Banking and currency crisis in Sweden and Finland: an explanation of the difference in intensity of the crises in the early 1990s

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Department of Economics

Faculty of Economics and Business

Universiteit van Amsterdam

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Banking and currency crisis in Sweden and Finland: an

explanation of the difference in intensity of the crises in the

early 1990s.

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Bachelor thesis

Author: Tom Koper

Student number: 6295592/10003369

Under supervision of Dr. K. Vermeylen

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1 Introduction

The current worldwide banking crisis, which started in 2007, is known as one of the worst financial crises so far. A lot of banks were brought in trouble by non-performing loans. These banks failed to estimate the real risk of these loans and had to revalue these loans on their balances. This led to distrust in the market and loans weren’t easy to get anymore. A credit crunch followed, which caused other loans to become non-performable loans. Although the major impact on the worldwide economy surprised a lot of economists, the Scandinavian countries were faced by a similar crisis before, in the early 1990s.

In this period Sweden and Finland were struck by a banking and a currency crisis. After financial deregulation in the mid of the 1980s led to a boom in the economy in the following years, a bubble burst at the beginning of the next decade. This caused a decrease in the GDP in both countries and an increase in the unemployment rate during the years of 1991-1993.

Table 1 Macroeconomic indicators for Finland and Sweden 1991-1993

Indicator Finland Sweden

Real GDP (average annual change

in %) -11.4 -1.6

Unemployment (%) 11.1 5.5

Current account/GDP (%) -3.8 -2.6

Although authors focus on the similarities of these crises – Jonung and others (2008) even referred to the countries as ‘economic twins’ – there was a big difference in the intensity of the crises in both countries. From Table 1 can be concluded that the Finnish crisis was way more intense than the Swedish counterpart.

The statement that Finland and Sweden were ‘economic twins’ wasn’t farfetched though, as the similarities in the main outline of the crises were clearly visible: after deregulation of the financial market both countries’ financial wealth increased rapidly, then they were hit by a banking crisis and this was followed by a currency crisis. But from the difference in the intensity of the crises can be derived that the statement doesn’t tell the whole story. If they were economic twins, why was the impact of the crisis on the Finnish economy way bigger than on the Swedish economy? Which difference in policy or macroeconomic factors caused the difference in intensity?

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This research is an attempt to answer these questions with the existing literature about this crises, and therewith to give a clear overview of the important differences in both crises. The reason to look at crises from the past (as this one) is to gain more insight into the causes and effects that such a crisis has, so that it can be better understood in the future.

To explore the differences in the economic (and governmental) circumstances between Finland and Sweden around the crisis in the early 1990s, the following research question must be stated: Which factors caused the economic crisis to be worse in Finland than in

Sweden?

To answer this key question of this research, a literature review is required. I tried - by concisely but thoroughly studying academic articles – to find the key factors that caused the difference in intensity of both crises. From now on, these factors will be qualified as

intensifying factors.

In order to provide a clear overview of these factors, in the next chapter – chapter 2 – a short description of the causes of banking crises and currency crises will be shown, with the intention to get some extra knowledge about where to focus on while searching for intensifying factors. In chapter 3 (Finland) and chapter 4 (Sweden) a detailed description of the circumstances in the crisis period will be given. After a short summary of the events during this period, I’ll focus on the macroeconomic fundamentals and the policy during the Finnish and Swedish crisis period (i.e. 1985 – 1993). In the fifth chapter the differences will be highlighted and their influence on the intensity of the crisis will be explained in the light of the knowledge about crises from chapter 2. The last part of my thesis is the conclusion in which I summarize my findings.

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2 Banking crisis and currency crisis

This chapter gives the main causes and effects of a banking and a currency crisis, in order to get a clearer understanding of which factors may intensify such a crisis. First, the course and the causes of a banking crisis will be outlined. After that the same will be done for a currency crisis.

2.1 Banking crisis

2.1.1 Definition of a banking crisis

A crisis in general is defined as ‘a policy emergency that calls for the rapid and decisive resolution of what may become an unsustainable situation’ (Gup, 1998, p. 7). But there is no easy definition of a banking crisis. Despite this, many economists gave their view of the best description. The IMF defined a banking crisis as followed: a situation, in which banks runs and widespread failures induce banks to suspend the convertibility of their liabilities, or which compels the government to intervene in the banking system on a large scale (Gup 1998). In the following this definition will be used.

2.1.2 Causes of a banking crisis

Many economists have listed factors that could initiate financial crises. These lists are quite similar, but they differ in detail. To get more insight into which features to focus on in the following, I’ll use a list of causes, enumerated by Goldstein and Turner (1998). In their paper they describe the origins of international banking crises. They brought the following 8 factors forward as ‘leading culprits’ in causing a banking crisis:

1. Macroeconomic volatility: external and domestic

2. Lending booms, asset price collapses and surges in capital inflows 3. Increasing bank liabilities with large maturity/currency mismatches 4. Inadequate preparation for financial liberalization

5. Heavy government involvement and loose controls on connected lending 6. Weaknesses in the accounting, disclosure and legal framework

7. Distorted incentives (for bank owners, managers and supervisors) 8. Exchange rate regimes

Behind every factor of these list lies an intuition – also provided by Goldstein and Turner - of how the factor intensifies/causes a crisis (1998). It’s not the aim of this research to give a full

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description of the effects of these factors. After the differences between the macroeconomic fundamentals and the policy of Sweden of Finland are discussed, I’ll describe the effects of these differences, according to the paper of Goldstein and Turner. This way, only the effects of relevant factors will be described. This contributes to keeping this thesis brief and concise. The description of the effects will be provided in the second part of chapter 5.

2.2 Currency crisis

Many economists make notice of the strong link between a banking crisis and a currency crisis. For example, Mishkin (1996) argues that, if a devaluation occurs, the position of banks are weakened further if they have a lot of foreign debt. In opposite causal direction, Velasco (1987) argues that when central banks finance the bailout of troubled banks by printing money, a currency crash might occur.

In the following a short description of a currency crisis will be provided and the causes of currency crises will be discussed.

2.2.1 What is a currency crisis?

Various descriptions of currency crises were brought forward in academic literature. According to Eichengreen and others (1995) a currency crisis has to entail a speculative attack. This attack causes the exchange rate to depreciate or it forces policymakers to defend the exchange rate by radically raising interest rates.

In addition, Hong and Tornell stated that - in general - a currency crisis has the following characteristics: a sharp depreciation of the exchange rate, a reduction of the foreign exchange reserves, an increase interest rates and a deterioration in the capital account (2005, p. 73). These characteristics were clearly visible in Finland and Sweden in the crisis period.

2.2.2 Causes of a currency crisis

The aim of this paragraph is to get a clearer understanding of which factors play an important role in intensifying or causing a currency crisis. The insight in this subject is useful in order to research concisely and precisely. The factors found in the literature – that might intensify a crisis – will be given extra attention in the comparison of both crises.

Reisen (1999) did research on the causes of currency crises. In this article several causes – based as well on historical knowledge as on macroeconomic theory – are brought forward. According to this paper, there are two ‘root’ causes for currency crises. The first is a distortive boom with excessively positive future expectations by all types of market participants

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(civilians, banks, policy-makers and companies). The distortion is strengthened by exchange rate pegs in combination with a difference between the domestic and worldwide interest rates. The positive future expectations leads to increased lending and borrowing. The difference between the domestic and worldwide interest rates enlarges the currency risk of residents’ portfolios. The intuition behind this is the following: it’s profitable to borrow in foreign currency at relatively lower interest rates and therewith increase your foreign debt. This increase of foreign debt makes the portfolio more vulnerable to domestic currency depreciations.

The second root cause is that the optimistic view of the market participants leads to an increase in willingness to take risks. This may result in weak domestic banking systems ‘as a result of heavy capital inflows and disorderly financial liberalization’ (Reisen 1999, p. 125). The interaction of these two ‘root’ causes leads on his turn to other potential causes of a currency crisis: over-borrowing, misjudgment of currency risk (and therefore an unbalanced portfolio) and spending booms. These factors make the currency more vulnerable to speculative attacks.

In the same article Reisen gives a more broad description of the causes of a currency crisis. But again, it’s not the aim of this thesis to provide a full description of these causes. After the comparison is made, I’ll look back into this article to judge whether the factors are indeed intensifying ones, or irrelevant for the matter.

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3 The Finnish financial crisis

In this chapter the course of the crisis in Finland will be discussed. I start with a summary of the course of events from 1985 to 1993. After that, I’ll focus on the economic policy around the crisis period in Finland. I’ll end the chapter with a discussion of the relevant macroeconomic fundamentals of the Finnish economy.

3.1 Overview of the boom and bust period

3.1.1 Background

The Finnish economic post-war growth has been relatively high, especially if you compare it to the average growth of other European countries. The main driver behind this success was a relatively high investment ratio, supported by a relatively high and stable profit share (Söderström, 1993, p. 144). On top of this, Finland didn’t experience any major rise in unemployment after the oil crises in the 1970s, which struck the most other European countries (Koskela & Honkapohja, 2001, p. 403). This all was achieved with a strongly financial regulated market: the domestic interest rate was regulated and the private sector couldn’t borrow abroad and the private bank had a lending ceiling (Koskela & Honkapohja, 2001, p. 402; Jonung et al., 2008). At the same time, Finland maintained pegged exchange rates. The Markka – the Finnish national currency - was pegged to a basket of 14 currencies (Söderström, 1993), which positively influenced their exports.

Despite the success, the pressure on the Finnish policy-makers to deregulate the financial market became unavoidable in the early 1980s. Two drivers behind this pressure was (1) the lending ceiling created a world of credit rationing in Finland (which wasn’t preferred by many citizens) and (2) the increase in liquidity in the corporate sector grew from foreign trade (Jonung et al., 2008)

3.1.2 Deregulation of the financial market

The financial market in Finland was severely regulated until 1984. The domestic bank lending rates were regulated and private borrowing from abroad was restricted (Koskela & Honkapohja, 1999, p. 403). A developed money and securities market, as well as a well-developed banking sector was absent (Bordes, 1993, p. 19).

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The deregulation of the financial market went stepwise. In the period of 1984-1986 the core of the financial market was deregulated. In chronological order the following acts were performed by the authorities: the lending rates were tied to bank funding rates (1984), then the restrictions on average lending rates were abolished and floating rates were allowed on some loans (1986). In 1987 open market operations on the Credit Default Swaps market were introduced. In 1988 floating rates on all loans were permitted. The last policy act in the process of deregulation was the allowance of prime rates as reference on all loans (1989) (Bordes, 1999, p. 20).

The deregulation of the financial market initiated a boom in the Finnish economy. Where the private sector couldn’t borrow freely before the deregulation, now they could easily choose where to borrow. This was because the supply of credit increased significantly, since foreign lenders entered the Finnish market. The freedom to borrow after a period of credit rationing led to a huge increase of debt and at the same time to strong economic growth, because of the consequence of private consumption growth (Jonung et al., 2008). This was the beginning of a boom, which would last for almost three years.

3.1.3 The boom period

The first signs of the boom were visible in 1987: GDP increased, the unemployment rate fell, and the inflation rate rose. As a consequence of the consumption growth, the current account balance deficit increased – due to increasing imports - by 2%. This trend strengthened in 1988 and 1989. GDP growth went up from 2.6% to 5.2% and the unemployment rate declined from 5.3% to a low 3.5% (WEO, 2014). The overheating became clearly visible in 1989, as the inflation rate rose to 6.5 percent, from 2.9 in 1986 (Currie, 1993, p. 115).

Table 2 Macroeconomic indicators during the 1980s in Finland.

Indicator 1981-1985 1986-1990

Real GDP (average annual growth

in %) 2.7 3.4

Unemployment (%) 5.3% 4.2%

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The boom in Finland was bigger than in the rest of Europe. One factor contributed heavily to the boom: the household savings rate fell and even grew negative. As a consequence the household liabilities/income rate increased from 50% (1983) to 78% (1988) (Bordes, 1993, p. 25). This was a consequence of the deregulation of the financial market: the freedom to borrow increased the easiness of getting a mortgage and other type of loans.

Graph 1 Household savings ratio (% of disposable income) and real after-tax lending rates, %

Source: Drees & Pazarbasioglu, 1998, p. 14

This increase in credit availability led to an increase for the demand of real estate. A bubble was created: housing prices went up by almost 40% (Currie, 1993, p. 109). There wasn’t solely a bubble on the real estate market, also stock prices went up because of speculation. The stock prices went up by more than 300% in the period of 1985-1989.

Graph 2 Real housing and stock prices in Finland (1970 = 100), %

Source: Currie, 1993, p. 109

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Because of these rises, the total housing wealth increase between the end of 1983 and the end of 1988 was 80% (!) in real terms (Bordes, 1993, p. 25; Mai, 2008, p. 2). This wealth increase was mostly build on the prospect of future increases of housing prices. It was at this point that the policy-makers recognized the Finnish economic growth as a boom instead of a trend.

Tightening monetary policy in the beginning of 1989 led a downfall in borrowing and therewith a downfall in consumption. This sharp downfall of the household consumption in 1989 initiated the burst of the bubble. When the prospects didn’t seem to be that great as was foreseen so far, the collapse on the real estate market as well in stock prices started. Both prices fell back sharply. On top of that, a revaluation of the Markka created a reduction in credibility of the inviolability of the Deutschmark/Markka policy (Currie, 1993, p. 115). This revaluation was the main reason for speculators to massively sell their Markkas. In 1989, the first signs of a slump became visible.

3.1.4 The bust period

The signs of financial distress became clearly visible when the number of households who couldn’t keep up their debt repayments strongly increased. This was due to the tightening of monetary conditions in western countries in the beginning of 1989. The interest rates rose (on average by 3%) and borrowing became too expensive for households (Bordes, 1993, p. 39-40). As a consequence of non-performing loans, the balance of banks deteriorated. The banks seemed to have been way too optimistic about their exposure to risk. With the change of perspective for the Finnish households, their attitude towards borrowing made a turn of 180 degrees. They made an attempt to drive up their savings, at the expense of their consumption. This strengthened the downfall and took the economy in a severe recession. At the same time the trade with the Soviet-Union (SU) – due to the disintegration of the SU - collapsed and this strengthened the slump even more.

Meanwhile the asset prices started to fall at the beginning of 1989, as a consequence of decreasing consumption of households. Agnello & Schuknecht found that the magnitude of the downwards shocks of housing prices was relatively big, compared to Sweden (2011).

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Graph 3 Housing price gaps computed as deviations of the real housing prices from trend of Finland, on a scale from 0 to 1. 0(zero) is no deviation from trend, 1 is 100% deviation from trend.

Source: Agnello & Schuknecht, 2011, p. 176

The decline of housing prices was a surprise to policy-makers as well as economists, since this happened without precedent in the Finnish history since World War II (Bordes, 1993, p. 42). On top of that, the stock prices fell to a level of less than one third of their peak value, as was demonstrated in graph 2. With the first signs of lower future growth in 1989, investors realized that this growth couldn’t be persisted at the previous expected pace. This forced the stock prices to decrease significantly and therewith created a self-enforcing effect: the decrease of stock prices led to a decrease in demand, which was followed by an even worse economic prospect. These two factors fed each other multiple times and this circle worsened the crisis.

The worsening of the state of the Finnish economy led to new rumors of (and speculation on) a re- or devaluation of the Markka. Although the spoken policy of Finland was to keep a fixed exchange rate, by 1989 they had adjusted their exchange rate 18 times since World War II (Söderström 1993, p. 146). These adjustments contributed to low unemployment by stimulating the growth in the export sector, but damaged the credibility of the Markka/Deutschmark parity.

In March 1989 the rumors proved to be true. The policy-makers revalued the Markka by 4% in order to counter the overheating. This revaluation stimulated the borrowers to borrow at high domestic rates. But the appreciation came too late. The economy was already beginning to slow by itself and the revaluation strengthened the slowdown. According to Currie (1993)

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a larger and much earlier revaluation – in the beginning of the boom – might have helped to keep interest rates high and might have slowed the expansionary pressures.

3.1.5 The consequences of the crises

The crisis started at in 1990 and continued to the middle of 1993. After 3 years of recession (real) GDP fell by 11.4% and the unemployment rose from 3% to 16% (WEO, 2014; Koskela & Honkapohja, 2001, p. 403). The last budget surplus in this period was in 1990 (6%), this was followed by three deficits of, respectively, -0.4%, -5.7%, -9%. Although this signals a huge increase of government debt, relative to Sweden the deficits weren’t that big.

3.2 Policy actions around the crises

3.2.1 Fiscal and Monetary policy

In his assessment of Finland’s economic crisis and economic policy Currie (1993) described the fiscal policy of Finland in the period prior to the crisis. He stated that fiscal policy wasn’t tightened sufficiently in the boom. Although the fiscal stance was countercyclical, it was too mild to counter the boom. It seems that the fiscal authorities misjudged the economic growth: they believed the growth in output was a trend, instead of a temporary boom (Currie, 1993, p. 121). This probably increased the deficit in the crisis period, because the fiscal policy remained – due to this misjudgment - expansionary instead of contractionary in the boom period. Another feature which increased the deficit was the rescue of the banking sector. This severely increased the government expenditure. A third (very important) feature of the fiscal policy was the generous tax provisions that allowed borrowers to offset interest payments against income tax, even at higher rates. For tax payers, the effect of borrowing was an effectively negative real cost of borrowing (graph 1). This was a big motivation for household to increase their borrowing.

In order to tamper the boom, the tax policy was reformed in 1989 and this made real estate investments less attractive (Drees & Pazarbaşioğlu, 1998). This incented the downfall of the economy and tampered the borrowing, since housing prices fell due to this change in policy, but this countercyclical policy was way too late to prevent a recession.

The monetary policy couldn’t protect the households and banks for currency risk. The freedom on the credit market led to an extraordinary explosion of foreign currency borrowing. This can be explained by the conception of the inviolability of the Deutschmark/Markka parity. Therefore the Finnish borrowed at low interest rates abroad, while they forgot (/misjudged) the reason why the home interest rate was higher (i.e.

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because of the market awareness of a possible devaluation of the Markka) (Currie, 1993, p. 111-115).

3.2.2 Exchange rate policy

Since the end of World War II the exchange rate of the Markka was pegged to the US Dollar. This peg was maintained until 1977. In the spring of this year the Finnish authorities pegged the Markka to a basket of 14 currencies (Söderström, 1993, p. 146). The pegging of the Markka had multiple reasons, but the main reason for a fixed exchange rate regime is to profit from the credibility of a foreign central bank. One of the 14 currencies, where the Markka was pegged to, was the Deutschmark. This was the main reason for Finland to peg their currency to this basket: in 1977 the central bank of Germany had the credibility where the Finnish wanted to profit from (Currie, 1993, p. 112).

The fixed exchange rate was hard to maintain. It led to very variable terms of trade, since the amount of incoming export money was very dependent of the exchange rates of competitors (Currie, 1993, p. 113). For example, when the US dollar devaluated and therewith the pegged Markka as well, the timber and paper world price went down and Finland received less money from exports than before the devaluation. This struck Finland extra hard, because of the great importance of timber and paper in the export sector. This made the Finnish economy way more volatile than other European economies.

Graph 4 Terms of Trade (1985 = 100).

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During the boom and the bust period the fiscal policy-makers lost their credibility to investors. Despite statements as ‘the Markka/Deutschmark parity is inviolable’, they revalued the Markka with 4% in March 1989 (Bordes, 1993, p. 43). According to Currie this was a tactical error: the loss of credibility initiated speculation against the Markka (1993, p. 115). In November 1991 the central bank devalued the Markka by 12.3% (Söderström, 1993, p. 146). This devaluation led to a huge net foreign debt increase, because of the increase in the real value of foreign currency relative to the domestic currency (Jonung et al., 2005, p. 10). The positive side of this devaluation was the stimulating effect on the exports, after years of an increasing negative growth on the current account balance, the negative growth fell and even became positive in the years following (WEO, 2014). Although the value of the currency fell with 12.3%, it was less than the Swedish Krona did (Mai, 2008, p. 4).

3.3 Macroeconomic fundamentals of the Finnish economy

In this paragraph the main features of the Finnish economy are highlighted. This knowledge of the Finnish economic fundamentals will give us more insight into the drivers of the intensity of the crisis.

3.3.1 Foreign indebtedness

The problem of foreign (currency) debt is mentioned before, when I wrote about the exchange rate policy of Finland. The impact of the foreign debt must not be underestimated. At the end of the boom period (the end of 1989) the foreign debt reached his peak level: 40 per cent of annual GDP (200 billion Markka) (Söderström, 1993, p. 147). This number even worsened after the devaluation in November 1991. At the end of 1992 Finland’s foreign (net) debt was almost 48% of the annual GDP (Bordes, 1993, p. 61). This increase of debt in foreign currency was due to the devaluation of the Markka as well as the decrease of the GDP. This can be stated from graph 3 (from Söderström, 1993, p. 149) and GDP growth in 1992 (WEO, 2014). Graph 3 shows that the amount of money borrowed in foreign currency decreased since the beginning of 1991 and even became negative in 1992.

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Graph 5 Bank lending to corporate and household sector, % change, per type of loan

The graph line = total lending

Grey shaded area = contribution of foreign currency loans White shaded area = contribution of bonds

Black shaded area = contribution of domestic currency loans

In contrary to foreign debt, the private sector of Finland held few foreign assets to offset the currency risk (Jonung et al., 2008). This made the Finnish very vulnerable to the devaluation of the Markka.

3.3.2 Current account balance

From 1960 onwards the current account balance was always in deficit, with exception of three insignificant surpluses (Söderström, 1993, p. 147). Since the Second World War the Soviet-Union was an important export country for Finland. In 1988 almost 17% of the total exports went to the Soviet-Union. When the Soviet-Union was disintegrated in 1989, the export fell sharply. Various authors wrote about the impact of the collapse of exports to the Soviet-Union (Jonung et al., 2008; Sutela, 2005). The Bank of Finland and the Finnish Ministry of Finance calculated that the downfall of exports to the Soviet-Union contributed for some 2-3% to the decline in the real GDP of Finland in 1991 (Sutela, 2005, p. 18).

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Graph 6 Finland’s trade with (former) Soviet-Union, share of total trade, %

Source: Söderström, 1993, p. 177

The total exports decreased further because of the slumps in the key export markets of Finland: Sweden and the UK (Currie, 1993, p. 105). From 1990-1993 the current account balance worsened each year, respectively with 5.0%, 5.3%, 4.6% and 1.3% (WEO, 2014).

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4 The Swedish financial crisis

This chapter will follow the same course as chapter 3, but in this chapter the crisis of Sweden will be examined.

4.1 Overview of the boom and bust period

In this section a background of the Finnish state of the economy before the boom and bust period will be provided. This is followed by a description of the course of the Swedish financial crisis.

4.1.1 Background

When Sweden entered the middle of the 1980s, there was a stable small GDP growth and a very low unemployment rate (around 3%). The unemployment rate didn’t increase due to the oil crisis in the 1970s (WEO, 2014). At the same time, the inflation rate was relatively high: on its peak in 1982 it reached the level of 13%. During the first half of the 1980s the inflation rate was on average 9% (Englund, 1999, p. 82).

Another factor of the Swedish economy was the government deficit. In the first half of the 1980s the deficit was about 5% annual on average (WEO, 2014). Few authors talk about the origin of the government deficit, but it’s seems to be a consequence of the remarkable growth in public spending in the 1970s and 1980s. Roudini & Sachs mentioned a remarkable growth of public spending in Sweden in the 1970s (1989, p. 106) and data of WEO shows us that the budget deficit remained in the early 1980s, despite an increase in government revenues (2014). It seems that the expansionary policy of Sweden was the main reason for the budget deficits. This presumption is strengthened by data used in a research of De Haan and Sturm (1997). This data shows us that the public spending ratio in terms of GDP was – by far – the highest of all OECD countries (on annual average from 1982 – 1992).

The financial system was strictly regulated since the Second World War. There were restrictions in foreign borrowing and investment, there was a lending ceiling and the domestic interest rate was determined by the Riksbank (central bank of Sweden) (Englund, 1999). Despite these regulations, the Swedish households were relatively heavy indebted (67% debt of disposable income). This was due to government-sponsored borrowing of university bills or housing purchases. With the increase of the financial activity, the regulations became more inefficient. In 1983 the financial deregulation was about to start.

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4.1.2 Deregulation of the financial market (1983-1985)

Within three years the financial market of Sweden was largely deregulated. The interest and lending ceilings were lifted, but the international transaction regulations stayed intact. The government still restricted investments and borrowing in foreign currency. It took until 1989 before the currency regulations were abolished (Englund, 1999, p. 84).

Just like in Finland, this change of policy created an increase in competitiveness on the credit market and increased the borrowings. But in contrast to Finland, the deregulation had no severely immediate impact on consumption and investment. Although it did change the spending behavior of the Swedish consumers, according to empirical studies the effect was quite small. Englund came with a striking description of the causes of the Swedish crisis (1999, p. 95):

‘Rather, the boom should be explained by the interaction of an overly expansionary fiscal policy, a monetary policy that was constrained by the fixed exchange rate, and a tax system that transmitted constant pre-tax real interest rates into falling post-tax interest rates in an environment of increasing inflation.’

The financial deregulation just seemed to be the lighter that incented the boom.

4.1.3 The boom period

The impact of the abolishment of financial restrictions was clearly visible since 1987. Although the GDP growth in 1986-1990 wasn’t a significant improvement compared to 1984 and 1985, it were significantly positive digits compared to the potential GDP. The difference between the potential GDP and the actual GDP in the years 1985-89 was on average 3.4% (WEO, 2014). At the same time the unemployment rate decreased to an all-time low record of 1.4% in 1989 (Englund, 1999, p. 89).

Table 3 Macroeconomic indicators in the 1980s for Sweden.

Indicator 1981-1985 1986-1990

Real GDP (average annual change

in %) 1.9 2.5

Unemployment (%) 3.2 2.0

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Economists and policy-makers strongly recognized the signs of an overheating of the economy. Although this strong recognition, it was hard to get support to change the expansionary fiscal policy into contractionary fiscal policy: since 30 years the government had significant surpluses.

The boom was also visible on the asset market. In August 1989 the annual growth rate in stock prices reached their peak: 42% above the January 1989 level.

The housing prices growth developed similarly (Englund, 1999, p. 89). The housing price growth wasn’t as big as it was in Finland, as demonstrated in graph 7. In the 5-year period prior to the bust, the housing prices went up by 44% in real terms, compared to 80% in Finland (Mai, 2008, p. 2).

Graph 7 Real house prices in Finland and Sweden, % (1982=100)

Source: Mai, 2008, p. 1

During the boom period the current account balance worsened due to overvaluation of the Krona with an average annual percentage around 1.5% (WEO, 2014). This was due to a combination of increased imports (probably because of the credit expansion) and decreasing exports.

In 1990 the economic growth came to an end. The slump started when the first reports of difficulties in finding tenants at this high price level appeared.

4.1.4 The bust period

By the end of 1990 the real estate index decreased by 52%, compared to the peak level in August 1989. A sharp rise in interest rates, a tax reform - which created an incentive to save -

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and a reform of macroeconomic policy (with focus on inflation) worsened the economic prospects and the first signs of a crisis appeared (Englund, 1999, p. 89).

In September 1990 several banks that had invested a lot in real estate, like the big bank Gota, went bankrupt. This was mainly because of the decline in the prices of real estate (Englund, 1999, p. 91). This initiated a banking crisis, since a lot of banks did business with this banks (which were characterized with high exposure to risk or heavy investments in real estate). The price fall of real estate continued till 1992 and stopped at a level just above the pre-deregulation standard (Mai, 2008, p. 1). The magnitude of the shock wasn’t as big as in Finland though (Agnello & Schuknecht, 2011). The Swedish economy in the crisis period was less volatile than the Finnish economy.

Graph 8 Housing price gaps computed as deviations of the real housing prices from trend of Sweden on a scale 0 to 1. 0(zero) means no deviation from trend, where 1 means 100% deviation from trend.

Source: Agnello & Schuknecht, 2011, p. 176

During this period the state had to inject capital into two of the major banks. While this kept these two banks alive, another major bank (Gota) went bankrupt because their costumers couldn’t afford their mortgage anymore (Englund 1999, p. 91). The defaults on these loans were too many for Gota to survive the crisis.

In contrast to the Finnish revaluation of the Markka in 1989, the exchange rate of the Krona stayed intact till 1992. In November 1992, the Krona was left to float (Englund, 1999, p. 93).

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4.1.5 The consequences of the crisis

The crisis lasted for almost 3 years. At the end of 1993, the total decrease in GDP was 5.1%. The unemployment rate went up to 9.3% and hadn’t reached its peak level yet. The unemployment rate stayed around this level until 1997, when it’s reached its peak level of 9.9 % (WEO, 2014). After surpluses in the government budgets from 1986-1991, the deficits were severe in the following years: from 1992-1995 the deficits were, respectively, 9%, 11%, 9% and 7%.

4.2 Policy actions around the crisis

4.2.1 Fiscal and monetary policy

The fiscal policy prior to the crisis was expansionary: borrowing was stimulated due to tax policy and university bills were government loans. On top of that the private sector had incentives to enlarge their mortgages in order to gain maximal tax deductibility on income. This al led to three decades of negative costs of borrowing and contributed to the above average indebtedness of the Swedish households (Englund, 1999).

Because of the recognition of the increasing competitiveness due to financial deregulation, the requirements of non-interest cash reserve requirements for banks increased from 1 to 3 percent. This was the only adjustment in monetary policy the government made in the deregulation process (Englund, 1999, p. 84).

In 1990 the fiscal policy changed and the incentives to borrow went away. The interest deductions declined from 50 to 30 per cent in 1991. This resulted in an increase of the costs of borrowing: the real after-tax lending rate went to 5%, compared to -1 per cent in 1989 (Englund 1999, p. 89; Drees & Pazarbaşioğlu, 1998, p. 14).

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Graph 9 Households savings (% of disposable income) and real after-tax lending rates, %

Source: Drees & Pazarbaşioğlu, 1998, p. 14

These changes in fiscal policy came with a change of focus of the Swedish Finance Ministry. In 1990, The Finance Minister thought the fiscal policy wasn’t restrictive enough en he quit his job because a lack of support. From then on the priority of the Ministry became decreasing the inflation rate (Englund, 1999, p. 89). This may have played a role in the decision to let the exchange rate float: in 1992 (after the currency was left to float) the inflation rate decreased from 9% to 2%.

To prevent future bank failures, the Swedish government created – with broad political support - the Bank Support Agency (BSA) in May 1993. According to Englund the decisiveness of this agency and limited wealth transfer to shareholders of banks in problems should be emphasized (1999, p. 92). But the creation of the BSA isn’t very relevant for this research, since Jonung (2008) states that in practice, few decisions were made. But the creation of the BSA did contribute to the huge budget deficits.

The budget deficits in the bust period are mostly due to rescue operations for the troubled banks. The Bank Support agency needed billions of Krona to save these bank and prevent an even more severe downfall of the economy. Another costly – but according to Englund a very important – government investment was the supply of liquidity for the banks (1999, p. 93). Englund states that many crisis were deepened by the lack of liquidity support. The

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consequence would be scarcity of credit, for the cause that foreign lenders refused to roll over short-term credits in the case of an impending devaluation.

In contrast to Finland, the policy on Swedish residents portfolio investments in foreign currency and foreigner’s investment in domestic securities were restricted till 1989 (4 years after deregulation of the rest of the financial market (Englund, 1999, p. 84). This might have reduced the currency risk of Swedish households and thereby reduced the consequences of the devaluation of the national currency.

4.2.2 Exchange rate policy

As mentioned before, the Swedish maintained a fixed exchange rate on their Krona, since 1977 pegged to a basket of 15 currencies (Englund, 1999). The exchange rate appreciated ongoing in real terms, but the Krona was devaluated six times since 1973. The prospect of new devaluations in the future led to distrust on the financial market and therefore high interest rates were very common.

In contrast to the Finnish policy-makers, the Swedish didn’t re- or devalue their currency at the end of the boom period. They maintained their fixed exchange rate and this reduced currency speculation in this period.

Just as in Finland the currency was left to float in the fall of 1992. This led to a depreciation of the currency of 19% in the following years (Mai, 2008, p. 4). The Swedish terms-of-trade improved because of this devaluation, resulting in a declining negative current account balance in 1993 and positive balance in 1994 (WEO, 2014) Of course this devaluation increased the net foreign debt, but in contrast to Finland, no real harm was done. The causes of this will be explained in paragraph 4.3.

4.3 Macroeconomic fundamentals of the Swedish economy

4.3.1 Foreign indebtedness

The restrictions on foreign investments of Swedish residents and the purchase of domestic securities by foreigners was strictly regulated until 1989. This contributed to a balanced net position in foreign currency of the banking sector, as well as the Swedish households. Although the Swedish private sector had big losses because of the depreciation in 1992 and 1993, these losses were almost completely offset by their gains on foreign assets. This made them little vulnerable to the devaluation of the Krona (Englund, 1999). It is important to keep

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in mind that these ‘balanced position’ was on average: multiple banks became into trouble because of the depreciation of the Krona, which strengthened the banking crisis.

Graph 10 1991: Stock of foreign direct investment in developed countries, % of GNP

Next to this foreign indebtedness, a few external macro shocks may have contributed to further downfall of the Swedish economy.

4.3.2 Current account balance and government debt

Just like neighbor country Finland, Sweden is a small open economy and therefore vulnerable to external events. The German reunification may have had great negative influence on the debts of the Swedish government in the 1990s (Jonung et al, 2008, p. 51). With this reunification the European interest rate rose and the Swedish government – characterized with great debt – had to face bigger budget deficits due to higher interest payments. The government debt was, indeed, way bigger in Sweden than in Finland.

The export sector didn’t seem to be struck by the crisis. Although the export volumes declined, the decrease was less than in the years before 1991. In 1991 the export market growth was

-2.5 per cent. This turned into strong positive two-digit terms in the years following due to depreciation of the currency, just as in Finland (Englund 1999, WEO 2014). The current account balance in the boom and bust period reached his lowest level in 1992, with a deficit of 2.8%.

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5. The comparison of the crises

From the above description of the course of and the policy around the crisis period a pentad differences arise. In this paragraph a concise enumeration of differences will be given, in the next paragraph the consequences of these differences from the view of macroeconomic theory will be provided.

5.1 Differences in policy and the macroeconomic fundamentals

In this literature review the following differences in the crisis period between Finland and Sweden were found.

1. The abolishment of the restrictions on foreign investments went way quicker in Finland then in Sweden. Where the Swedish kept these restrictions until 4 years after the deregulation of the rest of financial market (1989), the Finnish only waited 1 year with it (1987). Both the Swedish and the Finnish were heavily exposed to currency risk due to a significant amount of foreign borrowing. But while the Swedish private sector offset the currency risk by keeping a lot of foreign assets, the Finnish didn’t.

2. In 1989 the Finnish central bank revalued their currency with 4%. Sweden ignored the pressure on their currency and kept their fixed exchange rate at the same value.

3. Both the Swedish as the Finnish government chose to rescue the banking sector by injecting huge amounts of money into the banks. Although these rescue operations were quite similar, there was one difference. The Swedish created the Bank Support Agency, which was broadly trusted by the economic actors. In addition, the Swedish government provided liquidity support to the Swedish banks, were the Finnish didn’t. Due to this, the Swedish government faced big government deficit in the crisis years, when compared to Finland.

4. The Finnish export sector was very dependent of the Union. When the Soviet-Union fell apart, the export volumes decreased severely. Sweden didn’t face this problem, because of relative independence of the Soviet-Union.

5. The asset price boom and bust in Finland was stronger than the boom and bust in Sweden.

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5.2 Effects of these differences

In this paragraph the consequences – according to macroeconomic theory – of the above listed differences will be examined. The differences will be analyzed one by one in order to judge whether a factor intensified the crisis or not. The starting point is the ‘list of causes’ provided by Goldstein and Turner and enumerated in chapter 2.

The first difference – the Finnish didn’t offset their currency risk as the Swedish did – is an example of a potential cause of a banking crisis, according to Goldstein and Turner (2008). It’s an example of currency mismatches in an environment of increasing bank liabilities. Goldstein states that such a mismatch ‘can come badly unstuck when a devaluation occurs’ (1998, p. 15). In addition another argument is the findings that a high ratio of foreign investment to foreign debt contributes to a lower probability of a currency crash (Reisen, 2009, p. 123). In reverse, this can be interpreted that a low ratio of foreign investment to foreign debt – which was the case in Finland - raises the probability of a currency crash. In the light of these arguments, this difference can be seen as intensifying.

The second factor – the revaluation of the domestic currency by Finland – is not directly recognized as a cause for a crisis by Reisen (2009) as well as Goldstein and Turner (1998). But it would be premature to define this difference as irrelevant. According to Goldstein and Turner the exchange rate regime can make the currency more vulnerable to speculations (1999, p. 31). Further, Jonung et al. stated that the revaluation created expectations of devaluation (2008, p. 18). This may have contributed to the credit crunch since foreign lenders tend to ask higher interest rates to the Finnish. However, since no clear conclusion can derived from the literature, for now, I judge that this difference wasn’t that important in worsening the Finnish crisis (i.e. no intensifying factor).

The third factor – the relative large budget deficit of the Swedish government – isn’t listed in the list of causes of banking crisis which Goldstein and Turner produced (1998). Jonung et al. states that Sweden may have been struck harder by the increases of the interest rates at the beginning of the bust period, than others (for example: Finland) (2008, p. 51). This is an argument that can be used in favor to why the intensity gap between the two crises wasn’t even bigger. Since this is not the aim of this research, this difference seems to be irrelevant in the light of this thesis.

The fourth factor – the dependency of Finland to the Soviet-Union exports – has a big share in the external macroeconomic volatility, the first cause on the list of Goldstein and Turner (1998). The results of empirical research showed that less diversified countries are more likely to experience banking crisis, because of the volatility of these countries (Goldstein and Turner, 1998, 9-10). Specific to this situation, Pesola found that macro shocks had a severe

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impact on the Finnish economy, but not on the Swedish (2001). The contribution of the collapse of the exports to Soviet-Union to the decrease of the Finnish GDP is estimated on 2-3%. Therefore this factor can – clearly - be judged as intensifying.

The last factor – the relative big asset price boom and bust in Finland – is a part of another cause of a banking crisis. The occurrence of asset price collapses is a cause of a banking crisis (Goldstein and Turner, 1998). According to Mai the bigger the degree of the overextension at the peak of the boom and the magnitude of negative shocks in asset prices, the more vulnerable the economy is (2008). Since the assets were more overvalued and the magnitude of the shocks were bigger in Finland than in Sweden, from this can be concluded that this was an intensifying factor.

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6. Conclusion

To conclude my thesis I will summarize my findings and briefly present the

shortcomings of this research.

The research question I formulated is:

Which factors caused the economic crisis to be worse in Finland than in Sweden? In order to find answers to this question I did a literature

study. First, I gained more insight into the causes of banking crises and currency crises. Second I compared the Finnish and Swedish policies and macroeconomic fundamentals. This comparison led to a pentad differences between the two countries in the crisis period, which I analyzed with more general theory.

A lot of different – mostly Scandinavian - authors shined their light on the Finnish and Swedish crises. Although a lot of them focused on the similarities, Mai (2008) and Jonung (2008) described some differences as well. Bordes, Currie and Söderström (1993) wrote about the causes of the Finnish crisis, whereas Englund (1999) wrote about the Swedish causes. The aim of this thesis was to get more insight into the factors that intensified the Finnish crisis. In the end I found 3 of these intensifying factors in relevant literature.

The first intensifying factor found in this research was the external macro shock of the disintegration of the Soviet-Union. This led to a severe decrease of the export volumes in Finland, but not in Sweden. The second intensifying factor is the relative big asset boom and bust in Finland, compared to Sweden. According to literature a country is more vulnerable to financial crisis if their economy is more volatile. The fact that the Finnish private sector kept small amounts of foreign assets to offset their currency risk, and Swedish kept large amounts of this, is the last intensifying factor that I found in my research.

It has to be kept in mind that the list of causes I used in this essay is not excluded from debate. I chose the list which I thought was suitable for my research, but other authors may have produced better lists of causes for crises. In addition, the description of the Swedish crisis is based on just a few academic articles, since more essays on this subject were hard to find. The Finnish crisis was described in dozens of articles though. It would be preferable that this is better balanced in following studies on this subject. It’s also good to realize that a literature review on this subject can’t tell us to which degree a factor influenced the downfall of the Finnish economy. An empirical study must be provided in order to judge the degree of contribution to the intensity of the crisis, but unfortunately this was not the scope of this research.

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