SEK – A mysteriously weak currency - Part 2
With a strong record of balance of payments, contained inflation and world class public finances, one would think that the currency of Sweden would be strong. But the opposite is still unfolding. Decades of the sliding value of the SEK is one of the clearest trends in the global foreign exchange markets. In the previous article we looked at the selling of SEK from the Swedish government institutions, and in this article, we will look for more clues that may explain these historical developments.
Are Swedish households and pension funds carrying a large unhedged position of equity related investments in overseas market?
The debt carried by the households has been surging during the booming markets of real estate. Total household debt as of the 30th of April 2023 was 4903 billion SEK, of which mortgage debt represented over 80%. This placed the average Swede among the most indebted populations along with countries like Denmark and the Netherlands. Below is a graph published by Ekonomifakta that used data from Eurostat. According to the Eurostat data only the Danish population carries more debt on this measure. The alarming reports often only mention one side of the balance sheet, the debt side. When the assets also are considered, a different picture emerge. The assets of both the Danes and the Swedes are also very high. In fact, one could maybe conclude that these Nordic countries have populations with inflated balance sheets compared to other populations.
So, what kind of assets do the Swedes hold requiring all this dept? One obvious answer is housing, and that explains the aforementioned high levels of mortgage dept. Another important asset comes from savings.
According to the Swedish Investment Fund association A.K.A. Fondbolagens förening, the swedes are world leaders when it comes to savings in mutual funds. The estimated total of savings is over 6200 billion SEK, of which over 85% are in pure equity funds or mixed funds that contains both fixed income and equity. If one assumes that one third of the pure equity is invested in equity outside Sweden those investments would carry a position of well over 1000 billion SEK. The households would benefit from a weaker Swedish krona and vice versa.
Sweden has an array of different pension solutions. There is a base layer of a government “pay-as-you-go” system “Allmän pension-inkomstpension”, hereinafter called layer one. There is also a government scheme called “Premiepension”, hereinafter called layer two. Corporate pension schemes “Tjänstepension” negotiated with the trade unions, hereinafter called layer three.
Layer one amounted to 1696 billion SEK as per end of 2021, layer two, was 1689 billion SEK and layer three 3631 billion SEK, total savings was 7385 billion SEK vs. debt of 16325 billion SEK. This may sound imbalanced, but it is a pay-as-you-go system for the government pension that explains the gap.
In the below table you can see the assets and liabilities in the Swedish pension system. Values are in SEK billions as per end of 2021.
What does saving have to do with a weak currency?
Asset allocation is based on the belief that different asset classes have varying degrees of correlation with one another. The theory is that by mixing assets, a more stable performance will be achieved over time. This is often measured with risk-adjusted return calculations such as the Sharpe quote.
This publication by Riksbanken explains a system of how Swedish banks increasingly funds themselves in the international market and use the FX-swap market to convert these funds back to SEK. On the other side of these swaps are the institutional investors that needs to borrow USD and other currencies to make investments with a hedge. But again, large portions of the equity investments are normally not hedged.
The public pension Allmän pension-inkomstpension is a system backed up with five buffer funds, to cover lack of contributions to the system. These have gone through a series of changes over the years. Since 2001, there was a larger change by allowing more of the funds to be invested in equity. The goal for the system is not only to bridge payment gaps due to demographics, but also to support in the financing of the government pension payments.
The most recent change happened just a few years ago when the allowed share of unlisted investments was raised.
Looking at the buffer funds alone, the allocation into global stocks and emerging markets were between 34 and 38 percent in the different funds. It is common to leave the foreign exchange risk partly or fully unhedged in these types of positions. In the Riksbanken publication “Finansiell Stabilitet 2020:1” one can read that, there is a limit on how much of the assets in the buffer funds is allowed to carry foreign exchange risk, this limit is currently set at 40%. As an example, AP3 reported the unhedged position to be 19% of AUM, by the end of 2022.
The government fully funded scheme is called Premiepension and there, the assets match the liabilities. Investments are made by the individual taxpayer with a default government fund, if the taxpayer doesn’t make an active choice to invest in a private fund. According to the home page of AP7 the equity fund is invested outside Sweden to 99% and there are no hedges on these investments.
This system is more of a financed saving scheme, often managed by foundations that act independently from the company that contributes to the employees’ future pensions. There is a mutually owned insurance company that writes insurance to cover the liabilities among its members.
Direct investments in foreign equity are rarely hedged by the households since it requires access to trading in financial instruments, such as foreign exchange forwards and options. There are, of course, exceptions to this assumption.
The national statistics by SCB
Here is a report published by SCB (the national statistics agency).
This report describes the portfolio investments A.K.A, investments that are below 10% ownership in a specific entity such as a company or real estate. Those larger holdings are called direct investments. This is obviously only one side of the coin since it does not show the foreign portfolio investments which are substantial as well.
The mystery continues – or does it?
So why is the Swedish krona so weak? Is it even a mystery?
Countless attempts have been made to shine the light on this topic. Maybe the answer is right there in front of us. Could it be that investors in Sweden are riding the trend of the ever-weakening SEK by not hedging overseas investments to the same extent that foreign investors hedge their investments in Sweden. If so, this would lead to portfolio investment outflows of the SEK into other currencies, primarily the USD. To capture the net positions after considering all the portfolio flows, direct investments, as well as financial transactions aiming to hedge risks is a big task, to say the least. Maybe the households will start to trim their balance sheets now that the risk-free rate from amortizing mortgage debt suddenly is above 4% instead of 1%.
Short term the krona might be weaker due to the problems some companies face in the real estate sector. There is, however, a large difference compared to 1992. It is unlikely that there is a widespread use of un-hedged currency loans that finance the Swedish real estate investors this time. Back in the early -90s the exchange rate was fixed against the ECU (the predecessor of the EUR) and borrowers could borrow ECU several percentage points cheaper than SEK loans.
What could strengthen the SEK?
Factors that could strengthen the SEK in the short term are, private households trimming their balance sheet, previous decline in the SEK may change the supply and demand. Finally, depending on how the current stress in some real estate companies play out, this could lead to some repatriation of overseas investments when more juicy investment opportunities may arise in the home markets of the Swedish institutional investors.
Factors that could strengthen the SEK in the long term may be, a change in the balance of contributions and distributions of savings (today contributions are still higher), more focus on domestic investments by institutional and private investors, continued strong terms of trade. And maybe, a deeper co-operation between different government agencies, also considering the effect on the external exchange rate when, setting the mandates and the rules for portfolio managers.
If you the reader were waiting for an easy answer you might be disappointed, it is complex. It would be easier if, Sweden continuously operated with a higher inflation rate, trade imbalances or sub-par fiscal discipline. If that was the case, the decline would be motivated by macro-economic factors.
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DISCLAIMER: THIS IS NOT A FORECAST FOR THE EXTERNAL VALUE OF SEK. THE INTENTION IS MERELY TO HIGHLIGHT SOME FACTS THAT MAY HAVE PLAYED A ROLE IN THE PRICING OF THE SEK IN RECENT YEARS. WHAT HAPPENS FROM HERE WILL BE DECIDED BY YOU THE READER AND EVERYONE ELSE WITH A VESTED INTEREST IN THE FOREIGN EXCHANGE RATE OF THE WORLD’S LEADING CURRENCIES.
Is the correlation between the balance of payments and the external exchange rate broken?
Is the correlation between the balance of payments and the external exchange rate broken?
Director, Financial Risk Management
KPMG i Sverige