WHERE IS EMU AND WHERE IS EMU AND SWEDEN HEADING?SWEDEN HEADING?

Klas EklundSEB

March 1999

INTERNATIONAL SCENARIO INTERNATIONAL SCENARIO

• Global growth 1999 around 2%• Very low inflation. Low rates - but they are

bottoming• Shaky stock markets, volatile currencies• But no global depression

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

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.

RISKSRISKS

• More severe Brazilian effects• What if China and Hong Kong devalue? • Regional troubles in Mid East and South Asia• Y2KKrugman: “The world is a very scary place”

1. Hard landing in the US. Wall Street crash and ripple effects2. Failed monetisation in Japan. Yen causes new currency turmoil

USA: DEFIES GRAVITYUSA: DEFIES GRAVITY

USA CPI all items [c.o.p 4] USA Gross Domestic Product, Volume, AR, sa [c.o.p 4]

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98-5,0

-2,5

0,0

2,5

5,0

7,5

10,0

12,5

15,0

IMBALANCES IN THE USAIMBALANCES IN THE USA

USA Personal saving rate, AR, sa USA S&P 500 Composite index

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99100

200

300

400

500

600

700

800

900

1000

1100

1200

1300

-1

0

1

2

3

4

5

6

7

8

9

10

11

EMU: A GOOD STARTEMU: 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?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 FUTUREDIFFERING VIEWS OF THE FUTURE

EMU Consumer confidence indicator, s.a. EMU Industrial confidence indicator, s.a.

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99-35

-30

-25

-20

-15

-10

-5

0

5

10

-30

-25

-20

-15

-10

-5

0

THE SWEDISH MODEL IN THE SWEDISH MODEL IN CRISISCRISIS

• “The middle way”: Big government, big business and big unions

• 1970s through 1990s 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 INFLATIONGROWTH AND INFLATION

Sweden Consumer prices all items [c.o.p 4] Sweden Gross domestic product, Volume, s.a. [c.o.p 4]

86 87 88 89 90 91 92 93 94 95 96 97 98-5-4-3-2-10123456789

101112

-5-4-3-2-10123456789

101112

INFLATION AND UNEMPLOYMENTINFLATION AND UNEMPLOYMENT

Sweden Consumer prices all items [c.o.p 4] Sweden Unemployment per cent of total labour force (SCB)

86 87 88 89 90 91 92 93 94 95 96 97 98-1

0

1

2

3

4

5

6

7

8

9

10

11

12

THE SWEDISH ECONOMY TODAYTHE SWEDISH ECONOMY TODAY

• Currency, banking and budget crises have made the 90s 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 GROWTHSWEDISH GDP GROWTH

Sweden Gross domestic product, Volume, s.a. [c.o.p 4]

86 87 88 89 90 91 92 93 94 95 96 97 98-5

-4

-3

-2

-1

0

1

2

3

4

5

PURCHASING MANAGERS INDEXPURCHASING MANAGERS INDEX

Sweden Purchasing managers index

95 96 97 9840

45

50

55

60

65

70

CONSUMER CONFIDENCECONSUMER CONFIDENCE

Sweden Consumer confidence indicator

93 94 95 96 97 98-35

-30

-25

-20

-15

-10

-5

0

5

10

15

SWEDEN: KEY FORECASTSSWEDEN: KEY FORECASTS

1997 1998 1999 2000GDP 1,8 3,0 2,4 2,9Export 12,86,9 5,5 5,4Private consumption 2,0 2,7 2,9 2,4Savings ratio 0,8 1,5 1,3 1,3Unemployment 8,0 6,5 6,2 5,9Wage costs 4,5 3,5 4,0 4,3Current account 2,7 2,3 2,2 1,9Inflation (CPI) 0,9 0,4 0,5 1,5

SWEDEN: M0 and CPISWEDEN: M0 and CPI

M0 Inflation

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

5.0

7.5

10.0

12.5

15.0

17.5

-2.5

0.0

2.5

5.0

7.5

10.0

12.5

15.0

17.5

SWEDISH AND GERMAN SWEDISH AND GERMAN REPO RATESREPO RATES

Sweden Riksbank repo interest rate, close daily Germany Repo interest rate, close daily

Jul 94 Jul 95 Jul 96 Jul 97 Jul 98 Jul 992

3

4

5

6

7

8

9

10

11

RIKSBANK AND ECB RIKSBANK AND ECB INFLATION TARGETSINFLATION TARGETS

22

33

11ECB

inflationtarget

Riksbankinflation

target

THE POLITICAL SCENETHE POLITICAL SCENE

• The 90s 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 1998THE ELECTION 1998

1998: Per cent and seats

Left 12.0 43SDP 36.6 131Greens 4.4 16Centre 5.2 18Liberals 4.7 17Moderates 22.7 82Christ Dem 11.8 42

1994: Per cent and seats

Left 6.2 22SDP 45.3 161Greens 5.0 18Centre 7.5 27Liberals 7.2 26Moderates 22.2 80Christ Dem 4.1 14

STRAINS BETWEEN SDP - LEFTSTRAINS 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 UNCERTAINTYECONOMIC POLICY UNCERTAINTY

• Expenditure ceilings questioned• But the budget numbers are OK• Privatization will come• MoF 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 PROBLEMTHE 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 INVESTMENTSDIRECT INVESTMENTSBn SEKBn SEK

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98-200

-150

-100

-50

0

50

100

150

-200

-150

-100

-50

0

50

100

150

Outflows

Net

Inflows

SWEDISH AND GERMAN BOND YIELDSSWEDISH AND GERMAN BOND YIELDS

Sweden 10 year government bond, close daily [cma 5] Germany 10 year government bond, close daily [cma 5]

92 93 94 95 96 97 98 993

4

5

6

7

8

9

10

11

12

13

EUR/SEKEUR/SEK

swe19001/emu19001 [cma 5]

93 Jul 94 Jul 95 Jul 96 Jul 97 Jul 98 Jul 997,25

7,50

7,75

8,00

8,25

8,50

8,75

9,00

9,25

9,50

9,75

10,00

WHEN WILL SWEDEN JOIN THE EMU?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 EMUTHE SWEDISH ROAD TO EMU

19991999

20002000

20012001

June 13: EU Parliamentelection.Riksbank analyses ”fairvalue” of SEKLate autumn: SDP partyleadership states its viewMarch: SDP party

congressSeptember: Referendumor snap electionAfter that: SEK enters ERM2

Jan 1: Sweden chairsEUPreparations for euro

Jan 1, 2002Sweden enters EMU?

THE FORMAL ERM2 DECISIONTHE FORMAL ERM2 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– ERM2 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?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 TCWSEK vs TCWCentral parity 8.60Central parity 8.60

93 94 95 96 97 98 99 00 01

Ind

ex

105.0107.0109.0111.0113.0115.0117.0119.0121.0123.0125.0127.0129.0131.0133.0135.0137.0

Ind

ex

105.0107.0109.0111.0113.0115.0117.0119.0121.0123.0125.0127.0129.0131.0133.0135.0137.0

EUR/USD1,44

EUR/USD1,04

SEK vs TCWSEK vs TCWCentral parity 9.00Central parity 9.00

93 94 95 96 97 98 99 00 01

Ind

ex

105.0107.0109.0111.0113.0115.0117.0119.0121.0123.0125.0127.0129.0131.0133.0135.0137.0

Ind

ex

105.0107.0109.0111.0113.0115.0117.0119.0121.0123.0125.0127.0129.0131.0133.0135.0137.0

EUR/USD1,44

EUR/USD1,04

SEK PROs AND CONsSEK PROs AND CONs

• EMU-ERM2-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 CONCLUSIONSSEK 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 3,15 2,90 2,90 2,90 3,2510-year yield 4,26 4,25 4,45 4,75 4,85TCW 123,4 125,2 121,7 118,1 115,4