WHERE IS EMU AND SWEDEN HEADING Klas Eklund

WHERE IS EMU AND SWEDEN HEADING? Klas Eklund SEB March 1999

INTERNATIONAL SCENARIO The Asian deflationary process rolls on. Brazil in dire straits, but global effects less than feared; much was priced in. Different regions pull in different directions. 1. Emerging markets: Recession in Latin America. Russia has not bottomed yet. But Asia is turning. 2. Negative growth in Japan. Strategic monetary choice 3. US is strong but will slow down; a soft landing 4. Europe is braking, but will recover • • Global growth 1999 around 2% Very low inflation. Low rates - but they are bottoming Shaky stock markets, volatile currencies But no global depression

RISKS 1. Hard landing in the US. Wall Street crash and ripple effects 2. Failed monetisation in Japan. Yen causes new currency turmoil • More severe Brazilian effects • What if China and Hong Kong devalue? • Regional troubles in Mid East and South Asia • Y 2 K Krugman: “The world is a very scary place”

USA: DEFIES GRAVITY

IMBALANCES IN THE USA

EMU: A GOOD START • Convergence process worked well: A large number of countries, on time, credibility • Technically smooth transition to euro • Great potential for structural changes and reform – Price transparency – Economies of scale – Less currency volatility – Pressure on taxes • But great tests remain – Monetary and fiscal policies – Conflicts between ECB and national politicians – Federalism? • Will the SDP governments change the EMU’s role?

WHAT WILL THE ECB DO? • Many technical problems in getting started: How to measure monetary growth and inflation? • How to interpret the targets? • Core inflation rate is very low • Rates may be lowered if economy slows further – – But euro has weakened Political pressures question ECB’s independence German wage settlements are too high American rates have climbed • Conclusion: On hold for a while

DIFFERING VIEWS OF THE FUTURE

THE SWEDISH MODEL IN CRISIS • “The middle way”: Big government, big business and big unions • 1970 s through 1990 s a gradual crack-up of the old model • The water-shed: 1989 -92: Over-heating, tax reform, real interest rate shock, banking crisis, currency crisis and then budget crisis • Out of the crisis: – Resolution of banking crisis – Floating currency – EU membership – Independent central bank – Stricter budget process • Now: low inflation, strong budget, but still growth and structural problems

GROWTH AND INFLATION

INFLATION AND UNEMPLOYMENT

THE SWEDISH ECONOMY TODAY • Currency, banking and budget crises have made the 90 s volatile, while Sweden has adapted to Europe • After several weak years consumption is finally moving • But exports are slowing due to international slowdown • In total: Some slackening of GDP, but not severe • Slow improvement of labour market… …but structural reforms are badly needed • Extremely low inflation, which gradually will pick up • Riksbank can stay close to ECB levels. Will it go lower?

SWEDISH GDP GROWTH

PURCHASING MANAGERS INDEX

CONSUMER CONFIDENCE

SWEDEN: KEY FORECASTS GDP 1, 8 Export Private consumption Savings ratio Unemployment Wage costs 4, 5 Current account Inflation (CPI) 1997 3, 0 12, 8 2, 0 0, 8 8, 0 3, 5 2, 7 0, 9 1998 2, 4 6, 9 2, 7 1, 5 6, 5 4, 0 2, 3 0, 4 1999 2, 9 5, 5 2, 9 1, 3 6, 2 4, 3 2, 2 0, 5 2000 5, 4 2, 4 1, 3 5, 9 1, 5

SWEDEN: M 0 and CPI 17. 5 15. 0 12. 5 10. 0 7. 5 5. 0 2. 5 0. 0 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 -2. 5 0. 0 -2. 5 M 0 Inflation

SWEDISH AND GERMAN REPO RATES

RIKSBANK AND ECB INFLATION TARGETS 3 2 1 Riksbank inflation target ECB inflation target

THE POLITICAL SCENE • The 90 s have been turbulent and difficult for governments - and especially for SD Party. The Swedish model has been forced to adapt to Europe • 1998: A polarizing election - and a huge loss for SDP • A lot of soul-searching in several parties. The all-powerful Prime Minister is openly criticized • The parliamentary base of the Government is more fragile now. SDP needs support from two parties or more. • SDP co-operates with Left and Greens. Moves left in rhetoric - but is gradually forced to the right by markets and globalization. An untenable situation.

THE ELECTION 1998: Per cent and seats Left SDP Greens Centre 5. 2 Liberals Moderates Christ Dem 12. 0 36. 6 4. 4 43 131 16 18 4. 7 22. 7 11. 8 17 82 42 1994: Per cent and seats Left SDP Greens Centre 7. 5 Liberals Moderates Christ Dem 6. 2 45. 3 5. 0 22 161 18 27 7. 2 22. 2 4. 1 26 80 14

STRAINS BETWEEN SDP - LEFT • Globalisation will put pressure on taxes. Tax bases are becoming more mobile. Hot topic: Exodus of companies • The EMU issue is becoming more important by the day • Rigid labour market will make lower unemployment difficult to achieve • Slippages in the budget? Expenditure ceilings in danger • Internal strains inside the SDP and the Left • Conclusion: It will be difficult to make the alliance stick - but Mr Persson has still not decided when and how to change horses

ECONOMIC POLICY UNCERTAINTY • • Expenditure ceilings questioned But the budget numbers are OK Privatization will come Mo. F under siege. Conflicting power centers are built up. Negotiations on all fronts: Taxes, defense, pensions, nuclear power, labour market & wages • Long-term political uncertainty: What is Persson’s strategy? • How long will the alliance SDP-left last? When - and how- will SDP switch alliances? • Markets are normally nervous in such an uncertain situation. But the EMU process gives strength

THE TAX PROBLEM • Globalization threatens tax revenue – Flight of financial capital – Increasing brain drain – Even consumption is more mobile • Corporate tax is OK, but taxes on mid-managers and experts are becoming an acute problem • But slashing taxes on mobile bases is at odds with SDP ideology, redistribution aims and co-operation with left • Compromise in the pipe-line? Exceptions for ex-pats, promises of future cuts? • Too little too late?

DIRECT INVESTMENTS Bn SEK Inflows Net Outflows

SWEDISH AND GERMAN BOND YIELDS

EUR/SEK

WHEN WILL SWEDEN JOIN THE EMU? • No decision would mean breaking Maastricht treaty. But in reality, it is a political decision, depends on public opinion - which is turning – EMU has started – SDP governments in Europe – Turn-around of opinion in Denmark – Blair moves – EU chair in 2001 • Persson wants to move ahead – Extra SDP congress March 2000 – Referendum or snap election autumn 2000, – ERM-entry late 2000 – membership 1/1 2002?

THE SWEDISH ROAD TO EMU 1999 June 13: EU Parliament election. Riksbank analyses ”fair value” of SEK Late autumn: SDP party leadership states its view 2000 March: SDP party congress September: Referendum or snap election After that: SEK enters ERM 2 2001 Jan 1: Sweden chairs EU Preparations for euro Jan 1, 2002 Sweden enters EMU?

THE FORMAL ERM 2 DECISION • The government decides Swedish entry • Formally, Riksbank decides Swedish position on SEK level and band width • But in practice the Swedish position must be joint • Final decision taken by joint decision by – Ministers of finance in Euro zone – ECB council – ERM 2 participants (Denmark & Greece) • Decision taken after consultation with EU Commission and Economic & Financial Committee • The Riksbank needs one year before EMU entry

WHICH ENTRY LEVEL? • The Riksbank wants a firm SEK, the Government wants competitiveness • The ECB - and the Fins - want a strong SEK • EUR/SEK 8. 60 a possible level; gives TCW 115 • Note that when the SEK is tied to the euro, SEK will follow EUR vs US • Weak USD would mean much stronger SEK, tough structural demands. Puts pressure on government to want a weaker SEK • The ECB will say EUR/SEK decisive, not USD • Negotiations 8. 50 -9. 00. Forecast: 8. 60 • ERM central parity becomes conversion rate

SEK vs TCW Central parity 8. 60 EUR/USD 1, 04 EUR/USD 1, 44

SEK vs TCW Central parity 9. 00 EUR/USD 1, 04 EUR/USD 1, 44

SEK PROs AND CONs + • EMU-ERM 2 -discussion • Commercial flows • Global diversification of bond portfolios • • • - Budget negotiation worries Structural policy deficiencies Global financial turbulence No more support from short rates Swedish portfolio diversification Rapprochement to euro makes SEK less interesting • What if EMU opinion turns?

SEK CONCLUSIONS • • EMU dominates Riksbank wants SEK to enter ERM Stronger SEK dependent on EMU process U-turn on EMU would give volatility and SEK weakening because of foreign debt, economic policy and capital flows • Forecast: SEK TCW interval 124 -128 during spring, strengthening towards 119 if EMU-process on track

KEY FINANCIAL FORECASTS 990217 jun-99 sep-99 mar-00 dec-00 Repo rate 10 -year yield TCW 3, 15 2, 90 3, 25 4, 26 4, 25 4, 45 4, 75 4, 85 123, 4 125, 2 121, 7 118, 1 115, 4