Sweden’s property prices are facing a serious drop as the country’s former central bank governor warns of lofty household debt levels.

House prices in Sweden have risen fairly reliably over the last decade. This has been buoyed by ultra-low interest rates in a system where around half of people’s mortgages are financed with variable rates and many of the rest are on short-term fixed rates.

But now property prices are tumbling. And this downturn is not surprising given the “dysfunctional” nature of the market, according to Stefan Ingves, who headed Sweden’s Riksbank from 2006 to 2022.

“I’ve persistently time and time again said that the debt level in the household sector is just way, way too high and there will be a day of reckoning and eventually rates will go up, and now rates have gone up,” Ingves told CNBC’s “Squawk Box Europe” in an exclusive interview Tuesday. 

“What you see happening now is almost exactly what you would expect to see happening, and that is that households have to pay more and the interest rate sensitivity … is much higher,” Ingves added, which makes interest rate payments higher for a huge number of Swedish households.

The pandemic effect

During the Covid-19 pandemic, house prices across Europe continued to rise, and Sweden was no exception. Demand for property skyrocketed as working from home and a preference for domestic vacations prompted people to upsize their spaces.

On average, house prices were up as much as 30% compared to the pre-pandemic level of January 2020, according to Nordea Bank, as the Riksbank started purchasing mortgage bonds, trying to bring rates down and adding fire to an already hot housing market.

But now prices are falling, dramatically.

“As of November we are seeing prices nationally in Sweden fall 13% from the peak in February. That’s the largest downturn on the housing market since we had a big economic crisis in the nineties,” Gustav Helgesson, an analyst at Nordea, told CNBC.

Central bank rate hikes

In 2022, Sweden’s central bank undertook an aggressive interest rate hiking cycle that ricocheted through the property market.

In February, the Riksbank signaled its policy rate would remain unchanged at zero, and predicted an eventual increase for the second half of 2024. But in the bank’s next monetary policy statement just three months later, the rate was raised to 0.25%.

“They really just shifted from that meeting to the next one in April and started their hiking cycle,” Helgesson told CNBC.

Rates continued to increase throughout 2022, going from 0.25% to 0.75% in July, to 1.75% in September and 2.5% in November.

“This took many households by surprise … and I think that Swedish households … have been struggling to adjust to this cycle and foresee these very quick and dramatic rate hikes from the Riksbank,” Helgesson said.

Emil Brodin, an economist from the National Institute of Economic Research, said the extent of the rises were “a bit more than people expected” and that it had “gone more quickly than people thought.”

Helgesson characterized the change as a correction, rather than a bursting bubble, “but it is a painful and very fast correction,” he added.

Thomas Veraguth, head of global real estate strategy for UBS Wealth Management, described the correction as “a natural adjustment that is mainly explained by macroeconomic factors.”

20% drop in 2023?

A further policy rate increase is anticipated for February, with the benchmark widely speculated to hit 3%, leading economists to predict a further downturn in property prices.

Nordea Bank estimates a 20% drop in home prices from peak to trough.

“This is as a direct consequence of the Riksbank’s increased interest rate. They’ve increased from 0% to 2.5% and we expect them to continue to increase the policy rates to 3% in February,” Helgesson from Nordea told CNBC.

Handelsbanken also anticipates a dip in prices.

“Our present forecast is that housing prices will continue to fall over the coming months and stabilize only when mortgage rates have peaked during the spring,” Christina Nyman, head of economic research and chief economist and Helena Bornevall, senior economist, at Handelsbanken, said in emailed comments to CNBC.

The National Institute of Economic Research also expects a further drop in the next couple of months that will settle later in the year.

“We expect the prices to continue declining throughout the first half of 2023 and then a stabilization of the prices, which is based on the interest rates not moving further up. So basically once the interest rate is stabilised, we don’t expect prices to continue declining,” Brodin said.

But there is downside risk to the 20% estimate, according to the chief economist of SEB, Jens Magnusson.

“We do expect [house prices] to drop a few more percentage points … So it could go from 20% to 25% perhaps, but if that happens that would mean that it’s pretty much the pandemic uptick that is being reversed,” Magnusson told CNBC.

Sweden isn’t the only European country experiencing a plunging property market post-pandemic, with some economists forecasting a similar downturn of between 20% and 25% in Germany.

A return to pre-pandemic figures

The dip in the market is a correction that puts Swedish property back to its pre-pandemic state, according to some economists.

“We had about 20% increases during those two pandemic years, so obviously that is the first thing that will go now and I expect pretty much all of that to disappear and to decrease,” Magnusson said.

“As of now prices are still about the level at which we entered the pandemic,” Brodin told CNBC. “Basically the increase in house prices during the pandemic is erased,” he added.

But the former Riksbank governor signaled that the bumpiness in Sweden’s housing market stemmed from more fundamental issues than just a pandemic-induced fluctuation.

“We have not been hiding anything on the side of the central bank in the structural difficulties that we have in the housing market,” Ingves told CNBC.

“But at the same time, the political process has been such that there hasn’t been a willingness on the political side to sort out these issues and that’s why we are where we are,” he added.

The Government Offices of Sweden did not immediately respond to a CNBC request for comment.