Sweden may have managed to come out of the financial crisis much stronger than some of its European peers, but its ballooning level of household debt poses a serious threat to its economy and its neighbors, the International Monetary Fund (IMF) has warned.
Property prices in Sweden have risen sharply, rising 5 percent between March and May compared to the same period last year. In Stockholm, prices rose 7 percent year-on-year, with average house prices in the city now at $660,000. A recent SEB survey published last month showed 66 percent of household expect house prices to rise in the coming year. The booming housing market has encouraged Swedes to take on more mortgage debt, but concerns are growing over the risks this poses to banks.
Following its annual visit to Sweden, the IMF said a sudden drop in house prices could hit the banking system in the same way overleveraged households and subprime mortgages sparked the financial crisis in 2007.
Even though the country is not a member of the euro-zone. analysts are now comparing Sweden's contagion risk to southern Europe, where heavily indebted Greece helped trigger the euro zone debt crisis.
Low interest rates and easy monetary policy have helped household debt in Sweden grow to 175 percent of disposable income in 2013, the fund said. The figure rose to 19 percent if tenant-owned housing associations are included.
The benchmark interest rate currently has stood at 0.75 percent since December, when it was cut from 1 percent.
At the same time, inflation has fallen way short of the central bank's target of 2 percent for over a year. The country fell into deflation in May, when prices fell 0.2 percent, but the central bank has been reluctant to respond by cutting rates, fearing that might encourage households to take on even more debt.
"I think domestically this (housing) issue is becoming something of a lightning rod for criticism of the government," said analyst for Western Europe at Control Risks, David Lea.
"Nordic economies are all very intertwined, much more so than those of southern Europe and we saw how effective contagion was in those markets a couple of years ago," he said.
The central bank in Sweden, Riksbank, is now facing intense pressure to act after the IMF's warning that "financial instability in Sweden would quickly spread to other Nordic and Baltic countries" and annual CPI inflation fell further in May.
European economist at Capital Economics, Jessica Hinds said the fall in inflation in May from 0 percent to -0.2 percent will deepen fears that Sweden is falling into a "damaging bout of deflation."
"Headline inflation has been weak in Sweden for more than a year now, but the central bank has been slow to respond to the disinflationary trend for fear that lower rates would encourage highly-indebted households to take on yet more debt," she said.
"But the onset of falling prices will add to the growing pressure on the central bank for more action. We continue to expect the policy rate to be lowered by another 25bp, possibly as soon as next month," she added.
The IMF said the financial authorities in Sweden are addressing risks in the banking system by, among other things, implementing and going beyond EU-mandated capital requirements for banks.