Public Information Notice No. 01/98

Public Information Notice: IMF Concludes Article IV Consultation with Sweden

September 25, 2001

On August 31, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sweden.¹

Background

Sweden's strong growth and financial stability of recent years are rooted in the macroeconomic and structural reforms put in place in the wake of the crisis of the early 1990s. The crisis laid bare the adverse effects of high public sector employment, generous welfare benefits, high tax rates, and the strong sensitivity of government finances to the business cycles, it led to a consensus to streamline the large public sector role in Sweden. The dramatic policy transformation was anchored in the Riksbank's successful switch to inflation targeting; deregulation in key markets induced by EU membership; and a major fiscal adjustment entailing a substantial reduction in public spending, but also a further rise in the high tax burden. The economic revival of the past three years has been marked by a booming high technology sector, real growth averaging around 4 percent, buoyant incomes and employment, and low inflation and wages.

Economic activity slackened in the first half of 2001, albeit from a rapid pace. Export growth receded, reflecting primarily the sharp slowdown in the United States and the gathering weakness in Europe. Equity prices, dominated by Ericsson, mirrored the ascent and later decline in global technology stocks. The consequent adverse wealth effects have dampened consumption, and both consumer and business confidence have fallen more markedly than in the euro area. Employment has continued to grow, but is expected to taper off.

Headline and underlying (which excludes indirect taxes and interest costs) inflation surged unexpectedly in recent months to around 3 percent—at the upper edge of the Riksbank's tolerance band—mostly reflecting the effect of supply shocks and the weak krona. Domestic underlying inflation (which in addition excludes import prices) climbed to nearly 4 percent. Notwithstanding strong fundamentals, the krona has weakened substantially since mid-2000: from June 2000 to June 2001, the krona fell by 11 percent against the euro (15 percent in trade-weighted terms) pushing the real effective exchange rate close to its six-year low.

Sweden faces continued slower economic growth in the rest of 2001, followed by a return to potential output in 2002 with the projected global recovery. However, continuing weakness of the technology sector and depressed confidence may keep growth soft into 2002, risking a weaker rebound. Three-year wage agreements for 2001-3 embody moderate negotiated wage increases. Inflation is nevertheless projected to be slightly above the Riksbank's target over a two-year horizon, mainly due to the weak krona, and the effect of supply shocks.

Fiscal policy is anchored in a structural surplus target of 2 percent of GDP for the general government. The surplus target was exceeded by a substantial margin during 2000, as revenues continued to outpace budget estimates, contributing to a faster reduction in public debt than was earlier envisaged. The budget for 2001 continued the authorities' strategy of gradual reduction in the tax burden. The Riksbank's intervention in support of the krona in mid-June was followed by an increase in policy rates by 25 basis points in early July.

Executive Board Assessment

Executive Directors praised Sweden's recent impressive growth record and the deft macroeconomic management that underpinned it, consolidating the policy gains of the past decade. Directors noted that 2000 was the third consecutive year of buoyant activity, which had helped reduce unemployment sharply, and edged the economy closer to its productive potential. Inflation remained below the Riksbank's target, the fiscal surplus again exceeded the authorities' announced aim, and the public debt continued its downward trajectory.

Directors noted, however, increasing signs that Sweden is beginning to feel a downdraft from the worldwide slowdown in activity—reflecting particularly the key role of its high technology sector. They expressed concern that softening confidence and attempts by households to rebuild savings could add to the adverse external impulses, keeping growth subdued into early 2002. Directors considered, nevertheless, that the recent upturn in inflation and the prolonged fall in the krona illustrate the medium-term risks to inflation, especially given the current high rate of resource use in the economy.

Directors praised the design and steadfast implementation of Sweden's medium-term fiscal framework, and strongly endorsed the authorities' commitment to its structural surplus targets. They advised using the room provided by overperformance in relation to these targets for a reduction in the tax burden, focusing on distortionary taxes. Directors stressed that early tax cuts would help extend the downward trend in the size of government, and, at this juncture, would be well timed to counter any unexpectedly steep slowdown in growth. Directors considered it important to maintain the medium-term ceilings on nominal central government spending, and called upon the authorities to offset mandatory inflation-induced increases in some components of spending by discretionary cuts in others, if needed.

Directors concurred with the Riksbank's assessment that the spectrum of inflation risks had shifted to the upside, and that the degree of uncertainty in the forecast remained large. They emphasized the importance of a continued clear commitment to the Riksbank's inflation targeting framework, and, given the above target forecast for medium-term inflation, concurred with the decision to raise interest rates by 25 basis points in early July.

Noting both the successes and the drawbacks of the Swedish model, Directors felt that the structural reform agenda should aim to lift the potential rate of growth above its recent range of 2-2½ percent, while ensuring that the essential achievements of the welfare state were preserved and enhanced. They noted that the current strength of public finances and the recent broadly-shared gains in income and employment offered a window of opportunity to press ahead with reforms—in taxation, public spending, the labor market, and competition—that the forces of globalization, European integration, and demography made inevitable in the longer run.

Directors called for a medium-term program of balanced reduction in taxes and spending, aiming to maximize gains in efficiency and economic growth, while respecting distributional concerns. They saw a reduction in the high marginal effective tax rates on labor as a key priority. Coupled with reforms of the wealth tax, this would greatly improve incentives. In this context, they welcomed recent indications that the wealth tax threshold would be raised in 2002. On the spending side, concern was expressed about the rapid increase in sickness benefit payments during the recent upswing and Directors called for reassessing their extent and design, as well as the allocation of their financing between employer and state. They also noted that additional measures were needed to offset the fiscal impact of the demographic shock. While commending the built-in safeguards of the reformed pension system, Directors noted the need for further measures such as raising the effective retirement age to respond to a rising dependency ratio and the impact of population aging on non-pension expenditures.

Directors commended the authorities for implementing, from 2000, a balanced budget rule for local governments, noting their key role in the strategy of fiscal reform. They called for an early reassessment of the fiscal equalization system, which hampers the incentives for local authorities to increase their tax bases or to moderate their tax rate increases. It was noted that measures were being taken to mitigate these effects.

Directors noted the recent strong performance of the labor market. In this connection, they welcomed the encouraging outcome of the recent three-year wage agreements, as well as the strengthening of active labor market programs and a tightening of duration rules for the unemployment benefits. There was also support for easing distortions in the housing market created by de facto rent control, relaxing employment protection regulations, and further widening the compressed wage structure.

Directors stressed the critical importance of continuing the strides of recent years in deregulating the economy and in eliminating monopolies. They noted that the resulting higher level of competition would promote efficiency and growth. In this respect, rental housing, construction, transportation, and retail trade were cited as sectors which held the promise of substantial efficiency gains. Privatization of public enterprises operating in competitive markets would also be desirable.

Directors concurred that Sweden's financial system was well positioned to cope with the risk of a sharper downturn than now expected. They nevertheless encouraged expanded supervision and continued vigilance, and looked forward to the conclusions of the Financial Sector Assessment Program.

Directors praised the high level of Swedish official development assistance and welcomed Sweden's intention to further increase it in the coming years from the current level of 0.73 percent of GDP. They also commended the authorities for their pivotal role in the EU decision to grant improved market access to the exports of least developed countries.

Directors praised the high quality of statistics in Sweden, and deemed them adequate for surveillance purposes.