Public Information Notice No. 98/76

Public Information Notice: IMF Concludes Article IV Consultation with Sweden

September 25, 1998

On September 14, 1998, the Executive Board concluded the 1998 Article IV consultation with Sweden.¹

Background

Sweden’s welfare state came under sever pressure in the early 1990s when a number of factors—including the bursting of an asset price bubble and a cost crisis in manufacturing—came together to cause the country’s deepest recession since the 1930s. The fiscal deficit exploded—to above 12 percent of GDP in 1993—as tax revenue plummeted and expenditure, especially on unemployment benefits and other transfers, ballooned. The fixed exchange rate policy had to be abandoned in the context of the ERM crisis. The authorities’ efforts in recent years to restore policy credibility through a strong program of fiscal consolidation and by pursuing price stability in an inflation targeting framework have been highly successful. The fiscal accounts are set to record a surplus of at least 1½ percent of GDP in 1998 and inflation has for some years been exceptionally low. As a result, the krona has strengthened and the interest rate differential against the deutsche mark has narrowed sharply.

Following an export-led growth spurt in 1994-95, GDP growth slowed to just 1½ percent over 1996–97, reflecting stagnant domestic demand. Fiscal consolidation—through lower public spending and rising taxes which depressed disposable income—was an important reason behind the weakness of domestic demand. Employment contracted in 1996–97 but a commensurate decline in the participation rate caused open unemployment to remain unchanged at around 8 percent. With an additional 4–5 percent of the work force enrolled in labor market programs, total unemployment has been 12–13 percent in recent years.

The fiscal consolidation achieved under the 1994–95 program has been dramatic, and faster-than-expected, owing in part to an underestimation of the impact of the program on both revenue and expenditure, but also to sharply lower interest rates than assumed. Thus, notwithstanding additional spending of about 1 percent of GDP in 1998, the improvement in the fiscal balance between 1994 and 1998 is estimated to be about ½ percentage point of GDP better than envisaged at the outset.

With inflation and inflation expectations coming down—and with the fiscal deficit declining—the Riksbank was able to lower the its repo-rate incrementally by a total of almost 5 percentage points—to 4.1 percent—in the course of 1996. After holding steady for most of 1997, the Riksbank raised the repo-rate by 25 basis points in December 1997, when its forecast indicated that CPI inflation would rise into the upper half of the 1–3 percent tolerance range within twelve-to-twenty-four months. This was, however, reversed in June 1998 when the assessment of inflation prospects indicated that inflation was most likely to remain in the lower half of the tolerance range during the first half of 2000. Among the factors contributing to the improved inflation prospects were a firming of the exchange rate, lower import prices, partly owing to the Asian crisis, more moderate-than-expected wage settlements and cuts in indirect taxes.

With the fiscal consolidation program coming to an end and with interest rates low and asset prices—especially equity prices—high, the conditions for a strong and balanced recovery in the near term are in place. Growth is now projected to accelerate to around 3 percent in 1998 and 1999. The government assumes that strong growth will continue over the medium term, and that—along with the implementation of extensive education and training initiatives and early retirement schemes, which temporarily shrink the labor force—this will lower open unemployment to 4 percent by the end of the year 2000.

Executive Board Assessment

Executive Directors welcomed Sweden’s successful efforts in recent years to strengthen macroeconomic policies. In particular, they noted that the implementation of monetary policy in the inflation targeting framework had effectively achieved price stability and that the Fiscal Consolidation Program had eliminated the earlier sizable deficit. On a contrasting note, Directors expressed concern about the slow pace of structural reform.

Directors concurred with the view that, with the period of intense fiscal withdrawal associated with the Consolidation Program coming to a close, with interest rates low, and with continued economic growth in Europe, the conditions for a strong and balanced recovery were now in place. They noted, however, that there were risks to the outlook, notably from a deepening of the Asian crisis, the recent Russian crisis, or possible turbulence in international financial markets.

Directors considered that, given the slack that still prevails in the economy, the broadly neutral stance of fiscal policy and the generally supportive stance of monetary policy were appropriate. However, Directors observed that there was considerable uncertainty about the size of the output gap and the structural level of unemployment, and that this uncertainty complicated the assessment of the stance of macroeconomic policies beyond the near term. Directors therefore saw a risk that the ongoing cyclical recovery could run into capacity bottlenecks unless structural reforms were implemented to raise the productive capacity of the economy.

Directors considered that the intended fiscal stimulus in 2000 and 2001, which was outlined in the 1998 Spring Budget Bill, will be appropriate only if the projected fiscal surplus were to materialize and if output remained below potential. Without these conditions, fiscal stimulus at that stage of the cycle would likely contribute to overheating of the economy and put additional pressure on monetary policy, and would also be inconsistent with achieving the authorities’ target of a fiscal surplus of 2 percent of GDP over the cycle. If cyclical conditions did allow a fiscal stimulus, Directors would advise tax reductions rather than expenditure increases.

More generally, Directors felt that Sweden would benefit from a medium-term program of sustained expenditure and tax cuts to lessen the overall tax burden and the government’s role in the economy, in order to improve the environment for enterprise and job creation.

Directors expressed concern about the absence of significant progress on the structural front, especially in the labor market. They noted, in this context, that some of the fundamental problems which had contributed to the deep crisis of the early 1990s remained unresolved. The relatively fast wage growth, despite high effective unemployment, was of particular concern. Directors therefore stressed that fundamental labor market reform, including a better wage setting mechanism, would be desirable to help achieve a durable decline in unemployment and more rapid growth of potential output.

In this light, Directors expressed concern that the authorities’ National Employment Action Plan would be insufficient to address Sweden’s unemployment problem on a sustainable basis. They suggested that there was a need for market-oriented reforms that would spur employment growth. They suggested that, in addition to narrower wedges between wages paid and take-home pay, reforms should include greater wage differentiation, lower replacement ratios, and a shorter effective duration of unemployment benefits, as well as less cumbersome hiring and firing rules.

Directors welcomed the recently agreed pension reform, which will link benefits more closely to contributions and make the public pension system more resilient to adverse macroeconomic and demographic developments.

Directors noted Sweden’s decision not to participate in EMU from the outset, but some speakers recommended that Sweden give such participation positive consideration.

Directors warmly welcomed the authorities’ decision to begin to restore the level of official development assistance after some cutbacks during the Consolidation Program.