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)

Sources: Statistics Sweden and IMF staff calculations.

Sweden: Near Term Economic Developments, 2009–11

(Q/Q percent change, seasonally adjusted)

		2009					2010					2011
		Q1	Q2	Q3	Q4	Annual	Q1	Q2	Q3	Q4	Annual	Q1	Q2	Q3	Q4	Annual
Real GDP		−2.4	0.1	0.0	1.0	−5.0	2.1	2.0	1.6	1.7	5.9	0.4	1.1	0.7	−1.0	4.0
	Private Consumption	0.0	1.3	0.4	0.4	−0.2	1.8	−0.2	1.8	0.8	3.6	0.3	1.0	−1.0	0.5	2.0
	Public Consumption	1.1	−0.1	0.6	0.3	2.0	0.2	0.8	0.4	0.9	1.7	0.3	0.5	0.2	0.1	1.9
	Gross Fixed Capital Formatio	−7.8	−2.5	−2.7	1.0	−14.8	3.6	2.2	4.5	2.3	6.9	−0.5	2.9	0.8	1.5	7.0
	Exports	−5.9	−2.6	0.0	1.4	−12.4	4.1	4.6	1.9	4.3	10.3	0.6	1.1	2.7	−3.8	7.2
	Imports	−8.2	−5.0	4.6	2.5	−14.1	3.4	4.4	4.1	0.3	12.2	3.0	0.2	−0.2	−0.4	6.4
CPI		0.2	1.1	0.3	0.7	2.0	0.5	0.3	−0.2	1.2	1.9	0.0	0.7	−0.3	0.5	1.4
GDP Deflator		−1.3	1.9	4.5	−4.4	2.0	−0.7	1.2	4.8	−3.5	1.3	−1.6	1.9	4.6	−4.5	0.9
Nominal GDP		−3.6	2.0	4.6	−3.4	−3.1	1.4	3.3	6.5	−1.8	7.2	−1.2	3.0	5.3	−5.5	4.9

Sources: Statistics Sweden and IMF staff calculations.

View Table

Sweden: Near Term Economic Developments, 2009–11

(Q/Q percent change, seasonally adjusted)

		2009					2010					2011
		Q1	Q2	Q3	Q4	Annual	Q1	Q2	Q3	Q4	Annual	Q1	Q2	Q3	Q4	Annual
Real GDP		−2.4	0.1	0.0	1.0	−5.0	2.1	2.0	1.6	1.7	5.9	0.4	1.1	0.7	−1.0	4.0
	Private Consumption	0.0	1.3	0.4	0.4	−0.2	1.8	−0.2	1.8	0.8	3.6	0.3	1.0	−1.0	0.5	2.0
	Public Consumption	1.1	−0.1	0.6	0.3	2.0	0.2	0.8	0.4	0.9	1.7	0.3	0.5	0.2	0.1	1.9
	Gross Fixed Capital Formatio	−7.8	−2.5	−2.7	1.0	−14.8	3.6	2.2	4.5	2.3	6.9	−0.5	2.9	0.8	1.5	7.0
	Exports	−5.9	−2.6	0.0	1.4	−12.4	4.1	4.6	1.9	4.3	10.3	0.6	1.1	2.7	−3.8	7.2
	Imports	−8.2	−5.0	4.6	2.5	−14.1	3.4	4.4	4.1	0.3	12.2	3.0	0.2	−0.2	−0.4	6.4
CPI		0.2	1.1	0.3	0.7	2.0	0.5	0.3	−0.2	1.2	1.9	0.0	0.7	−0.3	0.5	1.4
GDP Deflator		−1.3	1.9	4.5	−4.4	2.0	−0.7	1.2	4.8	−3.5	1.3	−1.6	1.9	4.6	−4.5	0.9
Nominal GDP		−3.6	2.0	4.6	−3.4	−3.1	1.4	3.3	6.5	−1.8	7.2	−1.2	3.0	5.3	−5.5	4.9

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)

Sources: Statistics Sweden and IMF staff calculations.

Sweden: Near Term Economic Developments, 2012–13

(Q/Q percent change, seasonally adjusted)

		2012					2013
		Q1	Q2	Q3	Q4	Annual	Q1	Q2	Q3	Q4	Annual
Real GDP		0.8	0.0	0.4	0.5	1.0	0.7	0.7	0.7	0.7	2.3
	Private Consumption	1.1	0.2	0.2	0.2	1.5	0.5	0.5	0.5	0.5	1.6
	Public Consumption	0.0	0.2	0.3	0.3	0.2	0.2	0.2	0.3	0.2	0.8
	Gross Fixed Capital Formatio	3.4	−2.5	−0.5	0.1	3.5	1.5	1.5	1.5	1.5	3.0
	Exports	1.1	−0.1	0.5	0.5	0.0	1.5	1.5	1.5	1.5	4.4
	Imports	−0.4	−0.3	−0.2	−0.2	−1.2	1.5	1.5	1.5	1.5	3.5
CPI		0.1	0.5	0.5	0.5	1.2	−0.1	−0.1	−0.1	−0.1	2.0
GDP Deflator		−0.5	2.0	5.3	−3.6	1.9	−1.5	2.0	5.3	−3.6	2.0
Nominal GDP		0.2	2.0	5.7	−3.1	2.9	−0.8	2.7	6.0	−2.9	4.4

Sources: Statistics Sweden and IMF staff calculations.

View Table

Sweden: Near Term Economic Developments, 2012–13

(Q/Q percent change, seasonally adjusted)

		2012					2013
		Q1	Q2	Q3	Q4	Annual	Q1	Q2	Q3	Q4	Annual
Real GDP		0.8	0.0	0.4	0.5	1.0	0.7	0.7	0.7	0.7	2.3
	Private Consumption	1.1	0.2	0.2	0.2	1.5	0.5	0.5	0.5	0.5	1.6
	Public Consumption	0.0	0.2	0.3	0.3	0.2	0.2	0.2	0.3	0.2	0.8
	Gross Fixed Capital Formatio	3.4	−2.5	−0.5	0.1	3.5	1.5	1.5	1.5	1.5	3.0
	Exports	1.1	−0.1	0.5	0.5	0.0	1.5	1.5	1.5	1.5	4.4
	Imports	−0.4	−0.3	−0.2	−0.2	−1.2	1.5	1.5	1.5	1.5	3.5
CPI		0.1	0.5	0.5	0.5	1.2	−0.1	−0.1	−0.1	−0.1	2.0
GDP Deflator		−0.5	2.0	5.3	−3.6	1.9	−1.5	2.0	5.3	−3.6	2.0
Nominal GDP		0.2	2.0	5.7	−3.1	2.9	−0.8	2.7	6.0	−2.9	4.4

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.

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:

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)

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

^1/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.

^2/Data for SEB are gross impaired loans to total loans.

Summary of the Performance and Operation of Swedish Four Major Banks

(In percent unless otherwise indicated, end of period)

		Nordea			SEB			Handelsbanken			Swedbank			Median of 44 European and US banks
		2009	2010	2011	2009	2010	2011	2009	2010	2011	2009	2010	2011	2011
Capital
	Tier 1 core capital ratio to risk weighted assets 1/	10.3	10.3	11.2	11.7	12.2	13.7	11.7	13.8	15.6	12.0	13.9	15.7	10.2
	Tier 1 ratio to risk weighted assets 1/	11.4	11.4	12.2	13.9	14.2	15.9	14.2	16.5	18.4	13.5	15.2	17.2	12.3
	Total capital to risk weighted assets 1/	13.4	13.4	13.4	14.7	13.9	15.2	20.2	20.9	20.9	17.5	18.4	18.9	15.1
	Leverage (Tier 1 as a percent of total assets)	4.1	4.0	3.8	4.0	4.3	4.2	3.5	3.6	3.4	4.3	4.6	4.4	…
Assets
	Gross impaired loans to total loans at amortized costs 2/	1.9	1.9	2.0	1.5	1.3	0.8	0.6	0.6	0.4	5.9	5.2	3.4	3.7
	Net impaired loans to total loans at amortized costs	0.9	0.9	1.1	0.5	0.5	0.3	0.2	0.2	0.2	2.9	2.5	1.7	…
Earnings and profitability
	Return on assets	0.5	0.5	0.4	0.0	0.3	0.5	0.5	0.5	0.5	−0.6	0.4	0.7	0.7
	Return on equity	11.4	11.5	10.6	1.2	6.9	10.8	13.1	13.0	13.8	−12.7	8.2	12.2	8.4
Liquidity
	Loans to customers deposits	197.6	198.7	199.5	148.3	151.1	137.7	320.6	322.5	325.1	269.9	234.7	236.9	89.5
	Deposits maturing less than 3 months to total deposits	17.0	19.4	22.1	28.7	69.4	36.5	3.2	…	…	9.8	11.8	16.7	…
	On demand deposits to total deposits	74.7	71.9	68.9	55.4	14.7	49.0	93.7	…	…	82.1	82.6	76.3	…
Memorandum item:
	Total assets in percent of GDP	173.5	166.3	185.1	74.3	65.4	67.6	68.4	64.7	70.3	57.8	51.5	53.2	…

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

^1/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.

^2/Data for SEB are gross impaired loans to total loans.

View Table

Summary of the Performance and Operation of Swedish Four Major Banks

(In percent unless otherwise indicated, end of period)

		Nordea			SEB			Handelsbanken			Swedbank			Median of 44 European and US banks
		2009	2010	2011	2009	2010	2011	2009	2010	2011	2009	2010	2011	2011
Capital
	Tier 1 core capital ratio to risk weighted assets 1/	10.3	10.3	11.2	11.7	12.2	13.7	11.7	13.8	15.6	12.0	13.9	15.7	10.2
	Tier 1 ratio to risk weighted assets 1/	11.4	11.4	12.2	13.9	14.2	15.9	14.2	16.5	18.4	13.5	15.2	17.2	12.3
	Total capital to risk weighted assets 1/	13.4	13.4	13.4	14.7	13.9	15.2	20.2	20.9	20.9	17.5	18.4	18.9	15.1
	Leverage (Tier 1 as a percent of total assets)	4.1	4.0	3.8	4.0	4.3	4.2	3.5	3.6	3.4	4.3	4.6	4.4	…
Assets
	Gross impaired loans to total loans at amortized costs 2/	1.9	1.9	2.0	1.5	1.3	0.8	0.6	0.6	0.4	5.9	5.2	3.4	3.7
	Net impaired loans to total loans at amortized costs	0.9	0.9	1.1	0.5	0.5	0.3	0.2	0.2	0.2	2.9	2.5	1.7	…
Earnings and profitability
	Return on assets	0.5	0.5	0.4	0.0	0.3	0.5	0.5	0.5	0.5	−0.6	0.4	0.7	0.7
	Return on equity	11.4	11.5	10.6	1.2	6.9	10.8	13.1	13.0	13.8	−12.7	8.2	12.2	8.4
Liquidity
	Loans to customers deposits	197.6	198.7	199.5	148.3	151.1	137.7	320.6	322.5	325.1	269.9	234.7	236.9	89.5
	Deposits maturing less than 3 months to total deposits	17.0	19.4	22.1	28.7	69.4	36.5	3.2	…	…	9.8	11.8	16.7	…
	On demand deposits to total deposits	74.7	71.9	68.9	55.4	14.7	49.0	93.7	…	…	82.1	82.6	76.3	…
Memorandum item:
	Total assets in percent of GDP	173.5	166.3	185.1	74.3	65.4	67.6	68.4	64.7	70.3	57.8	51.5	53.2	…

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

^1/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.

^2/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)

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

^1/Structural balance takes into account output and employment gaps.

^2/Overall balance adjusted for the output gap, based on authorities’ measure.

Sweden: Medium-Term Fiscal Outlook

(Percent of GDP)

	2011	2012		2013		2014		2015		2016
	Prelim.	SB	IMF	SB	IMF	SB	IMF	SB	IMF	SB	IMF
Revenues	49.7	50.1	49.5	49.7	49.8	49.4	49.9	49.5	49.7	49.3	49.8
Expenditures	49.6	50.4	49.7	49.3	49.2	47.8	48.4	46.5	47.5	45.7	47.2
Net lending	0.1	−0.3	−0.2	0.3	0.6	1.6	1.5	3.0	2.1	3.7	2.6
Central government balance	−0.1	−0.3	−0.1	0.7	0.9	1.7	1.7	3.1	2.3	3.8	2.8
Pension system balance	0.5	0.2	0.2	−0.2	−0.2	0.0	0.0	0.0	0.0	−0.1	−0.1
Local government balance	−0.3	−0.2	−0.2	−0.1	−0.1	−0.1	−0.1	−0.1	−0.1	−0.1	−0.1
Structural balance (percent of potential GDP) 1/	0.2	…	−0.3	…	0.5	…	1.5	…	2.1	…	2.6
Structural balance (percent of potential GDP) 2/	−0.3	1.2	0.1	1.6	0.8	2.1	1.6	3.2	2.2	3.7	2.6
Output gap (percent of potential)	0.8	−2.7	−0.4	−2.1	−0.3	−0.9	−0.2	−0.4	−0.1	0.0	0.0
Employment gap (percent of potential)	−0.3	…	0.6	…	0.3	…	0.1	…	0.1	…	0.0

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

^1/Structural balance takes into account output and employment gaps.

^2/Overall balance adjusted for the output gap, based on authorities’ measure.

View Table

Sweden: Medium-Term Fiscal Outlook

(Percent of GDP)

	2011	2012		2013		2014		2015		2016
	Prelim.	SB	IMF	SB	IMF	SB	IMF	SB	IMF	SB	IMF
Revenues	49.7	50.1	49.5	49.7	49.8	49.4	49.9	49.5	49.7	49.3	49.8
Expenditures	49.6	50.4	49.7	49.3	49.2	47.8	48.4	46.5	47.5	45.7	47.2
Net lending	0.1	−0.3	−0.2	0.3	0.6	1.6	1.5	3.0	2.1	3.7	2.6
Central government balance	−0.1	−0.3	−0.1	0.7	0.9	1.7	1.7	3.1	2.3	3.8	2.8
Pension system balance	0.5	0.2	0.2	−0.2	−0.2	0.0	0.0	0.0	0.0	−0.1	−0.1
Local government balance	−0.3	−0.2	−0.2	−0.1	−0.1	−0.1	−0.1	−0.1	−0.1	−0.1	−0.1
Structural balance (percent of potential GDP) 1/	0.2	…	−0.3	…	0.5	…	1.5	…	2.1	…	2.6
Structural balance (percent of potential GDP) 2/	−0.3	1.2	0.1	1.6	0.8	2.1	1.6	3.2	2.2	3.7	2.6
Output gap (percent of potential)	0.8	−2.7	−0.4	−2.1	−0.3	−0.9	−0.2	−0.4	−0.1	0.0	0.0
Employment gap (percent of potential)	−0.3	…	0.6	…	0.3	…	0.1	…	0.1	…	0.0

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

^1/Structural balance takes into account output and employment gaps.

^2/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.

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.