scrutinized by a stridently independent fiscal council, are long established and credible. And the downward trajectory for debt they imply is resilient to standard shocks (See Box 2 and the 2011 Selected Issue Paper). But this is attracting capital inflows. Though not yet to the extent of Japan or Switzerland, these inflows have recently taken the krona to historic highs vis-à-vis the dollar and euro, further curbing export prospects.

And recent developments underscore the spillovers from the global economy

6. As global demand recovered, Sweden grew by 6.1 percent in 2010 and 4 percent in 2011. And reflecting the small employment gap and a negative output gap (estimated by staff at around ¾ percent for 2011), headline Consumer Price Index (CPI) has remained above the 2 percent target. But, as elsewhere in the region and Advanced Europe, momentum has weakened. After growing by a cumulative 2.1 in the first three quarters of 2011, Sweden’s Q4 2011 GDP surprised markets on the downside by contracting 1.0 percent in Q4, and then by growing 0.8 percent in Q1 2012.

Sweden: Near Term Economic Developments, 2009–11

(Q/Q percent change, seasonally adjusted)

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Sources: Statistics Sweden and IMF staff calculations.

7. In particular, exports, which surged back in 2010, softened through 2011 (albeit with a similar volatile quarterly path as GDP in Q4 2011 and Q1 2012)—with high frequency indicators suggesting that this overall muted performance continues. Alongside, fixed investment has also eased from 2010. Though the level of private consumption has not fallen, its growth remains lackluster despite resilient employment and incomes into the early part of 2012—in part reflecting that unemployment remains elevated relative to the immediate pre-crisis period. Excluding 2008–09, household confidence is low historically, while household credit growth has slowed by over 3 percentage points from a year earlier to 5½ percent. Declining wealth and a low confidence have led to further increases in household saving rates.

8. At the same time, while both temporary and permanent employment increased in 2010, with permanent jobs numbers now significantly surpassing pre-crisis levels, job creation seems to have slowed. And both labor force participation and unemployment remain high (the latter at around 7½ percent—some 1½ percentage points above 2008 levels). Within this, the proportion of young, older and long-term unemployed in total unemployment have all increased considerably relatively to pre-crisis, with flexibility—including via increasing use of temporary employment agencies—at a premium in hiring.

9. These output and labor market trends have also affected fiscal developments. Strong growth in 2011 was reflected through automatic stabilizers in a strengthening of the overall balance in 2011 by 0.2 of a percentage point of GDP, shifting to a small surplus of 0.1 percent from a deficit of 0.1 percent GDP in 2010. In this context, the temporary fiscal stimulus measures were phased out, including support to municipalities and county councils and investments in infrastructure and training. This, combined with the ongoing effects of previous reforms (including the reduction in sick-leave payments), reduced expenditure by 1.1 percentage points of GDP.

10. But the underlying fiscal stance remained supportive—notably reflecting the tax reduction for pensioners in 2011—with staff calculations suggesting that the 2011 outcome fell short of the 1 percent structural surplus target by 0.8 percentage points. Data for the first months of 2012 show a slowdown in central government tax revenue compared to the previous year, indicating that economic slowdown in the last quarter of 2011 is already taking a toll on revenues.

11. Meanwhile, demand for credit has held up. Corporate credit has recovered, albeit slowly, from the credit slump in the aftermath of the Great Recession. In the household sector, credit growth was very strong, but has decelerated to around 5 percent over the past year, reflecting in part the tightening of macroprudential regulations—such as LTV regulations, applying interest rate surcharges on loans above 85 percent of LTV.

12. In 2011 inflation averaged around 3 percent but underlying inflation measured by the CPIF (that is the CPI with a fixed mortgage rate) was lower at 1.4 percent, while CPIF excluding energy was lower still averaging around 1 over the year. The annual rate of increase of the CPIF amounted to only ½ percent in December 2011—as the economy slowed and the krona gained strength. The gap between the various measures of inflation remains wide as mortgage rates have led the CPI to increase more rapidly than the CPIF.

13. In line with these developments, following a series of steps between January and July 2011 that brought the repo rate from 1.25 to 2 percent alongside various macro prudential actions to cool housing markets, the Riksbank paused in August-September as Europe sovereign debt market strains intensified. It then lowered the policy rate by 25 basis points both in December 2011 and February 2012, reflecting the deteriorating external environment and benign inflation indicators. The pass- through of these actions to households’ mortgage rates has been less than complete, however (Box 3).

14. In that context, inflation expectations remain anchored near the target, and inflation fell below 2 percent Jan-Mar 2012—while core inflation (measured by the CPIF excl. energy) has averaged 1.1 percent. Growth in unit labor costs has been low, although it picked up slightly in the second half of 2011, reflecting a pause in the upward trend in labor productivity since the recovery began.

15. And conditions in Swedish banking markets have tracked the ebb and flow of those in European banking. Swedish banks’ risk-weighted capital ratios remain relatively high with negligible exposures to strained EA countries. In addition, earnings have increased—thanks to increased lending on the back of strong domestic growth—and loan losses have fallen to low levels—mainly reflecting an improved situation in the Baltic countries. As a result, access to international capital markets has remained secure.

16. But as stresses again mounted in Europe, CDS spreads and expected default frequency measures rose. This was most notable for Nordea, the largest Swedish bank, reflecting its exposures to the region and core advanced Europe. And in May 2012, Moody’s downgraded the long-term debt ratings for Nordea and Handelsbanken by one notch to Aa3, in part reflecting their reliance on wholesale funding. Moreover, generally poor capital market conditions have hit non-bank financial institutions, such as insurance. The average solvency ratio of life insurance firms has fallen sharply since the middle of 2011, although its level remains around 8 times minimum requirements.

17. On the external side, with weakening global demand since mid 2011, Sweden’s trade surplus shrank to its narrowest in more than a year at the end of 2011—as exports of goods fell after the summer. Nevertheless, with imports of investment goods also weak, Sweden’s current account remains positive (in 2011 Q4 at 7.2 percent of GDP), albeit still weaker than 2007 levels. In part, this is because the positive net income contribution has increased following a rebound in returns on portfolio investment in Europe.

18. In the financial accounts, capital inflows were concentrated into portfolio investment in government and corporate securities, balancing large but falling outflows through FDI and other investments. This shift seems to reflect growing uncertainty about Europe, strong confidence in Sweden’s macroeconomic policies, and ample global liquidity.

19. These recent macrofinancial developments all underscore the importance of spillovers into Sweden. But developments in capital flows and hence in the krona underscore that indeed “this time may be different”. In particular, with portfolio inflows strong, the krona was little changed vis-à-vis the euro during the first four months of 2012, after strengthening 1.6 percent in 2011, a marked contrast to 2008–09 when the krona weakened sharply as external conditions softened. While apparently still in the neighborhood of levels suggested by medium-term fundamentals—but indeed possibly with room for further appreciation—the contrast to 2009 in the krona’s response to deteriorating external circumstances could not be more marked (Box 4).

20. So continued weakness of activity is likely in 2012. Staff projects GDP growth to drop from 4 percent in 2011 to 1 percent in 2012, then to rebound to 2 ⅓percent in 2013, broadly tracking projections for activity in Advanced Europe and somewhat more optimistic than the Riksbank’s projection and consensus (both around ½ percentage point less, but based on information prior to the release of the Q1 2012 National Accounts).

21. Activity in 2012 is projected to be sustained by steady personal consumption (despite moderating house prices and some rise in unemployment, accommodative fiscal conditions, continued non-residential property investment, and strong international non-oil commodity prices). But net exports and business investment will remain sources of weakness, reflecting global demand and actions to tighten domestic bank regulations. Overall, the output gap is estimated at around zero in 2011 Q4, and under these projections, will open up again in 2012 (-0.4 percent), subduing core inflation.

Sweden: Near Term Economic Developments, 2012–13

(Q/Q percent change, seasonally adjusted)

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Sources: Statistics Sweden and IMF staff calculations.

22. For 2013, stronger European and global growth alongside continued momentum in consumption are projected to lift growth, closing the output gap again by end 2013. Inflation is expected to remain contained throughout the projection period thanks to a small and slowly-closing output gap.

23. Potential growth is projected to recover gradually to around 2½ percent, after falling an estimated ¾ of a percentage point from the pre-crisis trend, owing to the sharp decline in investment in 2009. Thereafter, the catch-up for investment “lost” during the crisis is expected to raise potential growth further.

24. But even apart from the strength of the krona, two elements in the domestic economy could amplify the impact of external slowdown and downside tail risk.

  • First, price-to-income ratios in the housing market remain elevated, with staff estimates suggesting overvaluation in the region of 10 percent. Thus, domestic housing fragilities could amplify the macroeconomic effects of external developments (Box 5).

  • Second, and despite some strengths—including the covered bond arrangements and the tier 1 capital ratios—the financial sector remains a concern. The system is large, concentrated, complex, and reliant on short-term wholesale funding. It also has significant domestic and regional exposure to real estate, with elevated level of household debt in Sweden (170 percent of disposable income), softening house prices, and a high share of interest-only mortgages. Furthermore, curbs in welfare insurance in recent years could make mortgage lending less secure than formerly. These fragilities could raise the prospect of increased credit losses in the event of a sustained regional recession.

The Implications for Policy

25. The core issue is the extent to which policies should now be set to anticipate downside tail risks or the central slow-growth EA scenario. The former would call for aggressive further accrual of buffers now in fiscal and financial sector policies while the latter would call for an accommodative stance now.

26. Policies have been set to address both near-term weakness and downside tail risks. In particular, in the financial sector, various steps have been taken to bolster resilience, with more underway. Alongside, the government budget remains firmly guided by its medium-term rules, thereby allowing stabilizers free rein to reflect the economic cycle. And with medium-term inflation expectations anchored at the target, the monetary policy stance remains accommodative with the policy rate negative in real terms. Both fiscal and monetary policy instruments have room to make decisive adjustments should tail risks materialize.

A. Financial Stability

27. Given the large size of the sector and its direct exposure to core EA countries, the financial sector represents a key contingent fiscal risk, given European tail risks. Efforts to contain the impact of these risks on Sweden are nested within the Basel III and broader EU initiatives, including CRD IV, while acknowledging that Swedish financial sector contingent risks may not be fully reflected in EU–wide prescriptions.

28. The system has a number of strengths:

  • In domestic markets, historically low mortgage losses, limited buy-to-let markets, open-ended personal liability, and well-developed welfare and social security systems (albeit some erosion in recent years), all curtail risks of major credit losses.

  • Externally, direct exposures to the most vulnerable peripheral countries are small, and market indicators also suggest small spillover risks arising from these countries.

  • Furthermore, over the past few years, banks increased capital ratios including through rights issues, retained earnings, and reductions of higher risk assets. As of end March 2012, under the Basel II definition, core Tier 1 capital ratios range between 12 and 16 percent, and even under much stricter new Basel III definition, common equity Tier 1 capital ratios are estimated to be between 11 and 15 percent.

  • And banks have strengthened overall liquidity—including as indicated by the Riksbank’s short-term liquidity measure—by increasing longer-term funding and liquid assets.

  • A stability fund was established in 2008, and the Deposit Insurance System was reformed in July 2011 to be fully consistent with the revised EU Deposit Insurance Directive.

  • And the 2008–09 crisis confirmed that the authorities’ crisis readiness is high.

29. Nevertheless, given heightened European tail risks, recognition of large fiscal contingent liabilities, and lack of a common European backstop, the authorities have not rested, moving ahead of European norms in some areas. In particular, in November 2011, the financial regulator (FI) proposed that the common equity Tier 1 capital requirements for four major banks would be at least 10 percent from the beginning of 2013, and 12 percent from the beginning of 2015. The move preceded the recent CRD IV consensus. Further, since July 2011, banks have been subject to new liquidity reporting requirements, which enable the authorities to monitor Basel III-type liquidity indicators. The next step planned is the introduction of the Liquidity Coverage Ratio (LCR) requirements in total currency position and for euro and US dollar currency positions separately in January 2013. Resources of the FI are being raised over the next few years, while legislative amendments have been made to clarify FI autonomy. And the Council for Cooperation on Macroprudential Policy (CCMP), comprising the Riksbank and the FI has been established to strengthen cooperation among supervisors and held its first meeting in February 2012. One of the CCMP’s tasks includes coordinating Sweden’s response to recommendations made by the ESRB and Basel committees.

30. In this light, the authorities’ recent stress tests suggest that even under severe EA recession scenarios, banks would be able to maintain a 10 percent core Tier 1 capital ratio under the Basel II definition—although one bank’s common equity Tier 1 capital ratio could go under 10 percent under the Basel III definition. This coincides with the broadly reassuring assessment provided by the 2011 FSAP Update.

31. However, while standard stress tests reassure the resilience of the Swedish banking system, current European circumstances suggest that a shock beyond historical experience could not be disregarded. Furthermore, the comfort of high risk-weighted assets is qualified by the fallibility of the measure. Raw common equity ratios are as low as 4 percent for some banks, while risk weighted assets continue to fall to around 25 percent of total assets—among the lowest in Europe. Further, direct and indirect exposures to the core EA and associated tail risks are significant. And despite progress, banks liquidity risks remain substantial, due in part to reliance on short-term funding, including on their US dollar books. Likewise, household debt continues to rise and is now 1.7 times disposable income, as highlighted in the 2012 EC Alert Mechanism Report.

32. Accordingly, further progress is needed urgently beyond simply focusing on capital ratios, to bolster financial system resilience:

Strengthen bank capitalization further, specifically by raising risk weights

  • High risk-weighted capital ratios in part reflect low risk weights for residential mortgages—reflecting Internal Rate Based (IRB) models. But these may overlook tail risks outside of historical experience, and so exaggerate resilience. Joint efforts by the regulators and the private sector to review the appropriateness of risk-weight calibration are underway. In this light, as a potential measure, imposing a regulatory floor on risks weights on residential

  • mortgages can be considered. More broadly, the appropriate use of IRB models should be under constant scrutiny by supervisors, and disclosure of methodology and assumptions can be further enhanced.

Strengthen liquidity requirements

  • A step following the planned introduction of the LCR regulation in 2013 includes preparation to introduce a Basel III net stable funding ratio (NSFR)-type measure in the medium term. Meanwhile, banks should continue to raise their NSFRs towards 100 percent and publish them. But the pace of balance sheet adjustments to meet the NSFR should be set in light of a review of their short-term impact on banks’ ability to collect deposits and issue longer debts and on the availability of “safe” assets under regulatory rules. In this regard, there are merits of reviewing the adequacy of Basel III liquidity standards for Sweden but any issues should be addressed in the context of ongoing international review of the Basel III standards.

  • Going forward, the stability fund may be reformulated to introduce a risk-based contribution so that a bank taking a higher risk should bear appropriately higher contributions. This should discourage banks from risky activity. However, this should be coordinated with EU level initiatives.

All these regulatory reform actions should be coordinated regionally

  • All major Swedish banks operate extensively in the Nordic-Baltic region, with Swedish authorities as the home supervisor. Sweden’s approach to regulatory reform is most advanced in comparison with other regional supervisors. Thus, notably with respect to the EU, the practice of extensive prior consultation and coordination with other authorities should continue, especially when regulatory standards are set beyond the ex-ante agreed margins, to minimize unintended regulatory arbitrage and to anticipate consequence to other jurisdictions.

And supervision intensity and crisis management needs to be further upgraded

  • If there are legal impediments to the FI’s authority to use Pillar II, these should be removed.

  • In addition, as recommended in the 2011 FSAP Update, legal certainty related to the FI’s power to take corrective and remedial against a weak bank should be resolved, while a special resolution framework for non-systemic financial institutions should be established.

  • With increased resources, the FI should further increase its accountability on resource uses. At the same time, a common understanding is needed that the additional resources should maybe used for FI’s financial stability mandate, rather than being driven into other areas including into the international regulatory reform agenda.

  • There are merits of formalizing the meeting procedures of the Domestic Standing Committee for crisis management, including by regularizing meeting schedule.

  • On the cross-border side, various bilateral and regional Memoranda of Understanding (MOU) and EU-wide arrangements provide the basis for cooperation. Importantly, the 2010 Nordic-Baltic MOU provides the principles of burden sharing. However, this has not been tested. As recommended in 2011 FSAP Update, the authorities are developing a framework to assess how the burden-sharing principles work, especially taking account of fiscal positions of each country. In this light, “war games” could be conducted.

  • But given that the existing cross border arrangements, mostly based on various MOUs, are not legally binding, more assurance is needed. And the ongoing efforts to establish “a resolution and recovery plan” for the largest Swedish banks can be extended to other major banks.

Extension of the CCMP is needed

  • Developing a macroprudential policy institution involves a learning-by-doing process. Given establishment of the CCMP, next steps include establishing a formal macroprudential authority, with a clear financial stability mandate, a set of authorized tools, and accountability obligations. The merits of including a mechanism to reflect regional perspectives are also worth considering.

  • To the extent that the sum of these initiatives slows credit supply and growth, monetary policy should take it into account in the setting of the repo rate and fiscal policy should also accommodate it via automatic stabilizers (see below).

Summary of the Performance and Operation of Swedish Four Major Banks

(In percent unless otherwise indicated, end of period)

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Sources: Banks’ annual reports, SNL Financial, and Fund staff calculations.

With the transition rules. Under the Basel II capital adequacy rules, Swedish banks are allowed to substantially reduce capital adequacy requirements due to their large mortgage portfolios. However, currently, the FSA applies transitional regulations, allowing banks to reduce capital requirements only in stages.

Data for SEB are gross impaired loans to total loans.

B. Fiscal Policy Framework

33. Given that output is close to potential, strong sovereign access to markets, alongside downside external risks and the modest deviation of the fiscal balance from its structural surplus target, the appropriate setting for 2012 would be a mildly supportive stance anticipating a phased return to the structural surplus target thereafter. Along this trajectory, automatic stabilizers would operate in case of moderately weaker/stronger than anticipated activity, with scope to reset the structural fiscal trajectory as well if the global economy deviates markedly from projections.

34. This fiscal stance would not only support near term activity in the face of downside risks, but also boost fiscal buffers by further lowering the public debt-to-GDP ratio in the central case. This would further increase the capacity of the Swedish economy to cope with a sharp and sustained shock by further increasing the likelihood that the sovereign could maintain market access even under severe adverse scenarios (See Box 2).

35. This fiscal trajectory is planned by the authorities. For 2012, as a result of the deceleration of growth and new discretionary measures being introduced as part of the 2012 Budget Bill, thebudget balance is expected to remain at -0.3 percent of GDP in 2012. Revenues would remain subdued in line with weak employment and consumption trends. Expenditures would rise modestly, driven mainly by higher social benefits. The structural balance would on the authorities’ estimates fall to 1.2 percent of GDP implying a stimulus of 0.2 percent of GDP. Based on staff estimates, the structural balance falls to -0.3 percent of potential GDP, implying a stimulus of 0.5 percent of potential GDP. The difference between staff and authorities’ estimates reflects different output gap estimates and different methodologies to calculate the structural balance.

36. Alongside, they have increased the expenditure ceiling between 2014–15 by SEK 20 billion. With this, the expenditure ceiling is expected to increase by 1½ percent in nominal terms over the next four years, which would leave a budgetary margin of about 1 ½ percent of GDP, based on the authorities’ assumptions.

37. Overall, the Budget Bill contains measures of about 0.4 percent of GDP, partly offset as some previous measures expire. Some of this relates to reforms enacted in 2011 which were reinforced by ancillary measures in Budget 2012. The main expansionary measures for 2012 are a lowering of the VAT rate for restaurant and catering services, extra funding for infrastructure investment and a package of active labor market measures (Box 6). Spending will continue to be reined in part due to the non-indexation of key expenditures, a further phasing out of temporary stimulus measures, a decline in unemployment expenditure as the economic recovery takes hold, and the effects of previous reforms (such as reforms of the sickness insurance system).

Sweden: Medium-Term Fiscal Outlook

(Percent of GDP)

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Sources: Ministry of Finance and Fund staff calculations.Note: SB: 2012 Spring Bill.

Structural balance takes into account output and employment gaps.

Overall balance adjusted for the output gap, based on authorities’ measure.

38. Over the medium term, the authorities plan for revenues as a percentage of GDP to remain largely unchanged, with the fiscal balance strengthening to target due to a declining expenditure ratio—in line with the 4-year nominal spending ceilings. The overall balance would exceed 1 percent of GDP by 2014, and continue to strengthen further over the medium term.

39. Alongside, the authorities have outlined a number of additional measures, contingent on the availability of fiscal space, that focus mainly on increasing labor supply and include further strengthening the “in-work” tax credit and further raising the lower threshold for the state income tax. They also propose reviewing corporate taxation, and tax cuts for pensioners.

40. In this context, the tax structure can be further improved to support growth in the more challenging global context. Tax expenditures are considerable—including multiple VAT rates which significantly curb VAT collections despite one of the highest standard VAT rates in the OECD. With distributional concerns attenuated by strong Gini coefficient scores of 0.23 and the possibility of direct support to low-income households through targeted spending, a restructuring of the VAT could improve the efficiency of the tax system. The resulting additional VAT collections would create room to implement reforms that reduce further the overall wedge between employers’ gross pre tax labor costs and real take-home pay.

41. Tax and expenditure measures aimed at supporting employment of vulnerable groups should be better targeted. Though it is too soon to measure the employment impact of recent reductions in employer social security contributions for young workers and of the VAT on restaurants, measures more specifically designed to affect workers with greater difficulties in entering the labor market would likely be more effective.

42. Additional measures could be put in place to reduce the procyclicality of local governments’ fiscal position. In view of the balanced budget rules at the local level, the authorities should consider the merits of allowing them greater flexibility to establish and manage rainy-day contingency funds. This is particularly important if, under current policy, the structural surplus target rule for the central government is procyclical ex-post (with the actual structural surplus exceeding historically the 1 percent target).

43. More generally, adherence to the fiscal surplus target rule over the medium term remains fully appropriate. Absent shocks, the rule will keep debt on a downward trajectory, but this is unlikely—as simple extrapolation might suggest—to make the Swedish sovereign a net creditor. Instead, that trajectory will be disturbed by standard business cycle downturns, pushing debt back up, and may be further disturbed by tail risk shocks. As evident from the global crisis, several countries with large financial systems experienced leaps in public debt, both reflecting the impact of automatic stabilizers and direct financial sector support. With those tail risks still evident in Europe, it remains appropriate for Sweden to maintain a determined effort—as reflected in its surplus target rule—to build buffers to increase its ability to withstand such risks, until those risks are eliminated (See Box 2). The Fiscal Policy Council continues to play an effective role in promoting public awareness of fiscal issues. Further increases in its resources and its focus on sustainability would reinforce the credibility of the fiscal framework. These fiscal policy settings would also allow monetary policy to respond to possible external developments—easing if capital inflows continue alongside weak external demand, and tightening if activity and domestic inflationary pressures surge.

C. Monetary Policy and Framework

44. With the repo rate above the lower effective bound and a fully flexible exchange rate and the krona likely to depreciate in an adverse tail risk scenario, monetary policy instruments have room to make decisive adjustments should tail risks materialize. Monetary policy should thus continue to be set according to the baseline scenario.

45. Under that baseline scenario, for now, given the benign inflation outlook, modest cost pressures and the prospect of a temporary slowdown in demand, the repo rate is appropriately set at 1½ percent. The rate path should, however, be adjusted to reflect the potential impact of stricter banking regulation and fiscal withdrawal as long as economic slack persist. Macroprudential instruments—e.g. tightening LTV rules further, adjusting risk-weighted assets, limiting loans’ length—should be deployed further if the housing market reflates once again.

46. The monetary and free floating exchange rate frameworks remain credible, as indicated by inflation expectations and recent reviews. However, persistent deviations of market forward rates (and survey expectations) from the projected official rate have occurred. Although inflation expectations have remained firmly anchored around the Riksbank’s medium-term target, continued credibility relies on markets believing the monetary authorities, to ensure an effective transmission of the short term policy rate to market rates, other asset prices, and the real economy. For these reasons, persistent and significant disbelief concerning the authorities’ projected policy rate outlook could, eventually impair the monetary transmission mechanism and, possibly, undermine broader credibility.

47. To address this issue, the Riksbank could start publishing macroeconomic forecasts conditioned on market-implied domestic and foreign forward rates, in addition to forecasts conditioned on its preferred path for the policy rate, and keep the commitment to publish its expected policy rate path under review (See Chapter III of the Selected Issue Paper).

48. Alongside, and in the context of initiatives to establish a macroprudential council, consensus on the mandate of the Riksbank with regard to asset prices and financial stability should be sought. And the Riksbank should raise its research efforts further in the area of equilibrium unemployment, including analysis of its composition, and of macrofinancial linkages as key inputs into policy rates setting.

49. And while gross international reserves are 50.4 USD or 344.7 SEK billion, some 23 percent of imports, and 14.8 percent of short term external debt, the liquidity gap approach developed by staff last year suggests that there is a case to increase foreign exchange reserves now.1 In particular, the probability that reserves might be exhausted in the context of a tail risk event, such as default by one of the European sovereigns now under market pressure, has risen relative to that likelihood a year ago. Should this probability rise further, the authorities should match their efforts to boost resilience in other areas by raising reserve cover also.

D. Structural Reform Policy

50. Sweden’s extensive structural reforms since the early 1990s have boosted trend growth and employment, as well as strengthening resilience to shocks. Thus, increases in unemployment in 2008–09 fell far short of expectations, and employment recovered promptly thereafter. And participation rates held up throughout, in contrast to a number of OECD countries.

51. However there are areas of concern:

  • The reforms could be better targeted at helping those particular groups of workers facing the most challenges, including workers with weak attachment to the labor market (for example, the reduction in payroll taxes for new entrants applies to the entire population of young potential workers, but only a fraction of these needs help in finding a job).

  • Recent reforms also reduced the scope and resources for active labor market policies. But shortfalls in the effectiveness of these programs likely reflected their particular design—elsewhere, such as in Denmark, reforms have better focused these initiatives rather than curtailing them.

52. In contrast to broad initiatives in other sectors, the Swedish housing market is substantially unreformed, notably the rental and sub-let markets which are subject to severe regulations. Given Sweden’s fast and ongoing urbanization trend, particularly toward the greater cities (Stockholm, Gothenburg and Malmo), the lack of rental property on the market has been one key determinant of house price surges (and house price resilience) over the past years. In this light:

  • Deregulation of rental markets could reduce shortages and improve employment prospects as well as skill shortages, particularly in the main cities, with likely impacts on potential output growth in the medium term;

  • This would help to raise investment in residential property—where Sweden scores amongst the lowest in the EU. This will require initiatives at the local and central government level to raise the amount of land available for construction, in order to ensure that supply rises in line with fundamentals and to prevent a further acceleration in prices.

The Authorities’ Views

53. The authorities agreed with the overall assessment of economic developments in Sweden and internationally, and the implications for policy including in the financial sector.

54. More specifically, they noted concerns with the macrofinancial implications of high household debt, and in this context sought early strengthening of bank capital and various improvements in the macroprudential policy architecture. In addition, they emphasized need to build fiscal buffers further, while, in that context, also seeing scope for free application of automatic stabilizers in the near term. This stance, and the recent relaxation of monetary policy would support activity, with macroprudential measures in place to stabilize the housing market. Policymakers stand ready to adjust policy settings in the event of a major global shock.

55. Within that overall agreement, however, some differences of emphasis from the staff were noted:

Financial Sector Policies

  • The authorities do not see strong evidence that the quality of new mortgage lending raises prudential concerns because borrowing households have sufficient capacity to repay debt even under macroeconomic stress scenarios, while more marginal borrowers are unlikely to have access to credit—so that, for instance, increases in temporary employment contracts in recent years would not materially affect overall risk of credit losses. Nevertheless, these matters would remain under close scrutiny.

  • The authorities agreed with staff that the status quo of the macroprudential supervisory architecture is not satisfactory, but they noted that the proper role of the Ministry of Finance in any better structures remains open. While all agree that the Ministry should be deterministic in resolution and crisis management, and that it should not be responsible for making stability assessments and recommendations at other times, there is not yet agreement on where to draw the line between those two circumstances, nor on how that line should be drawn. The matter will be considered further in the “Government Investigation on Financial Crisis Prevention and Management Issues” (the Franzén Commission), though the authorities intend, in the meantime, to put the Consultation group2 on a more solid footing.

  • The fiscal authorities emphasized need make progress to further reinforce financial sector stability but also cautioned that steps taken should not risk, inadvertently, causing disorderly adjustments in credit markets or financial institutions. In securing this balance, they inclined to proceed in a sequence, with initiatives phased according to the strength of economic conditions—accelerating in good times when markets could more easily absorb them, and being prudently paused otherwise.

Fiscal Policy and Framework

  • The authorities estimate a stronger underlying fiscal position than the staff for 2011–12. This reflects the authorities’ use of the OECD aggregate elasticity of 0.55, in contrast to the staff’s disaggregated adjustments using both output and employment gaps. Specifically, the fiscal authorities’ estimates of the cyclically adjusted balance in 2011–12 are 0.7 and 1.2 percent of potential GDP, respectively. Meanwhile, staff’s estimates are 0.1 percent of potential GDP for 2011 and -0.4 percent of potential GDP for 2012.

  • In contrast to staff’s view that further stimulus in 2013 should be contingent on weaker than expected activity, the authorities indicated that they see scope, partly reflecting their estimate of the structural surplus, to implement discretionary measures in 2013, specifically to undertake greater investment spending.

  • The authorities see recent measures to address youth unemployment, such as the reduction in employer social security contributions and the reduction of the rate of VAT on restaurants, as a way to increase the opportunities of young workers entering the labor market, while staff believes that better targeted measures would be more appropriate.

Monetary Policy and Framework

  • The authorities see the existence of a large and persistent wedge between their projected official rate and markets’ implied interest rate expectations as somewhat problematic, while emphasizing that measurements of implied expectations are inherently imprecise and uncertain. The wedge is not seen as harming the central bank’s credibility on the grounds that inflation expectations continue to remain anchored around the inflation target. They intend to continue publishing their own preferred policy paths, as it has served well as a communication tool.

  • The current understanding in the majority on the MPC is that it is appropriate to take into consideration financial stability issues. This stance will be reviewed in the context of initiatives to establish a macroprudential council.

  • The monetary authorities have participated in a domestic discussion on estimates of the long-run sustainable rate of unemployment. Further analysis will be made, even though the returns in terms of improved information for rate setting are seen as low.

Staff Appraisal

56. Sweden has long secured strong growth, low inflation, declining government debt, rising incomes, and a strong external position. But trade and financial linkages mean that prospects are closely tied to those of Europe—reflected in the V-shaped passage through the Great Recession, and rising stresses in the banking system and declining underlying growth momentum since mid-2011.

57. Monetary and fiscal policies have responded well to this cycle, both tightening appropriately as output recovered in 2010–11 and easing in the latter parts of 2011. And on the structural side, various actions were launched in support of employment. Nonetheless, with exports likely soft, muted annual GDP growth is projected in 2012, albeit with activity regaining steam from mid-year, with European fragilities implying significant tail risks.

58. Policies are well calibrated. In particular, the government budget remains firmly guided by its medium-term rules, thereby allowing automatic stabilizers to operate. And with medium-term inflation expectations anchored at the target, the monetary policy stance remains accommodative. And policies have room to make decisive adjustments should tail risks materialize.

59. But the challenges are extensive.

60. On the financial stability side, though direct exposures to strained Euro Area economies are negligible and risk-weighted bank capital is high, the financial system is large, directly exposed to Europe, highly concentrated, and reliant on wholesale funding, with low raw capital ratios. Furthermore, vulnerabilities are apparent in elevated household debt, the soft housing market, and employment and income uncertainties. While standard financial sector stress tests reassure, shocks could go well beyond the historical norms they assume.

61. In this light, the EU-wide banking regulations under the Fourth Capital Requirements Directive will be key. Given the common floor, the particular risks in Sweden and the lack of a common European banking backstop argue for full use of the flexibility for national regulators given in that agreement to implement country-specific macroprudential policies.

62. So the authorities rightly plan to raise capital requirements for the four major banks in steps in 2013 and 2015, augmented by needed increases in risk weights for mortgages, alongside tighter liquidity regulations and strengthened supervisory resources, focus, and coordination. In this context, the practice of extensive prior consultation and coordination with European partners should continue.

63. But considerably more remains to be done. Additional steps include ensuring that supervisors are able to make effective use of “Pillar 2”, and securing an appropriate application of the additional regulatory resources that have been provided. Other necessary steps include strengthening early intervention and resolution powers of the supervisors, assessments (as for capital) of the adequacy of international liquidity standards for Sweden, extension of resolution planning to all major banks, and deepening regional supervisory coordination and crisis management under the Nordic-Baltic arrangements. Establishment of a macroprudential authority is under consideration. It will be key to have clarity on the stability mandate, decision-making structure, tools, and accountability—all respecting the independence of the Riksbank and bank supervisors.

64. On the fiscal side, output close to potential, strong access to market financing, risks tilted to the downside, and the credibility of the medium-term fiscal rules framework all call for and allow for the automatic stabilizers to operate unimpeded. And given tail risk of large jumps in public debt, this budget stance also retains appropriately large fiscal buffers.

65. In this context, both the modest relaxation of the fiscal deficit in 2012 which leaves public debt on a downward trajectory, and the framework of rules targeting 1 percent of GDP surplus over the cycle and nominal expenditure ceilings are appropriate.

66. In addition, the tax structure could be more “growth friendly”, notably via better-targeting of tax and expenditure measures. And actions to bolster further the Fiscal Policy Council—notably by further increasing its resources and its focus on sustainability—would reinforce the credibility of the fiscal framework.

67. On the monetary side, the stance is appropriately accommodative given the benign inflation outlook, modest cost pressures, and a temporary slowdown in demand. Monetary policy should continue to be set according to the baseline scenario—offsetting any drag on activity emanating from prudential actions while slack in the economy remains. The stance of policy can be adjusted rapidly if tail risks are realized. Macroprudential instruments should be deployed further if the housing market reflates once again.

68. The monetary and free floating exchange rate frameworks remain credible. However, given persistent deviations of market forward rates from the projected official rate, the Riksbank could also start publishing macroeconomic forecasts conditioned on market implied forward rates, and keep the commitment to publish its expected policy rate path under review. Alongside, consensus on the role of asset prices and financial stability in monetary policy objectives should be sought.

69. And on structural reforms, with labor market entrants particularly exposed to European tail risks, steps being actively considered by the social partners to increase the accommodation of new entrants in employment contract structures are strongly supported. And in the housing sector, deregulation of rental market could reduce shortages and improve employment prospects, notably in the main cities.

70. It is recommended that Sweden remains on the standard 12-month Article IV consultation cycle.

Should Sweden Be Concerned of Adverse Inward Spillovers from Europe?

So far Europe’s sovereign debt turmoil had modest financial and trade effects on Sweden. While Sweden’s stock and credit market volatility increased as the crisis erupted in the summer of 2011, corporate bond spreads have increased modestly since early September, and short-term funding markets have been largely unaffected, owing to the economy’s relatively strong fundamentals. In addition, government yields have declined benefiting from investors’ flight to quality. However, in the last quarter of 2011, Sweden’s trade account has been significantly impacted by the European crisis due to its considerable exposure to European trade.

Going forward, a scenario of increased financial market stress in Europe, could trigger larger effects. With 70 percent of Swedish total exports going to the EU, Sweden’s direct trade exposure is large. In addition, spillovers of Europe to the rest of the world may affect Sweden’s exports indirectly. Further developments could increase uncertainty of the global recovery, soften the EU demand for Swedish exports, and dampen global demand for commodities—which Sweden exports.

Sweden: Exports to Europe

(Percent of GDP, merchandise exports)

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

Despite recent pressures in European banking markets, there have been no material dislocations in Swedish financial markets. Sweden’s banks’ total financial claims on peripheral European economies are modest as a share of assets and Tier-1 capital. Claims on smaller European economies (like Denmark and Finland) linked to the Euro Area as well as on larger European economies, including the U.K., are significantly larger, however.

Sweden: Banks’ Total Financial Claims on the Nordic-Baltic Region, 2011

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Sources: Bank of International Settlements, Haver Analytics, Statistics Sweden, and Fund staff’s calculations.

Fiscal Buffers: How Big Are They? How Big Should They Be?

Fiscal buffers are adequate if the Swedish sovereign is able to maintain market access through and after a “large” shock. This critically depends on the impact on public debt of the shocks that could occur, and the threshold debt level at which market access is lost.

In this regard, a useful exercise is to replicate the experience of countries severely affected by the global financial crisis, within the Swedish fiscal framework. Specifically, the exercise entails using as macroeconomic assumptions for the fiscal forecast the observed growth, employment, consumption, financial sector support, and real exchange rate developments of the United Kingdom, the United States, and Iceland since 2008. The main advantage of this approach is that the shock is plausible (and has in fact taken place elsewhere recently, in the contest of the global turmoil) and would allow each macroeconomic factor to respond in a distinct manner to the shock. This exercise does not assume any type of fiscal policy response, either to contain the decline in growth or to reverse the deterioration of the fiscal accounts.

Table 1 shows the projections. If economic activity were to behave as it did in the United Kingdom and the United States, the fiscal deficit would deteriorate by about 3 percentage points of GDP, through a combination of lower revenues as consumption contracts, and higher expenditure in response to the decline in employment. Debt to GDP would rise to about 50 percent of GDP, including the cost of the banking sector support.

In contrast, the impact of a shock like that faced by Iceland would be more severe. The fiscal balance would deteriorate by about 8½ percent of GDP, mainly due to a collapse in consumption and employment. In this case, debt to GDP would rise above 80 percent of GDP, including the financial sector support (assumed to be only half that of Iceland, in proportion to the size of Sweden’s financial sector).

The second step in the analysis is to consider at what level of public debt Sweden risks losing market access. Determining such a threshold is difficult. Sweden’s experience during the 1990s crisis showed that the sovereign was able to retain market access with debt to GDP ratios close to 75 percent, but at a high cost. This suggests that debt ratios beyond this level could result in market pressures. Furthermore, under a tail scenario affecting Europe in coming years, this threshold could well be optimistic, as many countries would simultaneously be seeking to finance large borrowing requirements in the context of disorderly global financial markets.

This analysis has clear implications for the authorities’ current policy stance. While Sweden would be able to accommodate a shock similar to that recently faced by the United Kingdom and the United States without losing market access, it is unlikely to be able to absorb a shock as large as seen in Iceland. In this light, the authorities’ preference to continue to build buffers is cautious, but given the scale of the impact of possible European tail risks, appropriately so.

Sweden: Alternative Fiscal Shocks

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Sources: IMF World Economic Outlook and Fund staff calculations

How Strong is the Pass-through from Repo Rates to Mortgage Rates in Sweden?

As emphasized by analysis by the Riksbank in the February 2012 Monetary Policy Report, the pass-through of monetary policy impulses from the policy rate to mortgage rates has weakened according to various measurements over the past year. When assessed relative to before the crisis this phenomenon is milder but still not equaled in peer countries, with the exception of the United Kingdom.

Prior to the crisis, mortgage pass-through, measured by the simple correlation coefficient between the repo rate and the effective interest rate on housing loans to households and NIPSHs, indicated that Sweden had a very strong transmission to long-term rates in this category of lending. The correlation coefficient of 0.99 compares favorably with the U.K. (0.82) and well above that of the U.S. (0.67) and Germany (0.65).

Since 2008Q1, the pass-through in Sweden (measured by the correlation coefficient between the policy and mortgage rates) has dropped marginally, though, according to this metric (to 0.96), even if it remains higher than that of any of the comparators.

Mortgage Interest Rate Passthrough from Repo Rates

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Sources: Haver Analytics and Fund staff calculations.

Calculated as the correlation coefficient of the effective interest rate on housing loans to households and repo rates.

Competitiveness and the Equilibrium Real Exchange Rate

Since September 2008, the Swedish krona has fluctuated substantially, and the krona has now (end March 2012) appreciated in real effective terms by over 25 percent since its trough in early 2009 (and by around 30 percent against the euro).

According to OECD PPP-measures of February 2012, the krona is at its highest level for 40 years.

However, staff’s estimates based on the IMF’s new External Balance Assessment (EBA) methodology, suggest that the krona remains undervalued relative to its long-run equilibrium, broadly in line with the assessment arrived at using the IMF’s old CGER methodology using data up to Fall 2011.

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There are caveats to these results:

1. Staff’s longstanding finding of undervaluation sits uneasily with the absence of distortions and no foreign exchange rate intervention for over a decade

2. Pension and other social protection reforms—notably a phased shift to defined contributions pension scheme and a progressive shrinkage in transfers, like unemployment benefits—since the mid 1990s have raised household net saving—but these factors are not reflected in the CGER or EBA.

3. While the EBA is based on a NFA of 20 percent of GDP, the cumulative sum of current account surpluses over the past decade suggests NFAs around 100 percent of GDP—qualifying Sweden as a financial centre. This would raise its CA/GDP norm in the EBA analysis.

4. So great caution is needed when inferring krona misalignments based on the sustainability of the country’s NFA/GDP trajectory. Alongside other indicators the staff assessment is that the currency is competitive, although there are wide margins of uncertainty.

In line with these considerations, the staff’s overall assessment is that Sweden’s structural current account is now around 2–4 percent higher than what suggested by medium-term fundamentals, which, in turn, have been strong relative to the Euro Area, including from wage moderation, and safe-haven flows.

The strength of the external sector suggests an undervaluation. However this likely reflects some structural factors such as higher savings rates following the phased-in pension reform, which are unlikely to adjust quickly.

1 The range in the first cell captures differences in the cyclically-adjusted current account and the current account norm in the new EBA estimates.

How Vulnerable Is Sweden’s Housing Market?

The residential real estate cycle may have reached its long-predicted peak in Sweden. Housing starts halved over 2011 while the real prices dropped substantially in the second half of 2011 (-3.5 percent cumulatively) and remained flat in 2012 Q1 (q-o-q). The surge in late 2010 and early 2011, following the decline through 2008, appears to have been due to buyers taking advantage of the low interest rate environment and to the abolition of the real estate tax in 2008 in favor of a municipal tax set at the lower of SEK 6,825 (around 969 euros) or 0.75 percent of the property’s assessed value. Indeed, in the two years to 2011 Q2, residential investment (+37 percent) took off again, contrary to more muted developments during the previous recovery, offsetting the sharp drop in new homebuilding experienced during the global crisis.


Advanced Economies: Previous versus Current Housing Cycles

Citation: IMF Staff Country Reports 2012, 154; 10.5089/9781475506068.002.A001

Sources: OECD and Fund staff calculations.

Going forward, several factors may indicate further downward pressure on house prices. First, price-to-income and price-to-rent ratios remain 1.1 and 1.4 standard deviations respectively above historical averages. Second, staff’s model-based estimates from the Early Warning Exercise (EWE) and Vulnerability Exercise for Advanced Countries (VEA) suggest an overvaluation around 11–12 percent, exceeding the 10 percent threshold. (The EWE real estate model combines these three indicators to create a heat map for house price valuation.) Moreover, the predicted path of house prices based on WEO income projections suggests a decline of almost 5–6 percent through 2017.

These indicators put Sweden among the advanced countries where a house price correction is most likely to take place. Yet, the point estimate for the house price disequilibrium (the difference between actual prices and estimated equilibrium or long-run prices) is not large by historical standards, and Sweden ranks only 9th among 22 advanced economies in the VEA sample in terms of potential overvaluation.

Furthermore, other components of residential real estate vulnerability (namely, potential impact on GDP, household balance sheets, and mortgage market characteristics) remain moderate or low in Sweden, compared to other advanced economies. That said, with most mortgages being “rollover” mortgages with terms of at most five years, any future interest rate increases could put additional strains on already highly indebted households.

Key Measures in the 2012 Budget Bill

With ongoing global uncertainty, the 2012 Budget Bill announced the implementation of temporary measures that balance the need to address the slowdown in economic activity while keeping public finances in good order. These measures, some of which are temporary, are estimated at about 0.4 percent of GDP for 2012 and 2013. The measures with the largest fiscal impact include:

Lowering of VAT rate of restaurant and catering services: Reduction of the VAT rate from 25 percent to 12 percent. This would bring it in line with the VAT rate on food and hotel services.

Infrastructure investment: Temporary augmentation of funds for infrastructure maintenance and investments on road and railway networks, giving priority to the most economically important routes.

Labor market measures: Structural measures to improve employment services and monitoring of job seeking activities, and more places in labor market programs for people at risk of long-term unemployment. Temporary increases in the number of employment training and work experience places, and in the number of places in vocational education.

Tax measures of business and savings: Simplification of taxation of foreign experts, changes in the rules of closely held companies (3:12 rules), introduction of investment savings account, changes to the taxation of endowment insurance, and increase the deduction for research and development expenditure.

Sweden : Reforms in the 2012 Budget Bill

(Percent in GDP)

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Sources: Ministry of Finance and Fund staff calculations.
Table 1.

Sweden: Selected Economic Indicators, 2009–13

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Sources: IMF Institute, Riksbank, Sweden Ministry of Finance, Thomson Reuters Datastream, and Fund staff calculations.

Based on relative unit labor costs in manufacturing.

Table 2.

Sweden: Financial System Structure, 2002–11

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Sources: Financial Supervisory Authority, Riksbank, and Fund staff calculations.

Including branches in abroad.

Not including minor local companies

Market value of funds

Number of institutions is computed on unconsolidated basis.

Table 3.

Sweden: Financial Soundness Indicators: Banks, 2003–11

(End of period, in percent)

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Sources: Financial Supervisory Authority, Riksbank, and Fund staff calculations.

From 2007, the calculation of capital base follows rules under Basel II.

On consolidated basis

From 2010 onward, exposures to credit institutions are included.

Non consolidated bases, and parent banks only. Monetary financial institutions include banks and housing credit institutions.