Sweden—2014 Article IV Consultation: Concluding Statement of the Mission
June 13, 2014
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.
Sweden’s economy is gathering speed
1. Sweden’s economy has performed relatively well since the crisis. Supported by monetary and fiscal policy and improving household confidence, real growth reached over 1½ percent in 2013, lifting GDP to nearly 15 percent above its 2009 trough—far ahead of many other European economies. A range of labor market reforms over the past years have contributed to a solid employment growth and greater labor market participation. However, with global demand still lagging, unemployment has been higher than expected—especially among the young, low-skilled, and immigrants. Also, despite a narrowing output gap, inflation has declined, reflecting, in part, diminishing price pressures in global energy and food markets.
2. The outlook is for accelerating growth. After a very strong fourth quarter in 2013, lower inventory accumulation and higher imports slowed growth early in 2014. However, staff expects private consumption to continue to expand and investment to pick up during the year. Along with a continued recovery in trade partners, staff now projects GDP growth of 2.6 percent in 2014 (revised down slightly from 2.8 percent) and 2.7 percent 2015 (up from 2.6 percent). Against this background and with gradually fading external disinflationary pressures, inflation is expected to pick up as well, to about 1½ percent in 2015.
But risks are rising as well
3. Financial instability is an increasing concern. House price increases have picked up again, exceeding 7½ percent annual growth for single-family homes and 12½ percent for tenant-owned apartments in April. Household credit growth also remained strong, pushing household indebtedness to almost 175 percent of disposable income in 2013, and over 190 percent if debt from tenant-owned housing associations is included. Recent data indicate that household debt ratios are high across all income groups, but particularly so for indebted lower-income households who are especially vulnerable to income, interest rate, and house price shocks. The aggregate net asset position of households is solid, but a large share of assets is illiquid and has limited value as a buffer. As a consequence, a large and sudden drop in house prices would lower consumption, employment, and growth, and ultimately impact the banking system. Sweden’s large and regionally connected banks are also vulnerable to unexpected financial tensions in the wider Nordic region or surges in global financial market volatility. Conversely, financial instability in Sweden would quickly spread to other Nordic and Baltic countries.
4. External risks, such as moderating global trade, could aggravate worries about low inflation. An intensification of geopolitical tensions or an unexpected decline in global trade could adversely affect Sweden’s growth outlook. While long-run inflation expectations are currently well anchored, such spillovers could also prolong or deepen the period of very low inflation, causing inflation expectations to fall significantly below the inflation target. This, in turn, could act as a drag on growth if households and firms defer expenditures in anticipation of lower prices in the future.
Addressing financial risks is the key policy priority
5. Policies are underway to further strengthen banks’ capital and reduce housing bottlenecks. The authorities are introducing the macroprudential toolkit under Basel III, and will be using it to raise risk-weighted capital requirements significantly above the Basel minimum. Additionally, the Financial Supervisory Authority (FSA) is increasing mortgage risk weights to 25 percent, close to the 35 percent standard Basel approach. In this context, the newly established Financial Stability Council is a helpful forum for discussion and cooperation on financial stability policies between all authorities involved. The government has also taken steps to mitigate housing supply constraints, such as putting forward proposals to streamline the permit process for new construction and to improve the use of the existing housing stock (e.g., by making subletting of apartments more flexible).
6. However, there are urgent macroprudential and structural policy challenges. To stem the increase in already high levels of household debt, moving beyond credit supply measures to directly contain mortgage demand is a priority. This will help free the Riksbank to pursue its inflation target with less concern about financial stability risks. With the recovery firming up, there is scope for additional reforms to reduce unemployment, further increase housing supply, and shift towards fiscal consolidation to preserve Sweden’s fiscal buffers.
The financial stability agenda has to include demand-side measures
7. It is time for a comprehensive set of macroprudential actions that, gradually implemented, would help steer mortgage credit demand towards a sustainable path. The current Loan-to-Value (LTV) cap of 85 percent is high compared to the levels of around 75 percent in many other advanced economies. Furthermore, evidence suggests that some households have been by-passing the cap through supplementary unsecured loans. There is little incentive to amortize debt, with nearly 40 percent of mortgage borrowers failing to reduce their debt levels in 2013. Average amortization periods are extremely long by international standards. This suggests a comprehensive set of measures:
• Most importantly, a binding maximum amortization period for new mortgages should be introduced if progress under the self-regulatory approach remains limited.
• In addition, a Debt Service-to-Income (DSTI) limit would improve households’ resilience against future income and interest rate shocks and make the LTV cap more effective.
• A further reduction in the LTV cap to 75 percent could also help stem the rise in mortgage debt levels.
Fundamentally, reducing the tax deductibility of mortgage interest and reforming the property tax in a gradual fashion would reduce a key incentive for households to accumulate mortgage debt and it would promote shorter amortization periods.
8. Alleviating housing market supply constraints would address an important underlying factor behind the rise in residential property prices especially in urban areas. The demand for housing is outstripping supply, reflecting ongoing rapid urbanization and immigration trends, and has resulted in higher house and apartment prices, driving up the size of mortgages. Containing these house price pressures will require a continued and strong effort to expand more significantly the stock of affordable housing, including additional reforms to zoning, permitting, and the rent-setting process. Public infrastructure investments coordinated with municipalities would increase the attractiveness of housing investments by the private sector.
9. Further improvements in leverage ratios and liquidity positions would add to the banking sector’s resilience.
• Capital: Recent improvements in risk-weighted capital ratios largely reflect adjustments in corporate risk weights, in part due to changes in internal models, and have not translated into similar increases in leverage ratios (i.e., equity relative to total assets). A higher leverage ratio would bolster banks’ ability to absorb losses. Given high and rising household debt, the countercyclical capital buffer should be set at or close to 2½ percent, the maximum value subject to international reciprocity.
• Liquidity: The maturity mismatch in the Swedish banking system is particularly large, reflecting the large role of covered bonds and short-term wholesale funding. This suggests that banks’ Net Stable Funding Ratios (NSFR) should approach the minimum level of 100 percent even before the Basel III requirements are formally implemented. In addition, to encourage banks to self-insure against a potential krona liquidity squeeze, introducing a minimum Liquidity Coverage Ratio (LCR) requirement in Swedish krona could be considered.
10. The size and regional orientation of Sweden’s banks calls for additional progress towards effective cross-border supervisory cooperation and resolution frameworks. The implementation of the EU Bank Recovery and Resolution Directive (BRRD) should allow the completion of the work of the Nordea Crisis Management Group (CMG) and facilitate a binding ex-ante burden sharing agreement. The option of joining the Banking Union should be kept open, not least because of its potential to further improve cooperation and coordination across the Nordic-Baltic region.
Monetary policy still has to balance inflation and financial stability risks
11. Absent decisive action to address financial stability concerns, the Riksbank is faced with a dilemma. Macroprudential policy should be the first line of defense, but with high and increasing household debt, monetary policy may have to “lean against the wind” and follow a less supportive policy course than warranted by short-term macroeconomic conditions alone. Indeed, while much of Sweden’s very low inflation can be traced to weak or falling import prices and the strong growth outlook points to higher inflation in the future, there is a risk that inflation could remain below target longer than expected.
12. The current monetary stance appropriately balances price and financial stability risks—but changes in this balance would warrant action. Should inflation expectations further decline significantly below the 2 percent target—for example, because of an additional and sustained deviation of actual from projected inflation or should growth disappoint—lowering the repo rate further and keeping it low for longer than suggested by the Riksbank’s current policy path would be justified. This would, however, add greater urgency to the immediate implementation of effective macroprudential measures. In contrast, a substantial increase in risks to financial stability would shift the balance of risks such that the Riksbank would have to raise interest rates earlier than otherwise to help contain financial vulnerabilities.
Structural policy can help reduce unemployment
13. Recent reforms and relatively strong GDP growth have fostered employment growth—but unemployment remains high especially among vulnerable groups. The introduction of an Earned-Income Tax Credit (EITC), reforms to disability insurance, and enhanced Active Labor Market Programs (ALMPs) have resulted in a substantial expansion of the labor force. Increased immigration inflows have added to these dynamics. While employment growth has been fairly strong overall, particularly in the services sector, job prospects for the low-skilled, especially youths, foreign-born, and older workers, have remained more subdued. This has contributed to the substantial rise in unemployment, much of which is estimated by staff to be structural.
14. Further reforms can help accelerate and sustain the transition of vulnerable groups into employment. The Swedish wage formation process has contributed to creating one of the most compressed wage distributions among OECD economies. While this process has, on average, delivered wage growth in line with productivity, it can limit employment opportunities at the lower end where unemployment is most pronounced. Here social partners could help by exploring ways to increase wage flexibility at the firm level. But, it will be equally important to continue to help the young and the low-skilled to add to their human capital, which will allow them to gain better-paying, higher-productivity jobs. ALMPs also have a crucial role to play, such as the recent reforms to vocational training, but are most effective when aligned with employers’ needs. Well targeted and limited-duration wage subsidies can also help.
Starting fiscal consolidation now will preserve buffers
15. Fiscal policy is rightly turning toward consolidation. The measures in the 2014 Fall Budget and Spring Fiscal Policy Bill resulted in a substantial structural fiscal expansion at a time of—at least with hindsight—significantly improving growth. Starting in 2015, a structural consolidation path with adjustments of about ½ percent of potential GDP per year would be in line with the expected strengthening of the economy and help the government achieve its goal of a headline fiscal surplus of above 1 percent of GDP by 2018. The government’s “krona-for-krona” strategy—as assessed by the Fiscal Policy Council—is a promising approach to keep the budget on track.
16. The current fiscal framework has served Sweden well. The framework’s net lending target of 1 percent of GDP over the cycle is compatible with the need to preserve a prudent borrowing capacity for the potentially large contingent government liabilities arising in a small open economy with an aging population and a large financial sector. In this context, there are synergies between fiscal consolidation needs and efforts to rein in financial stability risks, including gradual reforms of mortgage interest deductibility and the property tax to contain mortgage credit growth.
The mission thanks the authorities and other counterparts for their hospitality and the high quality and openness of the discussions.