On August 28, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Sweden.1
Sweden’s economy is gaining speed. Following a moderate slowdown in 2011–12, GDP growth reached 1.6 percent in 2013 and is set to accelerate further, driven by robust household consumption and strengthening private investment. The output gap is narrowing and employment is growing solidly. However, with the labor force expanding even more strongly—reflecting both past reforms and Sweden’s growing immigrant population—unemployment has remained high and has been borne disproportionately by the young, low-skilled and foreign-born. This suggests that much of the increase in unemployment is structural. At the same time, inflation has remained very low, driven by external and domestic factors. Financial stability is an increasing concern, against a background of high and rising household debt and fast house price growth.
Financial instability is the key downside risk, especially in the context of Sweden’s large banking system. Household debt has reached 190 percent of disposable income on some measures, more than two thirds of new mortgages have variable rates, and a significant share of household net-assets is illiquid. Against this background, adverse shocks to interest rates, house prices, or income could quickly translate into lower consumption, higher unemployment, and reduced growth, and ultimately impact the banking system, especially if these shocks occurred at a time of high global funding stress. Sweden’s large and regionally connected banks are also vulnerable to financial tensions in other Nordic countries and the Baltics. Conversely, financial instability in Sweden would affect the rest of the region.
An extended period of very low inflation or a drop in global trade triggered by rising geopolitical tensions also pose risks. Lasting low inflation could cause longer-run inflation expectations to fall significantly below the inflation target. This, in turn, could act as a drag on growth if households and firms defer expenditures in anticipation of lower prices in the future.
The policy framework is supporting the recovery and strengthening bank balance sheets. Fiscal policy will remain expansionary through 2014, and the Riksbank has lowered its policy rate to near zero. Minimum mortgage risk weights are set to rise to 25 percent at the end of 2014, and the Basel III toolkit is being deployed mostly ahead of time. But even though first steps have been taken to strengthen mortgage amortization and address housing supply shortages, these measures are unlikely to stop household credit growth against a background of record-low borrowing costs and strong expectations that house prices will continue to increase.
Executive Directors welcomed the Swedish economy’s strong economic performance, which reflects supportive macroeconomic policies and strong household demand. However, Directors noted that high and rising household debt and house prices pose financial stability risks and complicate the conduct of monetary policy in the context of very low inflation and high unemployment. They encouraged the authorities to persevere with their prudent macroeconomic management while addressing emerging vulnerabilities.
Directors generally supported the authorities’ intention to embark on fiscal consolidation soon, in light of the favorable growth outlook. They emphasized, however, the need to calibrate the pace of adjustment so as not to hamper the economic recovery. Directors also agreed that achieving the authorities’ medium-term surplus goal would help preserve the policy room necessary to tackle rising demographic pressures.
Directors recognized that monetary policymakers face the challenge of balancing macroeconomic concerns against financial stability risks. While the recent policy rate cut should help keep inflation expectations well anchored, very low interest rates could further fuel household borrowing, calling for an earlier policy reversal than warranted by price stability concerns to contain financial stability risks. Accordingly, Directors considered that additional steps will be needed to manage the associated tradeoffs through additional
Directors welcomed the authorities’ ongoing initiatives to strengthen bank balance sheets, but saw scope to further improve capital buffers and liquidity positions. Directors also recommended introducing gradually macroprudential measures that target credit demand directly, including statutory amortization rates, lower loan-to-value caps, and limits to debt service-to-income ratios. Phasing-out the tax deductibility of mortgage interest payments would further reduce incentives to accumulate debt. Given the size and orientation of Sweden’s banks, Directors also highlighted the importance of strong cross-border cooperation among supervisors, and a number of Directors encouraged the authorities to consider the potential benefits of joining the European banking union.
Directors agreed that housing supply rigidities need to be addressed to contain house price pressures. In this context, they also saw scope for measures to improve the allocation of the existing housing stock, for example, through tax reform and changes to the rent-setting process.
Directors commended the authorities for the broad labor market reforms undertaken in recent years. Nonetheless, they saw a need for further efforts to address more effectively the high unemployment, particularly among vulnerable groups. They recommended exploring ways to increase wage flexibility and developing vocational training programs aligned with employers’ needs.
Directors took note of the staff’s assessment that the value of the krona is broadly in line with medium-term fundamentals. They also took note of the staff’s assessment that Sweden’s strong external position reflects mostly structural factors.