Public Information Notice No. 99/87

Public Information Notice: IMF Concludes Article IV Consultation with Sweden

September 2, 1999

On August 25, 1999, the Executive Board concluded the Article IV consultation with Sweden.¹

Background

The Swedish economy came under severe pressure in the early 1990s when a number of forces--high wage and price inflation, the bursting of a bubble in real estate prices and bank shares, a consequent banking crisis, and a forced exit from the currency peg against the Ecu--brought on the country's deepest recession since the 1930s. The damaging effects from the combination of high public sector employment, generous welfare benefits, high tax rates, and a high sensitivity of government finances to the business cycle were laid bare by the recession and led to a loss of confidence in the credibility of Sweden's financial policies. Since then the authorities have done much to restore stability and credibility, through a swift resolution of the banking crisis and the adoption of solid macroeconomic policies centered on inflation targeting and a strong fiscal consolidation program. The success of these policies has been evidenced since 1993 by exceptionally low inflation and a competitive and generally stable floating exchange rate; and more recently by a fiscal surplus and strong economic growth.

Progress on structural reform--especially on taxation and wage formation--has been less pronounced. Real GDP growth accelerated to 2.9 percent in 1998, as a result of a strengthening of domestic demand. Private consumption was aided by sizeable real wage increases, declining unemployment, increased government transfers to households, and rising asset prices, while investment was boosted by a combination of improved profit conditions, a healthy economic outlook, and lower interest rates. Employment rose by 1 ½ percent in 1998, and by a further 2 percentage points during the first half of 1999, while the open unemployment rate fell to 5 ½ percent. Including the 3½ percent of the work force that is still enrolled in labor market programs, total unemployment is around 9 percent. The external current account position has been in surplus since Sweden abandoned its fixed exchange rate in 1992.

Fiscal adjustment has been dramatic since the implementation of the consolidation program in 1994. A combination of spending cuts and tax increases, augmented by reduced interest costs, produced a structural improvement amounting to 10 percent of GDP and led to a fiscal surplus of 2.2 percent in 1998. Even so, total government expenditure and taxation account for well over half of GDP and are far above the industrial-country average. Looking ahead, expenditure control is being reinforced by a comprehensive reform of the old-age pension system and supplemented by a nascent program of restructuring and privatizing public-sector enterprises. These policies are expected to reduce consolidated gross debt from 75 percent of GDP in 1998 to 51 percent in 2002, while net debt would fall from 15 percent to zero.

Consumer prices have been stable over the past 12 months, while the underlying inflation rate (which excludes the effects of changes in interest rates, indirect taxes, and subsidies) has been 1.2 percent. With inflation remaining that subdued, the Riksbank was able to lower short-term interest rates gradually by a total of almost 1 ½ percentage points. With no further change in interest rates, the Riksbank projects that the gradual elimination of unutilized resources in the economy will push underlying inflation to about 2 percent (the central point of the target range of 1-3 percent) over the next two years.

With fiscal policy turning slightly expansionary and interest rates staying low, conditions are in place for a continuing recovery. Growth is projected to remain around 2 ¾ percent through 2001, with favorable employment growth pushing the employment-population ratio toward the official objective of 80 percent. The open unemployment rate is projected to decline to 5 percent in 2001.

Executive Board Assessment

Executive Directors welcomed Sweden's successful efforts in recent years to restore macroeconomic balance by implementing prudent fiscal and monetary policies. The shifts from a large fiscal deficit in the early 1990s to a surplus in 1998 and from high inflation to stable prices were major achievements. Directors noted that the program of fiscal consolidation pursued since 1994 was primarily responsible for the strengthening of the public finances, and that the inflation targeting approach to monetary policy had been successful in achieving low inflation. Directors also reiterated their praise for the way Sweden had restored the soundness and profitability of the banking and financial sectors after the crisis of the early 1990s. In the past year, these strengthened policies and institutions had helped Sweden to weather the international turbulence in financial markets and to generate substantial economic growth. Directors considered, however, that the main challenge now facing the authorities is to build on their successful macroeconomic policies, and to implement more far-reaching structural reforms--especially on taxation and wage formation--so as to sustain strong economic growth and reduce unemployment.

Directors agreed that conditions seemed favorable for a continuation of growth in the near term. Interest rates were low, the fiscal consolidation program was largely complete, and a general economic recovery was under way in Europe. Although it was difficult to make an accurate judgment of the amount of slack in the economy, they agreed that some room for expansion remained, and that the strong pattern of growth expected in Sweden did not pose an immediate threat to stability. Directors expressed concern, however, about the continuing large increases in real wages, and noted that bottlenecks and inflationary pressures could reemerge as the economy approached capacity limits in one or two years. In these circumstances, they stressed the need for the authorities to remain vigilant and to be ready to act preemptively to stifle any inflationary pressures. Directors also cautioned that additional demand stimulus was unnecessary at this time, and saw scope for structural reform to enhance the economy's flexibility further.

Directors viewed the central goal for fiscal policy--to average a fiscal surplus of 2 percent of GDP over the business cycle--as appropriate. While noting Sweden's commitment to social welfare, Directors observed that the economic role of government was still remarkably pervasive, and they considered that further reductions in taxation--which would require lower spending levels--would enhance economic efficiency and the prospects for economic growth. Directors welcomed the specification of ceilings on central government spending, and noted that adherence to the announced ceilings through 2002 would be crucial for achieving the fiscal goals. A few Directors also noted the importance of spending control by local authorities.

Directors supported the authorities' stance on monetary policy. Adherence to an inflation target had enhanced both transparency and credibility, and the central bank had been able to reduce interest rates cautiously as inflationary pressures had gradually subsided in recent years. Although inflation in the consumer price index had been persistently below the lower end of the target range for the past three years, Directors recognized that the gap had resulted primarily from changes in interest rates and indirect taxes. To enhance the clarity and credibility of monetary policy further, some Directors encouraged the Riksbank to switch to an inflation target that excluded at least the effects of changes in interest rates, such as the European Union's Harmonized Index of Consumer Prices or an index of underlying inflation.

Directors welcomed Sweden's decision to keep open the possibility of joining the European Monetary Union (EMU) within a few years. Although some Directors wondered if Sweden would have much to gain from joining the EMU--since it already enjoyed both stable prices and a stable exchange rate--several of them thought that Sweden would benefit from the greater unification with other European economies that would come with EMU participation. Other Directors noted that, given Sweden's recent economic progress, the decision was at least as much political as economic.

Directors noted that the present favorable economic situation provided a good opportunity for Sweden to undertake structural reforms that would be needed, sooner or later. In this connection, they observed that the main distortions in the Swedish economy arose from the tax structure and the wage bargaining process. Marginal tax rates were high, and wage differentiation was compressed. Directors welcomed the authorities' intention to reduce taxes over the next few years, while stressing that care should be taken to keep tax cuts from stimulating demand while the economy was close to capacity. Priority should be given to reducing those taxes that are causing the greatest distortions, including those on wealth as well as labor and capital income.

Directors stressed that tax reforms should be accompanied by a comprehensive reform of the unemployment insurance system and greater wage differentiation in order to foster employment creation in the private sector. They considered that reform of the labor market should not be delayed, as such reform would help the authorities to achieve their ambitious employment objectives. Directors considered that a reduction in the tax wedge, streamlining of unemployment benefits, and reform of the wage bargaining process should receive the highest priority, as these would enhance Sweden's overall competitiveness. In this regard, they regretted the slow progress in implementing the recommendations of the Öberg Commission on reforming the wage bargaining process, and thus encouraged the authorities to foster the necessary public consensus in favor of labor market reforms.

Directors welcomed the impending pension reform, which will link benefits more closely to contributions and is expected to ensure the continued solvency of the public pension system. Also on structural reforms, some Directors recommended that the authorities accelerate the process of privatization of state-owned enterprises, while other Directors endorsed the policy of first improving the efficiency and performance of these enterprises.

Directors expressed satisfaction with the strengthening of the regulation and supervision of the financial system in recent years. Nonetheless, they encouraged the authorities to continue this process while monitoring closely the evolution of financial system risks and emerging vulnerabilities.

Directors recorded their appreciation for Sweden's aid program, and welcomed the authorities' decision to begin restoring the level of official development assistance after the cutbacks of recent years.