Statement by Pernilla Meyersson, Alternate Executive Director for Sweden, August 28, 2014

Sweden’s economy has re-gained speed, following supportive macroeconomic policies and strong household demand. Employment has been rising, but the labor force expanded even more, resulting in higher unemployment mostly among vulnerable groups. Inflation remains very low, driven by external and domestic factors. At the same time, financial stability risks are an increasing concern, reflecting high and rising household debt, accelerating house prices, and Sweden’s very large banking system.

Abstract

Sweden’s economy has re-gained speed, following supportive macroeconomic policies and strong household demand. Employment has been rising, but the labor force expanded even more, resulting in higher unemployment mostly among vulnerable groups. Inflation remains very low, driven by external and domestic factors. At the same time, financial stability risks are an increasing concern, reflecting high and rising household debt, accelerating house prices, and Sweden’s very large banking system.

The Swedish authorities would like to thank the mission team for the report as well as for the open and constructive policy discussions during the Article IV consultation with Sweden. The authorities broadly agree with the conclusions and recommendations of the staff report.

Recent economic developments and outlook

Macroeconomic developments in Sweden have been relatively favorable in recent years, given the situation in the world economy. The Swedish economy has recovered after the financial crisis at a pace similar to that in the US and much faster than in the UK or the euro area. Sweden is one of the few countries where GDP per capita is higher now than it was prior to the crisis. Employment has been growing steadily by about 1 percent per year since2010. Labor force participation is the highest in the EU. However, the unemployment rate is still high due to increased labor supply and participation rates. Monetary and fiscal policies have responded forcefully to the crisis. The need to support the economy by economic policy measures will gradually decline as growth picks up and inflation increases.

The authorities broadly share staff’s assessment of the economic developments and risks in Sweden and internationally. According to recent data, however, GDP growth for the second quarter was lower than expected and annual growth for 2014 will most likely be lower than projected at the time the Article IV report was written. The recovery in the Euro area is moving more slowly than anticipated. Nevertheless, the main scenario is that growth in the Euro area increases in 2015 and that the international economic recovery takes hold. This, together with a continued expansionary monetary policy, should lead to a higher growth in the Swedish economy in 2015.

The growth in consumption and housing investment in the Swedish economy is relatively strong and is expected to continue increasing at a good pace. As demand from abroad strengthens, growth in the more export-dependent business sector will pick up. The labor market has shown resilience and the outlook is stable. The labor force is expected to grow at a slower pace going forward. And, as growth picks up, employment will rise faster and unemployment will fall.

Due to the low inflation over the past years, a further cut in the repo rate was made in July. The repo rate was cut by 0.5 basis points to 0.25 percent and the path indicates a slow increase of the repo rate towards the end of 2015.

Financial stability, macroprudential policy and financial reforms

The authorities share the view that addressing financial risks is a key policy priority and that it is important to make further progress on the financial stability agenda. The authorities see household debt as a key downside risk to the economic development. Besides decreasing growth and increasing unemployment, shocks to the economy in the high-debt environment can affect financial stability in Sweden and the entire Nordic region given the high interconnectedness in the Nordic (and Baltic) financial systems.

The authorities agree that measures are needed to address increases in house prices and household debt. Several measures, such as a mortgage cap, increased capital requirements, and higher risk weights for mortgages have already been implemented. Since many of the implemented measures have focused on credit supply, further measures should focus on credit demand. The government’s efforts to strengthen financial stability have led to banks voluntarily promoting stricter amortization regarding mortgages. However, the authorities agree with staff that actions in order to further improve amortization are necessary and should be a priority. Measures must be taken in a gradual manner to avoid jeopardizing the economic recovery.

The authorities agree that further progress is needed to increase the resilience of the banking system. The Riksbank shares staff’s view that imposing a leverage ratio requirement and a countercyclical buffer of 2.5 percent, would be a desirable way to increase the shock absorbing capacity of the banking system. The Riksbank has a recommendation to activate the countercyclical buffer at 2.5 percent in its latest FSR. During the fall, the Financial Stability Council will discuss further on non-risk-weighted capital (i.e. leverage ratio) measures.

The Riksbank agrees with staff that further steps to reduce liquidity risks, through the banks rapidly approaching a Basel III NSFR measure of 100 percent, and introducing an LCR requirement in Swedish krona, would strengthen the banking system. The Riksbank also has recommendations regarding these measures in its latest FSR.

Monetary policy

Staff points out that persistently low inflation in an environment of rapidly-increasing housing prices and a related high growth in credit to households, implies a difficult balancing act for monetary policy. This is a dilemma that Swedish monetary policy has struggled with for some time. Since mid-2011, CPIF inflation has gradually been drifting below 2 percent, which suggests that monetary policy could have been even more expansionary. On the other hand, rapid increases in household debt and house prices create the risk of serious macroeconomic consequences of the kind some other countries have experienced. The Executive Board of the Riksbank therefore has seen a need to, to some extent, take such longer-term risks into account when making the repo-rate decisions.

In this balancing act, the particularly low inflation outcomes since last autumn have successively increased the need for monetary policy to put greater weight on the short-term development of inflation. In doing so, there is less risk that long-term inflation expectations will become de-anchored from the target. This will increase the likelihood of achieving the inflation target within a reasonable time span. At the same time, the more expansionary monetary policy now is associated with higher risks linked to household indebtedness and the housing market. Several members of the Executive Board have therefore stressed the importance of other authorities taking relevant actions.

The Riksbank would like to emphasize that, when it comes to monetary policy considerations, the main concern has been the risks regarding financial imbalances and their macroeconomic consequences - with depressed growth, higher unemployment and possibly difficulties in achieving the inflation target - rather than risks to the stability of the financial system. That being said, in a very negative scenario, financial imbalances may not only lead to unfavorable macroeconomic outcomes, they can also pose risks to financial stability.

It is noteworthy that the Swedish economy has coped relatively well during the years since the financial crisis. Sweden is one of the few countries where GDP per capita is higher now than it was prior to the crisis and the share of the working-age population in employment has also held up well. This reflects the fact that Sweden was not in the epicenter of the financial crisis. Unlike many other countries, Sweden has not experienced a fall in housing prices and difficult deleveraging processes in various parts of the economy. The different economic situation in Sweden compared to the US and many European countries has called for a different emphasis in monetary policy deliberations.

Fiscal stance

The Ministry of Finance broadly agrees with staff’s fiscal assessment even though the Ministry’s assessment of the output gap and the structural balance in the near term is higher than staff assesses. The Ministry agrees with staff that the need to support the economy through fiscal policy measures is gradually declining as the growth outlook improves and resource utilization picks up.

The Ministry of Finance agrees with staff that returning to surplus is vital in order to protect jobs and welfare in a small, open economy like Sweden. Sustainable public finances will provide scope for the automatic stabilizers to operate effectively and for active fiscal policy in the next recession, if necessary. Since many other countries, due to problems in their public finances, will have less capacity to tackle the next recession with fiscal policy, there are strong arguments in favor of Sweden building up surpluses again and maintaining a low level of debt.

In addition, as pointed out by staff, Sweden has a large financial sector and the latest crisis in particular has shown that this is a potential risk for the economy and public finances. However, earmarking fiscal surplus and buffers for the financial sector may lead to moral hazard. The Ministry of Finance therefore emphasizes that strong financial market policy measures are the first-best option to protect against such fiscal risks.

Output gap

Staff presents a more pessimistic picture of the potential of the Swedish economy than is assessed by the Ministry of Finance (as well as the OECD and the European commission). The differences between staff and the Ministry in assessing the size of the output gap are to a large extent related to different assessments of the extent to which structural reforms have lowered the equilibrium unemployment. The Ministry of Finance believes that the low wage growth and the low inflation indicate a large output gap compared to staff’s assessment. In addition, indicators on e.g. labor shortages are below average levels, which is in line with the assessment that there is a low level of resource utilization on the labor market.

Structural balance

The staff forecast for the public sector net lending in Sweden is broadly in line with the authorities’ forecasts for 2014–2016. However, staff makes a considerably more pessimistic assessment of the structural balance than the Ministry of Finance, especially for the years 2014 and 2015. The different views on the structural balance are mainly explained by staff’s assessment that resource utilization is more strained.

Staff assesses the government’s fiscal policy to be pro-cyclical in 2014. According to the Ministry of Finance’s assessment a small deterioration of the structural balance in 2014 is, however, appropriate considering the low resource utilization in the economy.

Structural issues

Labor market

The Swedish labor market is strong in an international comparison. Swedish labor force participation is the highest in the EU and Sweden has managed to maintain high labor force participation throughout the crisis. Partly as a consequence of Sweden’s generous policy towards asylum-seeking refugees, Sweden has had a growing immigrant population. At the same time, numerous reforms have been implemented to increase labor force participation. Higher labor force participation implies less exclusion, but also that more vulnerable groups enter the labor force. Higher labor force participation initially leads to higher unemployment. In the long run, however, employment growth is determined by labor supply as most people who enter the labor market eventually find jobs. Staff assesses that unemployment has remained high much due to structural factors. According to the Ministry of Finance’s assessment, however, today’s elevated unemployment level is due to a sharp rise in labor force participation combined with lower demand for labor following the financial crisis.

As staff points out, the increase in unemployment from the pre-crisis level has been disproportionally borne by vulnerable groups and, despite solid employment growth in 2013, the unemployment rate remains flat. With regard to unemployment among young people, it is worth mentioning that a large share of this group is studying full time.

Important steps have been taken to increase labor demand and improve education/training opportunities to help individuals find a job, in particular those in vulnerable groups. Such measures include improvements in the teaching of Swedish to immigrants, the introduction of an entry recruitment incentive, increased resources to subsidize employment, and increased income tax credit for people over 65. Nevertheless, further steps are necessary to increase employment and reduce structural unemployment. One step in this direction is the initiative by the government to engage in talks with the social partners about how to obtain a more inclusive and flexible labor market. Within this framework, vocational introduction agreements have already been signed between social partners in important sectors and negotiations are ongoing in several other sectors. This will help young people establish themselves in the labor market.

Taxation

Staff mentions the possible need for tax reforms. The government would like to emphasize that as taxation-related measures overall may have a large economic impact, such measures require broad, long-term political agreement, which does not exist at present.

Regarding property taxation, there are no plans to increase recurrent property taxes on privately owned properties. The former property tax was criticized as being unfair and lacked popular support and legitimacy.

The issue of mortgage deductibility is difficult. A too rapid phase-out of deductions for interest payments can have negative effects on household consumption and the economic recovery. A reduction in mortgage deductions would also disproportionately affect households that are highly leveraged, e.g. younger households who just entered the market. Any changes to the level of mortgage deductibility must be made on a long-term basis and with broad political consensus, to reduce uncertainties.

Housing supply

In general, the observations and recommendations by staff are in line with the analysis and policy objectives pursued by the Swedish government. Having said this, changes within these areas take time and they will consequently be subject to reforms for an extended period of time.

As to the need to reform regulations concerning zoning and permits, the government focused its second term (2010-2014) especially on easing administrative and legal rules that slow down and complicate the planning and building process. Among other things, an inquiry was tasked by the government to review opportunities to streamline a judicial review of municipal decisions that have been appealed against under the prevalent Planning and Building Act. Work on improving how regulations concerning planning and building can be made more efficient and conducive to housing production will continue.

As to the rent-setting process, it was, in conjunction with the regulation of the Municipal Housing Companies, subject to reform in 2010 (the new rules being valid from January 1, 2011). Changes have been made in the special rules applying to new rental housing. For example, the time period during which an exemption from the ordinary rent setting rules is valid was prolonged from 10 to 15 years as late as from February 1, 2013.

As to public infrastructure investments as an available policy measure, the government agrees with staff that such measures should be implemented. Accordingly, the government recently presented a program that contains substantial long-term investments in housing, public transport, and railways.