IMF Executive Board Concludes 2008 Article IV Consultation with SwedenPublic Information Notice (PIN) No. 08/105
August 11, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2008 Article IV Consultation with Sweden is also available.
On August 1, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sweden.1
A center-right government took office in 2006 and is boosting labor participation and reducing reliance on the welfare state. The government has cut some income taxes and reduced benefit and active labor market programs. It is continuing strong fiscal policies to reduce debt.
Swedish banks have been resilient to global financial turmoil, but risks are rising. Share prices have dropped, and CDS spreads have widened, especially for those banks exposed to the slowing Baltic economies. Vulnerabilities have been mitigated by strong conditions in the Swedish economy, so far, even though Swedish house prices also warrant monitoring.
The economy has performed well, but is sensitive to global demand and activity is now moderating. Exports have benefited from sound competitiveness, but euro-area and US slowing is causing them to decelerate. Private consumption growth has been relatively smooth, as employment and wages have picked up, and disposable income further benefited from tax cuts. Investment expanded rapidly in recent years, as capacity tightened and supported by a competitive krona. Employment growth reached 2 percent, and the unemployment rate declined from 8 percent in 2005 to 6 percent in early 2008.
Tight capacity constraints boosted prices and wages. Inflation increased from ½ percent in 2005 to 4 percent in May 2008. Energy and food prices boosted the headline, but the core rate also rose to 2.9 percent. Wages have firmed up, and the Riksbank is monitoring second round effects. Unit Labor Costs (ULC) increased when labor productivity fell at the peak of the labor cycle.
The Riksbank has gradually raised the policy rate to 4.50 percent in July 2008. Fiscal policy remains strong, and the general government balance is expected to exceed the 1-percent-of-GDP structural surplus rule in the next few years. The 2009 budget, expected this fall, has some policy room to respond to the slowdown.
With strong fiscal adjustment and high private savings, the external current account surplus reached 8 percent of GDP. The trade surplus is 7 percent of GDP, and growing net external assets and favorable returns contributed net factor payments of 2 percent of GDP. Sweden's large foreign aid budget contributes outflows in excess of 1 percent of GDP.
Following global financial turbulence, the economy is expected to slow to 2 percent in 2008 and 1¾ percent in 2009. Risks to growth for 2008 are balanced. Risks for 2009 depend, among other factors, on developments in the banks. If funding costs normalize and the Baltics achieve a soft landing, stable credit expansion should support growth. If turmoil persists, Swedish housing prices fall, or Baltic exposures sour, a credit crunch could slow growth below the forecast. Sweden's long-term outlook appears sound.
Executive Board Assessment
Executive Directors commended Sweden for its strong economic performance with high output and employment growth, moderate inflation, a well-functioning financial system, solid public finances, and a favorable external position. Directors welcomed that successive authorities have addressed demographic challenges, first with pension reform and now with labor supply measures. Although subject to some uncertainty, Sweden's economic prospects are promising, provided that the financial and economic risks are managed carefully. The main challenges ahead are to continue to strengthen the financial system's resilience to adverse shocks and to firmly anchor inflation expectations.
Directors emphasized that the Swedish financial sector is performing well and that its financial indicators appear to be sound. They stressed the increasing importance of financial-real economy linkages, with the financial turbulence showing that markets react to dents in confidence with high speed and increasing costs that can lower growth. This adds a premium to sound bank management, supervision, and regulation. Swedish banks' strategy of diversifying into Baltic neighbors offers opportunities, but also requires tight risk management to minimize contingent claims.
Directors noted that market signals were indicating that banking risks have increased. While rating agencies, the Riksbank, the Financial Supervisory Authority (FSA), and the banks themselves are confident that they are able to cope with adverse events, Directors pointed out that increased interconnectedness in financial systems could accentuate the impact of shocks and spillovers. They encouraged the authorities to complete the draft law on a new banking resolution framework as soon as possible, and recommended that it be applied in a comprehensive manner. Directors welcomed the meaningful progress made by the authorities in addressing the 2002 Financial Sector Assessment Program (FSAP) recommendations, and agreed that an FSAP Update could help identify the policies and measures needed to bolster further financial sector resilience.
Directors considered that the current position of the krona provides Sweden with strong competitiveness, and noted the staff's assessment that the krona is somewhat below its estimated medium-term equilibrium value. With the krona likely to appreciate gradually over the medium term, the current account surplus should decline toward a level consistent with medium-term fundamentals. A firmer krona would also assist in mitigating foreign price pressures.
Directors welcomed the Riksbank's recent increase in the policy rate, given that inflation has risen well above the upper limit of the target band, and indicators of core inflation and inflation expectations had picked up. As short-term price pressures should not be allowed to seep into second-round effects, Directors stressed that monetary policy should remain as firm as needed to clearly break inflation expectations, and welcomed the upward bias in monetary policy.
Directors commended the authorities for their exemplary fiscal performance, and observed that Sweden now has some fiscal room to respond to a slowdown. Directors considered that the 2009 budget could include some targeted tax cuts and moderate increases in public investment in infrastructure, Research and Development, and pre-schooling to strengthen further long-run supply conditions. They welcomed the authorities' recognition that cautious policies remain warranted, given the possible drop in revenues as the economy slows. Also, tax measures could turn out more costly than expected over time and long-run aging costs remain uncertain.
Directors saw merit in further pursuing the intertemporal public sector balance sheet, which could be included in the Budget Bills, updated on an annual basis. Such a balance sheet would provide additional transparency to the fiscal position and forward-looking strategy, thereby enriching the public debate and informing policy. Periodic independent updates of the estimates of aging costs could also be useful.
Directors welcomed the authorities' continued efforts to pursue structural reforms to increase employment. Supply reforms in labor taxation should increase transparency in the tax and benefit system and reduce compliance costs. Evaluations of the efficacy of the labor supply measures by the authorities and stakeholders are welcome to make sure that these deliver the intended effect.
Directors praised the authorities for the high level of official development assistance, noting that it has exceeded 1 percent of GDP.