OREANDA-NEWS. Fitch Ratings has affirmed Sweden's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'AAA' with a Stable Outlook. The issue ratings on Sweden's senior unsecured foreign and local currency bonds have also been affirmed at 'AAA'. The Country Ceiling has been affirmed at 'AAA' and the Short-Term foreign currency and CP IDRs have been affirmed at 'F1+'.

KEY RATING DRIVERS
Sweden's 'AAA' ratings reflect high income per capita, strong governance indicators - even in comparison with 'AAA' rated peers - and a track record of sound economic policy management.

The Swedish economy has expanded by 2% on average over the past five years, recovering strongly from the recession of 2008. Boosted by expansionary monetary policy, GDP growth accelerated to 3.8% in 2015, more than double the estimated growth rate of the 'AAA' median (1.7%). The main driver of this was domestic demand - in particular private investment. Fitch expects growth to slow only slightly over the next two years, to 3.2% this year and 2.8% in 2017.

Strong growth has translated into labour market improvements. The unemployment rate had fallen to 7.0% in January from 7.8% in January last year. We expect a further fall to an average of 6.8% in 2016. At the same time, demographic trends, notably higher immigration, will make a further sharp fall in unemployment unlikely. Sweden received almost 163,000 asylum applications (which is around 1.6% of total population) last year, more than double the 2014 number. The precise impact and the persistence of sharp increases in population and inward migration are uncertain. In the short term, we expect a boost to economic growth, mainly from higher government spending and construction. At the same time, it may take time to absorb substantial inflows into the labour market and for the new arrivals to find jobs.

Despite strong growth, inflation and inflation expectations are still low. With the krona appreciating, the Riksbank loosened monetary policy further by cutting its policy rate to -0.50% from -0.35% in February. Consumer price inflation was 0.4% in February, while underlying inflation (excluding mortgage payments) was 1.1%. The Riksbank's latest projections suggest that the policy rate may stay negative for the next two years. We expect inflation to pick up this year and next, as base effects from low import prices drop out of annual comparisons, and higher resource utilisation pushes up labour costs. Collective wage agreements for around three million employees expire over the coming months, with industrial unions having asked for a 2.8% settlement.

Above-forecast economic growth led to a sharper than expected fall in the government deficit last year. The deficit declined from 1.6% of GDP in 2014 to 0.3% in 2015. The improvement was driven by a fall in the expenditure ratio of 0.8 percentage points. We expect the deficit to rise slightly over the forecast horizon, to 0.5% of GDP this year and then to 0.8% in 2017. Following the budget last year, extra spending of SEK11bn (around 0.3% of GDP) was allocated to face the refugee crisis. Overall the Ministry of Finance estimates that government expenditure by 2017 will be SEK40bn (around 1% of GDP) higher than it would have been otherwise, due to the impact of the extra migration flows.

We estimate that the government debt to GDP ratio fell back to 43.6% in 2015, from 44.8% in 2014. This is in line with the 'AAA' median. Strong economic growth and low interest costs will push the debt to GDP ratio down to 42.2% in 2016 and 41.2% in 2017.

In our view, high household indebtedness and house prices pose risks to macroeconomic developments in Sweden. Corrections in house prices or in households' willingness to take on more debt may lead to a retrenchment in domestic demand. House prices rose sharply in 2015, pushed up by strong real incomes growth and low interest rates. Over the year as a whole they rose by just under 15%. In recent months, the rise in prices appears to have slowed down slightly, with annual growth declining from 15.9% to 14.3% between 3Q15 and 4Q15. The household debt to income ratio rose to 176.6% in 3Q15, up from 171.8% a year earlier.

The Swedish banking sector is large relative to the size of the economy, and is inter-linked and concentrated, with the four major banking groups' assets (including overseas) amounting to around 350% of GDP. Swedish banks are well-capitalised (the four major banks had an average Common Equity Tier 1 capital ratio of 18.4% at 3Q15) and have lower funding costs than many European peers. At the same time, they are structurally more reliant on wholesale funding, leaving them vulnerable to market funding shocks.

RATING SENSITIVITIES
The Outlook is Stable, which means Fitch does not expect developments with a high likelihood of leading to a rating change. However, future developments that could, individually or collectively, result in downward pressure on the rating include:
-A severe macroeconomic shock - potentially originating in the household sector - leading to a pronounced deterioration in public finances through higher deficits, rising debt and lower GDP growth.
-A sizeable systemic shock to funding conditions in the financial system , given the size of the banking sector.

KEY ASSUMPTIONS
Fitch assumes that the Swedish authorities remain committed to the current fiscal policy framework. The current fiscal policy rule states that the government should run an average surplus of 1% of GDP over the economic cycle.

In its debt sensitivity analysis, Fitch assumes on average a primary balance of 0.6% of GDP, trend GDP growth of 2.4%, GDP deflator growth of 1.8% and a nominal effective interest rate of 1.8%. On the basis of these assumptions, the government debt to GDP ratio would fall back to 28% by 2025.