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Sweden and the IMF
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On July 31, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sweden.1
Sweden's strong macroeconomic performance of the past five years is rooted in a credible, rule-based policy framework consisting of the Riksbank's inflation targeting regime and a sound medium-term fiscal framework. Strong public finances have enabled a process of gradual reduction in the high tax burden to begin. Structural reforms reinforced by EU membership have helped raise efficiency and mitigated distortions associated with Sweden's large welfare state. These policies paved the way for growth averaging over 4 percent per annum during 1998-2000 driven by large productivity gains, especially in the technology sector. A thorough pension reform has restored actuarial balance to the public pension scheme in the face of the coming demographic challenge.
A cyclical slowdown in domestic demand coupled with global economic weakness led to slower growth in 2001. Private consumption stagnated despite rising disposable income, owing to adverse confidence and wealth effects from the continued plunge in stock prices. Exports suffered their weakest year in a quarter century, as telecom exports—the driving force behind the recent rapid growth—fell by about a third. The weak krona and supportive fiscal and monetary policies, however, helped contain the severity of the slowdown.
Even though growth slowed down, resource utilization remained high. This, together with structural rigidities and a sequence of relative price shocks, contributed to the persistence of wage and price inflation. The fading of the beneficial effects of earlier deregulation in telecom and electricity sectors, and one-off factors such as animal disease and higher oil prices also added to inflation pressures. As a result, inflation remained well above the Riksbank's 2 percent target, before falling to 2 percent in May 2002. Wage growth accelerated to 4¼ percent, exceeding that in the main trading partners, exacerbating the adverse impact of the cyclical slowdown in productivity growth on relative unit labor costs.
The krona has turned around, reversing a trend of prolonged weakness. Relatively low Swedish interest rates, the bursting of the bubble on Sweden's technology-centered equity market, as well as the relaxation of investment rules for pension funds from 2001 led to sizable portfolio outflows, contributing to depreciation pressures. In the fifteen months through September 2001, the krona depreciated by 16 percent against the euro, but appreciated by 4½ percent against the euro through May 2002—prompted in part by political signals about the adoption of the euro.
While the Riksbank was concerned about growing inflation risks, it cut its policy rate by 50 basis points following September 11 in concert with the worldwide move toward policy easing. As uncertainty subsided, this easing was fully reversed in March-April 2002 to rein in persistent inflation pressures, contributing—together with the strengthening krona—to some tightening of monetary conditions. Although subsequently policy rates were kept unchanged, a tightening bias was maintained.
Public finances remain strong, with fiscal policy firmly anchored in the medium-term framework consisting of a general government surplus target, nominal expenditure ceilings for central government, and a balanced budget requirement for local governments. In 2001, the general government surplus rose to about 5 percent of GDP, benefiting from large dividend distributions and exceptionally high revenues from capital gains taxes. The fiscal stance—calculated as the change in the structural balance corrected for these timing effects in revenues—was nevertheless expansionary to the tune of 1 percent of GDP.
An economic recovery has begun and is expected to gather speed in the second half of the year. With a projected pick-up in domestic demand and in the world economy, activity is expected to strengthen further in 2003. The key downside risks to growth are possible adverse confidence effects from the continuing difficulties of the world telecom sector and a weaker-than-expected global recovery. Inflation is projected to recede toward the Riksbank's 2 percent target over the two-year horizon.
Structural problems may hold back medium-term growth. The Swedish price level substantially exceeds the EU average in part due to market imperfections, notably in construction and retail trade. A compressed wage scale and relatively high marginal effective tax rates contribute to work disincentives. In recent years, a surge in sickness absenteeism and continued high levels of disability retirement have eroded effective labor supply. Finally, de facto rent control and employment protection regulations limit labor market flexibility.
Executive Board Assessment
Directors noted that sound macroeconomic policies, underpinned by a rules-based framework, together with the structural reforms implemented over the past decade, have been instrumental in Sweden's recent strong economic performance. Economic growth has been relatively robust, employment rates are high, the general government and the external current account register large surpluses, and the public debt is declining. Directors observed that the sound policy framework has increased the resilience of the Swedish economy and helped maintain positive growth in the face of the current global economic slowdown.
Directors noted that economic activity is projected to pick up from the second half of this year, on the strength of rising external demand and a favorable competitive position. However, they stressed that the outlook is uncertain. In the near term, the projected recovery remains vulnerable to continued difficulties of the world telecom sector, and adverse confidence effects from declining equity markets. More fundamentally, Directors expressed concern that a shrinking effective labor supply and continuing rigidities in product and labor markets could undermine the economy's supply response. Thus, they recommended more emphasis on policies for enhancing productivity and labor supply to create the basis for sustainable high growth.
Directors endorsed the monetary tightening by the Riksbank earlier this year, and welcomed the decline in headline inflation to around the target level in recent months. However, they cautioned that, if the recovery gathers pace as projected, demand pressures —combined with labor and product market distortions—could again push inflation above the target. In light of this concern, Directors supported a "wait-and-see" approach, with a bias toward further tightening of monetary policy in the near term. Directors also expressed confidence that, in the event of a decision to adopt the euro, Sweden's sound macroeconomic fundamentals should ensure a smooth transition from the inflation-targeting regime to exchange rate stability.
Noting remaining uncertainties—and some fragility—in the projected recovery of the economy, Directors supported Sweden's near-term fiscal plans. In particular, they considered that a moderately expansionary stance in 2002 is warranted, and that the shift to a broadly neutral stance in 2003 is appropriate. They stressed the importance of implementing the announced fourth and final step of the income tax reform in 2003, with parallel measures to contain expenditure.
Directors praised the design and steadfast implementation of Sweden's medium-term fiscal framework. They considered the targeting of a surplus of 2 percent of GDP over the business cycle to be appropriate. This target was generally viewed as giving sufficient room for stabilization policy during downturns, even given the deficit ceiling of the Stability and Growth Pact, while allowing enough scope to bring down Sweden's high tax burden. Directors noted that the surpluses projected by the authorities appear to be consistent with this target. They welcomed the authorities' firm commitment to nominal expenditure ceilings: this is essential to ensure that the general government surplus target will continue to be met. Directors stressed, however, that continued spending pressures may necessitate further adjustment efforts. They considered that a modification of the expenditure rule could prove useful, particularly to ensure that discretionary spending does not use up the cyclical margins built into the budget by the authorities.
Directors stressed that fiscal and structural policies should focus on strengthening the economy's supply side. Beyond the current program of tax reform, the authorities should follow through on their intention to pursue a further balanced lowering of taxation and spending, aimed at reducing distortions and maximizing growth and welfare. Key measures in this context would include reducing the high marginal effective tax rates on labor income, reforming the wealth tax, and containing the rapidly rising budgetary costs of early retirement and sickness absence.
Concerning the system of sickness benefits, Directors considered it essential to put in place reforms that would rein in escalating absenteeism, while ensuring adequate social benefits to those in need. The sharp rise in absenteeism has contributed to higher costs, lower productivity, and a large increase in public spending, with adverse implications for public finances and the economy's supply potential. While Directors saw the government's program of improving occupational health as an important first step, they urged greater emphasis on changes in the incentive structure to address moral hazard issues. They suggested tightening eligibility criteria, as well as increasing employers' financial responsibility.
Directors encouraged the authorities to enhance labor mobility by easing employment protection rules and by liberalizing the rental housing market. The case for reviewing policies affecting the integration of immigrant labor into the labor force was also mentioned. Directors saw a need for further widening the compressed wage structure, restraining wage growth to reflect gains in productivity, and focusing active labor market policies toward the long-term unemployed and job search support.
Directors noted that the momentum of deregulation seems to have slowed in recent years. They stressed the need to enhance competition in the economy, especially in retail distribution, air transport, pharmaceuticals, construction, and rental housing. They also noted that further progress in privatizing public enterprises operating in competitive markets would be desirable.
Directors welcomed the favorable findings of the Financial System Stability Assessment, which concluded that Sweden's financial system, and its regulatory and supervisory arrangements, comply with international codes and standards. They noted that stress tests, as well as recent experience, indicate that the major financial groups remain robust to market and credit risks in the event of a downturn. However, the concentration of the major financial groups' exposures to a relatively small number of counterparties, and residual risks in the securities settlement system, are considered potential sources of vulnerability that need close monitoring. In light of the systemic importance of large Swedish banks in several countries, Directors welcomed the authorities' intentions to review and strengthen the resources and powers of the supervisory authority, and to address the risks in the securities settlement system. They commended also the recent joint Nordic risk management exercise, and the authorities' plans to develop further their arrangements for crisis prevention and management in consultation with other relevant jurisdictions. Directors also welcomed the authorities' legislative efforts to combat money laundering and the financing of terrorism.
Directors praised the high level of Swedish official development assistance and welcomed the authorities' intention to raise it further from its current level of 0.73 percent of GNP.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.
IMF EXTERNAL RELATIONS DEPARTMENT