Mr Heikensten discusses the new currency and the Swedish economy
Speech by the First Deputy Governor of the Bank of Sweden, Mr Lars Heikensten, before the
Swedish Shareholders'Association in Sölvesborg, Bromölla, on 23/1/99.
On New Year's Day, ten currencies in Europe were replaced by a single, common currency. The
changeover went well, no doubt exceeding some expectations. The elaborate systems that were
used in earnest for the first time to transmit cross-border payments functioned properly, with no
serious technical hitches. This made it possible to establish a uniform instrumental rate for
monetary policy throughout the euro area. The new currency also had a favourable reception in
financial markets, accompanied by falling interest rates.
EMU has thus got off to a successful start. But the challenges posed by monetary union and any
risks connected with the project are mainly of a different nature. They are economic and political,
affecting the participants as well as non-euro countries. With eleven countries subscribing to a
single monetary policy, the conditions for economic policy in Europe have changed. So have the
terms for Sweden and economic policy here. These matters have not yet been discussed at all
fully in Sweden.
Under these circumstances, I shall be opening our debate today by touching briefly on four
issues: the new challenges posed by the euro to economic policy in Europe; the consequences for
Sweden; the path of the krona's exchange rate; and current monetary policy.
Challenges to EU economic policies
The euro's successful launch was underpinned by intensive preparations. Now that the euro has
been introduced, there is still work to be done to ensure that the monetary union also functions
properly in the longer run.
One of the major challenges is to achieve a good working relationship in the euro area between
the single monetary policy and other components of economic policy. Achieving this interaction
can be difficult even at the national level. Sweden's problems in the 1980s are a good example:
fiscal policy was not sufficiently tight to counter the rapid expansion of credit and neither was
the supply side functioning all that well, which also contributed to the overheating. In the
monetary union, the single monetary policy has to mesh with the national fiscal, wage and
structural policies of eleven countries.
While decisions about the other components of economic policy are still mainly national, they
are highly important for the monetary union's success. It is envisaged that good interaction will
be achieved in that the euro countries monitor each other and jointly discuss their national
policies. Starting from mutually agreed policy guidelines, each EU country is to present regular
accounts of how it intends to fulfil the common objectives. If a country's policy diverges from
the agreed guidelines, the idea is that other countries will protest at an early stage; each country
must shoulder its share of the responsibility for this.
The work of constructing uniform rules has made most progress in the field of fiscal policy. Here
the Stability and Growth Pact lays down clear constraints on budget policy: the countries are to
strive for budgetary positions close to balance or in surplus in the medium term and under
normal circumstances they are to prevent the budget deficit from exceeding 3 per cent of GDP. A
process has been set up for supporting the forces in each country that back a responsible policy.
The process gets its muscle from the ultimate possibility of applying sanctions to countries that
do not follow the guidelines.
The background to the EU countries' agreement on strict guidelines in this field is the concern
about the size of government debt and the central role of fiscal policy in relation to monetary
policy. Fiscal policy affects price stability both via the level of economic activity and via
expectations of future inflation. Without the support of generally consolidated fiscal policies in
the euro area, the task of achieving price stability would be a heavy one. Problems and
shortcomings in fiscal policy hit growth and employment in that they necessitate a level of
interest rates that is higher than otherwise.
Today, far too few countries fulfil the medium-term fiscal policy objectives and the major euro
countries have very small margins to the Pact's definition of an excessive deficit. This can lead
to problems in the Union, particularly if a weaker economic development were to result in further
budgetary deterioration.
Considering the size of government debt in a number of EU countries, continued adherence to a
tight budget policy is to be desired. Such a policy can make further interest rate cuts possible if
economic activity slackens and inflation prospects improve. There is a consensus on this today in
the European Union but reaching an agreement on how the countries should share the burden of
adjustment can be difficult. It will no doubt require many lengthy discussions, which have
already begun, between the finance ministers of the euro countries.
Consequences for Sweden
The Riksdag (Sweden's parliament) has decided to stay outside the monetary union at present.
We are accordingly continuing to conduct our own monetary policy with a flexible exchange rate
and an inflation target.
The political consequences of being outside the euro area were considered by the Riksbank in its
submission on the report from the EMU Enquiry. The conclusion that the consequences would be
considerable has been reinforced now that the monetary union has started with eleven countries.
This would be even clearer if Denmark and the United Kingdom were to decide to join.
It is also clear, from discussions in which I have taken part, that the advent of the euro has been
accompanied by closer collaboration on the construction of economic policies in Europe, as well
as on Europe's actions on the global stage. In these respects Sweden now carries less weight.
A distinct message that we intend to remain outside the euro area for the foreseeable future
would probably weaken our influence in the European Union still more. Our partners in Europe
would then be less interested in allowing for our positions on other matters as well. The
monetary union is, after all, one of the Community's most central integration projects.
On the other hand, the economic consequences of Sweden still having a flexible exchange rate
should not be exaggerated, at least in the short run. Basically, the development of the exchange
rate and interest rates depends on how we manage Sweden's economy relative to the euro area. If
we succeed in making our economic policy credible, the costs of remaining outside for some
years should not be unduly high. But our decision not to participate does mean that we need to be
extra clear in demonstrating our determination to implement a sound economic policy, focused
on sustained growth with low inflation and high employment. There are no easy short cuts, even
in the short run.
That Sweden, as a euro outsider with a flexible exchange rate, will have to live with exchange
rate fluctuations is evident from events last autumn. We know from international experience that
floating exchange rates do in fact float. Not even good economic fundamentals suffice to ensure
stability in financial markets. Here we have a price for being outside the monetary union.
The exchange rate
The exchange rate is an important but elusive item in assessments of inflation. Last autumn, the
main assessment was that the krona would become successively stronger as the financial
turbulence subsided and relatively more importance was attached to the favourable economic
fundamentals, which include low inflation and a growing surplus on public finances. Recently,
moreover, it seems that such a process has begun. Signals of a move by Sweden towards the
monetary union may perhaps have acted as a catalyst here.
The new political signals about the handling of the EMU issue have brought the question of the
krona's equilibrium level to the fore. Participation in the euro area means that at some stage the
krona's exchange rate with the euro will have to be locked. In the discussion that will then be
held with colleagues in Europe, the actual decision will be a matter for the Government. The
Riksbank, however, is responsible for choosing the conversion rate we find reasonable on
Sweden's behalf. Meanwhile, we must bear in mind that we are dealing with negotiations
between Sweden and the other EU member states, so it may be inadvisable to get tied down in
matters of detail at an early stage.
The Riksbank has made it clear on numerous occasions that it considers the krona to be
undervalued. Much of the debate on this issue has stemmed from an article on the krona's
equilibrium exchange rate that was published early in 1996 in our Quarterly Review. The article
was intended to serve as a basis for public debate; in our opinion it provided the best foundation
that was then available for discussing the krona's long-term value.
The krona's equilibrium value is naturally something that the Riksbank considers continuously
and the analysis is constantly being developed. Accounts of various aspects of the exchange rate
have been presented in the Inflation Report. The material that will be produced in the event of
Sweden deciding to participate in ERM2/EMU will have to incorporate the additional
information since 1996. It should also be noted that the levels and intervals that were presented
in the article refer to the krona's trade-weighted exchange rate and are therefore not directly
applicable to the question of a reasonable central rate for the krona against the euro. Furthermore,
the euro is a new currency. Arriving at just the right future exchange rate for the krona against
the euro is therefore not exactly easy.
Although the financial markets are naturally eager to know, at this stage it is too early to allow
the discussion of the krona's path to focus on specific intervals or levels. But the course is
clear-in the event of a euro peg, the rate for the krona will be stronger than the current level.
Current monetary policy
In conclusion I should like to say something about the monetary policy situation in Sweden.
International economic prospects gradually deteriorated during 1998. Knock-on effects from the
crisis that originated in Asia were included from an early stage in the Riksbank's spectrum of
risks. Early in 1998, it was judged that they would be countered by other factors, not least a good
development of domestic demand. In June, however, when price tendencies proved to be more
subdued than expected earlier, the repo rate was lowered by 0.25 percentage points.
During the autumn, increasingly clear signs of an international slowdown were accentuated by
growing turbulence in financial markets. The Riksbank considered that the effects on the
Swedish economy and the path of inflation would be of a magnitude that warranted an easing of
the monetary stance. In November the repo rate was accordingly lowered in two steps from 4.10
to 3.60 per cent. In the December Inflation Report the assessment was still that in one to two
years time, both CPI and underlying inflation would be below the Riksbank's price stability
target of 2 per cent. On December 16th the repo rate was therefore lowered by another 0.20
percentage points to 3.40 per cent. With this cut, the monetary stance was considered to be well
balanced; responsibility for monetary policy's future formulation was left to the Riksbank's new
Executive Board, which would be taking over in the new year.
Since the publication of the December Report, international economic activity can hardly be said
to have changed appreciably for the better. Prospects for both the euro area and the Japanese
economy seem to have worsened, if anything, at least for the coming year. In the euro area it is
manufacturing which has weakened in particular, while consumption still seems to be following
a relatively favourable path. Developments in the United States are still fairly strong but some
slowdown is still foreseen. The situation in Brazil in recent days has created some renewed
unrest in international financial markets, with a limited flight to safe assets. This, too, may affect
future international activity, though the turbulence in the wake of the falling real seems, if
anything, to have been less than expected.
The economic statistics for Sweden suggest that industrial activity may go on weakening. The
picture of total resource utilisation is still difficult to assess but there is much to suggest that the
proportion of unutilised resources is still comparatively large. Forward indicators, such as
incoming orders, also point to a further deterioration.
At the same time, households' expectations of their own economic situation indicate that the
development of private consumption will remain relatively good. Household optimism is
supported by increased employment and a favourable development of disposable income.
However, the sustainability of this development is uncertain, as it was last autumn, partly
because households and firms differ in their assessments of the future. Negative news from the
business community may make households more pessimistic, and so may renewed unrest in
financial markets. Recently, moreover, there have been tendencies for households to be more
uneasy about their own economic situation.
A more positive development is favoured by the fact that the international financial crisis has
subsided. During the autumn there were strong fears that financial problems would subdue
international activity for several years. With the normalisation to date, the probability of this has
decreased.
The December outcome for consumer prices was somewhat lower than expected. The CPI fell
0.6 per cent, which can be compared with our forecast of a fall of 0.3 per cent. The main
explanations are a weaker development of commodity prices and falling interest rates.
The assessment of future inflationary pressure has to take these and other factors into account. At
the same time, the downward path of market interest rates in recent months represents a demand
stimulus further ahead. This, too, must be considered in the assessment of inflation.
If nothing untoward happens, the Riksbank's next monetary policy meeting will be held on
February 11th. It will then be up to the new Executive Board to evaluate the information that has
been received and decide the level of the repo rate.