Swedish Financial Crisis 1990 – 1992

Name: Kevin McSweeney

Student Number: 112472212

Module Code: EC3213

Course/Year: BSc Finance 4

Word Count (Excluding References): 1489

IntroductionThe period of Financial Instability that I shall discuss in this report is that of Sweden from 1991 to 1993. This crisis was set alive first by a forceful deregulation in Swedish Credit Markets, stimulating

private sector borrowing, resulting in the overheating of the domestic economy. This was exacerbated by a sudden spike in real interest rates and Sweden’s currency issues with its fixed Krona rate. The monetary authorities in Sweden had to respond quickly, and we shall see that the Riksbank (Swedish Central Bank) stepped in to guarantee all Swedish deposits and float the Krona. Some of the immediate effects from this crisis was an extensive rise in unemployment and damage to Sweden’s economic activity.

In the course of this report, I shall discuss the background to the crisis, how the Monetary Authorities responded, and I shall evaluate if the correct course of action was taken.

Context for the CrisisAfter World War Two, Sweden was very much a highly regulated country in the area of public finances. There were tight capital controls in place to limit the exposure of the Swedish Krona to external currency pressures, as well as liquidity ratio regulations for banks, both imposed by the Riksbank (Swedish Central Bank). In 1951, as part of the Bretton Woods Agreement, the Krona became pegged to the American Dollar. The Riksbank had the power to set interest rates and direct credit flows to where they felt they were needed. A key policy of was that of low interest rates, so that credit was always in demand. Swedish banks were mandated to invest in government bonds, whereas their lending to the public was tightly regulated.

Financial Regulations were softened during the 80s at an unexpected rate. The lending ceilings and liquidity ratio constraints for banks were lifted. Commercial banks were allowed to lend at a more rapid pace, and borrowers could receive funds at the low existing interest rate. The private sector used the increasing value of its assets as collateral for further borrowing, namely property assets. The real interest rate was mainly negative at this time due to the factors of high inflation and the tax rules in Sweden at the time that made interest payments deductible.

The biggest catalyst in this deregulation was the expansion of global financial markets. Swedish banks were losing out on this activity due to the tight capital controls imposed on them. The Riksbank knew that this deregulation would increase competition in the banking sector, so interest-bearing cash reserve requirements for banks were increased from 1% to 3%, to help keep the banks adequately capitalised.1

The economy immediately felt the impact. From 1986 to 1990, lending by financial institutions increased by 136%2, and household borrowing increased by 86%3. There was a sizeable increase in asset prices, especially in the property market.

1 Englund 1999

2 Englund 1999

3 Financial Accounts of Statistics Sweden

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Figure 1: Real price and rent indexes for centrally located office properties in Stockholm, (deflated by CPI) (Source: Sveriges Riksbank, Financial Stability Report 2009:2)

Increased credit availability had fuelled construction industry growth. Towards the end of the 80s, Sweden ran into a current account deficit. Due to the strength of the Krona and its expansive domestic focused policies, the export market also shrunk as a result. Monetary policy at the time was hinged on the policy of the pegged Krona. This policy had the aim of avoiding a devaluation, which occurred a number of times in the 70s and 80s, and also to keep inflation under control.

The end result of all this activity was the creation of a financial bubble in the Swedish economy, based on increased debt within the private sector, and over-lending by the financial system. Sweden was seen as a small yet stable welfare economy that was out of reach of turmoil in International Financial Markets. However, it was the isolated policies that were in play by the Swedish monetary authorities that were to be the spark that ignited the problem.

Crisis ModeIn 1990, Real interest rates were suddenly pushed up dramatically.

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Figure 2: Swedish Real after Tax Interest Rate from 1980 to 2010 (Source: Statistics Sweden)

This was caused by factors such as the reunification of Germany, which increased European Rates, and also heavy speculative attacks on the Krona due to the pegged rate policy’s ailing credibility. To defend the Krona, the Riksbank was forced to increase the domestic interest rate higher than the European average. Then, it was a classic bubble burst. Asset prices fell due to the increased interest rate pressures, which created big balance sheet losses. The value of tangible assets in Sweden declined by about 30%4. Money fled to savings accounts. The savings ratio increased from a negative level at the end of the 1980s to about 8 percent in 1993.5

The real estate industry came to a standstill and the level of overinvestment in this sector became evident from the drastic rise in bankruptcies. Unemployment rose significantly also, from 2% to over 8%6. The banks were in a distressed state. In September 1992, the Government introduced a blanket guarantee for all deposits in the banking system and set up a Banking Support Authority, the Bankstodsnamd. The total cost of this came to about 65billion Krona.7 The guarantee was supported at the time, due to the country's relatively low level of public debt (55% of GDP).8

As well as this Banking Crisis, there was also a major currency issue to deal with. The Krona was under huge speculative pressure and the credibility of the pegged rate regime was being undermined by domestic pressures like the slowdown of credit and the fall in output. The Riksbank tried to save the Krona by increasing the interest rates, but this proved unsustainable in the long run. In November 1992, after two implementations of austerity programmes to prevent it, a floating rate was introduced, which led to a 20% devaluation at the end of the year.9 After the introduction of the floating rate, interest rates were lowered and the Swedish economy started to grow again, fuelled by competitive exports.

4 Jonung, Kiander and Vartia, 2008

5 Jonung, Kiander and Vartia, 2008

6 ADBI Working Paper Series, Jonung, 2009

7 Englund 1999

8 TRÉSOR-ECONOMICS No. 105 – September 2012 – p. 3

9 Englund, 1999

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Analysis of the Monetary Authorities’ ActionsAn argument could be made that this period of financial instability started and ended with the monetary authorities of Sweden. Was the process of deregulation a good idea in the first place? The tight, controlling policies in place before this deregulation were never going to last indefinitely. No country would have been able to shun away from the international financial markets forever. The advantages of increased credit provision for the economy were becoming more attractive. The problem was not the idea of deregulation, but how it was administered. Sweden, as a financial regulator, was inept to control how it relaxed its policies properly due to its inexperience. By having such as tightly controlled system for so long, when the credit floodgates opened, very few knew how to deal with it adequately. The authorities could have consulted with outside influences to get a better picture of what they were getting themselves in to.

The monetary policies employed by the Riksbank were criticised. The pegged Krona Rate, which worked in a relatively isolated economy with tight controls, became undone with the growth in the Swedish economy and the rapid influx of capital. The pegged rate came under unsustainable speculative attacks due to the fact that many investors and speculators imagined that Sweden would struggle to survive this period of very high interest rates. The Riksbank was possibly too late in fully realising the damage being done by the pegged krona regime, but leaving it as long as they did allowed borrowers to alter their currency positions.

However, with all this doom and gloom, the cost for the bank support policy initially amounted to 3.6% of GDP10. The Government and the Riksbank were coherent, positive and decisive with its actions, be it with the guarantee or the floating rate change, when it was fully understood that these actions were necessary. The Bankstodsnamnd, a legacy of the crisis, was set up as a support authority for ailing banks, alongside asset management corporations to purchase bank loans.

Today, how methods of the Swedish Authorities dealt with their crisis can be seen as a blueprint for how to deal with these events. Apart from a couple of privatisations, Swedish banks survived this period and continued to function. Public losses were recouped not long after with the sale of government-acquired assets. Arguably the most important factor is that the monetary authorities’ actions gained the public’s trust. This support assisted the government in the implementation of their policies, and for the policies to be successful.

Referenced Works Peter Englund (1999), “The Swedish Banking Crisis: Roots and Consequences”, Oxford

Review of Economic Policy Vol.15 No.3.

10 Laeven and Valencia (2008a)

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Jonung, Kiander and Vartia, (2008), ‘’The great financial crisis in Finland and Sweden: The dynamics of boom, bust and recovery, 1985-2000’’, European Economy Economic Papers 350.

Lars Jonung (2009), ‘’Financial Crisis and Crisis Management in Sweden. Lessons for Today’’, Asian Development Bank Institute, No. 165

Guillaume Chabert & Laurent Clavel (2012), ‘’Lessons for today from Sweden's crisis in the 1990s’’, Tresor Ecominics No. 105. (https://www.tresor.economie.gouv.fr/File/377309)

Luc Laeven and Fabian Valencia (2008), ‘’Systemic Banking Crises: A New Database‘’, IMF Working Paper P.46.

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