Public Information Notice No. 05/124

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Sweden

September 15, 2005

On September 7, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sweden.¹

Background

Growth in the Swedish economy continued to exceed that in the euro area in 2004. The acceleration in growth was driven by the global recovery and supported by a stimulative monetary stance. Export growth was led by a strong recovery in the telecommunications and automobile sectors, and, combined with rising capacity utilization and record low interest rates, helped sustain a revival of business investment after a three-year slump.

Despite the strong cyclical upturn, employment continued to decline and unemployment rose further. Apart from the usual lags in a cyclical upswing, the subdued labor market reflected the interplay of several factors. Hours worked rose as the very high level of sickness absence observed in recent years began to decline. The momentum of productivity gains was maintained as restructuring continued apace in the business sector. High tax wedges and a relatively compressed wage structure continued to weigh on the labor market.

Strong productivity growth and the subdued labor market kept inflation below target, creating the room for monetary easing in early 2004. Wage moderation, combined with continued strong productivity gains, reduced unit labor costs, keeping underlying inflation pressures in check. Headline inflation was also kept low by declining non-energy import prices and, more recently, falling food prices, reflecting intensified foreign competition in the retail trade sector.

The strong competitive position of the Swedish economy is reflected in continued large current account surpluses. Despite some recent depreciation in early 2005, the krona remained broadly stable in nominal as well as real effective terms over the year to May 2005. The stock market continued its steady recovery on the back of strong corporate earnings. Long-term interest rates declined, with the yield on 10-year government bonds falling below that on corresponding German bonds in recent months compared with a premium of 50 basis points at the beginning of 2004.

The fiscal outturn for 2004 was significantly better than expected, but the budget for 2005 foresees a sharp fall in the general government structural surplus. Cuts in income and wealth taxes are only partially offset by expenditure restraint as additional resources are devoted to labor market programs and employment subsidy schemes. Prospects of achieving the 2-percent structural surplus target for the general government have receded beyond the medium-term policy horizon. Margins under the expenditure ceilings for the central government are too narrow to provide leeway in the event of unexpected shocks and reliance on tax expenditures for compliance with the ceilings has increased.

The Riksbank's decision to cut the policy rate by 50 basis points in June 2005 reflected a significant worsening of the outlook for growth in 2005.The weaker than expected outturn for the first quarter and the consequent downward revision to the inflation forecast weighed heavily in the Riksbank's assessment. While a cut was widely expected, its magnitude took the market by surprise.

The outlook for growth and inflation in 2005-06 remains generally favorable, although the risks are tilted to the downside. The staff sees the weakening of growth as temporary and forecasts growth to be sustained at 2 ½ percent. The macroeconomic policy stance in both years is set to be strongly stimulative. Household consumption is expected to gather speed on the back of tax cuts, continued low inflation, and rising confidence, while business investment is set to pick up strongly reflecting emerging capacity constraints, continuing low interest rates, and favorable profit opportunities. Several indicators point to an imminent recovery of the labor market, which so far has been elusive. The weakness of growth in the first quarter of 2005 indicated by preliminary national account estimates is primarily due to temporary factors. With the output gap continuing to narrow and productivity growth decelerating, CPI inflation is projected to rise gradually, but is still expected to remain close to 2 percent, despite the rise in oil prices.

Downside risks to the growth outlook have increased, primarily from external sources: lower growth in the euro area than currently projected, a further depreciation of the U.S. dollar, and persistent high oil prices. The adverse impact of the failure of euro area growth to pick up as expected is likely to be cushioned to some extent by the recent diversification of Swedish exports towards emerging markets in Europe, Asia and the Middle East. The most prominent domestic risk is a further delay in the expected recovery of the labor market.

Executive Board Assessment

Executive Directors commended Sweden's remarkable economic performance in recent years, underpinned by large productivity gains, persistently low inflation, and a comfortable external position. Directors noted that much of this performance can be traced to a stable policy regime of fiscal discipline and credible inflation targeting. They encouraged the authorities to build on their successes and pursue their structural reform agenda with renewed vigor in order to address the challenge of population aging and fully realize the benefits of global integration.

Directors considered that prospects for growth remain favorable in 2005-06, with macroeconomic policies fully supportive of demand. They noted, however, that a less favorable external environment, including persistently high oil prices, and a possible delay in the expected recovery of the labor market, pose risks to the prospects for growth. Some Directors also pointed to the risk of a slowdown in household consumption.

With inflation projected to be below target over the next two years, Directors viewed the Riksbank's decision to cut the policy rate by 50 basis points as appropriate. However, with the outlook for growth appearing to turn more favorable than perceived at the time of the decision, interest rates may need to be raised at some point to safeguard the inflation target. Directors welcomed the Riksbank's recent initiatives to refine its communication strategy.

Directors commended the authorities' continued strong political commitment to sound public finances and their strong record in this respect. Nevertheless, the substantial fiscal stimulus planned for this year and next, in spite of the favorable economic outlook, was seen by many Directors as indicating a gradual shift away from the spirit of the fiscal framework. In particular, they pointed to the postponement of the goal of achieving the 2-percent surplus target beyond the medium-term policy horizon and the narrowing of the contingency margins under the expenditure ceilings for the central government. Directors recognized that these strains are not likely to be costly in the short run, and were reassured by the authorities' continued commitment to the fiscal framework. Nevertheless, straining the fiscal framework in relatively favorable economic circumstances could reduce the room for fiscal maneuver in the event of a downturn, and could be costly later when fiscal pressures from population aging intensify.

Against this background, Directors considered various possible improvements to help preserve the credibility of the fiscal framework. Most Directors supported the view that clarifying the criteria for assessing compliance with the surplus target—by specifying the interpretation of "over the cycle"—would improve fiscal transparency and accountability, and avoid entrenching a procyclical bias to fiscal policy. To enhance the discipline imposed by the ceilings on central government expenditures, Directors suggested establishing a formal link between the surplus target and the expenditure ceilings. Directors also recommended reevaluating the existing framework for intergovernmental fiscal relations, with a view to enhancing the incentives for fiscal discipline and efficiency for local authorities. Some Directors saw merit in setting up an independent body to assist in the implementation of the fiscal framework, in order to enhance transparency and strengthen enforcement. Many other Directors, however, saw no need for creating such a body, given the authorities' strong commitment to sound public finances and the evidence of already considerable independent fiscal comment and debate.

Directors underscored that further reforms of the tax-benefit system should remain a priority in order to alleviate the disincentive effects on labor supply and employment creation, and achieve the authorities' ambitious labor market and social policy objectives. While Sweden's generous child and elderly care system is exemplary, especially as it encourages high female labor participation, Directors highlighted several other elements of the tax-benefit system that discourage work effort. In particular, they stressed the importance of lowering the tax burden at the lower end of the wage distribution, and of further steps to reduce sickness and disability absences, especially among younger workers. Directors also recommended some streamlining of the benefit system and tightening of its administration to foster work effort and to help ensure the viability of the extensive social insurance system in the face of increasing globalization. Some Directors suggested that active labor market programs be scaled down, given their limited effectiveness.

Directors encouraged the authorities to accelerate the pace of other structural reforms to enable Sweden to address long-term demographic challenges from a position of economic strength and reap the full benefits of enhanced global integration. They welcomed the progress in recent years, but pointed to the need to further raise competition in important sectors, including construction, pharmaceuticals, and retail trade. The authorities were also encouraged to consider steps to deregulate the housing market, and to open up the provision of services by local governments to greater competition.

Directors viewed Sweden's financial sector as sound, underpinned by the recent sizeable improvement in bank profitability and corporate financial positions. While systemic risks in the financial sector appear remote, Directors nevertheless supported the view that risks associated with the high level of household borrowing and the rise in property values call for continued close monitoring.

Directors praised Sweden's continued commitment to a liberal international trading system and its high level of official development assistance.