The economy has shrunk. Output shrank by about 8% (q-o-q) in the second quarter of 2020 and 3% for 2020 as a whole (Figure 2), which is in line with the performance of the other Nordics.

While industrial production rebounded after disruptions in supply chains in the spring of 2020, service activity remains muted, as the pandemic lingers, hampering face-to-face interactions. GDP is expected to recover gradually when distancing measures are eased. Private consumption will be supported by high savings, but its growth may remain subdued due to uncertainty and higher unemployment (Table 1).

Vaccines offer hopes for a return to normal life, which would boost the recovery, but uncertainty remains high. Possible setbacks in vaccination campaigns and the spread of new variants of the virus could delay the recovery. As a small open economy, Sweden is exposed to global trade tensions and with a large banking sector highly reliant on wholesale funding, it is vulnerable to international financial turbulences.

Fiscal policy has propped up the economy. Fiscal space, with gross government debt at around 35% of GDP before the crisis, has been appropriately used to damp the recession. The budget balance moved from a small surplus in 2019 to a deficit of more than 3% of GDP in 2020 and 2021, which provides strong support to the economy, even though it is relatively small by OECD standards (Figure 3). Fiscal policy needs to continue supporting businesses and households affected by the pandemic.

Monetary policy is highly expansionary. The Riksbank projects that its policy rate will stay at zero until at least end-2023 and has stepped up its bond buying programme in response to the pandemic. It has also provided ample liquidity to stabilise the markets and support for lending. As inflation is projected to be below target for the foreseeable future, continued monetary accommodation is appropriate. The scope for further loosening is limited, as negative policy rates may lower bank rates only marginally, the size of the government bond market is limited and mortgage and corporate bond-buying could fuel excessive risk taking, notably in property markets.

Some financial vulnerabilities remain. The banking sector is solid, although interconnectedness and reliance on wholesale funding create vulnerabilities. Household debt is high and housing prices are rising rapidly. In response, the mortgage amortisation requirement, which was lifted during the pandemic, will be reinstated in September 2021. If fast housing price increases continue, macroprudential policy should be tightened. The banking system is also exposed to potential losses from commercial real estate, which faces heightened uncertainty in the wake of the pandemic.

Labour market adjustment calls for reforms. Ongoing improvements in the insolvency framework will ease firm restructuring. Sweden should capitalise on its strengths in digitalisation and environmental policies to boost productivity and further green growth.

Unemployment was rising even before the pandemic. Sweden was suffering from labour market mismatch, with unfilled vacancies coinciding with high unemployment for low-skilled workers and immigrants. The pandemic has exacerbated this problem, particularly for temporary and non-standard workers, as many vulnerable workers usually hold jobs requiring face-to-face interaction. Unemployment has risen further despite a generous short-time work scheme.

Investment in skills is more important than ever. In response to the crisis, the government has allocated additional funds to increase the number of places in education. Measures taken in recent years to improve education outcomes are starting to bear fruit. Nevertheless, vocational education and training is still considered less attractive by prospective students and matches employer needs less well than in the best performing OECD countries, which calls for reinforcing coordination between public authorities, schools and firms. Strengthened cooperation with the social partners would also help address re-skilling and up-skilling needs, which the pandemic has increased due to digitalisation and structural change.

Improvements in the insolvency framework could facilitate smooth business restructuring. The transposition of the European Commission Preventive restructuring directive approved by the EU Council in June 2019 into Swedish legislation should facilitate early-stage restructuring.

Broad labour market reforms will increase flexibility and security. The social partners have agreed on a package of reforms to enhance flexibility, adaptability and security, which the government plans to implement by mid-2022. The reform will reduce the gap in employment protection between permanent and temporary workers, develop opportunities for retraining and re-skilling and strengthen unemployment insurance.

Easing rent control for new dwellings is part of the government programme. Over time, the reform would raise the dwelling stock, lower housing prices and facilitate labour mobility, notably for low income households.

Digitalisation offers opportunities to boost productivity. The pandemic has accelerated the move towards on-line activities, in which Sweden was already a frontrunner. The government is raising investment to extend the coverage of broadband to rural areas. However, the share of tertiary graduates in ICT and data analysis is rather low, which contributes to holding back the diffusion of big data analysis and limits firms’ digital and data-driven innovation. While business R&D expenditure is among the highest in the OECD as a share of GDP, ICT accounts for a relatively small part. Overly frequent security breaches undermine trust in ICT tools, potentially slowing their adoption.

Sweden has long been a leader in the fight against climate change. Carbon emissions per capita have been declining steadily since the 1970s and Sweden has set the ambitious objective of net zero carbon emissions by 2045. An independent climate policy council monitors the adequacy of policies to meet the climate goals.

Having picked the low-hanging fruit in reducing greenhouse gas emissions, further progress is challenging. Road transport, industry and agriculture are the largest greenhouse gas emitters. The carbon tax rate for industries outside the EU Emissions Trading System (EU ETS) is now aligned on the general rate. The government supports ambitious and risky projects for decarbonising industry, for example through green credit guarantees. However, it lacks a clear roadmap for achieving CO₂ emission reduction in road transport in a cost-efficient way and to reduce emissions from agriculture.

Geographic inequalities have become more pronounced, requiring policy adjustments.

Regional inequality is low by OECD standards, but has been rising over the past decades, fuelling discontent in parts of the country whose inhabitants feel left behind. Large cities attract an increasing share of the younger population and enjoy higher productivity growth, while providing adequate public services to an ageing population is increasingly challenging in rural areas.

Central government grants and fiscal equalisation support equal access to services around the country. However, the fiscal equalisation system and state grant design could be improved. Moreover, digitalisation could be used more effectively to enhance public service provision, including through developing further the public infrastructure for data and information sharing.

Regional growth could be promoted further, in particular by strengthening the role of universities in regional knowledge and innovation networks and reinforcing urban-rural connectivity. This would create more economic opportunities for local and regional development and help foster well-being and social cohesion.