On Sweden’s household debt problem

Sweden has been one of the countries to have best weathered the economic crisis. Despite a hiccup in its domestic economy and the extra deflationary impulse from souring loans to the Baltics in 2009, the Swedish economy has been remarkably resilient. Yet, the economy has begun to falter, in large part because of its connectedness to the euro zone. The Swedish central bank, the Riksbank, has cut interest rates to 1% as the economy slows. But it is housing inflation and the related high levels of household debt which are the true Achilles heel for Sweden.

Over the past few days, I have highlighted a number of posts on the Swedish economy in the links and promised to say a bit more about Sweden in a separate post. Fred Sheehan beat me to it with the last post here at Credit Writedowns on Sweden and Canada. I recommend reading his analysis. I want to frame the issues from my point of view, however.

Before the global financial crisis began in earnest, I had begun to sound the alarm on the four most vulnerable bubble economies, the UK, the US, Spain and Ireland. In August 2008, I looked at two response models from the 1990s for dealing with the crisis I believed would come. First, I looked at Japan’s crisis response and decided it was unclear whether the Japanese response helped or hindered the economy in recovering. On the other hand, I called the Swedish banking crisis response  a model for the future because the Swedes wrote down asset valuations quickly, liquidated their banks’  bad debts and separated liquidity and solvency concerns quickly.

In my view, of the bubble economies, Ireland has most closely followed the Swedish response model though the euro tether and the large size of Irish bank balance sheets relative to the size of the domestic economy has hindered Ireland’s success relative to Sweden’s in the 1990s. Moreover, Sweden didn’t really nationalise its banks as is assumed. The UK and the US have more closely followed the Japanese model and I am sceptical about how long-lasting the reprieve this will give these countries. We will be able to understand more clearly during the next economic downturn as we did in Japan in 1997. Spain is now being forced into an Irish-style response, again with less success because of the currency, the socialization of losses, increased state liabilities for a currency user state, and the relative size of the bad mortgage loans.

Yet, during this particular downturn Sweden has not done what it did in the 1990s. About the time I was extolling the Swedish 1990s banking crisis response, the Swedish daily Dagens Nyheter was pointing out that the IMF considered Sweden’s house prices even more overvalued than US housing. Sweden’s response this time was to cut interest rates to zero percent and even charge banks 25 basis points for holding reserves in an effort to get them to lend.  Politically, it is much easier to try to recapitalize the banks through higher margin spreads in a steeper yield-curve environment. The Swedish reflation approach re-ignited the concerns about a bubble as early as 2009. But, unless the bubble collapses and problems are as severe as they are in Spain and Ireland, everyone tries to do it this way.

That brings us to the recent articles on Sweden. As I mentioned earlier, Sweden’s housing overvaluation was higher than the United States’ in 2008. And while prices have fallen 6% in real terms since the peak, house prices are still very highly valued after what Macro Business, a widely-read Australian economics blog, calls an increase in house price of 165% in real terms from 1996-2010. This has left behind a mountain of household debt.

Bloomberg wrote recently:

While the pace of credit growth has eased, household debt still reached a record 173 percent of disposable incomes last year, the central bank estimates.

That far exceeds the 135 percent peak reached at the height of Sweden’s banking crisis two decades ago. Back then, the state nationalized two of the country’s biggest banks after bad loans wiped out their equity. Nordea Bank AB is the product of a series of state-engineered mergers born of that crisis.

So house prices in Sweden were more overvalued than prices in the US in 2008. House prices in the US fell by a third and they fell by 6% in Sweden. Meanwhile Sweden’s household debt levels are now higher than they were when they suffered a banking crisis twenty years ago. In my view, this combination is what makes Sweden vulnerable.

Now, Macro Business seems to tout Sweden’s response in its article because the macroprudential regulatory response has been more aggressive than it has been in Australia where similar overvaluation problems exist.

They write:

So here we have another nation with a housing problem looking to implement curbs on mortgage lending via macroprudential tools. But that’s not the end of it. Sweden has a weakening economy, in part a result of an overvalued currency (though less so than ours). Nonetheless, the Riksbank, Sweden’s central bank, has also slashed interest rates by 75bps points to 1% in the last year and is forcing down the krona:

Swedish krona

Regular readers will notice that this is the very prescription recommended at MB for the past 18 months. Install macroprudential tools, break the link between interest rates and the currency, slash rates and allow the currency to boost the tradabele sector without bursting or growing further overpriced assets.

Australian authorities need to look at Sweden.

Another article extoling the macroprudential approach taken by Sweden can be found in Bloomberg, starts off this way:

Sweden, home to Europe’s safest banks, says the key to avoiding the next financial crisis is to ignore calls for harmonized capital rules and apply individual regulatory standards to match national risks.

The Financial Supervisory Authority in Stockholm, which requires Swedish lenders to adopt more rigorous capital rules than those set by the Basel Committee on Banking Supervision, says industry demands to target uniform requirements don’t take into account the lessons of the most recent financial crisis.

“It would be silly, and negative, to have exactly the same rules in all countries,” FSA Director General Martin Andersson said in an interview. “While we should have minimum levels in all countries, different nations should be able to go above those minimum levels — otherwise we delete the experience we have made in the past few years that we sometimes have to do more to remove imbalances in individual countries.”

Banks in Sweden — a AAA rated nation struggling to contain record household debt — face a different set of risks than their peers elsewhere in Europe. Rules guiding the industry need to reflect that, Andersson said. It’s a viewpoint that has won support from the financial regulator in the U.K., home to Europe’s biggest banking hub.

On the other hand, another Bloomberg article by the same author takes a more sceptical tone from the outset:

Sweden’s financial regulator says it’s ready to tighten restrictions on mortgage lending to stop banks feeding household debt loads after a cap imposed during the crisis failed to stem credit growth.

“Swedish households today are among the most indebted in Europe and we cannot have household lending that spirals out of control,” Martin Andersson, the director general of the Financial Supervisory Authority, said in an interview in Stockholm. “If that would happen, we can utilize the two tools we do have again, or look at other alternatives.”

The FSA is ready to enforce a cap limiting home loans relative to property values to less than the 85 percent allowed today, Andersson said. Banks may also be told to raise risk weights on mortgage assets higher than the regulator’s most recent proposal, he said. The watchdog has other measures up its sleeve should these two prove inadequate, he said.

As most of the rest of Europe grapples with austerity and recession, the region’s richer nations, including Sweden, Norway and Switzerland, have been battling credit-fueled housing booms. And with southern Europe sinking into a state of deeper economic decline, the prospect of monetary tightening remains remote. That’s adding to pressure on Swiss and Scandinavian regulators to counter the effect of low interest rates on their markets.

In these articles, the stress is on macroprudential regulation as a cure-all for credit excesses. I am considerably more sceptical of the ability of macroprudential regulation to work when monetary policy is creating incentives for households to take on more debt. This is the also the Canadian model where household debt is also a problem despite the increasingly restrictive macroprudential regulatory environment. And in both cases, I believe those economies are extremely vulnerable to an economic downturn, especially given that their low policy rates leave them little room to use monetary policy to counteract a deflating asset bubble. At least the last article points out that Swedish households are among the most indebted in Europe. But the article makes it seem like the Swedes are doing all the right things.

Due to the Swedish response to the crisis, the Swedish economy was booming again by 2010. In early 2012, the Swedes were still reporting strong numbers – so much so that later in the year Swedes were even speculating in the deflating Spanish housing market. However, the Swedish economy is now decelerating along with the rest of Europe, though the free-floating currency does give Sweden more flexibility. The economy grew 0.9% in 2012 and is expected by economists to grow at a faster 1.2% rate in 2013. Consumer prices are on the verge of deflation and unemployment is 8%. Economists expect the Riksbank to cut rates another 25 basis points to deal with the slowdown. Blooomberg gives the full rundown here.

I see Sweden in the same light as Denmark and the Netherlands that have already seen their housing bubbles pop and are now dealing with the fallout of systemic banking problems. The Economist ranks Sweden as having one of the most overvalued housing markets on a price to rent and price to income basis. The question, therefore, is how the Swedes get back to fair value. Does the economy grow above trend while property price increases level off? Or do property prices drop? Historically, when we see household debt levels rise as high as they have in Sweden, the outcome is usually one of debt stress from a recession causing deleveraging in the household sector and concomitant decreases in property values. 

Given the low and decreasing policy rates in Sweden, I would expect the outcome to be lower house prices and a popping bubble as it has been in Denmark and the Netherlands. The household debt levels are too large to be able to withstand an economic downturn without significant household deleveraging. And that necessarily means a popping housing bubble and fall in house prices. It is only when this happens that we will understand whether the macroprudential approach can overcome the credit acceleration impulse that easy money has created. In the meantime, a good trading angle to deal with this would be to be long large Irish banks and short large Swedish ones.

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