Sweden - 2006 Article IV Consultation Concluding Statement
November 14, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
November 14, 2006
1. The Swedish economic scene has undergone a striking transformation during the past year. A strong upswing is underway, once again outpacing the euro area by a wide margin. The rapid and broad-based recovery has, however, failed to make a durable dent in unemployment, leaving too many Swedes excluded from the gains of growth. Including the underemployed and persons supported by social transfers, over a fifth of the working-age population remains economically inactive. Against this backdrop, a newly elected government has launched a far-reaching program of reforms, with an ambitious goal of addressing this widespread exclusion from the labor market. The direction of these reforms is broadly in line with the IMF's calls in recent years for streamlining the welfare state to address the challenges posed by demographics and globalization.
2. The current cyclical conjuncture is an opportune moment to launch an ambitious reform agenda. The momentum of the ongoing boom—with economic growth at well over 4 percent this year—is likely to carry forward into 2007. Despite some easing back as output approaches capacity limits, the economy is on course for another year of strong growth. With continued robust gains in disposable incomes and household wealth, private consumption will continue to serve as the engine of demand expansion, even as business investment tapers off. Export growth will remain healthy, supported by a strong competitive position. The incipient recovery in employment is expected to strengthen, supported by the new policy initiatives, and total unemployment, including persons in labor market programs, should begin to fall as well. As productivity decelerates, wage gains of 3½ to 4 percent should keep labor costs consistent with inflation, projected to rise gradually to the target of 2 percent. Despite the expected monetary tightening, both monetary and fiscal policies in 2007 are set to remain supportive of demand.
3. The reform program is rightly centered on restructuring the extensive tax and benefit systems to steer more people toward gainful employment. A tax cut aimed at low and average income earners, amounting to around 1½ percent of GDP, is intended as the first step in a long overdue effort to bring down the high tax wedge on labor. This step is complemented by changes in the system of unemployment and sickness insurance, including a reduction in benefit levels and stricter enforcement of eligibility criteria. The changes are intended to underline the dual role of social insurance as a safety net and as a support to facilitate the transition back to work. A scheme to lower social security contributions for young and older workers should encourage employers to recruit and retain these groups. A revamping of the extensive labor market programs will focus on matching jobseekers with vacancies and raising competition in employment services. Although the magnitude and timing of the impact of these complementary initiatives is uncertain, they are expected to alleviate the adverse effects of the compressed wage structure on the employment prospects of low-skilled workers.
4. Looking ahead, the authorities need a critical mass of strategic tax cuts to generate a virtuous cycle of growth. The government's announced intention to implement a second stage of cuts in income taxation in 2008, subject to the health of public finances, is therefore welcome. A substantial reduction in the still high tax wedge on labor will ensure a durable rise in effective labor supply. The authorities recognize that the high level of social security contributions impedes demand for labor, especially in the services sector. It is important to find ways to resolve the difficulties in reducing this barrier to hiring labor.
5. Room for the tax cuts will need to be found within the constraint of the fiscal framework. The new government's strong political commitment to sound public finances is welcome and reinforces the credibility of its economic program with the markets and the public. Expenditure restraint is needed to alleviate the pro-cyclical bias of fiscal policy in the near term and create room for additional tax cuts over the medium term. Stricter enforcement will go some way toward reducing spending on sickness benefits, which continues to be large. The coming heavy pressures on age-related spending could be addressed in part by increased use of private suppliers to deliver the same quality of public services at lower cost. The intention to increase competition in health care and social services is welcome in this context. The government may, nevertheless, need to seek cuts in broad categories of public consumption as well.
6. The fiscal framework could be refined further to improve its transparency and accountability. The framework has served Sweden well in ensuring fiscal discipline, and the new government has rightly decided to preserve it. The target of a surplus for the general government of 2 percent of GDP over the cycle remains appropriate. However, as we have commented in the past, the target lends itself to different interpretations, making it difficult to assess compliance and compromising the effectiveness of the framework. Ambiguous targets can lead to lax policies in good times, requiring a procyclical correction in bad times and undermining public confidence in the framework. The lack of a precise anchor for fiscal policy also calls into question the discipline of expenditure ceilings. The government's decisions to restore the three-year horizon of spending ceilings and to reduce reliance on tax expenditures are therefore welcome, as is the intention to improve the framework in the context of the Spring 2007 budget.
7. The fiscal framework could be explicitly embedded in a macroeconomic framework and monitored by an independent economic council. While the fiscal surplus target seems broadly consistent with long-term fiscal sustainability, it would assist public understanding of its rationale if it was clearly linked to the objective of sustainability of public debt, in the context of long-run demographic and growth projections. An independent council of experts could have responsibility for deriving the annual structural surplus target in a macroeconomic context, with estimates of variables such as output and employment gaps, and translating the prescriptions of the framework into a target for the headline budget balance. The fiscal framework could also be refined by explicitly linking the surplus target with the expenditure ceilings and by instituting clear guidelines that restrict the use of accounting devices, such as tax expenditures. The council could also conduct ex post assessments of budgetary outcomes. Such an innovation would be consistent with Swedish traditions of transparency and accountability in public policy and contribute to international best practice in this important area.
8. With inflation expected to rise over the next two years, the Riksbank will need to tighten monetary policy further. Since early this year, it has begun to withdraw the strong monetary stimulus in place for the past two years. However, with real interest rates close to zero, the monetary stance remains quite accommodative. A neutral policy rate-consistent with an inflation target of 2 percent-would be about 4 percent. With inflation rising toward the target, output at or above capacity, and a substantial fiscal stimulus in 2006-07, there is scope for continued tightening, broadly in line with current market expectations.
9. The inflation targeting framework continues to firmly anchor inflation expectations. Recent changes to the framework have helped improve the clarity and transparency of monetary policy communication. Moreover, the publication of an inflation forecast based on how markets expect interest rates to evolve has enhanced the policymaking process itself, providing a more internally consistent forecast and helping enrich the policymaking debate. Further modifications to the framework—using its own forecasts for interest rates that are consistent with achieving the inflation target, for example—would keep the Riksbank at the forefront of international best practice. An evolution of the framework in this direction can be expected, as already signaled by the Riksbank. The forthcoming evaluation report commissioned by the parliament should spark further debate on the future direction of the framework.
10. The financial system has strengthened and remains stable. Bank profitability is high, and capital levels are adequate to absorb moderate economic shocks. Asset quality has improved significantly, as household and corporate balance sheets have strengthened in recent years. While household debt has risen sharply, debt service burdens remain manageable, even if interest rates continue to rise. Equity markets have recovered from their slump earlier this year, and house price inflation is showing signs of slowing to a more moderate pace. Nevertheless, asset prices, especially those for real estate, need to be monitored closely.
11. There is a need for improving the legislative framework for bank resolution. The recent difficulties in revoking the license of a small deposit-taking institution on a timely basis clearly illustrate this. While this case involved no systemic risk, we encourage the authorities to address the weaknesses in the legal framework.
12. The pay-off from labor market reforms could be enhanced by initiatives to promote competition and reduce the burden of regulation. Although Sweden ranks well on many international indicators of business climate, evidence of informal barriers to entry in sectors such as construction suggests scope for improving competition and encouraging entrepreneurship. Moreover, as emerging countries catch up and the demographic transition potentially reduces risk-taking, aggressive policy initiatives to inject greater dynamism will be necessary. The government's plans to sell some of its holdings in state-owned enterprises are welcome in this context. Deregulation in the housing market would make an important contribution to raising efficiency and promoting labor mobility. As global integration gather pace, it would be important to preserve Sweden's generally liberal approach to trade, investment and immigration. A faster pace of deregulation of markets at home would help realize the full benefits of enhanced integration.
13. The government has embarked on a course that is both courageous and necessary. It is courageous because it confronts some long-held beliefs and vested interests. It is necessary because it will help ensure that the much-admired Swedish model of an inclusive society thrives in the face of the challenges of demographics and globalization. The international community will be watching the progress of this endeavor with keen interest.