Sweden: Bye-Bye Boom Time?

So far, Sweden has been a strong performer…

Since the last global recession in 2001, Swedes have enjoyed a marked improvement in their standard of living. On average since then, Swedish growth has averaged 3.1% while the Euro area has averaged 1.6%. In 2007, growth between the two regions converged. Our base case for 2008 has Sweden holding up better than the Euro area, with growth close to trend at 2.4% against 1.6% for the Eurozone. This assessment is based on a recovery of net exports, which weighed heavily on growth in 2007, and the absence of any indications of a coming credit crunch. However, the risks to this base case are on the downside.

Economy faces a smorgasbord of risks.

Downside risks for Swedish economic performance are evident both internationally and domestically. From an international perspective, Sweden’s openness makes the economy vulnerable to the worldwide slowdown in the year ahead. Domestic risks, on the other hand, arise from a possible reversal in the housing market as well as weaker productivity growth – particularly given recent strong wage growth. Depending on the precise constellation of events, the next year may therefore turn out to be a testing one for the Riksbank, particularly since challenges arise from the supply side as well as the demand side of the economy.

International Risks: catching the American cold?

The degree of openness of the Swedish economy has grown steadily over the last 15 years, with exports now making up about half of Sweden’s GDP. While there are obvious benefits to increased participation in the international division of labour, the country is now even more vulnerable to an external slowdown. Sweden’s exports are still mostly shipped to the industrialised world. Of course, Swedish firms are gradually conquering new markets – the share of exports going to China is currently 2%, twice as much as in the early nineties. Yet exports already slowed in 2007, when both the US and the Eurozone economies were in good shape. If these economies slow substantially next year, as we anticipate, Sweden will feel the impact, too.

Domestic risks: housing, consumption and productivity.

Swedish house prices have increased by an impressive 130% in real terms over the last 10 years (see Exhibit 2). Our colleagues David Miles and Vladimir Pillonca (see European Economics: Financial Innovation and Housing and Mortgage Markets, 17 July 2007) estimate that slightly more than 50 percentage points of this increase can be attributed to expectations of further increases in house prices, while only around 30 percentage points can be put down to the reduction in real interest rates. At the same time, household indebtedness as a proportion of disposable income has reached 140% (see the Riksbank’s latest Financial Stability Report). In 2H07 house prices ground to a halt; if the housing market goes into reverse, household balance sheets will be affected substantially.

The overall impact on consumption will then depend on the strength of this wealth effect, and on the evolution of disposable income. If the latter turns out well – which, in turn, will depend mainly on households’ employment situation – then there should be little to fear from any reasonable correction in house prices. Recent consumer confidence indicators show first signs of pessimism in the outlook of Swedish households – including for their future employment prospects. If consumption does slow markedly it will compound the effects of the international slowdown, particularly since domestic demand has already made up for the shortfall in exports during 2006 and 2007. A mitigating factor may prove to be some of the reforms the government enacted recently, many of which will take effect from 2008. Lower income taxes, for example, will result in higher disposable income, which will be good for consumption. And a property tax freeze may support a weakening housing market. Overall, however, we see the risks emanating from the housing market as substantial.

Another likely slowdown next year is in labour productivity. This has grown swiftly over the last few years, averaging 3% between 2002 and 2006. This is unlikely to persist at such a mature stage of the cyclical expansion, with employment having expanded considerably: Companies are now having to hire less productive workers, or find it increasingly difficult to find workers with the right skills. In the first three quarters of 2007, labour productivity growth has already slipped to 2.2%.

Wage growth on the other hand will continue to be strong. This year’s wage negotiations for a significant proportion of employees have locked in an average level of nominal wage growth well above 3 percent annually over the next 3 years (see Riksbank, Monetary Policy Report 2007:2). Such wage increases would not be worrisome if labour productivity maintains its pace or even slows somewhat below 2% next year. But productivity growth in the vicinity of 1%, combined with even a moderate amount of wage drift, would result in faster unit labour cost growth. Some relief may again come from the income tax cut mentioned above: To the extent that it influences labour supply substantially – and immediately – it will expand potential output and employment and thereby ease cost pressures. We do not think that any effects on labour supply will materialise that quickly, though.

Implications for monetary policy.

A benign scenario for monetary policy in Sweden may be that the international slowdown cools the economy sufficiently so that no further hikes are required. Indeed, we anticipate the Riksbank to remain on hold for at least 1H08, a profile that mimics our expectations for the ECB. From the central bank actions, therefore, we do not expect any substantial impulses for bond spreads.

Yet problems may emanate from the supply side of the economy. As explained above, unit labour costs are set to rise on the back of lower productivity growth and strong wage increases. This may be reinforced by the impact of high energy and food prices - these are already having an impact on inflation. Although we expect oil prices to slightly ease next year, past increases will keep feeding into prices over 1H08. This would significantly narrow the Riksbank’s room for manoeuvre: Lowering interest rates to counteract the adverse demand side developments outlined above will be difficult if underlying CPIX inflation keeps creeping upwards. At the time of writing, CPIX inflation is just shy of the 2% Riksbank target but on a clear upward trend. While we do not expect CPIX inflation to exceed the Riksbank’s upper tolerance level of 3% next year, it may well move towards that level. A lot will depend on the productivity growth rate that will prevail, a variable which is very difficult to forecast.

By Spyros Andreopoulos London
Morgan Stanley
December 16, 2007