The European currency crisis in the fall of 1992 and summer of 1993 had strong effects in Sweden. This motivates the study of the developments in the country regarding exchange rate regimes, monetary policy, interest rates and inflation dynamics, among others in this period.
Sweden’s financial deregulation in 1985 increased the incentives of households and companies to borrow money at the prevailing rates to finance consumption and investment in the real economy. A large portion of credit was channeled into asset markets and rising inflation rate accompanied the evolution of the economy, which peaked in 1990. This credit boom reduced substantially the savings ratio of households. The construction sector grew, fuelled by the increase in the price of real assets, while growth in exports became negative and imports soared. The overheating of the Swedish economy was characterized by a faster rate of domestic inflation and lower domestic unemployment than in the rest of the world, which led to a decrease in Swedish competitiveness. Thus, Sweden was undergoing a boom phase.
The expansionary impulse that the deregulation of 1985 created was not countered by any contractionary policy measures until 1989-91. The devaluation of 1982 was declared the last of its kind. Sweden’s Central Bank, the Riksbank, did not counter the overheating by revaluing the krona. Therefore, controls over capital flows and interest rates had given the central bank a significant degree of freedom to conduct monetary policy in spite of the pegged exchange rate regime.
Sweden’s bust phase saw the inflation rate to decrease markedly after having reached a peak of about 10 per cent in 1990. The krona was subject to several speculative attacks due to falling credibility (growing financial crisis, fall in industrial output, unemployment) of the pegged krona rate policy. When the real interest rate rose, the price of assets declined in a downward spiral. The fall in asset prices reduced wealth of households, since assets had been financed by loans of which the nominal value remained unchanged. The real interest rate shock created a sharp fall in aggregate demand and unemployment increased from 2 per cent to a level close to 8 per cent.
Consequently, a floating exchange rate was introduced on 19 November 1992, meaning a substantial depreciation of the Swedish currency close to 30 per cent. The downturn was halted by the depreciation of the currency and Sweden’s economy turned upward in 1993.
As the krona floated, interest rates gradually decreased. Exports were the major driving force behind the recovery, however, the fall in short- and long-term interest rates was equally important. The fall of the krona in November 1992 allowed the Riksbank to move to lower interest rates. Policymakers were not ready to go back to a fixed krona rate again. The Riksbank announced unilaterally a policy of inflation targeting in 1993, with a target inflation rate of 2 percent yearly increase within a range of plus/minus 1 percent.
Monetary policy turned expansionary after the decision to float in the fall of 1992. As the economy started to grow during the recovery, budget deficits were reduced due to automatic stabilizers.
In conclusion, expectations of a pegged exchange rate clearly fuelled capital inflows and optimistic risk assessment in financial markets drove positive wealth effects, which in turn led to a further strengthening of aggregate demand. However, unexpected negative impulses (speculation against the peg of the krona, rising real interest rates, international downturn, etc.) changed the economic and financial outlook. The capital inflow was reversed into an outflow and the supply of credit declined. Domestic policymakers tried to stop the outflow of capital by increasing domestic interest rates, hence, hurting indebted firms and households. The quick rise in real interest rates increased the frequency of bankruptcies and unemployment led the central bank to act and allow the currency to float, lowering interest rates.
Thus, Sweden used monetary policy to subsidize those sectors of the economy that the government wanted to support with low interest rates and an ample supply of credit. The large number of policies to safeguard the functioning of the banking system was crucial. In addition, it is important to note that central banks can defend against a speculative attack both by borrowing foreign reserves and by raising interest rates. However, not all speculative attacks are defended by the central bank: Sweden defended against its September 1992 speculative attack, but not the attack that took place in November 1992.
Nuno Lourenço, 85
Nuno Gominho, 612
Macroeconomic Analysis
References
Jonung, L., Kiander, J., & Vartia, P. (2008). The great financial crisis in Finland and Sweden. European Commission, Directorate-General for Economic and Financial Affairs.
Rebelo, S. (2000) Comment on “Interest Rate and Borrowing Defense Against Speculative Attack” by Allan Drazen
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