Sweden--2002 Article IV Consultation, Concluding Statement of the IMF Mission
May 16, 2002
Sweden—2002 Article IV Consultation
May 16, 2002
1. The Swedish economy displayed considerable resilience in the face of the worldwide slowdown in economic growth in 2001. This resilience was rooted in sound macroeconomic policies and structural reforms implemented over the past decade. The well-designed fiscal and monetary frameworks ensured stability and policy credibility, while the strength of public finances made it possible in the past few years to begin reducing the high tax burden. Looking ahead, the challenge is to create the basis for sustainable high growth in the medium term by shifting the focus of the policy agenda toward enhancing productivity and labor supply.
2. The slowdown in Sweden was relatively mild and is expected to be short-lived. The adverse external environment—especially in the high technology sector—impeded exports and, combined with heightened uncertainty stemming from the falling stock market, depressed sentiment in 2001. The damage to confidence kept private consumption unusually subdued even with rising disposable income. However, the weak krona improved the competitive position and, coupled with a supportive policy stance, helped the economy weather the downturn. Despite the slowdown, inflation surged to around 3 percent—well above the Riksbank's target of 2 percent—reflecting some transitory influences but also the high degree of resource use in the economy.
3. Economic activity is projected to pick up in the second half of this year and to gather pace into 2003. The continued strength of employment and disposable income provides a sound basis for the growth of domestic demand. However, the incipient recovery is still somewhat fragile. It is especially vulnerable to the continued weakness of the telecom sector, which contributed handsomely to productivity and export growth in recent years. Adverse confidence effects from declining asset markets could also inhibit the expected rebound in consumption. Moreover, large wage increases, low productivity growth, and rigidities in product and labor markets could undermine the economy's supply response.
4. The persistence of high headline and underlying inflation has become a cause for concern. For sure, several transitory factors related to weather, animal diseases and energy prices accounted for part of the rise in inflation. Nevertheless, indicators of underlying inflation have risen sharply as well. A number of influences seem to lie behind the rise in underlying inflation of the past year. First, resource utilization was probably above the level consistent with stable inflation. Second, wage inertia has contributed to large wage increases despite flagging productivity growth and to a surge in cost pressures, particularly in the service sector. Third, the beneficial effects of earlier deregulation on the price level have faded out. Finally, rigidities in various markets have contributed to an element of "structuralist" inflation, with a sequence of relative price shocks leading to increased inflation.
5. The gradual tightening of the monetary stance by the Riksbank in recent months underlines its commitment to meeting the inflation target. The central expectation is for inflation to decline. The cyclical recovery in productivity combined with the projected moderate rise in unemployment and the easing of labor shortages should contain unit labor costs to a level consistent with the inflation target. The recent increases in the policy interest rate should help restrain wage and price pressures stemming from a rise in inflation expectations. On the other hand, unemployment is low and there are scant signs of a slowdown in the growth of labor costs. As the recovery gathers pace with inflation already high, demand pressures, combined with labor and product market distortions, could push inflation above the target. All in all, a "wait-and-see" approach is appropriate in light of the uncertain outlook, but the Riksbank should stand ready for further monetary tightening if inflation pressures do not decline.
6. Fiscal policy remains firmly anchored in the medium-term framework. The general government surplus of 1.8 percent of GDP now expected for 2002 is lower than projected at budget time. The shortfall is largely due to weaker growth of revenues reflecting a more subdued recovery than projected earlier. The structural surplus would nevertheless remain in line with the authorities' target of 2 percent over the cycle. The implied moderately expansionary fiscal stance is appropriate in view of the still fragile recovery. However, the expenditure ceiling is likely to come under pressure due to a continued rise in sickness payments, disability pensions, and to some extent, inflation-induced increases in other spending areas. In this context, the government's firm commitment to keep expenditures within the ceiling is a welcome affirmation of its adherence to the fiscal framework.
7. The projected general government surplus in 2003 would be in line with the surplus target. The broadly neutral fiscal stance is consistent with the expected rise in resource utilization. It would be desirable to implement the announced fourth and final step of the income tax reform in 2003. In case the completion of the reform were to threaten the surplus target, it should be financed through expenditure cuts. Moreover, it is imperative to contain spending on sickness benefits and disability retirement to avoid breaching the expenditure ceiling or crowding out other expenditures.
8. The medium-term fiscal framework will serve the Swedish economy well in the coming years. The recent proposals of the Johansson Commission for changes in the fiscal framework in the event of euro area membership are important and will no doubt be thoroughly debated. In broad terms, the mission sees no urgency for major changes to Sweden's well-functioning fiscal framework. The surplus target of 2 percent on average over the cycle appears adequate on current projections to address the adverse impact on public finances of the demographic transition over the coming decades. At the same time, the target offers considerable room for stabilization policy during downturns even under the deficit ceiling of the Stability and Growth Pact. However, a modification of the expenditure rule may be warranted, given that the budget margins—partly intended for cyclical fluctuations in spending—have all too often been used up for discretionary increases in spending. A modified expenditure rule should be explicitly linked to the surplus target and structural revenue projections. A good case can also be made for symmetric cyclical fluctuations in expenditures bound by a ceiling so as to allow for overspending on cyclical categories during downturns, offset by underspending in upturns.
9. The focus of fiscal as well as structural policies—independent of the EMU debate—should be on strengthening the supply side of the Swedish economy. Beyond the current program of tax reform, it is important for the government to follow through on its general intention to pursue a balanced set of reductions in taxation and spending aimed at reducing distortions and maximizing growth and welfare. In this context, the focus should be on reducing the high marginal effective tax rates on labor income and a structural reform of the wealth tax. The forthcoming report of the Commission on the Mobility of Tax Bases could provide the basis for continuing the process of tax reform.
10. The recent favorable performance of employment should not obscure the need for further reforms to enhance wage flexibility and labor mobility. Employment and participation rates have risen markedly to among the highest in the world, notably for women and older people. Limiting the duration of unemployment benefits and the introduction of the Activity Guarantee scheme are welcome steps. However, further improvements in the functioning of the labor market are needed. Wage growth needs to be restrained to reflect gains in productivity. The focus of active labor market policies should continue to shift toward the long-term unemployed, job search support and improvements in the efficiency of programs. Finally, labor mobility should be enhanced by easing employment protection rules and by reducing housing market distortions through liberalizing the rental housing market and promoting competition in the construction sector.
11. The decline in unemployment has brought moral hazard problems associated with the welfare system to the surface. The stark rise in absenteeism on account of sickness has emerged as an issue with major implications for public finances and the economy's supply potential. The increase is especially large among the long-term sick—almost a quarter million workers were absent from work for over 60 days in 2001, nearly 75 percent more than in 1998. Adding in disability retirement, 20 percent of the labor force is lost to the workplace. These developments contribute to higher costs, lower productivity, and a large increase in public spending. It is essential to reform the system of sickness benefits so as to rein in absenteeism while ensuring generous social benefits to those in need. The government's 11-point program is a step in this direction. However, greater emphasis would need to be placed on correcting the incentive structure and on changes in eligibility criteria.
12. The authorities should give renewed impetus to the process of enhancing competition in the economy. The momentum of deregulation seems to have slowed in recent years. Despite participation in the EU internal market since 1995, the price level in Sweden remains about 20 percent above the EU average, with around half of this differential ascribed to insufficient competition in certain sectors. Although notable progress was made in liberalizing product markets, particularly in the utilities and telecom sectors, greater efforts to strengthen competition are needed in areas such as retail distribution, pharmaceuticals, air transport, and especially construction and rental housing. Further progress in privatizing public enterprises operating in competitive markets would also be desirable.
13. The recent assessment of Sweden's financial system by the IMF concluded that the system was sound and complied well with international codes and standards. While the economic slowdown has weakened the performance of the four major financial groups, stress tests as well as recent experience indicate that they remain robust to market and credit risks in the event of a downturn. Nevertheless, concentration of their exposures to a relatively small number of counterparties and residual risks in the securities settlement system are potential sources of vulnerability. Regulatory and supervisory arrangements comply well with international standards. In light of the systemic importance of large Swedish banks in several countries, the authorities' plans to develop further their arrangements for crisis prevention and management in consultation with other relevant jurisdictions are welcome.
14. In conclusion, the Swedish authorities deserve to be commended for their continued achievement of the objectives of growth, stability and social welfare. Abroad, Sweden's record of a high level of development assistance continues to set an example for many other advanced economies.