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Finland

Author(s):
International Monetary Fund
Published Date:
October 1995
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I. Introduction

This paper reviews developments in the Finnish economy since the last report on Recent Economic Developments was issued in July 1993. The main body of the paper discusses the domestic economy, public finances, money and credit, and the balance of payments. In addition, Appendix I reports on the robustness of various inflation indicators, providing background to the process of establishing a monetary policy framework under a floating exchange rate. Appendix II reviews possible structural causes for high unemployment and discusses reform proposals. Appendix III analyzes macroeconomic shocks that triggered the latest recession and discusses the role of financial factors in the transmission of those shocks economy-wide.

Finland is currently experiencing a strong recovery from the severe 1991-93 recession that reduced output by about 12 percent and put almost one fifth of the labor force out of work. The recovery originated in the export sector, but has recently spread to almost all sectors of the economy. In 1993-94, exports soared in the wake of improved external competitiveness, owing to the depreciation of the markka through early 1993, moderate wage increases, and strong productivity gains. More recently, exports have also benefitted from an increasingly favorable international environment. Since late 1994, the recovery has broadened to include domestic demand, supported by the reversal of debt-deflation dynamics. Strengthened balance sheets and reduced indebtedness have rekindled private investment, while brighter employment and income prospects have also prompted an increase in private consumption and a decline in the saving rate. However, while employment began to rise in early 1995, the unemployment rate remains very high.

While the real sector of the economy has been recovering, fiscal policy still has to cope with the consequences of the recession. Even with considerable fiscal consolidation efforts in the 1993-95 budgets, the central government budget deficit has continued to widen, and public debt has been on an unsustainable path. Against this background, the newly elected Government announced in April 1995 a fiscal program aimed at stabilizing the ratio of central government debt to GDP by 1997. It envisages permanent expenditure cuts of 4 percent of GDP over the next four years, half of which are to be implemented in the 1996 budget.

The monetary environment changed significantly after the currency was floated in September 1992 and the Bank of Finland adopted an explicit inflation target of two percent in early 1993. In the event, inflation has remained well below target, supported by a strengthening of the markka which, by March 1995, had almost appreciated to its pre-float level vis-à-vis the ECU. During the first half of 1994, interest rates rose sharply after financial markets were hit by turbulence. A tightening of monetary policy starting in late 1994 has contributed to a flattening of the yield curve and a reduction of long-term interest rates. At the same time, however, the financial sector is still affected by the legacy of the 1991-92 banking crisis and again suffered losses in 1994.

The economy is currently undergoing substantial structural change, prompted by the EEA agreement in early 1994, the EU accession in January 1995, and the need to reduce the high unemployment rate. The most dramatic changes are taking place in agriculture, as producer prices have dropped sharply to EU levels at the beginning of this year and agricultural support is expected to be reduced gradually to levels comparable with CAP support. In addition, the banking and insurance sectors are expected to be exposed to more foreign competition as the result of the EU’s single market regulations. With respect to the labor market, the centralized wage bargaining system was abandoned in favor of branch level negotiations for the last two wage rounds. Moreover, the wage partners and the Government concluded an agreement in May 1995 that will significantly improve the finances of the occupational pension schemes.

II. The Domestic Economy

1. Overview

Propelled by exports, the Finnish economy is rebounding vigorously from its severe recession. In 1994, real GDP grew by 4 percent from its trough in 1993, which was some 12 percent below the peak in 1990. The momentum of the recovery continued in early 1995; in the first quarter, real GDP was 6 percent higher than one year earlier. Just as the recession was to some extent exacerbated by external shocks and displayed features of a debt-deflation cycle in the wake of the domestic overheating in the late 1980s, some of these shocks and financial factors are currently acting in reverse and are supporting the recovery.

While in 1992-93 domestic demand weakened sharply, net exports made a positive contribution to growth. Initially, exports were boosted mainly by the sharply improved external competitiveness, following the depreciation of the markka in 1991-93, combined with moderate wage increases and improved productivity. Over the past year, in contrast, the more favorable international environment helped sustain the export boom despite the sharp appreciation of the markka. As a result, manufacturing production has expanded briskly.

A broadening of the recovery to domestic demand is currently being supported by the reversal of debt-deflation dynamics. The surge in profitability in the export sector has allowed large segments of manufacturing to strengthen their balance sheets and reduce their indebtedness. As a result, in 1994 private investment recovered modestly from levels that were some 50 percent below its peak in 1990. Similarly, while households had raised their saving rate in the past few years against the background of bleak economic prospects and high debt burdens, brighter employment and income prospects have recently prompted an increase in private consumption and a decline in the saving rate. Stronger consumer confidence is also increasingly supported by lower household indebtedness and higher asset prices. Stock prices have bounced back to record highs and housing prices have risen--albeit modestly--from their much depreciated level.

2. Domestic demand

The unprecedented recession was characterized by an unusually sharp drop in domestic demand. Whereas real GDP declined by about 12 percent in 1990-93, domestic demand dropped by 18 1/2 percent (Chart 1 and Table 1). The volume of private investment collapsed by 50 percent, while private consumption--driven primarily by reduced demand for consumer durables--fell by 12 percent from its overheated level in 1990.

CHART 1FINLAND GROSS DOMESTIC PRODUCT, 1986–91

Source: OECD Analytical Database.

1/ Components of real GDP are annualized from X-11 seasonally adjusted series.

Table 1.Finland: National Accounts Summary, 1991-95
In Billions of

Finnish Markkaa at

at Current Prices
Annual Percentage Changes at

Constant 1990 Prices
199419911992199319941995 1/
Consumption396.2-1.9-4.1-4.31.33.5
Private281.5-3.6-4.9-3.92.05.0
Public114.62.5-2.2-5.3-0.4-1.0
Gross fixed investment77.5-20.3-16.9-18.62.815.0
Private64.8-23.1-19.6-18.95.419.0
Public12.7-0.2-2.0-17.4-8.5-5.5
Final domestic demand473.7-6.8-7.0-7.3-1.5
Stockbuilding 2/3/6.4-1.31.21.01.40.5
Total domestic demand480.2-8.3-5.6-6.03.36.0
Exports of goods and services181.2-6.610.016.712.57.5
Imports of goods and services149.8-11.71.10.712.611.0
Foreign balance 3/1.42.14.20.8-0.5
Gross domestic product511.6-7.1-3.6-1.63.95.0
Memorandum items:
Selected price deflators
Exports of goods and services-1.56.76.51.05.5
Imports of goods and services0.67.28.6-0.21.5
GDP2.50.72.42.53.5
Sources: Statistics Finland, National Accounts; Ministry of Finance, National Budget February 1995; Economic Survey 1994; and data provided by the Finnish authorities.

Official projections.

Including the statistical discrepancy.

Changes in percent of GDP in the preceding year.

Sources: Statistics Finland, National Accounts; Ministry of Finance, National Budget February 1995; Economic Survey 1994; and data provided by the Finnish authorities.

Official projections.

Including the statistical discrepancy.

Changes in percent of GDP in the preceding year.

Following a 35 percent depreciation of the real effective exchange rate (ULC basis) between mid-1991 and early 1993, the main impetus for recovery originated in the export sector. Net exports contributed on average 2 1/2 percentage points to GDP growth in 1991-93 (Chart 2). By mid-1993, most domestic demand components had bottomed out, and have since trended upward, albeit slowly. In 1994, when real GDP grew by 3.9 percent, the main contribution to growth, in fact, stemmed from domestic demand (3.1 percentage points), whereas net exports contributed just 0.8 percentage points.

CHART 2FINLAND CONTRIBUTIONS TO REAL GDP GROUTH, 1986–94

(In percent)

Sources: 1994 Statistical Yearbook; Finnish authorities; and staff calculations.

The turnaround in domestic demand is also reflected in private consumption. In 1993, the volume of private consumption declined by 4 percent, as real disposable income dropped by almost 5 percent and the savings rate fell moderately from 10 1/2 percent to 9 1/2 percent, still a relatively high level by Finnish standards (Table 2). Consumption of durable goods continued to shrink (by 13 1/2 percent), following declines in the previous two years of more than 20 percent (annual rate). In response to the depreciation of the markka, tourism expenditures abroad fell particularly fast (by 24 1/2 percent).

Table 2.Finland: National Income and Household Disposable Income, 1991-95
In Billions of

Finnish Markkaa

at Current Prices
Percentage Change from Preceding

Year Except as Noted
199419911992199319941995 1/
Wages and salaries205.0-0.1-5.7-7.01.88.0
Employers’ contributions to social insurance59.61.9-5.3-0.85.39.5
Net property and entrepreneurial income77.1-39.30.232.439.4
National income at factor cost341.8-7.3-4.9-0.79.1
Indirect business taxes less subsidies59.4-9.0-5.11.17.5-1.5
National income at market prices401.2-7.5-4.9-0.48.811.0
Household disposable income289.07.01.1-1.10.37.5
Household consumption1.8-1.0-1.0-0.1
Memorandum items:
Saving ratio 2/8.410.49.56.57.0
Real household disposable income 3/1.3-2.9-4.8-1.56.0
Households’ indebtedness ratio 4/78.875.572.169.565.0
Sources: Statistics Finland, National Accounts. Ministry of Finance National Budget February 1995; Economic Survey 1994; and data provided by the Finnish authorities.

Official projections.

Household saving as a percentage of disposable income.

Deflated by the private consumption deflator.

Households’ outstanding debt at end of period as percent of disposable income.

Sources: Statistics Finland, National Accounts. Ministry of Finance National Budget February 1995; Economic Survey 1994; and data provided by the Finnish authorities.

Official projections.

Household saving as a percentage of disposable income.

Deflated by the private consumption deflator.

Households’ outstanding debt at end of period as percent of disposable income.

Last year, however, witnessed a turnaround in private consumption. Although real disposable income dropped by an additional 1 1/2 percent (less than expected), the volume of private consumption rose by 2 percent. As a result, the household saving rate fell by 3 percentage points to 6 1/2 percent (Chart 3). The turnaround in consumer confidence was likely prompted in part by the emergence of a downward trend in unemployment, a sharply reduced debt service burden due to lower interest rates, and an indebtedness ratio that had declined by about 10 percentage points since 1991 to below 70 percent of disposable income. In addition, housing prices recovered modestly from their low point in early 1993.

CHART 3FINLAND HOUSEHOLD SAVING AND INDEBTEDNESS RATIOS, 1985–94

(In percent)

Source: Finnish authorities.

1/ Household debt in relation to disposable income.

The pickup in domestic demand was particularly brisk in the first few months of 1994, as sales of durable goods (in particular car sales) rebounded, fueled by replacement demand. As this surge leveled off, the pickup spread to other consumer goods categories. For the year as a whole, durable consumption rose by 9 percent in real terms. However, although the markka strengthened last year, consumers cut their tourism expenditures abroad by a further 10 percent.

Public consumption has continued to decline as a result of ongoing fiscal consolidation. In 1993, the volume of public consumption dropped by 5 1/2 percent, with broadly similar rates at the central and local government levels; wages in the public sector were essentially frozen and employment declined. In 1994, however, the volume of public consumption declined by only 1/2 percent, although employment in the public sector fell by 2 percent.

Confirming that fixed capital formation is typically one of the most volatile components of domestic demand, the recession was characterized by a sharp drop in the gross fixed investment ratio from 28 percent of GDP in 1989 to 15 percent in 1993. This drop was in part a correction to the investment boom in the late 1980s, which had expanded the capital stock so rapidly, particularly in the sheltered sectors, that part of the capital stock became economically obsolete.

However, as export industries began to approach capacity constraints, the collapse in investment bottomed out in mid-1993, although year-on-year the volume of private investment fell by almost 19 percent in 1993 (Table 3). By contrast, in 1994 the volume of private investment rose by 5 1/2 percent. Boosted by favorable profitability, reduced indebtedness in manufacturing, and lower interest rates, investment in machinery and equipment rose sharply by 22 percent. Investment grew most rapidly in capital-intensive industries, such as the paper industry, where even greenfield plants are being constructed in response to the surge in world prices for paper and pulp. However, weak demand in the sheltered sectors, together with the legacy of a sizable capital overhang from the late 1980s, has kept investment activity in domestically oriented sectors generally subdued. That said, a more differentiated picture is emerging in the sheltered economy. For example, while construction investment overall dropped again in 1994 (by 6 percent) and residential building declined by 2 percent, industrial construction rebounded as industrial building permits almost doubled in 1994.

Table 3.Finland: Gross Fixed Investment, 1991-95
At Current

Prices Percent

of Total
In Constant Prices;

Annual Percentage Changes
199419911992199319941995 1/
Total gross fixed investment100.0-20.3-16.9-18.62.115.0
Of which: Private83.6-23.1-19.6-18.95.419.0
By type of asset
Buildings41.5.-16.2-19.2-20.5-6.09.5
Other construction13.7-5.2-8.3-7.7-7.0-2.0
Machinery and equipment44.8-30.2-16.0-19.822.028.5
Memorandum item:
Gross fixed investment as percentage of GDP22.418.414.915.216.5
Sources: Ministry of Finance, National Budget February 1995, and data provided by the Finnish authorities.

Official projections.

Sources: Ministry of Finance, National Budget February 1995, and data provided by the Finnish authorities.

Official projections.

Public investment has been cut sharply over the past two years. Following a small decline in the volume of public investment in the early 1990s, in 1993 such investment dropped by 17 1/2 percent, mainly as a result of fiscal consolidation. The downward trend continued in 1994, with the volume of public investment falling by 8 1/2 percent. In the main, local governments have reduced their fixed capital formation, while the central government has kept its investment broadly constant, even in relation to GDP.

Stockbuilding largely mirrored the cyclical turnaround. Weak domestic demand, high interest rates, and significant uncertainty about the future outlook caused inventories to continue to decline in 1993. However, because the decline was smaller than in the previous year, stockbuilding made a small positive contribution to growth in 1993. By contrast, inventories were increased in 1994, particularly in manufacturing, as industrial production grew rapidly. In addition, higher imports ahead of the impending rise of some tariffs associated with EU accession added to inventories, while the retail trade reduced its inventories in anticipation of a sharp drop in food prices to EU levels. Overall, stock building contributed 1 1/2 percentage points to real GDP growth in 1994.

The saving-investment balance indicates that some of the debt-deflation dynamics are in the process of being reversed. In 1993, profitability in the export sector boosted enterprise saving sharply; it almost doubled in relation to GDP, while capital formation continued to shrink (Table 4). Moreover, even though dissaving of the public sector grew to 5 percent of GDP, the current account deficit narrowed to 1 percent of GDP from 4 1/2 percent in 1992. In 1993, households maintained a high saving rate. However, having achieved some success in reducing their indebtedness in 1994 as the economic outlook and employment prospects brightened, the household saving rate declined by 2 percentage points. In contrast, higher profitability in the export sector boosted enterprise saving by a further 4 percentage points of GDP while public sector saving improved by 2 percentage points. As a result, the 2 percentage point rise in capital formation in 1994 was more than offset by domestic saving, and the current account registered a surplus equivalent to 1 percent of GDP in 1994, the first surplus in 15 years.

Table 4.Finland: Financial Balances, 1991-95(In percent of GDP)
19911992199319941995 1/
Gross national saving15.012.113.617.521.0
Households8.810.09.37.07.0
Enterprise3.24.38.312.215.0
Financial institutions0.50.10.80.81.0
Nonprofit institutions0.20.10.20.30.5
Public sector 2/2.4-2.3-5.0-2.9-2.5
Gross capital formation20.516.714.616.418.5
Statistical discrepancy---0.50.3-0.3-0.5
Current account balance-5.5-4.6-1.01.12.5
Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Includes semi-public pension funds.

Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Includes semi-public pension funds.

3. Sectoral output, employment, and productivity

The recession has brought about a correction of some of the sectoral imbalances that were created by the domestic overheating in the late 1980s when manufacturing was being crowded out by expanding domestic services. Since late 1991, there has been a strong rebound in exports, boosted by improved external competitiveness. As a result, manufacturing output has surged by 30 percent cumulatively over the past three years. In contrast, the sheltered sectors have so far remained weak and have significant excess capacity available. 1/ Nonetheless, signs of a turnaround have been emerging even in domestically oriented sectors.

Growth in the manufacturing sector, which has been expanding since late 1991, accelerated from an annual rate of 5 1/2 percent in 1993 to 12 percent in 1994, and has been growing at a similar pace so far this year (Table 5). In the first quarter of 1995, value added was 13.5 percent higher than a year earlier. Production in the metal and engineering industry, a stellar performer during the recovery, rose last year by a robust 20 percent. Boosted by Nokia, the Finnish telecommunications company with a strong position in the world mobile phone market, growth has been most rapid in the electronics and electrotechnical branch. This branch, which now accounts for 30 percent of value added in the metal and engineering sector, increased production by an average annual rate of 25 percent in the past three years. Following annual increases in production of 10 percent in 1993 and 1994, further growth in the forest industry is increasingly limited by capacity constraints. The capital-intensive paper and pulp industry, which has been benefitting in the past two years from a surge in demand and sharply higher world prices, is running at full capacity. Even in manufacturing more generally, the degree of capacity utilization is estimated at about 90 percent. Moreover, the current production level in manufacturing, which is about 14 percent above the previous peak in the late 1980s, has been achieved without significant investment and hardly any new employment.

Table 5.Finland: Gross Domestic Product by Sector of Origin, 1991-95
Share in GDP

in Percent
Annual Percentage Changes in Volume
1994 1/19911992199319941995 2/
Enterprise sector79.7-8.9-3.40.26.05.5
Agriculture, fishing and hunting3.4-5.6-11.24.8--3.0
Forestry3.4-17.913.14.214.010.0
Mining and quarrying0.5-7.8-2.2-2.429.5-20.0
Manufacturing27.0-10.92.05.512.010.0
Electricity, gas, and water2.63.1-0.54.27.06.0
Building construction4.7-13.1-17.2-17.1-4.08.0
Other construction1.7-5.9-7.4-4.8-6.0-2.0
Commerce 3/10.6-12.4-11.8-5.04.05.5
Transport and communication9.2-3.7-0.52.07.55.5
Finance, real estate 4/17.4-3.4-4.61.6-0.54.0
Other services2.7-5.9-1.9-0.32.03.0
Less: imputed bank service changes-3.52.0-17.38.7-6.026.5
Government services18.21.2-2.2-4.6-2.00.5
Other 5/2.1-2.70.4-0.8-2.00.5
GDP at factor cost100.0-6.9-3.1-0.84.54.5
GDP at market prices-7.1-3.6-1.63.95.0
Sources: Ministry of Finance, National Budget February 1995, and data provided by the Finnish authorities.

Preliminary estimates as of May 1995.

Official projections.

Including hotels and restaurants.

Including insurance and business services.

Including nonprofit institutions and domestic services of households.

Sources: Ministry of Finance, National Budget February 1995, and data provided by the Finnish authorities.

Preliminary estimates as of May 1995.

Official projections.

Including hotels and restaurants.

Including insurance and business services.

Including nonprofit institutions and domestic services of households.

Although renovation of dwellings rebounded sharply last year (in part supported by public measures), building construction declined by a further 4 percent, following a drop of 17-percent in 1993. In particular, residential investment remained weak in 1994, as the number of completed housing units was the same as in 1993. This weakness is partly explained by the fact that housing prices--though stabilized--did not appreciate noticeably and long-term interest rates rose sharply in the first half of 1994. In contrast, industrial construction is poised to pick up as construction permits surged in this area last year.

The service sector presents a differentiated picture. Services that are closely related to manufacturing and foreign trade, such as transportation and communication, grew at the significant pace of 7 1/2 percent in 1994, following 2 percent growth in 1993. Private services overall, however, grew by just 2 1/2 percent, following a decline of 1/2 percent in 1993. The four-year decline in wholesale and retail trade finally ended last year, and the sector expanded in step with private consumption at about a 4 percent rate, in contrast to 1993, when it declined by 5 percent. In particular, sales of home appliances and cars picked up strongly last year (by 9 percent and 7 percent, respectively) as consumers shifted spending toward durable goods in response to a brighter economic outlook and improved net wealth.

Despite strong growth in the export-oriented sectors, employment declined again in 1994, albeit by just 0.8 percent, following a decline of more than 5 percent in each of the three previous years (Table 6 and Chart 4). 1/ In early 1994, the unemployment rate peaked at 20 percent and has fallen to 17 percent in June 1995. A labor market survey indicated that employment had increased by about 50,000 in the 12 months to May 1995. Reflecting the uneven sectoral developments, unemployment among males fell more rapidly than among females as sectors with a large female work force, such as services and the public sector, remained weak. Despite efforts to create jobs for young people, for instance through special labor market programs and by lowering entry wages, youth unemployment has remained steady at 33 percent in 1993-94. Similarly disturbing, the number of long-term unemployed continues to rise and reached 30 percent of all unemployed in early 1995, up from less than 3 percent in 1991.

Table 6.Finland: Labor Force, Employment, and Participation Rate, 1991-95
In Thousands
199419911992199319941995 1/
(Percentage change from previous year)
Labor force survey data
Population of working age 2/3,8240.60.60.50.60.4
Labor force2,480-0.9-1.2-0.7-0.20.4
Employment2,024-5.2-7.1-6.1-0.83.0
Agriculture and forestry167-4.3-5.6-7.0-4.0-4.8
Mining, manufacturing, and utilities426-9.7-9.8-6.40.55.2
Construction114-12.7-16.8-16.1-8.83.5
Services1,310-2.5-5.2-5.0-0.23.1
(In percent of the labor force)
Participation rate67.466.165.364.964.8
Unemployment7.613.117.918.416.3
Youth unemployment 3/14.525.233.533.631.0
Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Ages 15 to 74 years.

Ages 15 to 24 years.

Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Ages 15 to 74 years.

Ages 15 to 24 years.

CHART 4FINLAND LABOR MARKET, 1985–94

Source: Finnish authorities.

As in the previous three years, employment dropped most sharply last year in the construction sector (by 9 percent), while remaining almost unchanged in services. The secular decline in agricultural and forestry employment continued. Despite the sharp rise in manufacturing production, employment in industry barely increased, but hours worked rose modestly. As the room for further efficiency gains in industry is likely to diminish and capacity constraints are encountered, higher production is expected to translate increasingly into more employment in manufacturing.

In the economy overall, hours worked rose by about 1 percent in 1994, following declines in excess of 6 percent in the previous two years. Whereas in manufacturing hours worked rose by just 4 percent last year, they surged by 7 1/2 percent in some related service sectors, such as transportation. As value added increased in 1994 by 4 1/2 percent economy-wide, labor productivity improved by 3 percent, down from a gain of 6 percent in 1993. The improvement in labor productivity also slowed in manufacturing, falling from 11 1/2 percent in 1993 to 7 1/2 percent in 1994, as capacity utilization neared the full-capacity mark and further efficiency gains became more difficult to obtain.

4. Wages, income, and prices

The centralized wage bargaining rounds for 1992 and 1993 agreed on zero wage increases, which--given modest wage drift--resulted in wage moderation (Table 7). Breaking with tradition, the wage negotiations for 1994 were conducted on industry level and broadly continued the trend of modest wage increases. Negotiated wages in the public sector remained largely unchanged, while in export sectors negotiated wages were raised by a modest 1 1/2 percent to 2 1/2 percent. The agreements also provided for increased flexibility at the plant level with regard to working hours.

Table 7.Finland: Wages, Costs, and Prices, 1991-95(Annual percentage changes)
19911992199319941995 1/
Hourly wages and salary earnings6.41.90.81.75.0
Negotiated wages increase4.00.9--0.73.5
Wage drift2.41.00.81.11.5
Real hourly wage and salary earnings 2/2.2-0.7-1.40.73.5
Average hourly compensation 3/7.01.81.20.76.0
Unit labor costs 4/
Whole economy7.8-2.6-4.9-1.73.5
Manufacturing5.9-8.0-6.6-3.83.0
Producer prices of manufactured products-0.12.23.91.5
Consumer prices (1990 = 100)4.12.62.21.11.5
(December on December)(2.3)(1.6)(1.6)(2.0)
Basic price index for domestic supply0.31.13.31.42.5
GDP deflator, at market prices2.50.72.42.53.5
Sources: Bank of Finland Bulletin; Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Adjusted for the consumer price index.

Total wage and salary earnings and employers’ social insurance contributions from the national accounts, divided by hours worked. Thus, beside earnings and insurance contributions, compensation includes fringe benefits, overtime pay, and the effects of shifts in the structure of employment.

Index of compensation divided by a volume index of production.

Sources: Bank of Finland Bulletin; Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Adjusted for the consumer price index.

Total wage and salary earnings and employers’ social insurance contributions from the national accounts, divided by hours worked. Thus, beside earnings and insurance contributions, compensation includes fringe benefits, overtime pay, and the effects of shifts in the structure of employment.

Index of compensation divided by a volume index of production.

Reaching agreement in the 1995 wage round--again conducted at the industry level--proved more contentious, as negotiations for the public and domestic sectors were held after those in the export sectors. Almost all agreements required mediation, and two strikes in the public sector (by nurses and firemen) lasted 6-8 weeks. Negotiated wage increases ranged from a 2 1/2 percent basic increase in the public sector (where some employee groups, however, obtained larger wage increases) to 5 1/2 percent in the paper and pulp industry and some private services. It is estimated that on average negotiated wages will rise in 1995 by about 3 percent in the public sector and by 4-5 percent in the private sector.

An acceleration in wage increases has already become evident. Following a modest rise of about 2 percent in 1994, wages rose at an annual rate of 4 percent in the first quarter of 1995, including 1 1/2 percent wage drift. In manufacturing, the wage level was 7 1/2 percent higher than 12 months earlier.

In the past two years, household disposable income has been less volatile than earnings. Although wages and salaries dropped by 7 percent in 1993 as unemployment continued to rise, disposable income declined by a modest 1 percent thanks to higher transfers from the state and social security funds. Nevertheless, real disposable income fell by almost 5 percent. In 1994, notwithstanding the fact that economic activity was picking up and wages and salaries rose by a modest 2 percent, household disposable income was virtually unchanged in nominal terms and again declined in real terms (by 1 1/2 percent).

The moderate wage agreements in the past few years, in combination with sizable productivity gains, implied declining unit labor costs (ULC) during the recession. In 1993, unit labor costs dropped by almost 5 percent economy-wide and by 6 1/2 percent in manufacturing. However, as productivity gains diminished in 1994, the decline in ULC was less than 2 percent in the economy at large and just under 4 percent in manufacturing.

The further weakening of the economy in 1993 led to lower inflation, despite the sharp depreciation of the markka and an associated surge in import prices. Moreover, even as the economy has been recovering, inflation has remained subdued (Chart 5). Consumer price inflation (CPI) fell steadily throughout 1993, from an annual rate of 3 percent in January to 1 1/2 percent in December. At the beginning of 1994, CPI inflation dropped to an annual rate of just 0.2 percent due to a base effect as the increase in indirect taxes was much smaller than in previous years. In mid-1994, however, CPI inflation jumped to an annual rate of 1.6 percent, boosted by about 1 percentage point due to the new value-added tax and an increase in the fuel tax. Subsequently, CPI inflation has been below 2 percent as import prices have remained virtually unchanged over the past year given the steady appreciation of the markka. In connection with accession to the EU, food prices dropped by 7 1/2 percent in early 1995 (equivalent to a 1 percentage point decline in the CPI). That effect was, however, offset by an indirect tax increase. In June 1995, the annual rate of CPI inflation dropped to 0.9 percent, despite a month-on-month increase of 0.3 percent, as the base effect from last year’s VAT introduction dropped out.

CHART 5FINLAND INFLATION, January 1989 – June 1995

(Annual percentage change)

Source: Finnish authorities.

1/ Underlying inflation corrects consumer price inflation for the impact of indirect taxes and capital costs of owner-occupied housing.

The Bank of Finland’s inflation target of about 2 percent is specified in terms of underlying inflation, a measure that adjusts the CPI by the effect of indirect taxes and subsidies, and capital costs of owner-occupied housing. By that measure, inflation has been declining steadily from about 3 percent in mid-1993 to 1 percent in December 1994. Earlier this year, underlying inflation dropped sharply to an annual rate of 1/2 percent as a result of lower food prices and has remained low in recent months.

5. Structural issues

Finland joined the EU on January 1, 1995. While most sectors of the Finnish economy had already been exposed to the competitive implications of EU accession as a result of the European Economic Area (EEA) agreement that took effect in early 1994, EU membership will trigger significant structural changes in some service sectors and in agriculture. Banking and insurance, in particular, will be exposed to foreign competition to a much larger degree as the EU’s single market will facilitate entry of foreign financial institutions. This presumably will help accelerate the trend toward more efficient financial services in Finland.

The most dramatic changes will, however, take place in the food processing industry and in agriculture. The Finnish food industry has been characterized by relatively low productivity and high costs by international standards. In part owing to high transportation costs, competition could to some extent continue to be limited even as food imports are being liberalized. Nevertheless, the prospects of the food industry are tightly linked with the level of agricultural production in Finland. Since agricultural support will be substantial during the five-year transition phase, it is anticipated that agricultural production will remain relatively high, affording time for the food industry to adjust.

Finnish agriculture has traditionally been one the most protected in Europe. The OECD estimates that the producer subsidy equivalent (PSE) was 67 percent in 1994, significantly above the support level afforded by the EU’s Common Agricultural Policy (CAP). More specifically, farm support in Finland relied heavily on indirect support through high agricultural prices. With EU membership, however, agricultural producer prices dropped by some 40 percent. At the same time, the support mechanism was dramatically altered with more support being channeled directly through the state budget. As a result, the direct fiscal burden of agricultural support has increased considerably.

The sharp fall in producer prices, together with the lower support under CAP, will over the medium term prompt considerable change in the structure of Finnish agriculture. To soften the transition, Finland negotiated special exemptions for a transitional period: (i) the Government maintains the right to pay permanently special support to farming in northern regions (the so-called Northern Support); the support is paid from the budget and is expected to rise from Fmk 1.2 billion in 1995 to Fmk 2.5 billion in the year 2000; (ii) the Government is also authorized to pay transitory support in the next four years, which is projected to decline gradually from Fmk 5.7 billion budgeted for 1995; while the transitory support is mainly paid by the Finnish Government, the EU will contribute Fmk 1.2 billion annually during the transition period; (iii) in case of “serious difficulties”, additional support measures may be implemented (after negotiations with the EU Commission); the Government has indicated in this connection that it intends to negotiate an agreement that would allow additional national support for agriculture in southern Finland, an area that is not eligible for Northern Support. This type of support could reach about Fmk 1 billion by the year 2000.

Overall, while the EU’s contribution to Finnish agricultural support is projected to remain almost constant at about Fmk 3.3 billion in current prices over the next four years, the national contribution to agricultural support is projected to decline from Fmk 8.7 billion in 1995 to about Fmk 5 billion in the year 2000, including the envisaged permanent cuts of Fmk 750 million the Government plans to implement in 1996.

The new support schemes are designed to broadly maintain agricultural incomes at their level in recent years. The value of Finnish agricultural production dropped from about Fmk 22 billion before EU membership to an estimated Fmk 12.5 billion this year; at the same time, direct income subsidies rose from Fmk 4.3 billion in 1994 before EU membership to Fmk 12 billion this year. In the past few years, agricultural income has ranged from about Fmk 8 billion to Fmk 9.5 billion; the new support scheme is aimed at achieving comparable levels of income under the assumption of unchanged production. How in fact production will react to the drastic changes in the support schemes and to the lower producer prices is unclear, and no official projections have been published.

III. Public Finance

1. Overview

Fiscal policy in Finland in the 1970s and 1980s was conducted relatively cautiously as indicated by the fact that government outlays as a percent of GDP were consistently below the OECD-Europe average and public debt stayed below 20 percent of GDP (Chart 6). However, during the period of rapid economic growth in the late 1980s, welfare benefits and entitlement programs, including unemployment insurance, were expanded. These structural spending increases contributed to the rapid deterioration of public finances during the deep recession in the early 1990s. Despite considerable fiscal consolidation efforts in the 1993-95 budgets, the central government budget deficit continued to widen, and debt accumulated rapidly (Chart 7). Against this background, the newly elected Government that took office in April announced a new initiative with significant expenditure cuts over the next four years aimed at halting the debt accumulation.

CHART 6FINLAND PUBLIC OUTLAYS AND DEBT IN SELECTED COUNTRIES, 1978–94

(In percent of GDP)

Source: OECD Economic Outlook, June 1995.

CHART 7FINLAND CENTRAL GOVERNMENT FINANCES, 1985–95 1/

(In percent of GDP)

Sources: Finnish authorities; Bank of Finland, Bulletin; Ministry of Finance, Economic Survey (various issues).

1/ Data for 1995 are official projections.

2/ On a cash basis; including extrabudgetary funds.

The previous Government had come into office in 1991 with the objective of halting the growth of central government spending. Specifically, it aimed at reducing real expenditures by 1995 to their 1991 level. To that end, some structural changes in the budget process were initiated to facilitate parliamentary approval of spending cuts and to improve incentives for efficient spending decisions by local governments. Despite a number of substantial fiscal packages in 1992-93, central government expenditures continued to rise sharply (Chart 8). In particular, transfers to households rose steeply as unemployment surged. Moreover, since the recession turned out much deeper than expected, revenues stagnated.

CHART 8FINLAND CENTRAL GOVERNMENT BUDGET, 1988–95 1/

(In billions of Fmk)

Sources: Finnish authorities; and Economic Survey (various issues).

1/ Excluding extrabudgetary funds; on a cash basis.

As a result, the central government fiscal balance (revenue balance) deteriorated from a surplus of 1 percent of GDP in 1989 to a deficit of 11 percent of GDP in 1993. The net financing requirement, which includes financial investments, ballooned even more rapidly due to massive bank support to stem the banking crisis in 1992-93. The ensuing debt accumulation indicated clearly that public finances were on an unsustainable path. Moreover, interest payments grew almost four-fold between 1991 and 1995 to 4 percent of GDP.

In the 1995 budget, the Government broadly achieved its goal of reducing spending (excluding bank support and EU related outlays) to its 1991 level in real terms. Expanding on this fiscal consolidation effort, the new five-party coalition Government launched its own initiative earlier this year, aiming at stabilizing the central government debt-to-GDP ratio at about 70 percent by 1997. The fiscal program is based on permanent savings measures in the 1995 budget (2 percent of GDP) and envisages additional permanent spending cuts of almost 4 percent of GDP, with half of these cuts to be implemented in 1996. No major revenue increases are planned, but the Government intends to shift some tax burden from the tax on earned income to the tax on capital and corporate income. Financial markets reacted positively to the package; long-term interest rates declined by 100 basis points shortly after the program was made public in April.

2. Fiscal measures in 1991-94 1/

As the economy entered the recession in 1991, the Government announced as its fiscal objective to halt the growth in government spending. In early 1992, this objective was articulated in a medium-term framework for 1993-95 that explicitly set the target of reducing real budgetary expenditures in 1995 to their 1991 level. The expenditure objective was supplemented in early 1993 by the goal of stabilizing the central government debt-to-GDP ratio at below 70 percent by 1997. However, despite significant consolidation efforts and three major fiscal packages, expenditures and the deficit of the central government continued to rise through 1994.

To support implementation of the program, a number of structural reforms in fiscal policy were initiated. A constitutional amendment, adopted in mid-1992, allows most spending cuts to be legislated by Parliament with a simple majority instead of a two thirds (super) majority previously required. However, reductions in “acquired social rights” still need a super majority. To improve the efficiency of spending at the local level, transfers from the central government to local governments were changed from proportional reimbursements to block grants.

Building on these structural reforms, fiscal consolidation was implemented through fiscal packages that promised a growing impact of savings measures (Table 8). They included a large number of relatively specific spending cuts, including lower subsidies to industry, smaller family allowances, cuts in public pensions and in transfers to local governments, and measures to contain health care costs and lower the government wage bill. In addition, the Government attempted repeatedly to cut unemployment benefits, but withdrew its plans after strike threats.

Table 8.Finland: Fiscal Consolidation Efforts, 1993-96 1/(In percent of GDP)
1993199419951996
Expenditure cuts envisaged in the fiscal package
1992 April2.0------
October1.83.04.0--
1993 March--2.03.04.0
Total3.85.07.04.0
Expenditure cuts implemented
19933.41.71.51.4
19942.81.41.3
19952.2--
Total3.44.55.12.7
Source: Data provided by the Finnish authorities.

Based on the authorities’ assessment.

Source: Data provided by the Finnish authorities.

Based on the authorities’ assessment.

The implementation of these savings measures, however, fell short of what was envisaged. Although substantive, the impact of the measures, in fact, decayed over time, since not all of the savings were permanent. In the 1994 budget, expenditure cuts of about Fmk 14.5 billion were approved (well short of the effect envisaged from the combined October 1992 and March 1993 packages), and savings in wage and salary costs were smaller than anticipated. Moreover, three supplementary budgets added Fmk 6.4 billion in expenditures and Fmk 3 billion to the financing requirement. Some of the higher spending in the supplementary budgets served to promote private and public investment, and to provide education and jobs for young people. Most of the additional outlays, however, were due to nondiscretionary spending, such as unemployment benefits and interest on government debt.

On the revenue side, the tax rate on interest income was raised in 1994 to equal the 25 percent tax rate on corporate income; some user fees were introduced, and slightly higher revenues were obtained by switching the base of the fuel tax to energy content. Although the introduction of a VAT in mid-1994 was initially projected to raise extra revenues, it was at best revenue neutral in the end.

Despite the spending cuts implemented in 1992-94, which according to official estimates amounted to almost 5 percent of GDP in 1994, central government finances continued to deteriorate (Tables 9 and 10). Including extrabudgetary funds, the revenue deficit, which does not include financial transactions, widened to 10.6 percent of GDP in 1994, mainly as a result of fiscal slippages and a slower-than-expected recovery. With bank support equivalent to 1.5 percent of GDP, the net financing requirement, which includes financial transactions, remained at 12.7 percent of GDP. Central government debt reached 60 percent at the end of 1994.

Table 9.Finland: Central Government Cash Revenue and Expenditure, 1991-95
19911992199319941995 1/
(In billions of Finnish markkaa)
Excluding nonbudgetary funds 2/
Total revenue135.5127.9127.6128.2136.5
Taxes and revenue similar to taxes115.2105.1100.2104.3107.3
Income and wealth taxes39.532.029.132.232.8
Sales tax42.640.037.337.738.9
Duties on foreign trade1.31.71.51.50.3
Excise duties18.418.520.421.023.0
Other13.312.911.612.012.3
Other revenue20.322.827.422.929.2
Total expenditure165.1174.8181.6183.1197.1
Consumption50.153.850.852.252.4
Transfers103.7107.7110.4107.3118.5
Real investment5.35.04.33.72.9
Other expenditure6.08.216.120.023.2
Revenue balance-29.6-46.9-54.0-54.9-60.6
Loans repaid to the state0.81.22.81.50.6
Financial investment2.710.07.210.19.1
Financial balance-31.5-55.7-58.4-63.5-69.1
Including nonbudgetary funds 2/
Total revenue134.6126.6129.2128.6138.4
Total expenditure158.0168.0177.9182.9197.5
Revenue balance-23.4-41.4-48.6-54.3-59.1
Financial investment-32.3-71.8-61.0-64.9-69.8
(In percent)
Excluding nonbudgetary funds 2/
Revenue balance-6.0-9.9-11.2-10.7-10.9
Financial balance-6.4-11.7-12.2-12.4-12.4
Including nonbudgetary funds 2/
Revenue balance-4.8-8.7-10.1-10.6-10.7
Financial balance-6.6-15.1-12.7-12.7-12.6
Memorandum items:
Central government debt17.134.753.260.166.5
Defense expenditures (in billions of markkaa)8.99.39.08.58.1
Sources: Ministry Of Finance, National Budget February 1995; data provided by the Finnish authorities; Bank of Finland Bulletin.

Official estimates.

Funds close to the central government sector but normally not consolidated with the central government budget.

Sources: Ministry Of Finance, National Budget February 1995; data provided by the Finnish authorities; Bank of Finland Bulletin.

Official estimates.

Funds close to the central government sector but normally not consolidated with the central government budget.

Table 10.Finland: Central Government Revenue and Expenditure, 1991-95 1/
19911992199319941995 2/
(In millions of Finnish markkaa)
Revenue132,051125,771118,887123,964135,415
Property and entrepreneurial income6,4546,7839,1576,5065,710
Direct taxes40,06436,20127,82233,25034,010
Indirect taxes77,47874,40373,92777,12881,825
Contributions to social security schemes6,6616,6576,7156,2445,750
Current transfers from other government sectors9401,029797655680
Other revenues 3/4546984691817,440
Current expenditure144,685153,340166,684172,260182,730
Consumption36,59238,39936,03836,99536,805
Subsidies16,40216,21815,38814,54019,500
Social security benefits12,37913,7668,6168,9059,210
Social assistance and other current transfers13,23314,88615,83911,49314,300
Current transfers to other government sectors57,39558,79470,05274,96174,855
Other expenditure 4/8,68411,27720,75125,36628,060
Saving-12,634-27,569-47,797-48,296-47,315
Gross capital formation 5/8,3898,3087,2747,7546,900
Consumption of fixed capital and net capital transfers-1,017-4898181,554240
Financial balance (net lending)-22,040-36,366-54,253-54,496-53,975
(In percent of GDP)
Revenue26.926.424.724.224.3
Current expenditure29.532.234.733.732.8
Saving-2.6-5.8-9.9-9.4-8.5
Gross capital formation 5/1.71.71.51.51.2
Consumption of fixed capital and net capital transfers-0.1-0.10.10.3--
Financial balance (net lending)-4.4-7.6-11.3-10.7-9.7
Sources: Ministry of Finance Economic Survey 1994; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Imputed social insurance contributions and current transfers from other domestic sectors.

Mainly interest expenditure.

Including purchases of land and changes in inventories.

Sources: Ministry of Finance Economic Survey 1994; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Imputed social insurance contributions and current transfers from other domestic sectors.

Mainly interest expenditure.

Including purchases of land and changes in inventories.

3. The 1995 budget

The principle success of the 1995 budget lay in its broad achievement of the expenditure ceiling which was designed to reduce budgetary expenditures (excluding EU-related spending, bank support, and related interest expenses) to their 1991 levels in real terms. This was achieved through the implementation of expenditure cuts of about 2 percent of GDP. Nonetheless, owing to the net costs of EU membership (about 2 percent of GDP) and special once-off factors on the revenue side, such as an extra tax refund, the deficit is expected to rise this year to almost 11 percent of GDP.

To elaborate, the 1995 budget proposal allowed for budgetary expenditures of Fmk 194.8 billion, a sum broadly compatible with the expenditure ceiling when EU-related costs and bank support are excluded. 1/ Satisfying this expenditure total required spending cuts of Fmk 11.5 billion; some of these measures had already been in effect in 1994, but needed renewal. The bulk of the savings (about Fmk 8 billion) were cut from transfers to local governments. Subsidies to industry were also reduced modestly, as was public consumption. There were also some reductions in health insurance benefits. Entitlement rules for unemployment benefits were planned to be tightened, but this measure was the only savings bill that did not gain parliamentary approval. Overall, if EU-related expenditures are excluded, nominal expenditures before financial transactions are projected, after the first supplementary budget, to be at the same level as in 1994 (i.e., about 1/2 percent of GDP over the original expenditure ceiling consistent with the 1991 level of real expenditures). 1/

On the revenue side, barring an increase in the fuel tax, there are no major changes in taxation. Three special factors, however, are working to reduce revenues in 1995 by about Fmk 9.8 billion (almost 2 percent of GDP): (i) an additional income tax refund, which had been postponed from 1994, was paid in early 1995 (Fmk 3.6 billion); (ii) once-off sales tax refunds to the service and construction sectors reduce revenues by Fmk 1.4 billion, and delays in tax inflows in connection with the VAT reform imply a Fmk 2 billion loss in revenues; and (iii) Fmk 2.4 billion in VAT tax revenues are being transferred directly to social insurance funds this year (a practice which is envisaged to be discontinued in 1996).

The most significant changes in the 1995 budget are caused by membership in the EU. Considering the direct contributions to the EU, in net terms the budget is expected to receive Fmk 1.2 billion from the EU, an amount similar to the transitional compensation that Finland will receive in the first two years of membership (Table 11). Overall, however, the fiscal balance is negatively affected by Fmk 10.0 billion in 1995, since budgetary expenditures are projected to increase due to EU membership by Fmk 13.8 billion, while EU-related revenues will rise by Fmk 3.8 billion. This is mainly due to the expanded national support scheme for agriculture (Fmk 12.2 billion), which is designed to turn some of the subsidies previously obtained by inflated agricultural prices into direct income support. In net terms, the new agricultural support scheme will raise direct subsidies by Fmk 6 billion. In addition, the food industry and agricultural producers are being paid Fmk 1.4 billion this year as compensation for the depreciated value of stocks of agricultural products as the result of the 40 percent drop in producer prices in connection with EU membership.

Table 11.Finland: The Direct Fiscal Impact of EU Membership on the Central Government Budget, 1995-98(In millions of markkaa)
EstimateProjection
1995199619971998
Change in revenue3,8175,5085,0312,862
Revenue from the EU budget6,0955,9825,5055,536
CAP and structural funds4,7294,8254,9655,198
Common agricultural policy2,8612,9213,0013,066
Structural funds1,8681,9041,9642,132
Compensation1,2351,027410208
Collection fees131130130130
Other changes in revenue-2,278-474-474-2,674
Producers’ share in marketing of agricultural products-1,600-1,600-1,600-1,600
Excise duties-463-463-463-463
Value-added tax8502,6502,650450
Food stuffs1,6501,6501,650-550
Harmonization1,0001,0001,0001,000
Change of the VAT system-1,800------
Customs and levies-950-950-950-950
Tax relief scheme for agricultural producers-115-111-111-111
Change in expenditure13,82811,89711,57111,567
Contributions to the EU budget4,8625,8515,8135,851
VAT-based payment3,1973,0932,9492,785
GNP-based payment1,1412,1802,5893,056
Payments to the EIB, ECSC, and EURATOM52457827510
Other changes in expenditure8,9666,0465,7585,716
CAP and structural funds1,4491,4851,5451,713
Ministry of Agriculture and Forestry-5,909-5,909-5,909-5,909
The national scheme for agricultural aid12,22710,64810,30110,124
National share8,9477,3086,8816,639
EU share3,2803,3403,4203,485
Compensation for the depreciation of stocks1,400------
Support to food industries174230270270
EEA-related expenditure-255-255-255-255
Development aid-200-233-274-307
Other changes80808080
Difference-10,011-6,389-6,540-8,705
Source: Data provided by the Finnish authorities.
Source: Data provided by the Finnish authorities.

Including the first supplementary budget, the revenue deficit (excluding extrabudgetary funds) is projected to increase slightly to 10.9 percent of GDP in 1995. If extrabudgetary funds are taken into account, the net financing requirement will fall slightly to 12.6 percent of GDP owing to net financial investments of Fmk 10.7 billion (Fmk 8 billion of which is now budgeted for bank support). As a result, central government debt is officially projected to rise to 66.5 percent at the end of 1995.

4. The new Government’s fiscal program and the 1996 budget

The new Government that took office in April 1995 announced the fiscal objective of stabilizing the debt-to-GDP ratio at about 70 percent by 1997 and to bring it down thereafter. To achieve that goal, the savings measures in the 1995 budget (Fmk 11.5 billion) are to be made permanent, and additional spending cuts of Fmk 20 billion (almost 4 percent of GDP) are envisaged over the next 4 years; about half to be implemented in the 1996 budget. To strengthen the commitment to front loading, some cuts in agricultural subsides, child benefits, and student grants (with a total value of about Fmk 1.5 billion) are to be implemented already in 1995. 1/

As a first step, the Government approved an expenditure ceiling of Fmk 193 billion for the 1996 budget, which is officially estimated to require spending cuts of some Fmk 10 billion (Box 1). These spending measures are estimated to lower state expenditures cumulatively by an additional Fmk 4.5 billion in 1997-99. Decisions concerning the remaining Fmk 5.5 billion of cuts in subsequent years that are as yet unspecified will be made by early fall. Looking toward 1997, the Government has also indicated that it intends, in cooperation with the labor market organizations, to revise the system of unemployment benefits to obtain additional structural savings.

The Government envisages implementing its fiscal consolidation program without raising the overall tax ratio. However, it has announced plans to shift Fmk 5-10 billion of the tax burden on earned income to higher corporate and capital income taxation over the next four years. For 1996, the Government plans to reduce the pension and health insurance contributions paid by the insured. To offset the loss in revenue, the tax rate on capital, corporate, and interest income will be raised from 25 percent to 28 percent. In 1997, a further reduction of health insurance contribution rates is planned, compensated by an increase in environmental taxes and, if necessary, by a higher standard VAT rate.

Assuming the expenditure ceiling of Fmk 193 billion is adhered to in the 1996 budget, expenditures excluding EU-related spending and interest payments would decline by 4 percent in nominal terms compared to 1995. Revenues are projected to rise by 14 percent as the once-off factors that are depressing revenues in 1995 are reversed and the economy expands rapidly. As a result, the revenue deficit (before financial transactions) is envisaged to drop to 6 percent of GDP from about 11 percent in 1995. Moreover, the net financing requirement would almost halve to 6 1/2 percent of GDP as government funds for bank support are projected to drop sharply next year. Nonetheless, the central government debt ratio would rise to 70 percent of GDP at the end of 1996.

Box 1:Specified New Expenditure Cuts Envisaged in the 1996 Budget

(In million of Finnish markkaa)
State transfers to municipalities3,800
Subsidies to enterprises1,200
National agricultural subsidies 1/750
Child benefits 1/750
Index adjustments of unemployment benefits500
Subsidies to labor market and other unemployment expenditure500
Agriculture-related social benefits400
Wage and related expenditures350
Student grants 1/300
Sickness insurance300
National pension scheme300
Other social benefits300
Agricultural and regional development administration300
Housing subsidies250
Defense expenditures150
Total10,150

To be implemented in part already in 1995.

To be implemented in part already in 1995.

5. Local governments

While the finances of local governments deteriorated in the early stages of the recession in 1991 and 1992 to a deficit of almost 1 percent of GDP, subsequent spending cuts and some tax increases have restored financial balance (Table 12 and Chart 9). In 1994, local governments ran a surplus equivalent to 1.3 percent of GDP, although the surplus adjusted for the tax refunds postponed to 1995 is only about half as large.

Table 12.Finland: Municipalities’ Revenue and Expenditure, 1991-95 1/
19911992199319941995 2/
(In millions of Finnish markkaa)
Revenue92,00391,34594,05598,80998,700
Property and entrepreneurial revenue2,9913,8004,4454,9075,090
Direct taxes48,07446,06947,07854,23854,830
Indirect taxes and fees114127130135140
Transfers from central government39,65640,20641,29538,44737,525
Other revenue 3/1,1681,1431,1071,0821,115
Current expenditure93,12393,84391,95092,59895,065
Consumption79,15877,22373,50674,48276,680
Subsidies772810931815870
Social assistance and other income transfers6,4287,2514,4384,8255,000
Transfers to other government sectors3,0304,2348,5908,5468,510
Other expenditure 4/3,7354,3254,4853,9304,005
Saving-1,120-2,4982,1056,2113,635
Gross capital formation 5/10,2698,1136,1105,4755,980
Consumption of fixed capital and net capital transfers7,0606,7665,7526,1336,045
Financial balance (net lending)-4,329-3,8451,7476,8693,700
(In percent of GDP)
Revenue18.719.219.619.317.7
Current expenditure19.019.719.118.117.1
Saving-0.2-0.50.41.20.7
Gross capital formation 5/2.11.71.31.11.1
Consumption of fixed capital and net capital transfers1.41.41.21.21.1
Financial balance (net lending)-0.9-0.80.41.30.7
Sources: Ministry of Finance Economic Survey 1994; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Imputed social insurance contributions and casualty insurance benefits.

Casualty insurance premiums, pension expenditure and interest.

Includes purchases of land and changes in inventories.

Sources: Ministry of Finance Economic Survey 1994; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Imputed social insurance contributions and casualty insurance benefits.

Casualty insurance premiums, pension expenditure and interest.

Includes purchases of land and changes in inventories.

CHART 9FINLAND GENERAL GOVERNMENT FINANCES, 1988–95 1/

(In percent of GDP)

Sources: Finnish authorities; Economic Survey (various issues).

1/ Values for 1995 are official projections.

2/ EMU definition.

Local governments have been successful in absorbing significant cuts in transfers from the central government since 1993. Such transfers declined from 8 1/2 percent of GDP to 7 1/2 percent in 1994, and are projected to fall below 7 percent in 1995. To a small extent, the decline in revenue from the central government was offset by tax increases. In 1993, local income tax rates were raised modestly and a real estate tax was introduced. However, most of the adjustment to reduced transfers has been accomplished by cuts in spending, with current expenditures falling from a peak of 19.7 percent of GDP in 1992 to 18 percent in 1994, and to a projected 17 percent in 1995. As part of the sizable reduction in local government consumption, labor costs, which account for 60 percent of consumption expenditures, were reduced in 1994 by 2 1/2 percent in nominal terms through moderate wage agreements and reductions in employment. Based on the wage agreement reached in early 1995, labor costs are, however, projected to increase by 3 percent this year. The trend in local governments’ investment spending is also down; gross capital formation as a percent of GDP has declined by 50 percent between 1990 and 1994 to 1 percent.

6. Social security funds

a. Recent developments

Despite sharply higher transfer payments as a result of the recession, the financial surpluses of the social security funds have remained above the equivalent of 3 percent of GDP thanks to cash flow surpluses of employment-related pension funds (Table 13 and Chart 9). Nevertheless, in the past few years social security contribution rates were increased noticeably, in particular those paid by employees (Table 14).

Table 13.Finland: Social Security Funds’ Revenue and Expenditure, 1991-95 1/
19911992199319941995 2/
(In millions of Finnish markkaa)
Revenue95,623102,698123,653136,486143,865
Property and entrepreneurial revenue13,41414,71414,73813,92516,525
Social insurance contributions, compulsory56,91559,23163,62069,61673,600
By employers46,02242,40744,00846,95650,845
By insured persons10,89316,82419,61222,66022,755
Transfers from central government21,47724,15440,52248,48849,035
Other revenue 3/3,8174,5994,7734,4574,705
Current expenditure76,47090,115108,585117,007119,580
Consumption2,9692,8312,9983,1503,320
Social security benefits65,18775,31581,47481,75483,795
Social assistance and other income transfers5,9928,58019,02427,55728,140
Transfers to central government1,6482,3613,9724,0843,875
Other expenditure 4/6741,0281,117462450
Saving19,15312,58315,06819,47924,285
Gross capital formation 5/387492424616420
Consumption of fixed capital and net capital transfers236228227232235
Financial balance (net lending)19,00212,31914,87119,09524,100
(In percent of GDP)
Revenue19.521.525.726.725.9
Current expenditure15.618.922.622.921.5
Saving3.92.63.13.84.4
Financial balance (net lending)3.92.63.13.74.3
Sources: Ministry of Finance, Economic Survey 1994; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Casualty insurance premiums, imputed social insurance contributions and other current transfers from the private sector.

Interest and other comparable expenditure and insurance claims.

Includes purchases of land and change in inventories.

Sources: Ministry of Finance, Economic Survey 1994; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Casualty insurance premiums, imputed social insurance contributions and other current transfers from the private sector.

Interest and other comparable expenditure and insurance claims.

Includes purchases of land and change in inventories.

Table 14.Finland: Contribution Rates for Social Security Funds, 1990-94 1/(In percent)
19901991199219931994
Employers
Occupational pension funds16.9014.4015.5015.6016.70
National pension fund 2/3.072.943.203.433.41
Unemployment insurance1.403.706.006.306.10
Health insurance 2/1.821.561.901.912.03
Insured persons
Wage and salary earners3.255.256.908.328.32
Occupational pension funds----3.003.004.00
National pension insurance1.553.051.801.550.55
Unemployment insurance----0.201.871.87
Health insurance1.702.201.901.901.90
Pensioners1.705.256.707.456.45
National pension fund--3.052.802.551.55
Health insurance1.702.203.904.904.90
Source: Ministry of Finance, Economic Survey 1994.

Annual averages. The contributions of employers, and the unemployment and employment pension contributions of the insured as percentages of the total wages and salaries paid. The national pension and health insurance contributions of the insured as percentages of their income subject to local income taxation.

The average weighted by the payroll of different contribution categories.

Source: Ministry of Finance, Economic Survey 1994.

Annual averages. The contributions of employers, and the unemployment and employment pension contributions of the insured as percentages of the total wages and salaries paid. The national pension and health insurance contributions of the insured as percentages of their income subject to local income taxation.

The average weighted by the payroll of different contribution categories.

In 1993, benefits to households paid by social security funds increased by 27 percent over 1992, but with almost half of the increase due to the shift of child allowances and children’s home-care support from the central and local governments to the social security funds. Expenditure on unemployment security surged by 37 percent to Fmk 23.7 billion, and pension expenditures rose by 4 1/2 percent. Despite higher contribution rates from employees and pensioners, the financial balance of the social security funds weakened slightly to a surplus of 3 percent of GDP.

In 1994, benefits paid by social security funds rose by 9 percent. The shift of payments of study grants and housing subsidies from the central government to the social security funds accounted for almost half of this increase. Outlays for unemployment benefits fell by 4 percent as unemployment peaked in early 1994 and subsequently declined. Although social security contribution rates remained broadly unchanged, the financial balance of social security funds improved to a surplus of 3.7 percent of GDP.

In 1995, social security benefits are projected to increase by 3 1/2 percent. Outlays related to pensions will, as in the previous years, grow by about 4 percent, while health insurance expenditures are projected to rise by 6 1/2 percent. As unemployment benefits are envisaged to continue to decline, the financial surplus of social security funds is projected to rise to almost 4 1/2 percent of GDP.

b. Pension reform

As part of fiscal consolidation, some aspects of the public sector pension scheme were reformed in 1993. In particular, the standard retirement age and pension benefits were lowered to corresponding levels in the private sector. More far-reaching has been the decision in May 1995 to reform the private sector pension schemes to ensure their long-term sustainability without the need to raise contribution rates sharply.

The private sector pension system consists of a combination of occupational pension funds (TEL) with earnings-related pension benefits and a National Pension Scheme, which pays basic flat-rate benefits. TEL is partly funded, and about 40 percent of its assets are lent back to contributing firms. Since the system is not yet mature (it was established in 1962), contributions exceed pension benefit payments by a significant margin. As a result, in cash flow terms, TEL is running surpluses of more than 4 percent of GDP. Nevertheless, from a longer-term perspective, the system faces increasing pressure to raise contribution rates significantly.

To address this issue, in May 1995 the labor market partners and the Government concluded an agreement that will markedly improve the finances of the occupational schemes. The agreement is estimated to reduce pension expenditures over the long term by about 2 percent of GDP. In future, the pensionable income will be calculated based on the average of the last ten years (instead of four years) and index adjustments, which were previously based on the consumer price index and the index of wage and salary earnings with a 50-50 weighting, will now be based on a weighting scheme with 80 percent on the CPI and 20 percent on wage and salary earnings. In addition, the level of early retirement benefits will be reduced to raise the average retirement age from the current 58 years (the legal retirement age remains at 65). It is estimated that without these rule changes, the contribution rates would had to be increased by 2 percentage points in 1996. Now they are envisaged to be raised by 0.6 percentage points instead. The surplus of the TEL pension funds is estimated to increase from 3.2 percent of GDP in 1994 to 4.3 percent in 1995 and to remain at that level in 1996.

7. General government finances

The general government sector in Finland comprises the central government (including extrabudgetary funds), local governments, and social security funds, which include the privately managed but mandatory occupational pension funds (TEL).

The deterioration in the finances of the general government paralleled the recession until 1993, when current expenditures peaked at 59 percent of GDP and net borrowing reached almost 8 percent (Table 15 and Chart 9). Since then, while revenues have remained more or less steady in relation to GDP, current expenditures have dropped by 3 1/2 percentage points. Capital formation declined by more than one third (as a percent of GDP) since 1990, and was 10 percent lower in nominal terms in 1994 than in the previous year.

Table 15.Finland: General Government Finances, 1991-95 1/
In Millions of

Finnish markkaa
In Percept of GDP
199419911992199319941995 2/
Revenue271,66952.553.452.953.152.2
Property and entrepreneurial income25,4684.75.35.95.04.9
Interest income21,2183.94.65.14.14.1
Direct taxes87,48818.017.315.617.116.0
Indirect taxes and fees77,26315.815.615.415.114.7
Social security contributions79,69213.614.615.415.614.3
By employers54,79211.310.910.810.710.0
By insured persons24,9002.33.74.54.94.3
Other income1,7580.40.60.50.32.4
Current expenditure294,27451.457.059.257.555.7
Consumption114,62724.224.823.422.420.9
Subsidies15,3553.53.63.43.03.7
Social security benefits94,13916.419.419.518.417.4
Social assistance grants33,4803.24.35.96.56.0
Other current transfers10,3952.02.12.32.02.5
Interest25,9761.92.64.65.15.2
Other expenditure3020.10.20.20.10.1
Saving-22,6051.1-3.7-6.4-4.4-3.5
Gross capital formation 3/13,8453.93.52.92.72.4
Consumption of fixed capital and net capital transfers7,9191.31.41.41.51.2
Financial balance (net lending)-28,531-1.5-5.9-7.8-5.6-4.7
Memorandum items:
Gross public debt 4/23.141.557.160.165.0
Gross tax ratio46.845.747.245.146.5
Net tax ratio22.718.515.618.117.2
Sources: Ministry of Finance National Budget February 1995; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Includes purchases of land and changes in inventories.

EMU definition.

Sources: Ministry of Finance National Budget February 1995; and data provided by the Finnish authorities.

On a national accounts basis.

Official estimates.

Includes purchases of land and changes in inventories.

EMU definition.

Despite these expenditure trends, net borrowing of the general government (adjusted for the timing of the tax refunds) remained at about 7 percent in 1994, while the reported unadjusted net borrowing requirement declined to 5 1/2 percent. Reflecting the deteriorating finances of the general government sector in the early 1990s, public debt (EMU definition) rose from 14.5 percent of GDP in 1990 to 60 percent at the end of 1994. The debt ratio would have been 12 1/2 percentage points higher if debt were measured, as in the past, by the OECD/SNA concept. 1/

IV. Money and Credit

1. Overview

With the floating of the exchange rate in September 1992 and the adoption of an official inflation target in early 1993, the monetary environment in Finland has changed substantially. Following a depreciation of nearly 25 percent vis-à-vis the ECU between September 1992 and early 1993, the markka has recovered strongly, and by March 1995 returned to its former ECU intervention range. However, although interest rates declined steadily from the high levels reached prior to the float, financial markets were hit by turbulence in the wake of a global bond market weakening during the first half of 1994, precipitating a sharp rise of long-term interest rates and a steepening of the yield curve. That said, with the new Government pursuing strong fiscal consolidation and the Bank of Finland (BoF) having tightened monetary policy at the end of 1994, inflation expectations have moderated and long-term rates started to decline again. On operational matters, in late 1994 and early 1995, the BoF introduced a number of changes in market operating procedures, aimed at improving the efficiency of markets for bank and government paper and increasing the transparency of monetary policy. The financial sector is still coping with the consequences of the 1991-92 banking crisis and, despite consolidation efforts and continuing public support, again suffered losses in 1994.

2. The operation of monetary policy

a. The inflation target

Since September 8, 1992, monetary policy has been conducted under a floating exchange rate system after the BoF was forced to abandon the markka’s link to the ECU, following a period of financial instability. Although the markka depreciated sharply following the decision to float, real interest rates initially remained at high levels. Against this background, the BoF committed itself, on February 2, 1993, to stabilize inflation, defined in terms of an underlying inflation index, permanently at around 2 percent by 1995. 1/

With the loss of the exchange rate anchor, the BoF’s adoption of an inflation target was aimed at increasing the transparency of its monetary policy. 2/ At the same time, the BoF decided against employing an explicit intermediate target because it did not expect a strong relationship between money or credit aggregates and inflation to hold in the future. Three concerns have been cited. First, the banking crisis in the early 1990s created difficulties in interpreting standard money and credit aggregates; second, a large portion of debt was denominated in foreign currency, leading to balance sheet adjustments associated with exchange rate movements; and third, velocity has been unstable in the past.

With no obvious intermediate target available, the BoF has announced that it follows a number of monetary policy indicators to determine the stance of its monetary policy. The indicators comprise money and credit aggregates, in particular M1, short-term interest rates, the structure of interest rates (measured by the yield curve), and exchange rates. Further, the BoF continues to monitor developments in all sectors of the economy, using its macro-econometric BOF4 model to generate forecasts for key variables, including inflation, on a regular basis. However, although the structure of the BOF4 model is publicly known, the Bank has so far published neither inflation forecasts nor expected growth rates for its monetary policy indicators.

b. Instruments of monetary policy

During the past two years, the BoF has introduced a number of changes in the financial sector (see Box 2). Although the framework for monetary policy has remained largely intact, the measures were aimed at deepening the market for government securities, strengthening the signalling effect of policy actions, and increasing the efficiency of the financial system.

The BoF has continued its efforts to establish well-functioning markets in government paper. Owing to the low indebtedness of Finland in the past, relatively little government paper was issued before 1991, and secondary markets for government bonds and Treasury bills were practically nonexistent. Money market transactions were mostly based on CDs, issued either by the BoF or by commercial banks. However, as a consequence of the growing public borrowing requirement after 1991, the outstanding stock of government paper increased and the BoF started to hold bond auctions in June 1993, although the amounts involved were relatively modest. 1/ In spring 1995, the Treasury initiated its own auctions, eventually taking over operations from the BoF. Moreover, by applying discounts to risk-carrying securities, the BoF not only reinforced protection against credit risk but it also encouraged the wider use of government bonds and Treasury bills in money market operations.

Having switched to volume tender auctions, the BoF has created the possibility of using changes in the tender rate to signal its monetary policy stance to financial markets. Before December 1994, both the tender rate and its related money market rates used to change with every new auction. 1/ Now, using volume tenders with a pre-determined interest rate, changes in the tender rate are discretionary and less frequent; the BoF has in effect established a new headline interest rate. The previous headline rate, the base rate, is determined by the Parliamentary Supervisory Board and has lost in importance because only a small proportion of loans (about 5 percent of banks’ new lending) is still linked to it. 2/

Box 2.Recent Changes in the Monetary Policy Framework

Open-market operations

  • Starting December 1994, BoF auctions of one-month bank CDs are conducted as volume tenders at fixed interest rates (tender rates), replacing previously held interest rate tenders.

  • The BoF ceased to arrange tenders for primary dealers in government benchmark bonds in June 1995, following the initiation of similar auctions by the Treasury.

  • As of June 1, 1995, the BoF revised the criteria applied in the selection of counterparts in money market operations, opening up the possibility of additions to the list of counterparts in the future.

Collateral in money market transactions

  • Since December 1, 1993, the BoF insists on collateral from its counterparts in money market operations. Liquidity credits have to be fully collateralized while intraday overdraft limits were subjected to 25 percent collateral for banks having access to liquidity credits, and 100 percent for other banks. Since November 1, 1994, all banks are required to post full collateral for their overdraft limit.

  • As of June 1, 1995, the BoF accords priority status to risk-free securities used as collateral or in repo deals. It applies a discount of up to 5 percent (“haircut”) on securities other than government bonds, Treasury bills, or its own CDs.

Minimum reserve requirements

  • Effective October 1, 1995, commercial banks will be allowed to meet their minimum reserve requirements based on a monthly average.

The averaging of minimum reserve requirements will simplify commercial banks’ daily payment transactions and reduce the volatility of the overnight rate, thereby increasing the effectiveness of monetary policy. 1/ So far, the overnight rate has been subject to relatively wide fluctuations, prompted by the banks’ need to meet their reserve requirements on a daily basis. At the same time, the BoF’s criteria in the selection of counterparts have been slightly loosened in June 1995 so as to facilitate a possible enlargement of money markets in the future. 2/

3. Developments in key financial variables

Over the last two years, in line with policy objectives, the markka recovered strongly from the severe depreciation following the float. However, both exchange rate and interest rates experienced significant fluctuations.

The developments since June 1993 can broadly be divided into two periods. First, given the weakness of domestic demand and low inflation, the markka gained strength through early 1994, having passed its trough in March 1993, even as interest rates broadly declined. Prompted by turbulence in international capital markets that disproportionately affected small industrials and compounded by political uncertainty, however, long-term interest rates surged between February and August 1994, and the exchange rate came temporarily under pressure.

Second, starting in September 1994, after strong indications that the EU referendum would favor membership, the pressure on the exchange rate eased and interest rates fell slightly. Later in 1994, the strong support for EU membership prompted a further appreciation of the markka, which was bolstered by favorable terms of trade developments, the elimination of the external current account deficit, and a period of monetary tightening that started in December 1994. Moreover, long-term interest rates also fell significantly after the new Government announced its fiscal consolidation package in March 1995.

a. June 1993-August 1994

Favored by solid growth in the export sector, an ensuing improvement of the external current account, and also owing partly to foreign capital inflows, the markka strongly recovered from its post-devaluation losses during the second half of 1993, especially vis-à-vis major European currencies. The real effective exchange rate (REER; ULC-based) appreciated by 8.2 percent between September 1993 and February 1994 (Chart 10). During that period, the BoF intervened several times in the market to prevent excessive upward movements of the markka. 1/ At the same time, ten-year government bond yields had fallen to 6.4 percent in January 1994, only 60 basis points above German rates, reflecting increasing confidence in the Finnish recovery (Chart 11).

CHART 10FINLAND EXCHANGE RATES, January 1990 – June 1995

Sources: Bank of Finland; and IMF, International Financial Statistics and unit labor cost data server.

CHART 11FINLAND INTEREST RATE DIFFERENTIALS, January 1990 – June 1995

(In percentage points)

Sources: Bank of Finland, Financial Markets (various issues); IMF, data server.

1/ Vis-a-vis the Swedish 3-month treasury bill rate.

2/ Vis-a-vis the German money market rate.

Subsequently, however, Finland was affected by an international rise in long-term interest rates, associated with the increase of the U.S. federal funds rate in February 1994, and by increasingly negative market sentiment towards countries with unresolved fiscal problems. Compounded by concerns that the EU referendum might be defeated, 10-year bond yields rose strongly during the first half of 1994, reaching 11 percent in August. At the same time, a steepening of the yield curve was consistent with a resurgence of inflation expectations, partly owing to a lack of confidence in the BoF’s inflation target that had not yet been tested. Nevertheless, the subsequent pressure on the markka proved shortlived; the markka retained most of its gains against other European currencies, and even appreciated further vis-à-vis the U.S. dollar.

As for short-term interest rates, the BoF let the tender rate fall from 7 percent in August 1993 to below 5 percent in early 1994, owing to the appreciation of the markka. The base rate was also repeatedly lowered and fell from 7 percent in June 1993 to 5.25 percent in February 1994. 2/ As a consequence of this monetary easing, the 3-month HELIBOR rate fell by more than 100 basis points below the corresponding German rate in February 1994, resulting in Finnish short-term interest rates being briefly among the lowest in Europe (Table 16). 3/ However, with long-term rates increasing and the markka being under external pressure, the BoF saw no further room for lowering the tender rate in 1994. On the contrary, the Bank had to counter upward pressure on short-term rates by increasing liquidity in the banking system. Despite this, the 3-month HELIBOR increased by some 130 basis points, reaching a maximum of 6.0 percent in August 1994. Since German interest rates were falling at the same time, the differential increased to more than 1.5 percentage points.

Table 16.Finland: Money Market Rates and Rates Applied by the Bank of Finland, 1991-95(In percent: average of daily observations last month of quarter)
Interbank

Overnight

Rate
Bank of Finland Rates
Helsinki Interbank Offered RapeLiquidity

Credit Rate
Call Money

Deposit Rate
Base

Rate
1 Month3 Months6 Months12 Months
1991
1st qtr.18.9015.6614.7214.1013.6415.004.008.50
2nd qtr.13.4511.2911.2511.4111.5615.004.008.50
3rd qtr.19.8414.8013.2012.4512.0715.004.008.50
4th qtr.10.8912.5512.7812.7112.6315.004.008.50
1992
1st qtr.14.2712.9512.3812.0811.9915.004.008.50
2nd qtr.13.5813.5813.7013.8313.7615.004.009.50
3rd qtr.16.6517.7916.4115.2914.7119.15 1/13.43 1/9.50
4th qtr.10.2010.5510.6810.7010.7011.697.699.50
1993
1st qtr.9.138.998.908.698.629.965.967.50
2nd qtr.7.777.707.627.577.558.724.77.00
3rd qtr.6.356.816.686.496.297.763.766.00
4th qtr.6.226.165.905.685.528.214.215.50
1994
1st qtr.4.394.824.804.885.126.762.765.25
2nd qtr.3.935.205.616.246.867.183.185.25
3rd qtr.4.075.075.576.367.257.133.135.25
4th qtr.4.575.415.706.187.027.383.385.25
1995
1st qtr.4.665.786.066.487.077.753.755.25
Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

Prior to July 1992, both the call money deposit rate and the liquidity credit rate (then named the call money credit rate) were set by the Bank of Finland, whereas since July 1992 both rates are tied to the tender rate.

Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

Prior to July 1992, both the call money deposit rate and the liquidity credit rate (then named the call money credit rate) were set by the Bank of Finland, whereas since July 1992 both rates are tied to the tender rate.

The growth of monetary aggregates accelerated during the first half of 1994, following low growth throughout 1993. Annualized M1 growth reached 15 percent in July 1994, reflecting increasing liquidity of enterprises during the recovery and lower opportunity cost for liquid assets. 1/ M3 also grew rapidly, though partly caused by the government’s selling CDs to the public to reduce its cash fund holdings. However, absent special factors, broad money growth remained moderate: annual M2 growth rose from -1.5 percent in early 1993 to 7.5 percent in mid-1994 (Chart 12).

CHART 12FINLAND MONETARY AGGREGATES, January 1992 – May 1995

(Annual percentage change)

Source: Bank of Finland, Financial Markets (various issues).

As a result of increasing enterprise liquidity and low domestic credit demand, credit aggregates continued to fall over the period (Table 17). Outstanding markka loans declined by some 3-4 percent; total outstanding loans decelerated further, reaching an annual rate of decline of 10 percent in January 1994. During 1993, average lending rates fell along with interest rates, although banks increased their margins in order to improve profitability (Table 18). With long-term interest rates rising in 1994, lending rates also moved upwards, albeit to a lesser extent because only a small proportion of loans was tied to long-term rates.

Table 17.Finland: Monetary Survey, 1991-95
1st

Qtr.
2nd

Qtr.
3rd

Qtr.
4th

Qtr
1st

Qtr.
19911992199319941995
(In billions of Finnish markkaa; end of period)
Domestic credit464.3440.0405.6398.4391.9372.5369.2
Private470.9439.9403.7397.3389.6374.8365.8
Government-6.50.11.81.12.2-2.33.4
Net foreign assets-86.6-68.1-26.0-19.7-6.912.214.0
Of which:
Bank of Finland33.226.532.141.451.552.051.652.3
Other items, net-102.5-97.9-100.0-97.6-100.5-102.0-96.5
Broad money (M3)310.9310.7322.4333.3338.3333.6328.6332.2
Money (M1)130.6134.8141.8148.9153.4151.2154.4159.9
Transaction deposits120.1123.3128.7135.9140.4138.6140.4149.1
Other10.511.413.113.013.012.614.010.8
Quasi money180.3175.9180.7184.4184.9182.4174.2172.3
(Percentage change from 12 months earlier)
Domestic credit6.8-5.2-7.8-10.6-8.7-13.2-9.0
Private3.8-6.6-8.2-10.9-9.2-11.8-9.4
Broad money (M3)6.8-0.13.87.110.16.91.9-0.3
Money (M1)-7.73.25.19.513.112.38.97.4
Quasi-money20.6-2.42.75.27.62.8-3.6-6.5
Sources: IMF, International Financial Statistics; Bank of Finland Bulletin; and data provided by the Finnish authorities.
Sources: IMF, International Financial Statistics; Bank of Finland Bulletin; and data provided by the Finnish authorities.
Table 18.Finland: Interest Rates, 1991-95(Average of daily observations in last month of quarter; in percent per annum, except as noted)
Deposit Banks
Lending RatesDeposit Rates
Bank of Finland
Base RatesLiquidity Credit Rate 1/Average Rate,

New Lending
Average Rate,

All Lending
Average Rate

on Deposits
Average Rate

on Other

Funding
Average

Rate on

all markaa

Funding
Bond

Yield 2/
Memorandum Item
(Period Average)Inflation Rate 3/

1990 = 100
19911st qtr.8.5015.0014.9112.317.2915.079.6212.54.9
2nd qtr.8.5015.0013.5411.917.0512.358.6111.14.5
3rd qtr.8.5015.0013.9611.966.9512.958.8711.33.4
4th qtr.8.5015.0012.5112.157.0812.638.7112.44.1
19921st qtr.8.5015.0013.8111.977.2312.328.7711.33.0
2nd qtr.9.5015.0014.3912.617.4212.949.1512.23.0
3rd qtr.9.5019.1515.0013.017.8014.3910.0313.33.1
4th qtr.9.5011.6911.9812.347.0611.788.6210.92.3
19931st qrt.7.509.9611.2911.075.8710.047.309.42.7
2nd qrt.7.008.729.4410.354.759.086.188.42.1
3rd qrt.6.007.768.689.383.967.885.317.31.8
4th qrt.5.508.217.628.853.336.944.556.21.5
19941st qrt.5.256.766.788.172.885.773.856.70.4
2nd qrt.5.257.187.448.092.895.773.929.01.3
3rd qrt.5.257.137.868.193.045.994.119.91.9
4th qrt.5.257.386.718.053.116.174.109.51.6
19951st qrt5.257.757.808.163.226.714.229.21.7
Sources: Bank of Finland, Bulletin: and data provided by the Finnish authorities.

Average of daily rates. Call money credit rate until July 2, 1992.

Effective yield on fixed-rate taxable government bonds (4-5 years), secondary market.

As measured by the year-on-year percentage change in the consumer price index in the last month of quarter.

Sources: Bank of Finland, Bulletin: and data provided by the Finnish authorities.

Average of daily rates. Call money credit rate until July 2, 1992.

Effective yield on fixed-rate taxable government bonds (4-5 years), secondary market.

As measured by the year-on-year percentage change in the consumer price index in the last month of quarter.

b. September 1994-June 1995

The markka strongly appreciated again in the second half of 1994, amid indications favoring Finland’s joining the EU. Following the positive outcome of the EU referendum in October 1994 and the election of a new Government, publicly committed to fiscal consolidation, in March 1995, confidence in the markka was enhanced and, supported by monetary tightening, the currency appreciated further in early 1995. The markka continued to recover against the US dollar and major European currencies while remaining stable vis-à-vis the deutsche mark, including through some currency turbulence in European markets in February 1995. 2/ In March, the markka reached the ECU fluctuation range that had been adopted prior to the 1992 floating. Altogether, between August 1994 and May 1995, the REER increased by 7.3 percent.

Ten-year bond yields remained above 10 percent throughout 1994, some 250 to 300 basis points above German rates. Subsequent to the election of a new Government, which announced a strong fiscal consolidation package, long-term rates fell below 9 percent in April 1995, indicating newly gained confidence of financial markets. Despite these developments, however, the persistent steepness of the yield curve remains a sign of continuing uncertainty about the economy in the longer term.

Short-term interest rates peaked in August 1994 and fell slowly in the autumn of 1994. In December, the differential to German money market rates had again all but disappeared, and with cost pressures mounting, the BoF raised the tender rate by 50 basis points to 5.5 percent, switching at the same time to volume tender auctions. The monetary tightening continued during the first half of 1995, with further 25 basis point increases in the tender rate both in February and June. As a result, the 3-month HELIBOR climbed to 6 percent in February 1995, reaching a differential of some 140 basis points to German rates in March.

Monetary aggregates decelerated during the second half of 1994, with annual M3 growth becoming again negative in January 1995. As a consequence of rising short-term rates and stable prices, M1 growth also slowed down markedly, to an annual rate of 7.5 percent in March 1995 after having peaked at 15 percent in July 1994. M2 growth declined slightly during the fall of 1994, but has since remained positive as it was not affected by the CD sale of the Government in 1994.

Credit aggregates remained subdued, with markka bank deposits exceeding bank lending by Fmk 10 billion in December 1994, compared with rough equality in the year before. The decline in lending slowed somewhat towards the end of 1994, both in markka and overall lending, but a decisive turn towards growth has not yet occurred. As a consequence of weak credit demand, the increase in short-term rates was not reflected in higher lending rates, leading to narrower bank margins. Liquidity in the banking system has been abundant; indeed, the BoF’s credit facility has hardly been tapped since May 1994.

4. Capital markets and the banking sector

a. Capital markets

The outstanding stock of public and private bonds grew only slightly in 1994. Because of the corporate sector’s rapidly improved profitability and the low level of investment, corporate bond issues were considerably smaller than in the previous year. Moreover, owing to the sluggish demand for credit, banks did not need to tap the domestic bond market for long-term funding. In contrast, the central government’s share of new markka issues amounted to Fmk 31.5 billion, or 70 percent of all new issues.

The expansion of the secondary market for benchmark bonds continued. Three new primary dealers entered the market, and trading was substantially more active in 1994 than in the year before, reaching some Fmk 500 billion. In order to improve the functioning of the secondary market, the BoF and the primary dealers launched a market for bond forward contracts in January 1994. Trading was cautious at the outset. However, with increasing long-term interest rates, a growing number of investors began to use bond forwards as a hedge. In addition, interest rate futures based on government benchmark bonds have been offered by Finnish derivatives exchanges.

The upward trend in the stock market, which started in 1992, has been maintained during 1994 and the first half of 1995, although there were marked differences in performance among various industrial groups. Export companies’ shares surged with their increasing profitability, whereas bank shares started to decline in February 1994 as a result of the rise in long-term interest rates. However, the rise in the overall share price index, culminating in all-time high levels in June 1995, was largely owing to the strength of the shares of just a few large companies. 1/

b. The banking sector

As banks recover from the banking crisis of the early 1990s and work down their portfolios of nonperforming loans, profitability has improved only slowly. 2/ Operating profits declined in 1994 by 15 percent, primarily owing to low credit demand and the weakness in bond markets. Excluding institutions owned by the Government, bank credit losses of Fmk 11 billion, though down from Fmk 14 billion, exceeded their operating profit by Fmk 6.4 billion (Chart 13). If the Savings Bank of Finland (SBF) and its asset management company, Arsenal, are included, the banks’ losses before extraordinary items actually increased from Fmk 15.3 billion in 1993 to Fmk 18.8 billion in 1994. Overall, 7.5 percent of loans to the corporate sector were nonperforming at the end of 1994. The construction sector had the highest default rate with almost 18 percent, while about 8 1/2 percent of loans to the sheltered sectors were nonperforming.

CHART 13FINLAND DEPOSIT BANKS’ OPERATING PROFITS/LOSSES, 1990–94 1/

(In millions of Fmk)

Source: Bank of Finland.

1/ Prior to 1992, figures for Siltapankki and SBF are not shown separately. Arsenal was founded in 1993.

As of April 1995, the total bank support from the Government amounted to Fmk 51 billion (about 10 percent of GDP). In addition, banks had received government guarantees of Fmk 32 billion. Most of the support, except for a general capital injection of Fmk 8 billion to all banks in 1992, has gone to the savings bank sector, in particular to Skopbank (its former central organization) and to SBF, which was formed by the merger of 41 savings banks when the Government took it over in 1993 (Table 19).

Table 19.Finland: Bank Support, January 1991-April 1995(In millions of Finnish markkaa)
Total
Bank of FinlandCouncil of StateGovernment

Guarantee Fund
Capital

and Other
Guarantees
CapitalGuaranteesCapitalGuaranteesCapitalOther
1991
Skopbank4,3304,330
1992
Skopbank9,4446005803,00013,024600
Savings Bank of Finland1,09411,40012,494
Cooperative banks1,1081,108
Postipankki903903
Kansallis-Osake-Pankki1,7261,726
Unitas1,7491,749
Okobank422422
Security fund of the savings banks500500
Other160160
1993
Skopbank-2,722350300700-1,672300
STS Bank (Siltapankki)3,0363,036
Savings Bank of Finland-884-2,656-3,500
Kansallis-Osake-Pankki1,8001,800
Unitas1,0001,000
AMC Arsenal Ltd3,4421,5585,000
Security fund of the commercial banks-357-357
Security fund of the cooperative banks900900
Security fund of the savings banks-345-345
1994
Skopbank-1,220-600450256-514600
AMC Arsenal Ltd6,00028,0006,00028,000
Savings Bank of Finland-686232-454
1994
AMC Arsenal Ltd.8,000-5797,421
Total9,832--16,69032,00024,600-9151,03132,000
Source: Bank of Finland.
Source: Bank of Finland.

Although the most substantial bank support measures were already taken in 1992-93, efforts to consolidate and restructure the sector continued in 1994-95 with the sale of SBF, the creation of the asset management company, Arsenal, and the sale of Skopbank to the Swedish Handelsbanken. In October 1993, the sound assets (some Fmk 40 billion) and the branch network of SBF were sold to the four remaining banking groups (the private UBF and KOP, the Postbank, and the cooperative banks). SBF itself, while retaining its nonperforming assets, was turned into an asset management company owned by Arsenal, a new corporation established to manage bad assets. The objective for Arsenal is to restructure indebted companies, enforce collateral where necessary, and sell its assets in the real estate market. Owing to the problematic nature of the involved enterprises and the depressed conditions in the real estate market, particularly for corporate property, Arsenal is expected to require Government support over the foreseeable future. By the end of March 1995, Arsenal had received Fmk 19 billion in public bank support, and a further Fmk 28 billion in government guarantees.

The Skopbank transaction has a similar structure as the SBF sale. Skopbank’s sound assets (Fmk 4.4 billion) and its subsidiaries, including its mortgage and finance companies, were sold to Handelsbanken in June 1995. Skopbank will later also be converted into an asset management company.

In February, the two major Finnish commercial banks, UBF and KOP, announced plans for merging their operations into a new bank (called Merita) that started operations in mid-1995. It is anticipated that the merger will accelerate the consolidation and rationalization process in the Finnish banking system, where since 1990 the number of branches has been cut by 35 percent and the number of employees by 28 percent.

V. Balance of Payments

1. Overview

Between 1985-89, despite improvements in the terms of trade, Finland’s external current account deficit increased rapidly; a rising real effective exchange rate adversely affected competitiveness, and the boom in domestic demand crowded out exports, which grew more slowly than market growth. In 1991, the current account deficit remained at the 1990 level, despite a collapse of trade with the former Soviet Union and other Eastern European countries, since the economy was by then well into a deep recession. Even though the terms of trade deteriorated between 1991 and 1993, the surge in exports, owing initially to a fall in the real effective exchange rate and later to the recovery in partner countries, lead to a reduction of current account deficits.

Imports picked up in 1994 as the economy emerged from the recession, but the current account moved into a surplus supported by continuing export buoyancy and improved terms of trade. The ratio of net external debt to GDP, which had risen rapidly to 55 percent in 1993, declined in 1994. Also notable was the increase in the proportion of foreign debt accounted for by the central government.

2. Developments in 1993 and 1994

The surplus on the trade account rose considerably between 1991 and 1994, reaching about 6 1/2 percent of GDP in 1993 and 1994 compared to 1 percent of GDP in 1991 (Tables 20 and 21, and Chart 14). In 1993, the turnaround in exports that began the previous year gained momentum, with export volumes rising rapidly in spite of sluggish growth in Finland’s traditional export markets of OECD-Europe (Table 22). Export volume growth, though still in double digits, slowed in 1994 (due in part to some real exchange rate appreciation), even as export markets in Europe recovered and there were further improvements in terms of trade (Table 23, Chart 15). This slowdown also reflected emerging capacity constraints in the traded goods. 1/

Table 20.Finland: Balance of Payments, 1991-95(In billions of Finnish markkaa)
19911992199319941995 1/
Merchandise trade balance4.712.630.933.640.8
Exports, f.o.b. 2/91.1105.8132.6152.2174.3
Imports, c.i.f.2/86.393.2101.6118.6133.5
Nonfactor services balance-7.9-6.2-4.9-2.2-3.4
Transportation3.54.34.95.56.5
Travel-6.0-4.9-2.2-1.4-2.4
Other-5.4-5.6-7.6-6.3-7.6
Goods and services balance-3.16.426.131.437.4
Investment income, net-18.7-24.0-27.0-22.3 )-22.4
Transfers and other income, net-4.9-4.4-3.9-3.5 )
Current account balance-26.7-22.0-4.75.615.0
(In percent of GDP)-5.4-4.6-1.01.12.5
Capital and financial account balance17.313.90.923.5
Direct investment net-0.55.2-4.6-12.0
Inward-1.01.85.07.7
Outward0.53.4-9.5-19.7
Portfolio investment net33.234.835.137.4
Loans5.2-3.46.26.8
Trade credits-3.3--2.50.5
Other-17.2-22.7-38.4-9.1
Errors and omissions2.0-1.05.1-3.6
Overall balance-7.4-9.21.225.5
Changes in reserves, net (increase -)7.49.2-1.2-25.5
Sources: Bank of Finland, Bulletin various issues; and data provided by the Finnish authorities.

Official projections.

Including adjustment items.

Sources: Bank of Finland, Bulletin various issues; and data provided by the Finnish authorities.

Official projections.

Including adjustment items.

Table 21.Finland: Indices of Foreign Trade, 1991-95(Percentage change from previous year)
19911992199319941995 1/
Volumes
Exports, f.o.b.-8.79.018.612.98.0
Market economies-1.39.0
State trading countries-52.49.1
Imports, c.i.f.-16.7-2.1-2.719.310.5
Market economies….
State trading countries….
Unit values
Exports, f.o.b.0.56.24.91.76.0
Imports, c.i.f.2.310.512.4-2.81.5
Terms of trade-1.8-3.9-6.24.64.4
Sources: Bank of Finland, Bulletin; and Ministry of Finance, National Budget February 1995.

Official projections.

Sources: Bank of Finland, Bulletin; and Ministry of Finance, National Budget February 1995.

Official projections.

CHART 14BALANCE OF PAYMENTS, 1985–94

(In percent of GDP)

Source: Finnish authorities; Bank of Finland, Bulletin.

Table 22.Finland: Exports by Commodity Group, 1991-95
Share

(In Percent)
Volume

Price (Change in Percent)
Price

(Change in Percent)
1994199019911992199319941995 1/199019911992199319941995 1/
Agriculture and forestry1.9-20-11-174775-2234248585
Food, drink, and tobacco2.725-16636176-231312-12
Textiles, clothing and leather2.2-8-30-15127--127413
Wood industry9.2-6-1073922512-16--68
Paper, printing and publishing26.81-3510114-4-445-113
Chemicals10.2811126185----310-63
Basic metals8.3131112893-22-576-12
Metal products and machinery36.25-2114301215448342
Other products2.5
Total exports of goods100.02.8-8.79.018.813.08.0-1.20.56.25.11.56.0
Memorandum item:
Exports of goods and services1.4-6.610.016.712.57.50.5-1.56.76.51.05.5
Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Table 23.Finland: Indicators of Competitiveness, 1990-94
19901991199219931994
(Annual percentage changes in real terms)
Merchandise exports to market economies4.9-1.39.018.612.9
Non-oil imports of partner countries 1/4.90.8-4.12.05.8
Export market share 2/---2.113.716.36.7
Merchandise imports-4.0-16.7-2.1-2.719.3
Domestic demand-0.4-8.3-5.6-6.03.3
(Annual percentage changes)
Markka currency index 3/-1.14.214.813.8-7.0
Nominal effective exchange rate1.1-3.7-12.9-12.57.9
Real effective exchange rate 4/4.2-7.9-17.5-15.96.3
Unit labor costs in manufacturing8.25.9-8.0-6.6-3.8
Merchandise export unit values-1.20.56.25.11.7
Labor productivity in manufacturing3.20.612.111.47.5
Sources: Data provided by the Finnish authorities; IMF, Data Fund; and staff estimates.

Weighted by Finland’s exports to individual countries according to IMF, Research Department.

Volume of exports to market economies relative to non-oil imports of partner countries.

The Bank of Finland’s currency basket (weights based on total trade); a decline indicates an appreciation.

Relative unit labor costs (normalized) in manufacturing based on weights for 16 industrial countries as calculated by IMF Research Department.

Sources: Data provided by the Finnish authorities; IMF, Data Fund; and staff estimates.

Weighted by Finland’s exports to individual countries according to IMF, Research Department.

Volume of exports to market economies relative to non-oil imports of partner countries.

The Bank of Finland’s currency basket (weights based on total trade); a decline indicates an appreciation.

Relative unit labor costs (normalized) in manufacturing based on weights for 16 industrial countries as calculated by IMF Research Department.

CHART 15FINLAND EXTERNAL INDICATORS, 1980–95

(1986 = 100)

Sources: Bank of Finland; and IMF, International Financial Statistics and unit labor cost data server.

Imports, after declining cumulatively by about 24 percent in volume between 1990 and 1993, rebounded in 1994, increasing by 19 percent as domestic demand recovered and the markka strengthened. Import prices (in markka), which had been increasing rapidly during the period 1992-93 due to the depreciation of the currency, fell in 1994 by 3 percent, reflecting a strengthening of the currency. (Table 24).

Table 24.Finland: Imports by Commodity Group, 1991-95
Share

(In Percent)
Volume

Price (Change in Percent)
Price

(Change in Percent)
1994199019911992199319941995 1/199019911992199319941995 1/
Raw materials and other production necessities60.3-2-142-3228--21113-24
Crude oil5.4(2)(11)(-11)(-7)(20)-3(22)(-10)(7)(12)(-12)--
Other54.8(-2)(-16)(4)-2(22)9(-3)(3)(12)(14)(-1)4
Fuels and lubricants4.34-13151619-36149-8--
Investment goods14.3-10-30-17-11622521517-4-4
Consumer goods20.5-4-14-8-622103468-4--
Other0.7
Total imports of goods100.0-4.0-16.7-2.1-3.420.510.51.72.310.512.4-3.01.5
Memorandum item:
Imports of goods and services-0.6-11.71.10.712.511.01.00.67.28.7--1.5
Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

Sources: Ministry of Finance, National Budget February 1995; and data provided by the Finnish authorities.

Official projections.

The current account balance, following an improvement equivalent to 3 1/2 percentage points of GDP in 1993, registered a surplus of 1 percent of GDP in 1994. The move to a positive current account balance after many years was due to a lower services deficit and a decline in interest payments as the markka strengthened.

The Fmk 4 billion improvement in the services account balance in the last two years was mainly due to the substantial decrease in the travel account deficit as foreign tourist arrivals increased in response to the lower currency, while the number of Finns travelling abroad has not yet recovered to earlier levels due to the severity of the recession. The surplus on the transportation account continued to improve as the growth in foreign trade raised demand for transportation services (Table 25).

Table 25.Finland: Invisibles, 1991-95(In billions of Finnish markkaa)
19911992199319941995 1/
Transport, net3.54.34.95.55.8
Receipts7.58.610.411.411.9
Payments4.04.45.55.96.1
Travel, net-6.0-4.9-2.2-1.4-1.8
Receipts5.06.17.16.87.0
Payments11.111.09.28.28.8
Other services, net-5.4-5.6-7.6-6.3-6.0
Receipts5.67.79.410.811.5
Payments11.013.417.017.117.5
Total nonfactor, net-7.9-6.2-3.5-1.8-2.0
Receipts18.222.526.929.030.4
Payments26.128.731.831.232.4
Transfers and other income, net-5.2-4.4-3.9-3.5-3.8
Receipts5.35.96.55.78.0
Payment10.510.310.49.211.8
Investment income, net-18.7-24.0-27.0-22.3-20.2
Receipts10.06.47.68.711.5
Payments28.730.434.631.031.7
Total invisibles, net-31.8-34.6-34.4-27.6-26.0
Receipts33.535.441.043.449.9
Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

Official projections.

Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

Official projections.

Net investment income increased by about Fmk 4 1/2 billion in 1994, primarily owing to lower interest expenses and smaller losses of Finnish subsidiaries abroad. 1/ Both the reduction of the net foreign debt and the markka appreciation alleviated the burden of interest payments. These were factors which had worked in the opposite direction in the 1990-1993 period, when foreign borrowing of the public sector had expanded and the markka slid against the major currencies.

Over the last two years, the capital account has been dominated by private sector outflows and public sector inflows. The main channel for the private outflows were banks as Finnish firms repaid foreign currency loans. In 1993, public inflows (Fmk 49 billion) exceeded private outflows by about Fmk 9 billion, whereas in 1994 this difference more than doubled to Fmk 20 billion (on inflows of Fmk 30 billion). In 1994, with the current account in surplus, and a substantial positive balance in the capital account, the Bank of Finland’s foreign exchange reserves doubled, increasing by US$5.1 billion. Gross official convertible reserves (including gold) at the end of 1994 amounted to US$10.8 billion (Fmk 52.7 billion), equivalent to 23 weeks of imports (Table 26).

Table 26.Finland: Gross Official Convertible Reserves, 1990-94
1st Qtr.
199019911992199319941995
(In millions of U.S. dollars; end of period)
Gold (at SDR 35 per ounce)99.7100.296.396.296.287.5
SDRs216.9225.6107.8115.1325.1372.7
Reserve position in the Fund214.8275.1331.3302.7286.3306.5
Foreign exchange9,212.47,108.04,774.34,993.010,050.610,420.7
Total9,743.87,708.95,309.75,507.010,758.211,187.4
(In billions of Finnish markkaa)37.233.629.533.552.753.5
(In weeks of imports. c.i.f.) 1/
Gross reserves18.819.916.216.923.118.6
Sources: IMF, International Financial Statistics; and Bank of Finland, Bulletin.

Including adjustment items.

Sources: IMF, International Financial Statistics; and Bank of Finland, Bulletin.

Including adjustment items.

Portfolio investment constitutes the most important component of capital flows and in 1994 the net inflow increased by Fmk 2 1/2 billion to Fmk 37 1/2 billion. Net sales of foreign currency bonds abroad (Fmk 32 billion) in part financed the central government deficit. Foreign holdings of markka-denominated bonds fell by Fmk 8 billion as investors repatriated their gains from the markka appreciation. Foreign purchases of shares in Finnish companies continued at a brisk pace in 1994 (Fmk 13.2 billion and Fmk 12.7 billion in 1994 and 1993, respectively, compared to Fmk 0.4 billion in 1992), given the favorable outlook for the traded goods sector, and the lifting of restrictions on foreign ownership of stocks at the beginning of 1993.

Direct investment abroad by Finnish companies, which fell by a cumulative Fmk 4 billion in 1991 and 1992, doubled in 1994 compared to the Fmk 9 1/2 billion registered in 1993. Foreign direct investment in Finland, which was negative in 1991 when Europe was in a recession, continued to recover and jumped to Fmk 7.7 billion in 1994, an increase of almost Fmk 3 billion over 1993, possibly reflecting the positive outcome to the Finnish referendum on EU accession.

Large outflows from banks dominated short-term capital movements in 1992 and 1993. These outflows, which began in 1991, continued through 1992 and 1993, when the spread between domestic and foreign interest rates widened and confidence in the markka weakened. They fell considerably in 1994 as the markka appreciated and inflationary expectations were restrained.

Despite large-scale government borrowing, the surplus on the current account and the repayment of private sector foreign debt, coupled with the appreciation of the markka, resulted in a decrease in the external debt in 1994--net external debt amounted to Fmk 257 billion at end-1994 (50 percent of GDP), a decrease of Fmk 8 billion from end-1993. The central government’s share of net foreign debt at the end of 1994 was 70 percent, an increase of 8 percentage points compared to end-1993.

3. Structural changes in Finland’s external accounts

a. Exports and imports

The recent export boom has been broad based in terms of product categories. However, the trend since the mid-1980s towards a decrease in the relative importance of the forestry industries in exports and an increase in the share of the metal and engineering industries has continued in the 1990s--the share of forestry products fell from 56 percent in 1970 to 36 percent in 1994 while that of metal and engineering rose from 25 percent to about 45 percent over the same period. In tandem with the above movement, there has been a shift towards higher value added exports in all sectors: a relative increase in the more highly processed forestry products (such as printing and writing papers) compared to sawn timber and pulp, and within metal and engineering goods, a larger share of exports comprising electrical and electronic products.

The destination of Finnish exports is also undergoing a structural transformation (Chart 16). The share of exports going to OECD-Europe fell almost 7 percentage points to 75 percent between 1991 and 1994 while the share of South-East Asia has more than doubled since the beginning of the decade to almost 8 percent (Table 27). Also noteworthy has been the growth of exports to the Baltic states and the recovery of exports to Eastern Europe--the share of exports to former CMEA countries, which fell by half in 1991 (to 7 percent), rebounded to 12 percent in 1994.

CHART 16FINLAND GEOGRAPHICAL COMPOSITION OF FINNISH EXPORTS, 1986–94

(In percent of total)

Source: National Board of Customs.

Table 27.Finland: Direction of Trade, 1990-94(In percent of total)
ExportsImports
1990199119921993199419901991199219931994
OECD countries76.581.782.276.274.979.979.879.179.177.3
Sweden14.313.912.811.110.913.012.311.710.210.4
United Kingdom10.610.410.710.510.37.67.78.78.98.3
Germany 1/12.815.415.613.113.417.416.916.916.414.7
United States5.86.15.97.87.26.86.96.17.37.6
France6.25.96.75.35.14.34.24.64.64.1
Netherlands4.35.05.25.05.13.23.43.63.73.6
Denmark3.53.73.63.33.43.33.43.43.13.0
Norway3.03.33.53.23.23.44.54.04.94.8
Italy3.23.64.03.23.04.64.23.63.73.9
Japan1.41.51.31.62.16.46.05.55.86.5
Switzerland1.82.01.81.61.51.81.81.92.01.8
Other9.611.811.110.59.78.18.59.18.58.7
Non-OECD European countries13.77.06.89.512.011.910.910.210.912.5
Of which:
Russia 2/12.74.92.84.55.29.98.57.17.68.9
Other countries9.811.311.014.313.18.29.310.710.010.2
Of which:
Oil exporting countries1.72.11.82.41.60.91.51.60.50.5
Memorandum items:
EC countries46.551.253.246.946.545.945.847.246.543.6
EFTA countries20.320.619.517.016.719.619.919.018.318.1
Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

After October 1990 for unified Germany; for January-September 1990 figures for the German Democratic Republic are included in those for the Federal Republic of Germany.

Until the end of 1991, the Soviet Union; figures for Estonia, Latvia and Lithuania were included in those for the Soviet Union until October 1991.

Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

After October 1990 for unified Germany; for January-September 1990 figures for the German Democratic Republic are included in those for the Federal Republic of Germany.

Until the end of 1991, the Soviet Union; figures for Estonia, Latvia and Lithuania were included in those for the Soviet Union until October 1991.

Rapid economic growth in South-East Asia and the improved competitiveness of Finnish products in the 1990s combined with intensive marketing efforts on the part of Finnish firms, particularly after the collapse of trade with Eastern Europe in 1991, facilitated entry into Asian markets. The commodity composition of exports to South-East Asia differs from that of Finland’s total exports in that the share of metal and engineering goods is larger--about 70 percent of exports to the region--and the value-added content is higher than average. China and Thailand, the two largest South-East Asian markets for Finnish goods, are also key export markets for telecommunication products.

The share of imports in total domestic demand did not change much between 1970 and 1985, but in the latter half of the 1980s it expanded rapidly as demand far outstripped supply; all major categories of imports, with the exception of crude oil and fuel, rose as a proportion of total demand. At the same time, the share of imports accounted for by manufactured goods, both for consumption and investment, increased.

Import penetration remained high, even when domestic demand collapsed in the 1990-1993 period--the ratio of consumer good imports to domestic private consumption rose from 6 1/2 percent in 1980 to 10 percent in 1989 and then fell to about 8 1/2 percent in 1993, while the ratio of investment good imports to domestic investment in machinery and equipment, which had remained around 25 percent in the 1980s, was about 32 percent in 1993. The main reasons were the narrowness of the domestic production base (especially in consumer goods), and the loss of part of the production capacity as a result of the collapse of Eastern European trade in 1991 and the prolonged and severe domestic recession. The increase in the propensity to import was also due to structural changes in industry, in particular the higher output of metal and engineering products and the shift towards higher processed goods that use more imported inputs in the forestry sector.

b. External debt

Two changes characterized Finland’s net international investment position between 1988 and 1994: (i) net external debt increased rapidly, rising from 13 percent of GDP in 1988 to a peak of 55 percent in 1993, and (ii) the proportion of net external debt accounted for by the central government rose dramatically in the 1990s from 17 percent in 1990 to 70 percent in 1994 (Table 28).

Table 28.Finland: International Investment Position, 1990-94(In billions of Finnish markkaa; end of period)
1st Qtr.
199019911992199319941995
Liabilities306.6355.7437.6498.4504.8495.1
Direst investment in Finland18.717.419.324.431.533.9
Portfolio investment124.4167.3235.9304.9318.2304.7
Shares5.14.15.130.460.653.4
Bonds95.5141.1211.4265.6254.1251.6
Others23.922.119.48.93.6-0.3
Other investment163.5171.0182.3169.1155.0156.5
Loans51.968.978.391.484.680.8
Other111.6102.1104.077.770.475.7
Assets163.0181.4208.0233.4250.1252.7
Direct investment abroad40.844.844.954.669.670.2
Portfolio investment9.411.617.123.515.412.0
Shares0.80.40.51.31.00.7
Bonds6.47.08.710.74.85.5
Others2.24.27.911.59.65.9
Other investment112.9125.0146.0155.4165.2170.5
Loans24.828.535.334.025.022.4
Other88.196.5110.7121.4140.2148.1
Net investment position143.5174.3229.6264.9254.6242.4
Corporate sector34.928.530.549.971.663.9
Banks110.1107.482.348.231.922.7
Bank of Finland-36.7-34.0-27.5-33.3-52.6-53.3
Other financial institutions9.919.028.329.721.220.0
Central government24.852.7113.7167.4179.5186.0
Local government0.60.72.33.03.03.0
Memorandum items:
Gross external debt 1/ (in percent of GDP)282.8334.2413.2443.6412.8407.9
Net external debt 2/ (in percent of GDP)161.4198.0250.6266.1233.3226.0
Central government debt, net24.852.7113.7167.4179.5186.0
Central government debt, net (in percent of GDP)4.810.723.934.835.7
Net investment income 3/
(In percent of exports of goods and nonfactor services)-13.1-15.7-19.0-21.9-12.3-12.8
Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

Liabilities, excluding equity (direct investment and shares).

Net investment position, excluding equity (direct investment and shares).

Net interest and dividend income.

Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities.

Liabilities, excluding equity (direct investment and shares).

Net investment position, excluding equity (direct investment and shares).

Net interest and dividend income.

At the end of the 1980s, high investment demand generated by a rapidly growing economy coincided with the removal of constraints on foreign borrowing by the business sector and a decline in the household savings rate, leading to a run up of external debt by the private sector. Finnish firms were also attracted to borrowing in foreign currency because of the emergence at that time of large interest rate differentials between foreign and domestic markets.

The 1991-1993 period saw considerable foreign borrowing by the central government, precipitated by the need to finance large budget deficits resulting from a collapse in output and a rise in the unemployment rate to over 19 percent (Chart 17). Almost all the external borrowing was done through the issue of long-term foreign currency bonds. This increase in public sector borrowing took place at a time when the private sector was running down its foreign currency liabilities, prompted by higher perceived exchange risk, lower domestic interest rates, and a decline in investment. By early 1993, the central government’s net external debt exceeded that of the private sector, and at the end of 1994, amounted to Fmk 180 billion, over twice that of the private sector.

CHART 17FINLAND NET FOREIGN DEBT, 1985–94

(In percent of GDP)

Source: Finnish authorities.

4. Official development assistance

The recent deterioration in the budgetary situation and the re-evaluation of all areas of spending has led to a squeezing of Finland’s official development assistance (ODA). Also, the severe recession has had the effect of fraying the national consensus that had favored a liberal program of overseas assistance.

Finland’s budgeted ODA reached a peak of 0.81 percent of GNP in 1991. In the space of three years, it fell to less than half its peak level, amounting at current prices to US$356 million (0.38 percent of GNP) at the end of 1994. ODA net disbursements at constant 1993 prices, which rose from 0.32 percent of GNP in 1983 to 0.80 in 1991, have also decreased to levels of the early 1980s. Multilateral aid as a proportion of ODA disbursement fell from 38 percent in 1988-89 to 24 percent in 1994. The geographical distribution of bilateral aid also changed: the share of sub-Saharan Africa decreased from 63 percent in 1983 to 42 percent in 1993, that of Asia increased from 23 percent to 36 percent, that of America increased slightly, and that of Europe rose to 3 1/2 percent in 1993 from a negligible amount in 1983.

APPENDIX I Monetary Policy and Inflation Indicators

This appendix is intended to provide background to the process of establishing a monetary policy framework under a floating exchange rate in Finland. Following Friedman (1990) who argued for the inclusion of a broad set of economic variables in the monetary decision process, absent a practical intermediate target, the study tests indicator variables for their relevance in determining future inflationary pressure. Recent work on the formulation of inflation models is applied to obtain a set of inflation equations for Finland. The results show that a monetary conditions index, real and nominal effective exchange rates, and various import prices are among the strongest indicators, affecting inflation with a lag of between 5 and 11 quarters. Based on this finding, and on the assumption of unchanged policies, this methodology implies an increase of CPI inflation to an annualized 4 percent by the end of 1996, though this result must be interpreted cautiously as elaborated in the text.

This appendix is divided into four parts. The introduction outlines the current setting of monetary policy in Finland and discusses a strategy for identifying suitable strong indicators within the context of inflation models. Section 2 outlines the econometrics and analyzes the available data. Section 3 discusses the results of the evaluation and gives an inflation outlook for 1995-96; Section 4 concludes.

1. Introduction

a. The information variable approach to monetary policy

Mainly due to the lack of a stable money demand function, the inflation target of the Bank of Finland (BoF) is not linked to any intermediate target. Rather, the Bank’s policy can be described by what Friedman (1990, 1993) has termed an “information variable approach”. This term is used to define a policy that is guided by the central bank’s internal inflation forecasts in the absence of a feasible rules-based policy. The approach has two key elements: (1) it incorporates a broad set of information variables into the policy-making process, reaching beyond the usual indicator set of financial variables and aiming at high-quality inflation forecasts; and (2) it updates the set of information variables by frequently re-assessing the forecasting properties of each variable involved.

The adoption of an information variable approach offers several advantages in a situation where an intermediate target cannot be employed. First, indicators can be used to justify policy actions to the public, similar to an intermediate target (Pikkarainen and Ripatti [1995]). Second, variables that have high forecasting power but are not useable as intermediate targets (e.g., expectations-related variables) retain a role in the decision process. Third, erratic movements of an indicator do not necessarily trigger a change in policy because the central bank’s actions are no longer bound as if the variable was an intermediate target. Fourth, the new policy is flexible because monetary indicators that are no longer deemed valuable can be replaced by others that might have gained importance. It can thus be easily adjusted to a changing economic environment.

On the other hand, the new policy also poses two key challenges to the central bank. First, the set of monetary policy indicators has to be constantly verified and updated in order to produce reliable inflation forecasts. Second, the central bank’s room for discretion makes the information variable approach less transparent--and hence credible--to the public if compared to an intermediate target approach. Unless details of the decision-making process are largely revealed, there is no other way for the public to evaluate the performance of the central bank than by comparing actual and targeted inflation rates. Therefore, owing to the long lags involved in the monetary transmission process, 1/ the public is merely able to judge past rather than current behavior of the central bank. Consequently, it is harder for the bank to maintain credibility than under an intermediate target.

b. Monetary indicators and the inflation process

The identification and estimation of the inflation process is of central importance to the conduct of monetary policy under the information variable approach. To that end, this study will employ three recent approaches that have already been empirically implemented. First, Duguay (1994) has focussed on the role of interest rates and exchange rate movements and their effects on domestic demand and supply. Having established a firm empirical link between real GDP growth and changes in real short-term interest rates and the real effective exchange rate (REER), he has estimated a Phillips curve-type model in which inflation is linked to the output gap, changes in taxation, and import prices. The combined impact of interest and exchange rates on output is measured by a monetary conditions index (MCI) that plays a significant role in the decision making process of the Bank of Canada (Freedman [1994a,b]). 2/ The BoF has also recently conducted studies on the MCI (e.g., Pikkarainen [1993]).

Second, a strand of the literature originating from Hallman et al. (1989, 1991) has employed the quantity equation to derive a long-run equilibrium price level (denoted P*) that corresponds to potential output and the long-run equilibrium money velocity. Inflation is modeled as a function of the deviation of the actual price level from P*, which results in an error-correction mechanism that can be estimated.

Third, Ford and Krueger (1995) have estimated a model for Italy that decomposes price increases into wage and import price components. By estimating separate equations for the two components, they have been able to analyze the impact of foreign export prices, import-price pass-through effects, the output gap, and unit labor costs in a structural manner.

These models provide a good starting point for the analysis of Finnish inflation. However, referring back to Friedman’s (1993) notion of a monetary policy that is guided by information variables, they are not exhaustive from an information point of view. All of the approaches employ an error-correction mechanism (ECM) and, in their final specifications, include a variety of variables, ranging from exchange rates to tax indicators. However, since most specifications are derived from partial equilibrium analyses, they exclude variables that seem to bear no causal relationship with inflation but might be useful for forecasting.

It is relatively straightforward to address this shortcoming by including appropriate indicator variables in the respective models. To this end, the models will first be estimated in a standard way and, secondly, be augmented with a set of economic variables that are not necessarily related to the models on theoretical grounds. Since the addition of a good indicator will lead to a significant improvement of the forecast quality of a model, the variables can easily be ranked according to their relative contribution to inflation forecasts. 1/ Moreover, the use of more than one model for the transmission process makes it possible to check the ranking of the variables for robustness under different model assumptions.

2. Methodology and data

This section discusses the econometric strategy and data properties. The econometric strategy focusses on comparing the forecasting power of single indicators before deriving a final inflation equation. This is because the large number of possible indicators and lags makes it impossible to arrive at an inflation equation with a standard variable elimination technique. Therefore, variables that should appear in a final inflation equation are identified first. Moreover, since Finnish monetary policy is guided by individual indicators as well as by a complete macroeconomic model, this study also adds to the work conducted by the BoF itself (e.g., Ripatti [1995]). To prepare the ground for the next section, the time-series properties of the data are tested, and the set of possible indicator variables is briefly discussed.

a. The econometric strategy

The identification of strong indicators is based on different models of the inflation process. The models’ inflation equations are first estimated in a standard (“basic”) form before being separately augmented by a number of indicator variables and subjected to a series of forecast ranking tests. Finally, the most successful indicators are jointly added to the basic equation to yield a preferred inflation equation that can be used for forecasting.

The basic inflation equations are generally in the form of error-correction mechanisms, so that the right-hand side variables enter the equation in lags, differences, and--in the case of co-integrated relationships--linear combinations. Depending on the assumed order of integration, the models are estimated in the first or second difference of the price level.

Three models have been used to derive basic equations. First, in order to set a benchmark, a P* model has been estimated that includes all variables in first differences, irrespective of their order of integration. Velocity and output gaps are computed with a Hodrick-Prescott filter. Second, in order to pursue a more traditional approach, a standard VAR model has been derived from the quantity equation. Third, following Ford and Krueger (1995), inflation was modelled in the real sector, with import prices and wages as components of an inflation equation. This approach, denoted the wage-inflation model, yields an equation for CPI inflation whereas the first two models require modeling the GDP deflator (both series are depicted in Chart 18). Details of the econometric specification are discussed in the Annex.

CHART 18FINLAND GDP DEFLATOR AND CPI INFLATION RATES, 1965–94 1/

(In percent)

Source: Bank of Finland.

1/ Series are on an annualized basis.

In the following, a sequence of steps is repeated for each of the three basic equations:

  • First, a set of indicator candidates is created, consisting of macro variables thought to be relevant for the determination of the price level but not contained in the model. Each of the variables in this set is used individually in turn, with a large number of lags, to augment the basic equation. For each indicator candidate, the Schwarz model selection criterion is applied to determine the lag structure that yields the best fit to the data.

  • Second, having obtained one equation for each indicator candidate, two sets of forecasts are generated: (1) dynamic within-sample forecasts for 1993-94; and (2) one-step forecasts from rolling regressions over the whole sample period. The indicator candidates are then ranked according to the performance of their inflation forecasts. The accuracy of the forecasts is measured by the root mean squared error (RSME) criterion and by encompassing tests (Chong and Hendry [1986]). 1/

  • Third, the basic equation is combined with the most successful indicators to arrive at a preferred equation. This equation is used to analyze the inflation process in the recent past and to forecast inflation for 1995-96.

b. Integration tests

An overview of the augmented Dickey-Fuller (ADF) tests for variable integration is contained in Table 29. The tests use quarterly data up to the end of 1994, with the starting period varying between 1964 and 1978, depending on data availability. The procedure is mainly based on Perron (1988) who suggested to determine the appropriate lag order by consecutively reducing the number of lags until the coefficient of the longest lag becomes significant. To check the results, the lag order was also determined by the Schwarz model selection criterion. Where applicable, different results of the second procedure have been noted.

Table 29.Finland: Results of Integration Tests
Stationary VariablesDifference-Stationary VariablesVariables Stationary in 2nd Difference
(Order of Integration 0)(Order of Integration 1)(Order of Integration 2)
Dwelling price index

Import price index

Foreign export price index

HWWA raw materials price index

Fuel import price index
CPI

GDP deflator

Producer price index 1/

Raw materials import price index 1/
Output gapReal GDP

Industrial production index

Manufacturing output

Capacity utilization

Capacity utilization (manufacturing)

Wholesale sales index
GDP
Labor Productivity Vacancy Rate 1/Real wage index

Social security contributions

Unemployment rate
Wage index

Unit labor costs 1/
NEER 1/REER

Terms of trade
Real M1Real M2, Real M3

M1 Velocity

M2 Velocity

Monetary Conditions Index
M1, M2 1/, M3 1/

M3 Velocity 1/
Market yield on debentures 1/Bank lending rate

Market yield on tax-free bonds

Interest rate spread 2/
Money market rate 1/
Central government fiscal balance
Source: Staff calculations (see Appendix II for a description of the variables).

ADF-Tests using Schwarz criterion suggest order of integration 1.

ADF-Tests using Schwarz criterion suggest order of integration 2.

Source: Staff calculations (see Appendix II for a description of the variables).

ADF-Tests using Schwarz criterion suggest order of integration 1.

ADF-Tests using Schwarz criterion suggest order of integration 2.

The results clearly distinguish, except for import-related variables, between nominal and real series. In the event, all domestic nominal series (GDP, money supply, prices, and wages) are integrated of order two, that is, only the difference of their growth rates is stationary. If the series are reduced to their real values, however, they are found to be integrated of order one. Surprisingly, import-related prices (denominated in Finnish markka) are integrated of order one, which seems to be linked to the stationarity of the nominal effective exchange rate (NEER). This finding contradicts the generally held view that, because import prices constitute an important determinant of the domestic price level, they should also be related to it in the long-term. However, since the results are consistent for all import price series, they have been retained for most of the further analysis. On the other hand, the power of ADF tests is relatively weak, and the analysis should not be subject to purely technical considerations; therefore, this study will also take account of the possibility that the order of integration of some variables has not been properly identified.

c. Indicator candidates

In searching for suitable indicators, this study draws on earlier work by Griffiths (1994) who investigated the directions of Granger-causality between inflation and a large number of Finnish time series. The variables he identified as being potentially useful for forecasting inflation have been kept for this study:

- Industrial production- Manufacturing output
- Capacity utilization- Wholesale sales
- Unemployment- Vacancies
- M3- House prices
- Import prices- Raw material prices

Furthermore, this study enlarges the search by including additional variables that are frequently used in the discussion of inflationary pressures. These comprise both nominal and real effective exchange rates, producer prices and unit labor costs, as well as a number of interest rates and their spread.

Griffiths (1994) also constructed a monetary conditions index (MCI) that measures the impact of monetary policy on the output gap by weighing nominal exchange rate and interest rate developments. In order to compute the MCI, Griffiths followed Duguay (1994) by running regressions for the output gap on the bank lending rate (BLR), terms of trade, and NEER, using quarterly data from 1975-93. In his analysis, an increase of 1 percent in the bank lending rate had an effect on the output gap that was some 5.5 times larger than a 1 percent change in the exchange rate. 1/ Using this relation, the MCI is defined as:

with the quarter 1988:1 serving as base period. The MCI (in logarithms) and its components are depicted in Chart 19. An increase in the MCI indicates a tightening in monetary conditions, consistent with an exchange rate appreciation or an increase in bank lending rates.

CHART 19FINLAND THE MONETARY CONDITIONS INDEX AND ITS COMPONENTS, 1975–94

Sources: Bank of Finland; and staff calculations.

3. Results of the indicator evaluation

This section discusses the results of the indicator selection process separately for each of the basic models. First, the rankings obtained from the individual forecast contributions are presented. After having identified the best-performing indicators, the results from the preferred equations are summarized, followed by a discussion of the robustness of the findings. The section concludes with an inflation forecast for the years 1995-96.

a. Indicator tests

The best performing indicators and the applied ranking criteria are depicted in Tables 30-32 (see text box below for details of interpreting the tables). Four main observations can be made:

Table 30.Finland: Indicator Performance for the P* Model
RMSE * 1000Encompassing
ΔIndicatorLagsDyn.Rec.BasicPrefRank
--(Basic Model)--16.909.92------
ΔIndustrial Production517.379.59x14
Output gap------------
ΔCapacity Utilization517.129.96x18
ΔProducer Price Index5,1217.699.29xx12
ΔUnit labor costs215.697.52x7
ΔNominal effective exchange rate (ULC)6,1212.967.03xx3
ΔReal effective exchange rate (ULC)6,1013.857.66xx5
ΔImport Price Index517.199.76x16
ΔForeign export price index915.367.29xx2
ΔRaw materials import price index7,1016.979.89x17
ΔHWWA index (raw materials excl. energy)1115.858.08xx11
ΔFuels and lubricants import price index1,5,6,1116.029.71x15
ΔM14,5,9,1216.688.53x4
--M3------------
ΔMoney market rate11,1216.659.17xx10
ΔBank lending rate2,1215.339.25xx8
ΔMarket yield on debentures8,1115.029.24x9
ΔInterest rate spread916.979.61x13
ΔMonetary conditions index (MCI)612.287.38xx6
ΔCentral government fiscal balance1,2,3,4,715.247.17xx1
--(Preferred model)--11.105.00------
Source: Staff calculations.NOTE: RMSE is the Root Mean Square Error, reported for both dynamic and recursive forecasts. A “Δ” in the first column indicates that the series has been used in first difference. A lag “i” indicates that the quarterly variable xt-i has been contained in the equation. An “x” in the “Basic” column symbolizes that the indicator encompasses the basic model. An “x” in the “Pref” column means that the indicator is encompassed by the preferred model. The rank within the indicator set has been obtained by comparing all possible pairs of indicators. A lower number indicates a higher rank (see text box for details).
Source: Staff calculations.NOTE: RMSE is the Root Mean Square Error, reported for both dynamic and recursive forecasts. A “Δ” in the first column indicates that the series has been used in first difference. A lag “i” indicates that the quarterly variable xt-i has been contained in the equation. An “x” in the “Basic” column symbolizes that the indicator encompasses the basic model. An “x” in the “Pref” column means that the indicator is encompassed by the preferred model. The rank within the indicator set has been obtained by comparing all possible pairs of indicators. A lower number indicates a higher rank (see text box for details).
Table 31.Finland: Indicator Performance for the Money Demand Model
RMSE * 1000Encompassing
ΔIndicatorLagsDyn.Rec.BasicPrefRank
--(Basic Model)--18.207.04------
ΔIndustrial Production517.316.81x12
-Output gap8,1218.176.84x15
ΔCapacity Utilization918.106.69xx9
Δ2Producer Price Index1118.117.04x18
Δ2Unit labor costs1018.316.86x13
-Nominal effective exchange rate (ULC)4,6,714.156.27xx2
ΔReal effective exchange rate (ULC)5,6,10,1216.666.48xx4
ΔImport Price Index5,616.736.14xx1
ΔForeign export price index1118.916.94x10
ΔRaw materials import price index7,8,918.256.69xx8
ΔHWWA index (raw materials excl. energy)517.456.79xx11
ΔFuels and lubricants import price index5,617.236.52xx6
Δ2M11217.476.76xx7
--M3------------
Δ2Money market rate1020.017.00x16
ΔBank lending rate2,1215.106.45xx5
--Market yield on debentures------------
ΔInterest rate spread118.186.97x17
ΔMonetary conditions index (MCI)615.996.91x14
-Central government fiscal balance4,8,9,11,1218.886.27xx3
--(Preferred model)--13.184.40------
Source: Staff calculations.NOTE: RMSE is the Root Mean Square Error, reported for both dynamic and recursive forecasts. A “Δ” or “Δ2” in the first column indicates that the series has been used in first or second difference, respectively. A lag “i” indicates that the quarterly variable xt-i has been contained in the equation. An “x” in the “Basic” column symbolizes that the indicator encompasses the basic model. An “x” in the “Pref” column means that the indicator is encompassed by the preferred model. The rank within the indicator set has been obtained by comparing all possible pairs of indicators. A lower number indicates a higher rank (see text for details).
Source: Staff calculations.NOTE: RMSE is the Root Mean Square Error, reported for both dynamic and recursive forecasts. A “Δ” or “Δ2” in the first column indicates that the series has been used in first or second difference, respectively. A lag “i” indicates that the quarterly variable xt-i has been contained in the equation. An “x” in the “Basic” column symbolizes that the indicator encompasses the basic model. An “x” in the “Pref” column means that the indicator is encompassed by the preferred model. The rank within the indicator set has been obtained by comparing all possible pairs of indicators. A lower number indicates a higher rank (see text for details).
Table 32.Finland: Indicator Performance for the Wage-Inflation Model
RMSE * 1000Encompassing
ΔIndicatorLagsDyn.Rec.BasicPrefRank
--(Basic Model)--6.536.36------
ΔIndustrial Production4,10,127.144.53xx8
-Output gap56.516.39-x18
ΔCapacity Utilization96.406.38x16
Δ2Producer Price Index116.506.40x17
Δ2Unit labor costs56.366.18x12
-Nominal effective exchange rate (ULC)6,75.693.76xx4
ΔReal effective exchange rate (ULC)106.283.82xx2
--Import Price Index------------
ΔForeign export price index5,115.763.40xx1
ΔRaw materials import price index15.775.95xx5
ΔHWWA index (raw materials excl. energy)5,67.624.41x15
ΔFuels and lubricants import price index76.546.29x9
Δ2M1126.026.30x14
Δ2M376.984.80x11
Δ2Money market rate126.535.00x10
ΔBank lending rate6,106.516.18x16
-Market yield on debentures4,86.524.31x13
ΔInterest rate spread66.534.29xx7
ΔMonetary conditions index (MCI)6,104.904.20xx3
-Central government fiscal balance116.754.44xx6
--(Preferred model)--4.833.16------
Source: Staff calculations.NOTE: RMSE is the Root Mean Square Error, reported for both dynamic and recursive forecasts. A “Δ” or “Δ2” in the first column indicates that the series has been used in first or second difference, respectively. A lag “i” indicates that the quarterly variable xt-i has been contained in the equation. An “x” in the “Basic” column symbolizes that the indicator encompasses the basic model. An “x” in the “Pref” column means that the indicator is encompassed by the preferred model. The rank within the indicator set has been obtained by comparing all possible pairs of indicators. A lower number indicates a higher rank (see text for details).
Source: Staff calculations.NOTE: RMSE is the Root Mean Square Error, reported for both dynamic and recursive forecasts. A “Δ” or “Δ2” in the first column indicates that the series has been used in first or second difference, respectively. A lag “i” indicates that the quarterly variable xt-i has been contained in the equation. An “x” in the “Basic” column symbolizes that the indicator encompasses the basic model. An “x” in the “Pref” column means that the indicator is encompassed by the preferred model. The rank within the indicator set has been obtained by comparing all possible pairs of indicators. A lower number indicates a higher rank (see text for details).
  • The most successful indicators are linked to exchange-rate changes and monetary policy. There are only two indicators that are in the top group across all models, namely the nominal effective exchange rate (NEER) and the monetary conditions index (MCI). They are followed by a range of import-related indices, such as the import price index and the foreign export price index. Interest rates are less important on their own (only the bank lending rate appears in the VAR model), but they are of course related to the MCI.

  • Indicators from the real sector, i.e., GDP growth, productivity, and variables measuring capacity, perform poorly and are not in the top group in any of the models. However, this does not come completely as a surprise because either GDP or productivity is already included in the basic models. Therefore, one could indeed expect that, as indicators, they do not add much new information to the basic equations.

  • The full pass-through of exchange rate and monetary policy changes appears to take some 6-12 quarters. The MCI has a strong impact with a lag of 6 and 10 quarters; the NEER acts with a lag of between 4 and 12 quarters. The effect of import price changes is less clearly determined, but it appears that changes in foreign export prices are not immediately fed through into import prices. 1/ Foreign export prices are generally found to act with an 11 quarter lag, whereas the delay for Finnish import price changes is only around 5 quarters.

  • In Chart 20, the RMSEs do not lie close to a diagonal line as would ideally be the case. Whereas some indicators are in the top group for both types of forecasts (such as the NEER and the MCI), other indicators perform well only in one of the groups. This is seen most obviously for the fiscal balance which encompasses all but a few other indicators but yields a comparatively poor forecast. The consequences of this indication of structural change will be addressed below.

CHART 20FINLAND ROOT MEAN SQUARED ERRORS -- DYNAMIC VS. RECURSIVE FORECASTS

(In 1/1000 of percentage points)

Source: Staff calculations.

Note: BAS = basic equation;

BLR = bank lending rate;

GOV = central government fiscal balance;

MYD = market yield on debentures;

PRF = preferred equation;

FEX = foreign export price index;

IMP = import price index;

RAW = raw materials import price index.

How to read the result tables?

This box explains the contents of Tables 30-32, using the P* model as an example (Table 30).

  • The root mean squared errors (RMSEs) of the basic model are listed in the first row, both for the dynamic forecasts covering the period 1993:1 to 1994:4, and for the recursive one-step forecasts based on the whole sample period. The RMSEs of the dynamic forecasts are larger because the forecasts cover eight quarters rather than one, and use forecasts of the endogenous variable for later periods.

  • The list contains only indicator candidates with an above-average performance. It is noted whether an indicator was differenced to achieve stationarity, and which lags turned out significant. For example, industrial production was tested in first difference, affecting inflation most strongly with a delay of 5 quarters. The other columns comprise the RMSEs and the outcome of the encompassing tests, noting (1) whether the indicators add new information to the model by encompassing the basic model; and (2) whether they are in turn encompassed by the preferred equation. The rank indicates the relative position within the field of all indicator candidates, such that the lower the rank number, the more other indicators are encompassed. Finally, the RMSEs of the preferred equations are also listed.

  • In order to simplify the interpretation of the tables, Chart 20 contains a cross-plot of the RMSEs from both dynamic and recursive forecasts, showing all indicator candidates that were tested. In the lower left corner of the graph, the preferred equation is clearly singled out as the best performer, indicating that a combination of indicators is more powerful than a single indicator alone.

Summing up, it was shown that exchange rate and monetary policy changes have the strongest forecast performance within a large set of possible indicator candidates. They lead to the smallest forecast errors, the estimated lags are broadly similar across different specifications, and they encompass most other indicators. The results point to a structural change in the economy because dynamic forecasts--which cover a more recent period--would generally recommend a different set of indicators than recursive forecasts. However, even if some indicators may no longer be relevant, there are other indicators (the MCI and the nominal exchange rate) that have performed well both in the recent past and over the long run. This gives hope that these rather robust indicators might also live through any possibly ongoing and future structural changes.

b. The preferred equations

For each basic model, a preferred equation has been found by adding the most important indicators to the basic equation at once, and subsequently eliminating the insignificant lags. A summary of the resulting regressions is contained in Table 33. Further, Chart 21 compares actual inflation with dynamic simulations. Finally, Chart 22 contains within-sample forecasts for inflation in 1993-94.

Table 33.Finland: Estimation Results for the Preferred Equations
LagP* Model.Money DemandWage Inflation
Δ(GDP Deflator)Δ2(GDP Deflator)Δ2(CPI)
Δ2 GDP deflator 1/1-0.6179(7.21)-0.2289(2.17)
Δ2 GDP deflator 2/20.4961(7.57)-0.2710(2.71)
Δ2 GDP deflator3-0.2828(3.06)
Δ2 GDP deflator6-0.2320(3.35)
Δ GDP9-0.1910(3.81)
Output gap (y - y*)3-0.1213(3.12)
Δ Labor productivity60.2071(3.34)
Δ Labor productivity70.1868(3.38)
Δ Labor productivity12-0.1862(3.46)
Δ REER60.0568(2.81)0.1190(4.31)
Δ REER10-0.1211(3.95)
Δ REER120.0398(2.23)
Δ Import prices50.0993(3.19)
Δ Import prices6-0.1228(3.92)
Δ Foreign export prices110.0260(2.26)
Δ2 Raw mat. import prices10.0206(2.70)
Δ HWWA index50.0429(2.67)-0.0180(1.99)
Δ M140.1256(4.11)
Δ M150.1589(5.15)
Velocity gap (v* - v)10.1085(2.75)
Δ Bank lending rate20.5547(2.63)
Δ Bank lending rate120.9530(4.18)
Δ MCI60.3050(2.15)-0.1476(2.29)
Δ MCI10-0.2178(2.74)
EI3-0.3029(2.52)
EI8-0.6357(4.32)
EM10.0842(1.50)
CIp1-0.4719(2.00)
CIw1-0.3662(2.11)
Estimation period76:4 - 94:478:2 - 94:478:1 - 94:4
N 3/736768
R20.90490.80850.4135
Correlation Actual-Fitted0.85390.89950.6415
Autoregressive errors test 4/0.5064[.77]0.5105[.77]1.6038[.18]
Normality test1.6861[.43]5.0197[.08]0.6652[.72]
ARCH test0.5074[.73]0.1170[.98]0.7631[.55]
Source: Staff calculations.

Δ2(CPI) for the wage-inflation model.

Δ(GDP deflator) for the P* model.

N is the number of observations.

Test statistics are reported with p-values in brackets.

Source: Staff calculations.

Δ2(CPI) for the wage-inflation model.

Δ(GDP deflator) for the P* model.

N is the number of observations.

Test statistics are reported with p-values in brackets.

CHART 21FINLAND DYNAMIC SIMULATION OF INFLAYION, 1982–94 1/

(In percent)

Sources: Bank of Finland; and staff calculations.

1/ Series are on an annualized basis.

CHART 22FINLAND DYNAMIC INFLATION FORECASTS, 1992–94 1/

(In percent)

Sources: Bank of Finland; and staff calculations.

1/ Series are on an annualized basis. Shadowed area marks range of double standard error.

Among the three models, the P* equation gives the least satisfactory results. Judging from the diagnostic statistics, the fit of the regression is relatively good, but some coefficients have a sign that is hard to interpret from an economic point of view. First, the output gap enters with a negative sign, implying lower inflation in boom times. Second, the real effective exchange rate (REER) enters positively, apparently leading to higher inflation if the exchange rate appreciates; and third, the MCI and the bank lending rate also have positive signs, thereby indicating that tighter monetary policy would lead to higher inflation rates. On the other hand, the velocity gap and changes in M1 turn out to have the expected signs, whereas increases in labor productivity appear to have an upward impact in the long run.

In contrast, the equation for GDP deflator inflation derived from the VAR model appears to be somewhat more in line with economic expectations. As for the P* model, the overall fit is relatively good and all diagnostic statistics indicate a well-specified regression. The coefficients represent the same error correction mechanism that was already found for the basic model. As for the other variables, the import price coefficients, if taken together, have a positive sign and imply an import price pass-through that takes about 5-6 quarters. Changes in the bank lending rate turn out strongly positive, possibly indicating rising cost pressure on enterprises. On the other hand, however, the coefficients of both GDP growth and REER changes are similar to the P* model, implying a behavior of the GDP deflator that is hard to reconcile with economic theory.

Finally, the CPI inflation equation derived from the wage-inflation model is mostly in line with economic theory. Again, the error correction mechanism from the basic model still holds, and both ECM terms are strongly significant. Foreign export prices appear to pass through with a lag of 11 quarters, whereas changes in raw material prices seem to translate into increases of the inflation rate more quickly.

The fit of this model has greatly improved for the years after 1990, following large differences between actual and simulated inflation for most observations of the 1980’s. This may indicate that the CPI relation has changed during the last years. In the dynamic forecast, there is an overestimation of inflation increases during 1993, but the strong movements in 1994 are again well covered.

The GDP deflator and CPI inflation series appear to exhibit significantly different short-term behavior, as evidenced by the strong but opposite influence of major indicators. In particular, the GDP deflator models pose problems as the signs of a number of coefficients in the preferred equations are hard to explain with economic theory. However, a number of factors lead to the conclusion that the distinctive behavior of both equations should be relatively easy to explain by the different nature of the GDP deflator and the CPI. First, the basic models yield economically sound relationships; second, the significance of the indicators is about the same in all of the preferred equations; and third, the forecasts in general yield satisfactory results. For example, since export prices are part of the GDP deflator, a depreciation of the currency could first lead to a fall in the deflator before import price increases feed through the economy.

c. Inflation forecasts for 1995-96

This section discusses GDP deflator and CPI inflation forecasts based on the VAR model and the wage-inflation model, respectively. As for the within-sample forecast, the projections have been obtained dynamically, by assuming a future path for each of the exogenous variables involved, and then calculating the endogenous variables step-by-step, using the results as lagged values in subsequent steps. For comparison, forecasts were computed using both the basic and preferred equations.

The results should be interpreted with care, as they obviously suffer from a number of potential biases. The forecasts are computed for a period before which significant changes in the Finnish financial sector took place, with tests indicating a structural break at the end of the estimation period; they include, for reasons of data availability, variables that are no longer of central importance in the Finnish economy. Further, it remains to be shown that they perform better than forecasts derived from a multi-equation system that takes explicitly account of simultaneity.

The assumptions for the exogenous variables are detailed in Table 34. Under an unchanged exchange rate, both in nominal and real terms, import prices are assumed to grow by 2.5 percent, following inflation rates in the major industrial countries. Real GDP is assumed to grow by 5 percent and 4.5 percent in 1995 and 1996, respectively. Monetary conditions are assumed to tighten modestly in 1995. Since the NEER remains unchanged, the resulting growth of the MCI solely reflects an assumed increase in the bank lending rate by 1.3 percentage points during 1995. One should note, however, that owing to the lag structure of the models, the assumptions made for most of the indicators have no impact on the inflation rate before late 1996.

Table 34.Finland: Inflation Forecast: Assumptions and Results
Money Demand ModelWage-Inflation Model
1995199619951996
(Annual change in percent)
Assumptions
Real GDP5.04.5
Labor productivity2.3
Social Security Contributions 1/----
Vacancy Rate 1/0.40.2
REER6.0
Import Price Index1.21.21.2
Raw materials import prices 2/----
HWWA import price index1.21.2
M37.06.5
Market yield on debentures-1.01.2
Monetary Conditions Index1.3
Results
GDP deflator (basic model)0.11.6
GDP deflator (pref. model)7.32.3
Wages (basic model)4.65.5
Wages (pref. model)5.47.5
CPI (basic model)2.43.8
CPI (pref. model)4.64.7
Source: Staff calculations.

Change in percent of GDP or labor force, respectively.

Change of second order, in percent.

Source: Staff calculations.

Change in percent of GDP or labor force, respectively.

Change of second order, in percent.

The forecasts are depicted in Chart 23. The preferred equations imply a relatively strong buildup of inflation already in mid-1995. In contrast, the basic equation from the VAR model does not predict any significant inflation in 1995, and the wage-inflation model predicts a steady increase in inflation, amounting to 2.4 percent and 3.8 percent in 1995 and 1996, respectively. As shown in the tabulation below, the inflation increases implied by the preferred equations originate mainly from the bank lending rate and the MCI. Owing to the long lag structure, both variables still transmit effects of the markka depreciation in late 1992.

CHART 23FINLAND INFLATION FORECASTS, 1994–96 1/

(In percent)

Sources: Bank of Finland; and staff calculations.

1/ Series are on an annualized basis.

Contribution to Price Increases 1995-96
VAR modelWage-inflation model
BasicPref.BasicPref.
(In percent of total price increase)
Lagged inflation59.676.918.112.3
Error correction terms40.4-0.134.4-88.3
GDP growth35.5
REER-129.5
Import prices-24.947.0-34.0
Bank lending rate142.0
Monetary Conditions Index209.9
Total100.0100.0100.0100.0

The strong increase in inflation projected by the preferred equations is a straightforward consequence of the result that the monetary transmission process has been found to operate with lags of up to 12 quarters. Nevertheless, taking into account the conceptional difficulties by which this forecast is burdened, it must be doubted that this outlook gives a fully realistic picture, particularly when looking at the projected decline of inflation towards end-1996. On the contrary, it is likely that, as a consequence of over-capacity in the domestic sector, monetary shocks are currently transmitted less strongly through the economy than during normal times. If depressed demand conditions in the wake of high unemployment prevent a strong pass-through of the devaluation, both preferred models probably over-predict the inflation path to some extent. Moreover, the effects of the 1996 fiscal package that will also curb demand growth have not been explicitly incorporated in the models.

The outcome of the wage-inflation model can nevertheless be used to assess the potential for future CPI inflation. First, the inflation path predicted by the basic model sets a lower boundary, being mainly the result of increasing wages, following a growing number of vacancies. Second, monetary conditions remained expansionary during the complete first half of 1994, before an appreciating markka and a monetary tightening by the Bank of Finland led to an increase in the MCI. Therefore, taking into account that the MCI acts with a lag of some 6 and 10 quarters, it can be expected that pressures from the demand side will persist at least until end-1996, adding to the effect of import prices and wages. Consequently, a realistic assessment of the results could lead to the conclusion that inflation would increase more slowly than forecasted by the preferred model, stay closer to the basic model, but continue to grow to reach an annualized rate of some 4 percent at the end of 1996.

4. Conclusions

This appendix has identified a number of indicators that help to predict Finnish inflation. The most successful indicators are the nominal effective exchange rate (NEER) and the monetary conditions index (MCI). They are followed by a range of import-related indices, such as the import price index and the foreign export price index. Interest rates have been found less important on their own (only the bank lending rate appears in the VAR model), but they are related to the MCI. The results are based on a comprehensive set of forecasting tests under different economic assumptions.

The models have also produced further insight into the nature of the inflation process. On the one hand, real conditions appear to affect the price level rather quickly. Although the output gap and capacity measures are rarely significant in the models, wages react strongly to vacancies; and since the adjustment process in the estimated wage-inflation model is relatively strong, prices also appear to move closely in line with wages. On the other hand, the full pass-through of exchange-rate and monetary policy changes appears to last 6-12 quarters. The MCI is consistently found to be most effective with a lag of 6 and 10 quarters, and the NEER acts with a lag of 4-12 quarters. The effect of import price changes is less clearly determined, but it appears that changes in foreign export prices are not immediately fed through to import prices.

The results appear to be robust against changes in the underlying economic assumptions. By applying different ranking criteria, based on predicted values for both the immediate past and over the full sample period, the study has tried to address the problem of structural breaks in the data. This problem is particularly relevant for the Finnish economy; in particular, the liberalization of financial markets in the mid-1980s and its consequences pose considerable econometric difficulties. Again, however, it turns out that the strongest indicators are not affected by the choice of the ranking method.

Among the three models used, it appears that the approaches that model the inflation rate in changes rather than in levels have led to a superior outcome. Strikingly, however, the VAR and wage-inflation models (that analyze GDP deflator and CPI, respectively) exhibit significantly different short-term behavior as evidenced by opposite signs of several coefficients. Although this seems to be caused by the inclusion of export prices in the GDP deflator, further analysis is needed to explore why strong indicators, such as the MCI, appear with opposite signs in the preferred equations without affecting the overall quality of the forecasts.

The results of this appendix should be extended by subsequent work. In particular, it would be interesting to further investigate: (1) indicators that have not been included here, e.g., stumpage prices; 1/ (2) similar regressions based on monthly data; and (3) models that deal more explicitly with the consequences of structural breaks that may have affected the Finnish economy.

Annex: Estimation of Three Basic Models

a. The P* model

Following Hallman et al. (1991), the equilibrium price level p* is defined as the price level consistent with the current money stock and equilibrium in an economy’s goods and financial markets: 1/

with m3 denoting money supply, v* trend M3 velocity and y* capacity output. Subtracting the quantity equation, and assuming that the inflation rate depends on the deviation from its equilibrium level (the price gap) and previous inflation, one can write

where further lags of velocity and output gaps can also be included. Both output and velocity gaps have been obtained using a Hodrick-Prescott filter to calculate the trend values. The following specification yielded the best fit, resulting in the first of the three basic inflation equations of this section: 2/

Both velocity and output gaps have the correct signs, with inflationary pressure resulting from output exceeding potential and velocity falling beneath trend velocity.

b. The VAR model

Contrary to the P* approach, the following model will take account of the different statistical properties of the variables. In particular, the basic inflation equation has to be formulated in the second difference of the GDP deflator. Assuming that M3 velocity is positively dependent on interest rates, one obtains the following co-integration relationship:

where MYD is the market yield on government debentures and CIm a stationary residual. 1/

The VAR model was found to match the data best with only one lag. As could therefore be expected, the error-correction model (ECM) with the best fit turned out to be driven mainly by the lagged co-integration residual (the “error-correction term”). The only additional term besides the constant is a dummy variable (d88:4) that accounts for a large increase in money supply due to the anticipation of a capital gains tax tightening in early 1989. The estimation results were as follows:

with EY, EM, and EI denoting stationary residuals.

In order to arrive at a basic equation, the model contained in (5) had to be incorporated in a model for the second difference of the price level (Δ2p). To that end, (m3-p) is interpreted as a residual of the co-integration relationship between m3 and p. 2/ Consequently, Δ2p is related to Δ(m3-p) and Δ2m3 in an error-correction relationship. This relationship is augmented by remaining VAR variables (Δy, ΔMYD) and the residuals EY, EM, and EI so as to take account of the ECM estimated in (5). The final equation turned out to be:

As it turns out, growth in real money demand in excess of its equilibrium level tends to increase inflation with a one-quarter lag, whereas interest rate increases above equilibrium tend to lower inflation with a lag of between 3 to 8 quarters.

c. The wage inflation model

The last of the basic models formulates an equation for the growth rate of CPI inflation. Following Ford and Krueger (1995), it is assumed that the CPI is related directly to import prices and nominal wages. In turn, import prices and wages are dependent on a number of factors, including the exchange rate, domestic demand conditions, and the price level itself. Applied to Finland, three separate co-integration relationships emerge:

Import prices:

Real wage:

Mark-up:

where pim and w represent import prices and wages, pfx and poil are foreign export and oil import prices, VCR and SOC are the vacancy rate and social security contribution of employers (covering excess labor demand and non-wage labor costs), and CIim, CIw and CIp are stationary residuals.

Similarly to the VAR model, the basic equation has to be modeled in second differences, i.e. for Δ2p. This is done by formulating an ECM for the mark-up equation and adding the co-integration residuals CIim and CIw from (7) and (8), thereby incorporating deviations from the import price and wage equations equilibria. Again, insignificant lags and variables have been deleted to yield the following relation:

It follows that import price increases as well as deviations from equilibrium distortions have an immediate impact on inflation. Whereas the coefficient of CIp has the correct sign, one would expect that excessive real wage increases (indicated by a positive value for CIw) would push inflation upwards. On the other hand, CIp and CIw both contain prices and wages and, owing to the larger size of the CIp coefficient, their combined effect appears to be in the right direction.

References

    ChongY.Y. and D.F.Hendry (1986) “Econometric Evaluation of Linear Macro-Economic ModelsReview of Economic Studies5367190.

    DuguayP. (1994) “Empirical Evidence on the Strength of the Monetary Transmission Mechanism in CanadaJournal of Monetary Economics333961.

    FordR. and T.Krueger (1994) Exchange Rate Movements and Inflation Performance: The Case of ItalyInternational Monetary Fund Working Paper 95/41.

    FreedmanC. (1994a) “Formal Targets for Inflation Reduction: The Canadian Experience” in: J.A.H.de Beaufort Wijnholdset al. (eds.)A Framework for Monetary StabilityPapers and proceedings of an international conference organized by De Nederlandsche Bank and the CentER for Economic Research at AmsterdamOctober1993. Dordrecht: Kluwer.

    FreedmanC. (1994b) “The Use of Indicators and of the Monetary Conditions Index in Canada” in: T.J.TBaliũo and C.Cottarelli (eds.) Frameworks for Monetary StabilityInternational Monetary Fund.

    FriedmanB.M. (1990) “Targets and Instruments of Monetary Policy” in: B.M.Friedman and F.H.HahnHandbook of Monetary Economics IIAmsterdam: North-Holland.

    FriedmanB.M. (1993) “Intermediate Targets versus Information Variables as Operating Guides for Monetary Policy” in:J.A.H.de BeaufortWijnholdset al. (eds.) (1994) A Framework for Monetary StabilityPapers and proceedings of an international conference organized by De Nederlandsche Bank and the CentER for Economic Research at AmsterdamOctober1993. Dordrecht: Kluwer.

    GriffithsM.E.L. (1994) “Monetary Policy and Inflation in Finland” in:International Monetary FundFinland--Selected Background Issues and Statistical Appendix SM/94/219.

    HallmanJ.J.R.D.Porter and D.H.Small (1989) “M2 Per Unit of Potential GNP as an Anchor for the Price Level” Board of Governors of the Federal Reserve System Staff Study157.

    HallmanJ.J.R.D.Porter and D.H.Small (1991) “Is The Price Level Tied to the M2 Aggregate in the Long Run?American Economic Review81841858.

    McCallumB.T. (1990) “Targets Indicators and Instruments of Monetary Policy” in: W.S.Haraf and P.Cagan (eds.) Monetary Policy for a Changing Financial EnvironmentWashington, D.C.: AEI Press.

    Perron (1988) “Trends and Random Walks in Macroeconomic Time Series: Further Evidence From a New ApproachJournal of Economic Dynamics and Control12297332.

    PikkarainenP. (1993) “Intermediate Targets, Indicators and Stance of Monetary PolicyFinnish Economic Journal8952845.

    PikkarainenP. and A.Ripatti (1995) “The Role of Monetary Indicators in the Design of Monetary Policy” Bank of Finland Bulletin 67 (August) forthcoming.

    RipattiA. (1994) Econometric Modelling of the Demand for Money in FinlandHelsinki: Bank of Finland (D:79).

    RipattiA. (1995) Leading Indicators of Inflation in Finland: Pairwise Analysis of Causality and CointegrationBank of Finlandmimeo.

    SpolanderM. (1994) “The Role of Asset Prices in the Inflation Process in FinlandBank of FinlandBulletin66 (August) 914.

APPENDIX II Structural Causes of Unemployment--Issues and Policy

1. Introduction and summary

Structural factors, in addition to severe macroeconomic shocks, played an important role in the rise of Finnish unemployment to about 20 percent between 1990 and 1993. There is widespread agreement that labor markets could have reacted more flexibly to the recession. As a result, the Government and labor market partners are currently attempting to modify the institutional framework to facilitate more rapid adjustments in labor supply and demand.

Against this background, this appendix describes the ongoing discussion of Finnish labor market policy, focussing on structural issues. In Section 2, the mismatch between labor market supply and demand is illustrated by contrasting the sectoral differences in output growth with skill-related labor shortages and rising long-term unemployment. Section 3 describes four structural issues relevant for Finnish unemployment: (1) collective bargaining and wage inflexibility; (2) the nature of employment contracts; (3) labor taxation; and (4) unemployment benefits. Where available, the results of empirical studies are used to assess the impact of the respective issues on wage formation and unemployment. Section 4 describes the policy reaction of the Government as well as the strategies pursued by trade unions and employer associations. A set of policy recommendations by the Presidential Working Group on Employment (PWGE) is also presented.

The discussion of future policy measures has led to a number of concrete proposals. The current state of the discussion can be summarized in the following points.

  • By international standards, Finland’s unemployment benefits are generous and labor taxation is high. It is widely accepted that in order to return to a labor market equilibrium, the benefit system should be modified in order to encourage job search and allow a reduction of unemployment insurance contributions. This would entail not only a reduction in the level and duration of benefits, but also a reform in the financing of the system.

  • With sectoral wage dispersion low and wage drift high in Finland, opinions differ as to what degree of centralization in wage bargaining would be appropriate. However, the results of past wage rounds suggest that, as long as branch unions retain their key role in the negotiation process, the outcome is unlikely to be much affected by the choice of the bargaining framework. Greater flexibility in the wage structure could be achieved through a shift in wage negotiations from the branch level to individual firms. The 1993 wage round pointed in this direction by allowing greater room for individual pay rises.

  • A more effective active labor market policy has been demanded from several sides, including the labor market partners. In response to criticism, the employment subsidy scheme has already been modified, resulting in a greater focus on human capital formation. Given the current skill shortages in the economy, suggestions have been made for enhancing the efficiency of the public employment services through additional private efforts, such as job rotation schemes and closer cooperation of labor exchanges and enterprises.

  • The need for more flexible employment relationships is widely accepted. However, with unions aiming mainly at increasing employment, and employers targeting a reduction in unit labor costs, the nature of the needed reforms is still under discussion. The suggestions of the PWGE may provide a basis for a future compromise.

2. Demand and supply on the Finnish labor market 1/

The 1991-93 recession led to a steep rise in unemployment and caused a significant change in the structure of the labor market. The unemployment rate, which at 3.4 percent in 1990 was one of the lowest in the OECD, rose sixfold within four years to peak in January 1994 at 20.6 percent (nearly 500,000 persons). However, the ensuing surplus of labor supply did not lead to a noticeable decline in vacancies, even after the recovery began in 1994. This increasing mismatch between labor supply and demand is illustrated by an outward shift of the Beveridge curve (Chart 24). The nature of this structural change is threefold: (1) demand for labor relative to supply differs strongly across sectors; (2) demand has shifted toward high-skilled labor; and (3) effective labor supply has been reduced by high long-term and youth unemployment.

CHART 24FINLAND The Beveridge Curve: Unemployment and Vacancies, 1970-94

(In percent of labor force)

Source: Finnish Labor Review, 4/94, Ministry of Labor.

Labor demand across sectors reacted differently to the recession, picking up first in the export-related sectors. For example, the employment situation in the manufacturing sector has been improving since mid-1994 (Chart 25). 2/ In the other, mainly domestically oriented sectors, the downturn came to a halt as late as in early 1995. Sectoral unemployment rates therefore continue to differ widely, reaching as high as 35 percent for construction workers.

CHART 25FINLAND EMPLOYED PERSONS BY INDUSTRY, 1993–95

(Annual change in thousands of persons)

Source: Central Statistical Office.

Labor demand has also become strongly tilted toward skilled labor. Shortages of high-skilled labor occurred early in the recovery; e.g., specialists in shipbuilding or mobile telephone production were strongly sought after. Subsequently, skill shortages became an even more widespread problem, as evidenced by a recent Ministry of Labor survey--among the workplaces that experienced recruitment difficulties in 1994, lacking special vocational qualifications were cited as a reason in 40 percent of all cases. Partly as a consequence of these skill requirements, mobility between sectors continues to be relatively low.

Skill shortages have been compounded by the sharp increase of long-term and youth unemployment. The share of the long-term unemployed (those with a spell of one year or more) rose from below 3 percent in 1991 to 31 percent in April 1995, while the youth unemployment rate increased from 6.7 percent in 1990 to 33 percent in 1994. 1/ Although long-term unemployment appears to have reached its peak in January 1995, its share in total unemployment is likely to decline only slowly as individuals with shorter unemployment duration have higher re-employment probabilities. In the case of the long-term unemployed, effective labor supply is reduced as skills and motivation deteriorate with increasing duration of unemployment. Similarly, youth unemployment poses problems because important job-specific skills are not acquired by the unemployed. Young unemployed are also most likely to acquire a labor market “stigma” that deters potential employers.

3. Structural rigidities in the Finnish labor market

The outward shift in the Beveridge curve indicates that the labor market has become less efficient because, ceteris paribus, a larger surplus of labor has not led to a reduction in unfilled vacancies. Although this increased mismatch may be a transient phenomenon, caused by a gradual adjustment of labor supply to demand, it could also indicate that the structure of the labor market itself has changed. In this regard, a number of institutional features might preclude a fast return to lower unemployment. First, the collective bargaining system has been criticized for not delivering sufficient wage dispersion. Second, restrictions on the formulation of employment relationships are believed to adversely affect both labor demand and supply. Third, Finnish labor taxation has been criticized for being among the highest in the OECD. Fourth, generous unemployment benefits are thought to create disincentives to work, thereby reducing effective labor supply and driving up wages.

a. Collective bargaining and wage flexibility

While the framework for Finnish wage negotiations has traditionally been centralized, a move toward more decentralized branch level bargaining was made in 1993. However, already in the 1994 wage round, the objective of greater wage flexibility was achieved at a cost to overall wage moderation, leading to a renewed discussion of the appropriate degree of centralization. Empirical studies have so far produced inconclusive evidence regarding this issue. There are indications, however, that under centralized bargaining the labor market was subject to insider-outsider agreements that resulted in wages high enough to keep a substantial number of workers unemployed.

Before 1993, wage bargaining in Finland was conducted on three levels. The central institutions--the Confederation of Finnish Industry and Employers (TT) and the Confederation of Finnish Trade Unions (SAK)--would typically negotiate an agreement that served as a guideline for subsequent and more specific agreements between branch unions and employer associations. Agreements reached at the branch level, in turn, set guidelines for individual firms. In the few instances where no central agreement was reached, branch organizations had to work out separate deals. However, if a central agreement was reached, it was rarely the case that it was accepted by all branch organizations. In most cases, a number of unions or associations opted out and negotiated separate agreements.

This bargaining framework had two direct consequences. First, since Finland has a high degree of unionization and employer organization 1/, the wage agreements covered the vast majority of the labor force (Chart 26). The settlements were usually extended to the rest of the economy, with the wage partners effectively agreeing upon a general minimum wage. Second, the centralized agreements did not always produce wage increases high enough for expanding sectors. The bargaining system therefore contributed to a relatively sizeable wage drift as firms attracted labor by individually offering higher wages. 2/ In particular, wages in the export sector were often topped following positive terms of trade shocks.

CHART 26FINLAND DEGREE OF UNIONIZATION AND THE COVERAGE OF COLLECTIVE AGREEMENTS, 1990

(In percent)

Source: Parmanne (1995).

1/ Employed union members as a fraction of all wage earners.

2/ Wage earners covered by collective agreements as a fraction of all wage earners.

In an effort to counter the effects of wage drift on the earnings structure, the centralized agreements contained clauses that tried to ensure similar wage increases across sectors (Table 35). Besides general tax reductions promised by the Government, instruments used in the settlements included index clauses that guaranteed minimum real wage increases, and so-called earnings-development guarantees. The latter stipulated that, if in a particular industry the relative earnings increase would be lower than an agreed percentage, its workers would subsequently be eligible for a compensating rise in wages.

Table 35.Finland: Centralized Wage Agreements for Manufacturing Workers, 1980–95
Name of the AgreementPeriodAverage Increase

(Industrial Workers)
Changes Associated with

Comprehensive Settlement
1. Union level agreement1.3.80-28.2.8111.3 percent
2. Pekkanen I agreement1.3.81-28.2.83
First phase7.0 percent-revised conditions of eligibility for sick and maternity pay
Second phase8.4 percent
3. Union level agreement1.3.83-28.2.845.6 percent
4. Pekkanen II agreement1.3.85-28.2.854.0 percent-100 percent compensation above expected inflation

- revised unemployment benefits
1.3.85-28.2.863.8 percent-working time reduced
5. SAK/STK1.3.86-28.2.872.8 percent- 100 percent compensation above expected inflation

- earnings development guarantee

- working time reduced
1.3.87-29.2.883.4 percent- state support, tax cuts
6. Union level agreement1.3.88-1.3.905.3 percent
7. Combined economic and incomes policy statement1.3.89-28.2.903.6 percent- wage earners’ income increased 2.5 percent, indexation clause

-earnings-development guarantee over agreed increase, general and equity raise; tax revision
8. Kallio agreement
First phase1990-19915.4 percent- goal for growth in wage earners’ real disposable incomes, 4.5 percent

- earnings development guarantee, 4 percent over agreed increase

-indexation clause, tax measures

- working time questions, social policy measures
Second phase1991-19921.7 percent
9. Ihalainen-Kahri agreement
First phase1992-19930.2 percent- indexation clause

-wage earner contributions for unemployment benefits

- government measures, including unemployment benefits
Second phase1993-19940.6 percent
10. Union level agreement1994-19952.5 percent
11. Union level agreement1995-1996/975.0 percent
Sources: Central Organization of Finnish Trade Unions (SAK), and Eriksson et al. (1990).
Sources: Central Organization of Finnish Trade Unions (SAK), and Eriksson et al. (1990).

This bargaining framework attracted increasing criticism as it appeared unable to deliver sufficient wage flexibility to cope with rising unemployment. In the event, intersectoral wage dispersion in Finland has been relatively small compared to other OECD countries (Ötker [1994]), a consequence of the fiscal components and adjustment clauses contained in the wage settlements. On the other hand, supporters of the framework have pointed out that the dispersion has been increasing since the mid-1980s, mainly as a result of sectoral wage drift. The centralized bargaining approach was also praised for generating wage moderation during recessions, in particular during 1992-1993. 1/ Nevertheless, the need for greater wage flexibility became acute when the unemployment rate approached 18 percent in mid-1993 and, reflecting the uneven recovery, productivity growth differed strongly across sectors. Whereas the export sector would have felt overly constrained by a central agreement, even modest wage increases seemed inappropriate for certain domestic sectors. Consequently, the employers were not prepared to negotiate a central agreement in autumn 1993 and called for branch-specific settlements.

CHART 27FINLAND NEGOTIATED WAGES AND WAGE DRIFT, 1980–94

(Percentage change from previous year)

Source: Central Statistical Office.

As it turned out, the ensuing branch level agreements in 1993-94 contributed to a small increase in earnings differentials but led to relatively strong overall wage growth compared to previous years. At first, the 1993 negotiations, decentralized from the beginning, produced a fairly moderate outcome. Wage increases ranged from nil in the service and public sectors to around two percent in the booming exporting sectors. As a result, wage and salary differentials increased somewhat across industries; e.g., in the construction sector, earnings fell back to their 1990 level (Table 36). However, having agreed to low wage increases for three subsequent years, trade unions in the domestic sectors faced considerable pressure in the run-up to the autumn 1994 wage round. This led to significantly higher wage increases for 1995, ranging from 2.6 percent to 5.5 percent. The highest wage awards were in the paper and pulp industry, and the lowest in the public sector. The increases have created relatively strong cost pressures in 1995 (Table 37), prompting calls for a return to centralized bargaining.

Table 36.Finland: Wage and Salary Earnings by Industry, 1990-94
19901991199219931994
(1990 = 100)
Agriculture100.0105.9108.5106.9107.4
Forestry100.0107.0109.7113.3118.2
Mining and quarrying100.0106.3109.3109.3114.4
Manufacturing100.0106.1108.3110.0114.6
Building construction100.0104.7103.5101.2100.0
Trade100.0107.5110.3109.9110.5
Hotels and restaurants100.0105.0107.9108.2108.6
Finance100.0110.2112.7113.1116.9
Insurance100.0103.9105.9107.3107.8
Social welfare services100.0107.6111.0112.8113.9
Central government100.0105.4107.1107.1108.5
Local government100.0107.0110.0111.7112.6
Private100.0106.4108.1108.8110.9
Total100.0106.4108.4109.2111.0
Source: Central Statistical Office, Bulletin of Statistics, 1995: I.
Source: Central Statistical Office, Bulletin of Statistics, 1995: I.
Table 37.Finland: Estimated Increase of Labor Costs of Industrial Workers, 1990-95(In percent)
EstimateProjection
199019911992199319941995
Carry-over effect of previous years3.04.11.80.51.11.0
Contractual increases3.61.10.10.11.85.0
Wage drift3.31.60.71.21.01.5
Other1.3--0.7------
Nominal wages (per working hour)11.26.83.31.83.87.5
Social security charge-0.3-1.5-0.40.90.50.1
Change of employment pension insurance premium1.6---2.00.90.10.8
Unemployment insurance premium-0.20.71.81.7---0.7
Other insurance premia---0.1--0.20.1--
Total labor cost (per working hour)12.35.92.75.54.57.7
Source: Confederation of Finnish Industry and Employers.
Source: Confederation of Finnish Industry and Employers.

Empirical evidence. The effect of the pre-1993 bargaining framework for wage formation and unemployment has been analyzed in a number of empirical studies (Box 1). They suggest that both absolute and relative wage flexibility were lower in Finland than in other countries, and that the wage outcome did not depend on the level of centralization. Unemployment appeared to be associated with an insider-outsider problem, as indicated by the finding of hysteresis working through the wage setting mechanism. This coincided with wages being more responsive to unemployment among unionized workers than to general unemployment. Unemployment would be expected to fall slowly in such a case, except if positive shocks would hit the economy.

b. Flexibility of employment contracts

As in other industrial countries, nonstandard employment relationships are becoming increasingly common in Finland, mainly as a consequence of more capital-intensive production and increased job creation in the service sector. To reduce costs, employers call for fewer restrictions in the use of labor, and unions promote flexible options to increase overall employment. Alternatives discussed range from fixed-term contracts (limited to months or weeks of employment) to part-time work and flexible working hours. At the same time, firing restrictions, though protecting individual workers, are criticized for adversely affecting overall employment.

Box 1.Effects of the Negotiation Framework--Empirical Results

  • Most authors agree that the centralized bargaining framework delivered sufficient real wage flexibility to cope with output fluctuations in the early 1980s, and was not a cause for the 1991-93 recession (e.g., Currie [1993]). The reaction of wages to general unemployment, however, has been weaker than in other Nordic countries. However, wages react relatively strongly to unemployment among union members (Eriksson et al. [1990]). Finland seems to be the only Nordic country to exhibit hysteresis effects through the wage formation process (Calmfors and Nymoen [1990]).

  • Before 1990, the bargaining framework appeared to have only a negligible influence on the wage outcome (Eriksson et al. [1990]). Although decentralized negotiations produced above average outcomes, the difference was found to be statistically insignificant. One explanation is that before 1993, branch negotiations merely continued from where central negotiations ended, thus closely replicating a centralized settlement. Wage increases in decentralized rounds did not differ much across industries.

  • During the period 1970-85, relative sectoral wage fluctuations in Finland have been comparable to those in the U.K. and the U.S., and large compared to Sweden (Pissarides and Moghadam [1990]). However, despite these fluctuations, relative sectoral wages seemed to have reacted more to aggregate cyclical influences than to relative sectoral economic performance.

  • Concerning the impact of the wage drift, contradicting results have been obtained. Eriksson et al. (1990) found that future wage drift was being anticipated by wage agreements and thus had no independent role. On the other hand, Flanagan (1990) came to the conclusion that negotiated wages compensated only partially for wage drift, leaving a substantial degree of wage determination to the market. However, Finland was different from other Nordic countries where wage drift and negotiated wage increases were generally not related.

  • The earnings structure across different skills and employment categories in the Finnish industry has remained largely constant during the recession. Returns to education have declined since the early 1980s, in particular for nonmanual workers (Asplund [1994]).

  • The possibilities for concluding fixed-term employment contracts in Finland are limited and have to be justified by the temporary nature of the work or training. By 1991, the share of fixed-term contracts had risen slowly to reach some 13 percent of all employment contracts. This increase was associated with labor-market programs and institutional arrangements, such as child-care or study leave, that have encouraged the recruitment of temporary personnel.

  • There are few legal obstacles to part-time work in Finland. However, full-time employment has remained the norm even during the recession, and Finland therefore has a relatively small share of part-time workers (8.5 percent in 1994) compared to the OECD average (16.2 percent in 1991). Employers have encouraged part-time work only in times of general labor shortages, mostly to attract women into the labor force. Despite increased coverage by social and employment security provisions, part-time jobs have been associated with low pay, low job qualifications, and lack of opportunities for promotion (Lilja et al. [1990]).

  • With capital-intensive production processes in a number of industries, and shortages of skilled labor in the export sector, rigid working hours seem to create an obstacle for the enlargement of production and expansion of employment (PWGE [1994]). Although overtime work is allowed for up to 320 hours per year--which is rather high by international standards--regular daily and weekly working time has so far been restricted to 8 and 40 hours, respectively. Regular work is also not allowed over the weekends and public holidays. In recent years, there have been attempts to introduce greater flexibility, for example, during the 1993 wage negotiations, the metal industry switched to a new system of averaging hours over a one-year period.

  • Despite some tightening during the 1980s, regulations for employment termination have not been regarded as overly protective by Finnish employers, and were also not overly restrictive by international standards (Lilja et al. [1990]). However, during the past recession, the regulations may have provided some undue obstacles to labor force adjustments (PWGE [1994]). Employers are required to give notice at least two months before dismissals take effect, and in case of a disagreement between employer and employees, a negotiating period of at least three months has to be observed. The employer must provide a valid reason for dismissal 1/; in addition, the separation can only take place if a worker cannot be trained or transferred to another job within the company. Severance payments, however, are not required.

c. Labor taxation

There is a high degree of consensus among the Finnish public that labor taxation should be reduced to increase employment. Wage-related taxes and social contributions are part of the so-called wedge, i.e., the difference between the real labor cost to the producer and the real take-home wage for workers. 1/ The available evidence suggests that, although the wedge feeds mostly into after-tax consumption wages, a sharp rise in the wedge was a major factor behind the surge of unemployment during the latest recession.

In Finland, the wedge has been continuously widening during the past two decades (Chart 28). The wedge grew particularly strongly in the early 1990s, prompted by increases in the income tax rate and social security contributions. The Finnish tax wedge is among the highest in the OECD, mostly because of the high level of personal income taxation, both in marginal and in average terms. As of 1992, higher marginal income tax rates existed only in Belgium, the Netherlands, and Denmark (Chart 29).

CHART 28FINLAND THE WEDGE AND ITS COMPONENTS, 1973–94 1/

Source: Bank of Finland.

1/ Private sector excluding agriculture and forestry.

2/ The wedge is the difference between real labor cost and real consumption wage.

3/ The price wedge is the difference between the consumer price index and the output price index. See text for details.

CHART 29FINLAND OECD INCOME TAX RATES, 1992 1/

(In percent)

Source: OECD (1994).

1/ Single persons at 133 percent of the earnings of an average production worker.

Empirical evidence. The short-run response of wages and unemployment to changes in the wedge has been investigated in a number of econometric studies. Both Eriksson et al. (1990) and Calmfors and Nymoen (1990) found that the wedge was shifted mostly into after-tax real consumption wages, leaving real product wages unaffected. This implies that a widening of the wedge would lower the consumption wage, and thus reduce labor supply. In the same vein, tax relief in exchange for wage moderation would not produce significant reductions in real labor costs. This is in contrast to other Nordic countries where reductions in payroll taxes have had at least a short-run effect on the product wage (Calmfors and Nymoen [1990]).

By looking at long-run effects, Tyrväinen (1995) also computed responses of real labor costs to changes in the components of the wedge, finding a constant elasticity of 0.5 for all tax-related changes in the wedge. This result implies higher nominal wage demands in the long-run in response to tax changes, a reaction that was not modeled by the studies discussed above. From an international point of view, however, Finnish labor costs still appear to react moderately, increasing more than in the U.S. but less than in, say, Germany (Table 38).

Table 38.Finland: The Long-Run Response of Real Labor Costs to Changes in Wedge Factors
Employers’ Social

Social Security

Contributions
Consumption Tax

as Part of the

Price Wedge
Income Tax 1/
Australia0.50.50.5
Canada0.80.80.8
Finland0.50.50.5
France0.40.40.4
Germany1.01.01.0
Italy0.40.40.4
Sweden--1.0--
United Kingdom0.250.250.25
United States------
Source: Tyrväinen (1995).

Marginal and average tax rates are assumed to move conjointly.

Source: Tyrväinen (1995).

Marginal and average tax rates are assumed to move conjointly.

During the 1980s, the effect of the wedge on unemployment seemed to be relatively small (Lilja et al. [1990]). Subsequently, however, the wedge was found to be a significant cause for rising unemployment in the 1990s (Tyrväinen [1995]). According to model simulations, changes in the wedge until 1992 have added 4 percentage points to the current unemployment rate. Hence, a reduction in taxation should have beneficial effects of a similar magnitude, albeit with a lag.

d. Unemployment benefits

The Finnish unemployment benefits system consists of three schemes that differ mainly in eligibility, duration of payments, and means-testing (Table 39). The system pays a basic daily amount (Fmk 116) to any person registering as unemployed, regardless of previous employment history or unemployment insurance membership. This so-called labor market support is paid until retirement; it is, however, means-tested for those who have not worked previously or whose eligibility under the other benefit schemes has elapsed. Persons who worked for 6 months or more during the two years preceding unemployment are eligible, without means-testing, for the full basic daily amount for a period of 500 days (unemployment allowance). Members of unemployment insurance funds receive an additional 42 percent of the difference between their previous daily wage and the basic daily amount as unemployment insurance benefits. 1/

Table 39.Finland: Unemployment Benefits Scheme, 1994
FeatureUnemployment

Allowance
Unemployment

Insurance Benefits
Labor Market

Support 1/
EligibilityEmployed for 26 weeks during the previous two years 2/- Employed for 26 weeks during the previous 2 years- No employment requirement
- Members of unemployment funds- Persons falling outside the other benefit scheme
- Unemployed persons of age 55-60
BenefitsBasic daily amount (= Fml 116)Basic daily amount + 42 percent of (daily wage (minus) basic amount)Basic daily amount (= Fmk 116)
Means-testingNo 3/NoYes 4/
Duration500 days 5/500 daysUp to age 65
Waiting period5 days entrants)5 days3 months (except job-seekers right after graduation)
TaxabilityYesYesNo
FinancingStateEmployees, employers: State unemployment fund membership feesState
Active measuresNoNoYes
Source: Ministry of Labor.

Took effect in 1994.

Employment requirement became effective in 1994.

Until 1994 means-testing was applicable.

Means-testing is not applied to participants in apprenticeship, training, job experiments or other manpower policy projects.

Until 1994, benefits were paid for an unlimited duration.

Source: Ministry of Labor.

Took effect in 1994.

Employment requirement became effective in 1994.

Until 1994 means-testing was applicable.

Means-testing is not applied to participants in apprenticeship, training, job experiments or other manpower policy projects.

Until 1994, benefits were paid for an unlimited duration.

These benefits are relatively generous by international standards. Although benefits paid during the first years of unemployment are lower than in many other countries, the payment of benefits for an indefinite period under the labor market support scheme raises relative payments in subsequent years. As a result, the average replacement ratio for Finland is one of the highest in the OECD, especially if after-tax ratios are compared (Table 40).

Table 40.Finland: Unemployment Benefit Replacement Rates, 1991
Overall Average
Duration

Categories
First Year 1/Second and

Third Year 1/
Fourth and

Fifth Year 1/
GrossNet of Gross
Belgium5252524357
Denmark7467435260
Finland5844303845
France5837283748
Germany4136362843
Netherlands7056485158
Norway6241143940
Sweden806--2930
United Kingdom3127271823
United States2610101114
Source: OECD (1994).

With dependent spouse.

Source: OECD (1994).

With dependent spouse.

Unemployment benefits have a number of adverse effects on the labor market. First, by cushioning the impact of joblessness, benefits reduce internal pressure on unions to achieve wage moderation and, at the same time, discouraged wage differentiation and intersectoral mobility (Asplund and Kettunen [1994]). Second, the high level of benefits puts additional strains on social security finances when unemployment soars, as it did in the early 1990s. 2/ Third, Kettunen (1993) found that unemployment benefits lead to reduced job search effort of individuals, increasing the duration of unemployment and leading to a decline in effective labor supply. The disincentive effects of benefits are evidenced most clearly by a rise in re-employment probabilities around the time when benefits drop, and by the longer average unemployment duration for recipients of higher benefits.

4. The policy response

The sharp rise in unemployment has been accompanied by an intensive discussion of possible remedies among policy makers and labor market partners. The Government has increased its active labor market policies substantially, mainly through training measures and subsidized employment. The trade unions have focussed on the formation of skills and a more equal distribution of work, while the employers favor increased wage and employment flexibility and a reduction in indirect labor costs. Finally, a working group appointed by the President in April 1994 has recommended a number of measures for reducing unemployment.

a. The Government’s labor market policy

The Government’s response to rising unemployment has had three main elements. First, the main task of active labor market policy has been to facilitate the shift in resources from domestic into traded-goods sectors through training and other human capital forming measures. Second, in order to prevent human capital losses of the young and the long-term unemployed, labor market measures have been increasingly directed at members of these groups. Third, passive labor market policy has been used to cushion the impact of unemployment by paying unemployment benefits or facilitating the transition into retirement. The costs of these policy measures, and the number of participants are contained in Table 41.

Table 41.Finland: Active and Passive Labor Market Policies, 1990-94
Program1990199119921993199419901991199219931994
(In millions of Finnish markaa)
Public ExpenditureNumber of New Participants
Public employment services and administration589718782824876
Labor market training1,2931,6572,2442,2932,41736,10051,80073,00070,00081,700
Youth measures2522722935496789,6009,60012,30038,80045,100
Introduction to work and recruitment subsidies2836822413242,5003,7006,60020,70028,900
Support of apprenticeship and related forms of general youth training2242362113083547,1005,9005,70018,10014,800
Subsidized employment2,3593,3984,4493,8243,96675,500103,400125,100122,900155,000
Subsidies to regular employment in the private sector2313297777617719,80016,20030,40033,20048,500
Support of unemployed persons starting enterprises64941632732902,3003,5005,20012,40011,600
Direct job creation (public or nonprofit)2,0642,9753,5092,7902,90563,40083,70089,45077,30094,900
Public works to promote employment4044804305115662,5002,2002,2002,4002,200
Temporary state jobs6701,1781,2711,0021,00119,10027,00027,40024,90028,100
Grant to municipalities for temporary work9901,3171,8081,2771,34841,80054,50059,85050,00064,600
Measures for the disabled68874783682575416,10016,60019,50018,50017,300
Vocational rehabilitation22324333737535915,00015,10018,30018,50017,300
Employment subsidies and sheltered work4655044994503951,1001,5001,200
Unemployment compensation3,3278,58916,41021,87823,352
Basic and wage related benefits3,0918,01915,36120,96621,296
Labor market support--------1,475
Redundancy payments68194476408236
Bankruptcy pay guarantee168376573504345
Early retirement for labor market reasons2,6302,4802,3262,3102,378
Total11,13817,86127,34032,48834,440
Source: Confederation of Finnish Trade Unions.
Source: Confederation of Finnish Trade Unions.

Active labor market policies can be broadly separated into two categories. First, labor market training prepares unemployed workers for new jobs, providing them either with updated skills in their previous occupation or training them in entirely new occupations. In order to encourage enrollment in training measures, participants are entitled to a (taxable) basic daily amount of Fmk 116, plus a tax-free subsistence allowance. Second, selective employment measures include subsidized employment, support in self-employment, and direct job creation. These measures comprise special schemes for the employment of disabled persons, the young and long-term unemployed, and entrants to the labor market.

The number of persons entering labor market training has increased rapidly since 1990. In 1994, about 80,000 people were enrolled in programs which on average provided 5 months of training. Of those, young and long-term unemployed amounted to some 15 and 20 percent, respectively. At the same time, however, the share of labor market training in active employment measures is relatively small by international standards, reflecting a greater policy emphasis on subsidized employment measures. Between 1990 and 1994, the average number of participants in subsidized employment programs more than doubled from 30,000 to 65,000. More than 50 percent of the participants were long-term unemployed, and the young unemployed had a share of some 25 percent.

Although it is difficult to estimate the success of labor market training, the Government’s active encouragement of occupational change is reflected in a slight increase in “training mobility” from 46 to 49 percent between 1991 and 1994. 1/ However, the number of persons placed in a job immediately after training only amounted to 36 percent of all participants, compared to some 80 percent in the late 1980s. Indeed, the overall impact of labor market training on unemployment may be small: first, the participants comprise only a small share of all unemployed; second, the duration of the training measures falls short of building the skills that are in high demand; and third, training is still mainly concentrated in services, clerical work, and retail business where unemployment has been relatively high (Table 42).

Table 42.Finland: Training Mobility by ISCO Codes, 1991-93(In percent)
ISCO199119921993199119921993
Share of Training Participants

Moving Out of Sector
Share of Training Participants

Moving Into Sector
0Technical, natural science, etc.665754282123
1Health care, social work425360757672
2Administrative and clerical work302425666765
3Retail business838379757168
4Forestry and agriculture236662154941
5Transportation and communications404344443238
62Construction352828442926
70–72Textile, clothing, etc.715480382251
73–75Metal work303133282932
76Electricity303934453734
77Carpentry255272313666
6–8Other industrial work595282505162
9Service work524953565355
XNot classified989493917781
Average training mobility45.847.349.445.847.349.4
Source: Ministry of Labor Statistics.
Source: Ministry of Labor Statistics.

According to a recent study, subsidized employment measures seem to have had some positive impact on employment (Eriksson [1994]). Although there was some flow back into unemployment after participation, the job creation scheme seemed to enhance flows out of unemployment. The subsidies, however, have been criticized for distorting competition among enterprises and creating dead-weight losses. After a review conducted in 1994-95, the scheme was streamlined and reduced in scope. This led to a reduction in the number of subsidy schemes, minimum unemployment requirements were abolished, and subsidies to enterprises were limited to human capital formation (skills development, training, and rehabilitation).

b. Proposals by the labor market partners

In the recent past, unions and employer associations have cooperated in a number of important areas. They have publicly endorsed the central bank’s inflation target, and they reached an important compromise on a pension reform that is expected to reduce pension expenditure by 2 percent of GDP over the long run. Moreover, in the 1993 wage negotiations, the two sides increased the range for company-based wage increases contained in the central agreement, thereby increasing intra-firm wage flexibility. In addition, some of the contracts were concluded for a period of two years, with a view to creating a more stable environment for investment decisions.

The structural reforms so far agreed upon by labor market partners and the Government have led to some relaxation in labor market regulations, and were mainly aimed at increasing the re-employment chances of groups particularly affected by unemployment. First, in order to encourage the hiring of the young unemployed, wages for this group were allowed to fall below negotiated levels. Second, restrictions for the use of fixed-term employment were eased for the long-term unemployed. Third, private job matching agencies were recently approved, breaking the monopoly of the Ministry of Labor’s employment service. Despite these agreements, however, unions and employers continue to focus on different issues in their strategies for unemployment reduction.

For the trade unions, the formation of skills and an active labor market policy of the Government are the most important issues for the near future. They stress that Finnish long-run growth should not be secured by a low-wage strategy and see the need for a highly skilled workforce motivated by appropriate compensation. Consequently, the focus has shifted to reducing unemployment through more efficient employment measures and by distributing working hours more evenly. Regarding structural issues, the main position of the unions can be summarized as follows:

  • Unions regard last year’s wage agreements as broadly appropriate, given high profitability and strong competitiveness in the traded goods sector. Moreover, wage differentials are also believed to be sufficiently large as a result of the recent absolute wage losses in some sectors. Further decentralization of wage bargaining is being resisted because of equity considerations.

  • The taxation of wages, especially for the lower income groups, should be lowered and replaced by increased taxation of capital income.

  • To combine skills development with unemployment reduction, a job sharing scheme has been proposed that would allow the temporary replacement of job incumbents on training by unemployed workers. Moreover, employers have been urged to increase training in general, refrain from using overtime work, accept a reduction in working hours, and adopt a more flexible attitude towards part-time work.

  • The policy of general employment subsidies has been deemed both relatively inefficient and distortionary for competition (SAK [1994]); the unions have therefore advocated that subsidies be limited for training purposes. They also propose increased funding for the public employment service (to be used for additional job placement and training) and guaranteed coverage by labor market measures for those unemployed for more than two years.

From the employers’ point of view, the solution to the unemployment problem lies in greater labor market flexibility and a reduction of direct and indirect labor costs.

  • The wage bargaining framework should be de-centralized further, allowing firms, to an increasing extent, to pay wages according to their financial situation. This remains the long-run goal for the employer associations, despite a possible return to centralized negotiations this year (Ojala [1995]). In addition, the employers would like to achieve a stronger link between pay and individual productivity, e.g., by paying lower wages to job starters or formerly long-term unemployed workers.

  • Possibilities for the flexible use of labor should be increased, including through greater use of fixed-term and part-time contracts, and shorter negotiation periods for separations. However, a general shortening of working hours or the reduction of overtime work is rejected by the employers, as these measures would raise unit labor costs (TT [1995]).

  • In order to reduce indirect labor costs, employers see a need for reforming the unemployment and retirement legislation (TT [1995]). This would not only imply that unemployment benefits have to be lowered and early retirement discouraged, but also that employers should be relieved from financing non-employment related benefits (e.g., basic pension and sickness insurances). In addition, the recent pension reform, though welcome, is unlikely to be sufficient over the medium term and will require further action, such as an increase in the regular retirement age.

  • The need for qualified labor should be addressed by increasing the efficiency of public employment and training services. In particular, the cooperation between the public services and private enterprises should be improved.

c. Suggestions of the Presidential Working Group

In June 1994, the President of the Republic formed an independent working group and gave it the task of proposing a strategy for reducing unemployment. The six-person group consisted of representatives from labor market organizations and research institutes. The group presented its report in September 1994 (PWGE [1994]). It formulated a target of reducing unemployment to 200,000 persons (a rate of 8 percent) by the year 2000, including through a number of structural labor market reforms (Box 2). Although political parties were not consulted during the preparation of the report, a number of these suggestions have subsequently been incorporated in the program of the new Government.

Box 2.Recommendations of the Presidential Working Group

  • Labor market flexibility. (1) Reforming the Working Hours Act to bring it in line with arrangements of the 1993 wage bargaining round. (2) Reducing the maximum amount of overtime work to 200 hours per year. (3) Reducing the minimum notice period for dismissals to one month, and shortening the negotiating period to six weeks. (4) Enabling experiments with a 2 x 6 hour-shift in interested companies, including the creation of fixed-term and part-time jobs within the model. (5) Introducing a job rotation system on a voluntary basis.

  • Indirect labor costs. (1) Reducing the wedge by lowering the marginal income tax rate to 50 percent while shifting taxation to capital by increasing the corporate tax rate to 28 percent. (2) Reforming the financing of social insurance, in particular by reducing cyclical elements, so as to permanently reduce indirect labor costs by 4 percentage points.

  • Unemployment benefits. Government and labor market partners were urged to reform unemployment security system. (One alternative mentioned would foresee a 20 percent reduction in benefits after 130 days).

  • Active labor market policy. (1) Employment and training programs should cover 5 percent of the workforce in 1995-96, to be reduced to 3 percent by 2000. (2) Subsidized housing production should increase to 20,000 units per year, to be built mainly by formerly unemployed workers. (3) Youth unemployment should be reduced by creating 100,000 new training places by 1996, and subsidies should be used to place some 80,000 individuals in traineeships or apprenticeships. (4) Employment subsidies should be directed primarily to augment the human capital of job-seekers.

Source: PWGE (1994).
References

    AsplundR. (1994) Wage Differentials Wage Mobility and Skills in Finnish Industry The Research Institute of the Finnish Economy (ETLA)Discussion Paper525.

    AsplundR. and J.Kettunen (1994) Työttömyysturvan rahoitus ja sen uudistaminen (Reforming the Financing of the Unemployment Insurance)Helsinki: The Research Institute of the Finnish Economy (ETLA; B 104)

    CalmforsL. and R.Nymoen (1990) “Real Wage Adjustment and Employment Policies in the Nordic Countries” Economic Policy5398448.

    CurrieD. (1993) “The Finnish Economic Crisis: Analysis and Prescription” in: C.BordesD.Currie and H.SöderströmThree Assessments of Finland’s Economic Crisis and Economic Policy Helsinki: Bank of Finland (C:9).

    ErikssonT. (1994) “Unemployment in Finland” in: A.Björklund and T.Eriksson (eds.) Unemployment in Nordic CountriesAmsterdam: North Holland.

    ErikssonT.A.Suvanto and P.Varttia (1990) “Wage Formation in Finland” in: L.Calmfors (ed.) Wage Formation and Macroeconomic Policy in the Nordic CountriesOxford: O.U.P.

    FlanaganR.J. (1990) “Centralized and Decentralized Pay Determination in Nordic Countries” in: L.Calmfors (ed.) Wage Formation and Macroeconomic Policy in the Nordic CountriesOxford: O.U.P.

    KettunenJ. (1993) Re-employment of Finnish Unemployed WorkersHelsinki: The Research Institute of the Finnish Economy (ETLA; A 17).

    KoskenkyläH. and K.Pekonen (1993) “How Should Wages Be Determined in Finland?”Kansallis-Osake-Pankki Economic Review 11522.

    LiljaR.T.Santamäki-Vuori and G.Standing (1990) Unemployment and Labour Market Flexibility: FinlandGeneva: ILO.

    OECD (1994) The OECD Jobs Study (Part I): Evidence and ExplanationsParis: OECD.

    OjalaA. (1995) “Maximum Inflation As An Anchor” Unitas Group Economic Review 2:19951215.

    ÖtkerI. (1994) “The Structural Aspects of the Labor Markets and Unemployment in Finland” in: International Monetary Fund Finland--Selected Background Issues and Statistical Appendix SM/94/219.

    ParmanneP. (1995) “Inflation Is a Problem In All Agreement Sectors”Unitas Group Economic Review 2:19951618.

    PissaridesC.A. and R.Moghadam (1990) “Relative Wage Flexibility in Four Countries” in: L.Calmfors (ed.) Wage Formation and Macroeconomic Policy in the Nordic CountriesOxford: O.U.P.

    Presidential Working Group on Employment (PWGE) (1994) Unemployment Down to 200000Helsinki: Ministry of Labour.

    SAK [Confederation of Finnish Trade Unions] (1994) Economic Acceleration: More Confidence and More Work Executive Committee MemorandumMay241994.

    TT [Confederation of Finnish Industry and Employers] (1995) Tackling the Unemployment Program in Finland Updated inMay1995mimeo.

    TyrväinenT. (1995) Wage Determination in the Long Run, Real Wage Resistance and UnemploymentBank of FinlandDiscussion Paper 12/95.

APPENDIX III The Finnish Recession: Initial Shocks and Financial Factors

1. Introduction

The Finnish economy experienced a particularly severe recession in 1991-93. Real GDP declined by about 12 percent and the rate of unemployment rose from 3 1/2 percent to about 20 percent. This appendix attempts to identify the initial shocks that triggered the downturn and to examine factors that contributed to the depth of the recession. Special attention is paid to financial factors since the recession coincided with the collapse of asset prices and came after a sharp expansion of private credit. As some of these financial processes are presently acting in reverse, they are likely to play an important role in sustaining the rebound in economic activity that is currently under way.

The recession was preceded by a domestic overheating that was in part fueled by a surge in private credit, especially to households, in the wake of financial deregulation in the mid-1980s. Domestically oriented sectors expanded briskly as share prices tripled and housing prices doubled in real terms in 1986-89. Combined with positive external shocks, including much improved terms of trade, the surge in domestic demand led to GDP growth in excess of 5 percent in both 1988 and 1989.

The turning point was reached in the second half of 1989. Asset prices dropped precipitously, and the economic outlook changed fundamentally. Subsequently, domestic demand declined sharply. By mid-1993, real domestic demand had slipped by almost 20 percent, with the volume of private investment having fallen by an unprecedented 50 percent. Despite negative external shocks, such as the collapse of trade with CMEA countries, the export sector began to expand as early as late 1991, when the markka was devalued.

Against this background, Section 2 examines the role of various shocks--stemming from monetary and fiscal policy, external sources, and domestic demand--in triggering the downturn. The analysis suggests that fiscal policy was countercyclical and can therefore be excluded as a proximate cause for the economic slump. However, monetary policy may have contributed to the downturn. Just as the surge in asset prices came to a halt in 1989, the monetary stance was tightened considerably, primarily with the aim of slowing the domestic overheating. External factors, which are often mentioned as a major factor in the Finnish economic slump, certainly exacerbated the recession. However, external factors can hardly be considered a cause for the initial downturn, because the recession had already begun by the time trade with the former Soviet Union collapsed. Instead, the impulse for the downturn appears to have originated from domestic demand shocks. The results of a vector autoregression (VAR) analysis suggest that the sharp drop in asset prices in late 1989 triggered more or less immediately negative shocks to private consumption. Private investment, in contrast, reacted with a delay of at least two quarters, but experienced a second wave of shocks after the floating of the markka in 1992.

The fact that the recession coincided with significant financial fragility, including a banking crisis, strongly suggests that financial factors played a role in the depth and duration of the recession. In Section 3, it is argued that the sharp drop in asset prices, in combination with the high level of private indebtedness, triggered a debt-deflation cycle that aggravated the drop in domestic demand. It is also argued that worsened adverse selection and moral hazard problems in financial intermediation--in combination with disruptions stemming directly from the banking crisis--contributed to the slump. Moreover, the initial shocks were propagated into a sustained economic slump by the dramatic decline in corporate net worth, which affected critically corporate investment and employment decisions. Section 4 presents some concluding remarks.

2. Initial shocks

The economic downturn that began in early 1990 can in principle be attributed to three main factors: (1) policy shocks stemming from the stance of fiscal and monetary policy, (2) external shocks, and (3) shocks to domestic demand.

a. Policy shocks

Fiscal policy can be ruled out as a factor contributing to the economic downturn, since the fiscal stance as indicated by the fiscal impulse measure was largely countercyclical in the late 1980s and early 1990s (Chart 30). During the period of rapid growth in 1988 and 1989, the stance was contractionary; in fact, during 1989, in response to indications that rapid growth was continuing, fiscal policy was tightened over the course of the year. In 1990, by contrast, in anticipation of a slowdown in growth, the policy stance was eased in part through a comprehensive tax reform that reduced personal and corporate income taxes. Subsequently, fiscal policy remained expansionary in 1991 and 1992.

CHART 30FINLAND THE STANCE OF FISCAL POLICY, 1988–94

(In percent of GDP)

Source: Finnish authorities; and staff calculations.

The stance of monetary policy, however, may have played a role. In an attempt to slow the economic overheating and to arrest the rise in inflation, monetary policy was tightened in 1989. The markka was revalued in March 1989, at the same time as the run-up in asset prices had come to a halt (Chart 31). In the second half of 1989, the 3-month money market rate (HELIBOR) rose from 12 percent to 16 percent, and the yield curve became steeply inverted (Chart 32). The average rate on new bank loans increased by 3 percentage points. As tax reform curtailed the tax deductibility of interest payments on consumer loans and mortgages, and as inflation rose only slightly from an annual rate of 6 percent to 7 percent at year end, after-tax real rates moved up sharply. Moreover, since most mortgages and consumer loans carried variable interest rates, the higher rates had a more or less immediate effect on borrowers. Tighter monetary conditions in the second half of 1989 were also reflected in the slowing of the growth rate of broad money (M3) and bank lending from annual rates of 25 percent and 30 percent, respectively, in early 1989 to about 10 percent at the end of the year.

CHART 31FINALND HELSINKI STOCK MARKET INDEX, 1984–94

Source: Finnish authorities.

CHART 32FINLAND INTEREST RATES, January 1988 – June 1995

Sources: Bank of Finland, Financial Markets (various issues); IMF, data server.

b. External shocks

In popular discussion, the recession in Finland is often associated primarily with external shocks, in particular with the collapse of trade with CMEA countries in 1991 and the plunge in paper prices on world markets. Although these shocks had a significant effect on the economy and undoubtedly exacerbated the recession, they did not trigger the downturn, since they emerged well after the recession was underway. Moreover, having been negative in the late 1980s, the contribution of net exports to growth did not deteriorate significantly at the start of the recession and actually turned positive in 1990 (Chart 33). In fact, even in 1991 when the CMEA trade collapsed and paper prices fell sharply, the contribution to growth was positive (1 1/2 percentage points), although the volume of exports declined that year by 6 1/2 percent.

CHART 33FINALND CONTRIBUTIONS TO GROWTH, 1986–94

(In percent)

Sources: 1994 Statistical Yearbook; Finnish authorities; and staff calculations.

c. Domestic demand shocks

Having established that shocks from external sources did not play a major role in the initial stages of the recession, the analysis now turns to domestic demand shocks. The purpose of the analysis is to identify and quantify the effects of various demand shocks, which can be either autonomous or policy induced. Toward this end, a simple vector auto-regression (VAR) of the components of GDP is estimated, following the approach in Blanchard (1993). Real GDP is decomposed into private consumption (durable and nondurable), public consumption, residential investment, nonresidential investment, change in inventories, exports and imports (Chart 34). 1/ A five-dimensional VAR is estimated with private consumption, the three investment categories, and imports treated as endogenous, and public consumption and exports as exogenous variables. 2/ The VAR essentially regresses each endogenous variable on its own lagged values and the lagged values of the other variables (both endogenous and exogenous). The residuals from each equation simply represent forecast errors and can be interpreted as movements in a demand component for GDP that cannot be explained by the estimated historical relationship. In that sense, the residuals will be interpreted as “shocks” to the particular demand component. A negative residual indicates that the VAR is over-predicting the observed change in the demand component. A sequence of negative residuals suggests that the particular component under consideration was subject to a series of adverse shocks not explained by the system. 1/

CHART 34FINLAND COMPONENTS OF GROSS DOMESTIC PRODUCT, 1985–94

Sources: OECD, Analytical Database.

The demand shocks generated by the estimated VAR are presented in Table 43. 2/ The shocks are normalized by their estimated standard deviations, so that each shock is distributed with zero mean and unit variance. To facilitate examining the pattern of the shocks, the normalized residuals are cumulated over the boom and recession phase. The dramatic upswing prior to the recession is highlighted by cumulated shocks for the period 1986:Q1-1989:Q2. The results clearly bring out the consumption boom that preceded the deep recession in Finland. Mid-1989 is regarded as the starting point of the economic downturn because private consumption subsequently experienced negative shocks over three consecutive quarters.

Table 43.Finland: Cumulative Normalized Shocks
Private

Consumption
Nonresidential

Investment
Residential

Investment
Real GDP
Cumulative from 1986 Q1 to
1989 Q28.671.151.051.62
Cumulative from 1989 Q2 to
1989: Q3-1.15-0.060.93-0.50
Q4-1.61-0.051.55-0.14
1990: Q1-2.78-0.762.290.48
Q2-1.98-2.331.07-0.14
Q3-2.58-3.49-0.45-1.44
Q4-3.96-3.72-1.15-3.41
1991: Q1-4.53-4.320.35-4.55
Q2-4.89-5.86-0.63-5.80
Q3-3.94-6.64-1.18-5.51
Q4-3.68-6.50-0.43-6.37
1992: Q1-4.85-5.840.08-6.23
Q2-5.13-4.44-0.39-6.22
Q3-6.14-6.45-0.50-6.21
Q4-7.52-7.69-2.79-7.07
1993: Q1-8.61-8.70-3.23-7.35
Q2-8.10-9.51-2.60-6.33
Q3-7.99-9.77-2.99-5.74
Q4-7.59-10.47-2.59-6.32
1994: Q1-6.63-10.56-2.18-6.43
Q2-6.95-9.97-2.99-5.72
Q3-6.35-8.11-3.69-4.73
Q4-5.73-7.87-4.32-5.42
Sources: Staff calculations.
Sources: Staff calculations.

Negative consumption shocks built up rapidly between 1989:Q3 and 1991:Q1 (Chart 35). This suggests that consumption reacted immediately to the precipitous fall in asset prices. There were some positive shocks to consumption in the second half of 1991, but this was followed by a five-quarter sequence of large negative shocks as employment prospects worsened significantly in 1992 and 1993.

CHART 35FINLAND CUMULATIVE NORMALIZED SHOCKS, 1989–94

Source: Staff calculations.

The VAR results reveal two distinct phases in the slump of nonresidential fixed investment. Negative shocks to nonresidential fixed investment started in 1990:Q1, two quarters after the first negative shock to consumption. There is some evidence that in mid-1992 investment was poised for a recovery. But the floating of the Finnish markka in September 1992, which led to a sharp depreciation and substantially increased the burden of foreign-currency denominated debt for Finnish companies, appears to have adversely affected investment. In fact, the VAR results suggest that the shocks to nonresidential fixed investment between 1992:Q2 and 1993:Q4 were of a similar magnitude as those experienced in 1990:Q1-1992:Q1.

Residential fixed investment was also adversely affected in the early stages of the recession, but the accumulation of negative shocks took place much later than for nonresidential investment. The pattern of residuals reveals that the negative shocks to housing investment emerged primarily after the floating of the markka in the third quarter of 1992. The shocks to housing investment in 1994, even as consumption and investment recovered, reflect the continuing sluggishness of the housing market and indicate that it may take some time for the construction sector to rebound.

An auxiliary regression was used to analyze the movements in real output--real GDP was regressed on lagged values of the GDP components. 1/ The residuals of this equation are reported in the last column of Table 43; they represent errors in forecasting real GDP from past values of its components and have an interpretation similar to that of the other residuals. The results show that negative shocks to GDP accumulated rapidly between 1990:Q1 and 1991:Q4. After some dissipation of the shocks in mid-1992, the ERM crisis delivered a further blow to GDP growth, from which the economy started to recover only in 1994.

3. Financial propagation mechanisms

The unprecedented depth of the Finnish recession raises the question of how the initial shocks identified in the previous section were magnified and transmitted through the economy. 2/ Since the recession was preceded by a rapid buildup of private indebtedness and coincided with a period of financial fragility, this section focusses on two channels: (1) debt-deflation dynamics, and (2) propagation effects stemming from imperfect capital markets.

Debt deflation, first analyzed by Irving Fisher (1932, 1933), has recently attracted considerable attention as recessions in the U.K. and Sweden, like the one in Finland, followed a rapid surge in private indebtedness (Jonung et al. [1994]). Moreover, the drop in output appears to have been the greater the larger had been the rise in private indebtedness in the preceding years (King [1994]). This section attempts to identify the main elements of the debt deflation cycle in Finland. It is found that there are indications that debt deflation may have contributed in a significant way to the depth of the recession.

Factors stemming from the structure of capital markets appear to have played a role as well. In particular, the weakness of the Finnish banking system, in combination with aggravated adverse selection and moral hazard problems during the recession, likely led to some disruption in the flow of credit. In addition, the sharp drop in corporate net worth may explain in part the spectacular drop in private investment and employment, and the persistence of the recession.

a. Debt deflation 1/

The key idea underlying debt-deflation dynamics is that of a reinforcing spiral of lower asset prices, balance sheet adjustments, and declining domestic demand propelled by self-fulfilling expectations. An initial shock triggers a plunge in asset prices or prompts agents to realize that their debt burden is unsustainable. Agents respond by a reduction in their consumption and by distress asset sales with the aim of adjusting balance sheets. The distress sales, in turn, depress asset prices even further, aggravating balance sheet problems and triggering further cutbacks in consumption. Thus a self-reinforcing spiral gets under way, which is typically compounded by financial disruptions in the banking system.

Some elements of debt deflation can be identified in Finland. Following financial liberalization, and fuelled by rising incomes and improving terms of trade, household indebtedness surged from 60 percent of disposable income in 1985 to about 85 percent in 1989 (Brunila and Takala [1993]). Nonetheless, household net wealth improved since asset prices climbed to unprecedented levels; between the fourth quarter of 1985 and 1988, net wealth rose by 50 percent in real terms (Bordes et al. [1993]). House prices doubled between 1986 and 1989, and stock prices tripled over the same period.

In mid-1989, the turning point in asset markets was reached. As real after-tax borrowing rates rose sharply, in part due to reduced tax deductibility of interest payments, the sharp plunge in asset prices and the concomitant revision of income expectations made many households realize that their debt accumulation in the 1980s had been unsustainable. 1/ This realization, in turn, triggered balance sheet adjustments and a drop in spending on consumer durables. The household saving ratio rose sharply from its low level during the overheating as economic prospects deteriorated (Chart 36).

CHART 36FINLAND HOUSEHOLD SAVING AND INDEBTEDNESS, 1985–94

(In percent)

Source: Finnish authorities.

1/ Household debt in relation to disposable income.

Given the openness of the Finnish economy, balance sheet pressures were compounded by external debt, in particular the sharply increased burden stemming from foreign-currency denominated loans in the wake of the markka depreciation. In the late 1980s, much of corporate borrowing (about 40 percent) was denominated in foreign currency as corporations borrowed abroad in the belief that Finland would maintain its exchange rate peg. Even firms in the sheltered sector borrowed heavily in foreign currency at what appeared to be attractive terms. In 1991, external shocks, in particular the collapse of CMEA trade and the plunge in paper prices, led first to a 12 percent devaluation of the markka vis-a-vis the ECU in late 1991, and in 1992 pushed the markka off its exchange rate peg. Over the next six months, the markka depreciated by a further 20 percent. As the markka value of foreign-currency debt rose sharply at a time when the economy had already weakened dramatically, bankruptcies surged. The default rate on bank loans skyrocketed and a banking crisis erupted in 1992.

b. Factors stemming from imperfect capital markets

Financial intermediation, adverse selection, and moral hazard. Financial intermediaries are designed to alleviate the informational problems involved in the lending process. Clearly, borrowers have an informational advantage, knowing more about the quality of their projects. This leads to adverse selection problems, since it is difficult for outside lenders, including banks, to identify “good risks”. Moreover, moral hazard is involved in credit relationships since once a credit is disbursed the borrower has an incentive to use it for riskier projects. Steady monitoring by the financial intermediary is therefore required.

Typically, in deep recessions adverse selection and moral hazard problems are exacerbated. Higher lending rates tend to worsen adverse selection, as low-risk borrowers drop out of the pool of borrowers. In addition, a more uncertain economic environment makes assessing the creditworthiness of potential borrowers more difficult and skews the pool of applicants toward higher risks. Moreover, declining borrower net worth tends to aggravate moral hazard problems as some borrowers may be prone to pursue riskier activities (Bernanke and Gertler [1989]).

The extent of adverse selection problems is reflected in the “quality spread”, the interest rate spread between high-risk and low-risk borrowers (Mishkin [1991]). In Finland, financial fragility in the corporate sector and adverse selection problems emerged in early 1991. At that time, the spread between corporate and government bonds, which had been close to zero, widened to 2 percentage points, before peaking at 3 percentage points during the currency turmoil in September 1992 (Bordes et al. [1993]). This indicates that heightened adverse selection problems likely affected lending negatively both from the supply side (as banks were more reluctant to extend credit) as well as from the demand side (as high-quality borrowers were discouraged by high lending rates).

In principle, adverse selection problems can be alleviated by the provision of collateral. However, following the large drop in asset prices (including real estate), the value of collateral declined sharply, thus worsening the adverse selection problems. In Finnish surveys, small and medium-size firms, in particular, reported limited access to credit due to inadequate collateral.

Such informational problems, which typically emerge in any deep recession and can strain even a healthy banking system, were reinforced in Finland by the banking crisis. 1/ Nonperforming loans were heavily concentrated in the savings bank sector, which was almost entirely taken over by the state. As credit information is typically localized and cannot be easily transferred to another lender, it is likely that the far-reaching reorganization of the savings banks had adverse effects on small and medium-size borrowers. More generally, the disruptions in the banking sector likely had some negative effect on the availability of credit especially to bank-dependent borrowers.

Corporate net worth. Another implication of asymmetric information in financial markets is that a corporation’s net worth can have a decisive effect on investment and employment decisions, especially during recessions. As a result of informational imperfections in capital markets, the distinction between debt and equity is critical. While debt financing implies a fixed obligation to repay, thus creating the possibility of bankruptcy, equity does not convey such an obligation; the firm simply shares risk with its equity holders. Despite this apparent advantage of equity over debt financing, equity finance plays a very small role in raising capital (Stiglitz [1992]), in part because of the associated adverse selection problems: financial markets tend to interpret issuing equity as a negative signal (Greenwald, Stiglitz and Weiss [1984]). 2/ This has two implications: (i) debt financing is by far the dominant form of raising capital; 1/ and (ii) combined with significant bankruptcy costs, the predominance of debt finance implies that firms act in a risk-averse manner.

The risk-averse behavior of firms is primarily due to the threat of bankruptcy and can lead to significant shifts in their output, employment and investment decisions (Stiglitz [1992]). By affecting the likelihood of bankruptcy, changes in net worth and in the perceived risks inherent in the economic environment have a profound effect on a firm’s decisions (Stiglitz [1992], Bernanke and Gertler [1989]). As a result, net worth affects not only the availability and costs of external funds (Bernanke [1983]), but also the degree of risk aversion and thus firm behavior directly. Further, relatively small changes in demand can have large effects on profits and--to the extent that firms are in general highly leveraged--can have significant effects on a firm’s net worth and thus on the production, investment, and employment decisions.

In the late 1980s, the boom in the Finnish stock market provided opportunities for easier equity finance, since the adverse selection effects of equity finance were likely reduced in the booming stock markets. Firms were able to expand their net worth as market capitalization surged and corporate indebtedness as a percentage of GDP actually declined. In such an environment, firms expanded their investment considerably: the ratio of gross investment rose from 24 percent of GDP in the mid-1980s to 28 percent in 1989.

Just as the economic upswing was likely reinforced by the effects of improved equity positions (net worth), the downturn was probably deepened by the same factors as they acted in reverse. As asset prices started to tumble and private consumption dropped, firms perceived a fundamental change in the economic environment. Also, the sharp drop in profitability led to a significant reduction in corporate net worth. 2/ Both higher perceived uncertainty and lower net worth were factors that likely contributed to the drastic reduction in private investment and employment. The collapse of trade with the former Soviet Union in 1991 and the currency turbulence in 1992-93 probably heightened the sense of uncertainty.

Even though the export sector has been expanding since late 1991, investment and employment in that sector remained flat until last year. This could be interpreted as further evidence of the role of corporate net worth: despite an improved demand outlook in manufacturing, firms were reluctant to initiate investment projects and to hire employees because corporate net worth remained weak. Recently, investment in manufacturing has been picking up; however, the fact that most investment is currently financed by internally generated funds is a further sign that even firms in booming sectors remain reluctant to increase their debt ratios and instead are working toward improving their equity positions.

4. Conclusions

Various factors suggest that elements of debt-deflation and financial fragility played a role in Finland’s recession. The sharp plunge in asset prices foreshadowed the domestic demand shocks. As the VAR analysis indicates, private consumption reacted almost immediately to the asset price decline. Debt-deflation dynamics subsequently reinforced the downward spiral in asset prices, prompting households to curtail their demand sharply with a view to restoring balance sheets and to reducing their debt burden to manageable levels. Adverse selection and moral hazard problems worsened during the recession and--reinforced by the banking crisis--contributed to the disruption of credit flows. These disruptions, in combination with sharply reduced corporate net worth, are likely to have played a role in the negative supply responses, in particular, the drop in investment and employment. The VAR results suggest that the crisis in the foreign exchange markets in September 1992 constituted an additional shock to private investment due to increased uncertainty and a higher debt burden from foreign-currency denominated loans.

As the Finnish economy emerges from the recession, some of these factors are likely to work in reverse. Household debt has been reduced almost to levels prior to financial liberalization; a return to a normal saving-consumption pattern can thus be expected. Moreover, the stock market has rebounded strongly and housing prices have recovered, albeit modestly. Improved collateral values should increasingly facilitate access to credit even for the sheltered sector. Also, as the problems associated with the banking crisis are overcome, financial disruptions will diminish and debt financing will be facilitated. The recent high profitability in export sectors has largely restored corporate net worth in manufacturing. As a result, firms are expected to resort increasingly to debt financing again and investment is projected to pick up. This trend should also help the banking system return to normal levels of profitability.

References

Official estimates indicate output gaps in 1994 of 36 percent in construction and 25 percent in trade and services.

Labor market issues are also described in more detail in Appendix II.

Fiscal policy in the early 1990s was described in some detail in Section I of the Selected Background Issues (SM/94/219, 8/15/94) for the 1994 Article IV consultation.

Defense expenditures amount to Fmk 8,059 million (1.6 percent of GDP) and include Fmk 53 million for peace keeping operations. Of the total, Fmk 5,297 million are earmarked for operational expenditures and Fmk 2,518 million for the procurement of defense material.

The first supplementary budget for 1995 raised expenditures by Fmk 1.8 billion, mainly for special employment measures, some front loading of public infrastructure investments, and subsidies for housing renovation. These measures are to be financed by revenue increases without additional borrowing.

The measures were approved by Parliament in June.

According to the EMU definition, internal debts of subsectors of the general government are netted out. For instance, pension funds have increased their lending to the central government considerably over the past two years. At the end of 1994, the central government’s liabilities vis-à-vis pension funds stood at about 7 percent of GDP.

The indicator of underlying inflation (IUI) is derived from the consumer price index (CPI) by excluding housing prices (depreciation), mortgage payments, and the price effects of indirect taxes and subsidies. The IUI has been chosen in order to eliminate price movements directly due to policy measures, both of a fiscal and monetary nature.

In announcing an inflation target, Finland has followed the example of several other countries, including Canada, New Zealand, Sweden, and the U.K.

Outstanding central government bonds amounted to Fmk 120.4 billion in April 1995, compared to Fmk 35.2 billion at the end of 1991.

The interest rate on 1-week loans from the liquidity credit facility is set at 2 percentage points above the BoF’s tender rate; call money deposits with a daily maturity are remunerated at 2 percentage points below the tender rate.

In December 1994, the Supervisory Board decided against a 50 basis points rise in the base rate that was proposed by the BoF.

The minimum reserve requirements for deposits in commercial banks remain unchanged (2 percent for M1 components, 1.5 percent for M2 components not contained in M1, and 1 percent for M3 components not contained in M2) and are not remunerated.

The BoF, in its open-market operations, deals only with counterparts that have been approved by the Bank according to criteria related to size, activity on financial markets, and sound conduct of business.

Between September 1993 and June 1994, net foreign reserves of the Bank of Finland increased by Fmk 25.6 billion (nearly 100 percent), mainly caused by capital inflows and foreign borrowing of the Government.

Since February 1, 1994, the base rate has remained unchanged.

Nevertheless, owing to low inflation, real interest rates in Finland continued to be comparatively high.

In the long run, the BoF regards M1 as the most prominent monetary aggregate, due to the fact that the relation between M1, the price level, economic activity and interest rates has apparently not been affected by the floating. Moreover, M1 velocity has proved to be more stable than the velocity of the other aggregates.

The BoF’s only interventions were to smooth exchange rate movements.

In particular, the share of Nokia in total market capitalization rose to nearly 30 percent towards the end of 1994.

The Nordic banking crisis is discussed in detail in WP/95/61.

For example, data from the Finnish Forest Industries Federation indicate that, except for sawn wood, all sectors of the forestry industry were operating at over 95 percent of capacity in the first quarter of 1995. This is in contrast to the situation in 1990-91 when Finnish exports were impeded by considerable world overcapacity in the forestry industry and world prices for forestry products fell by 30-50 percent.

The losses of Finnish subsidiaries located in foreign countries are recorded as negative retained earnings in factor income.

It is common to find estimates for lags that amount to up to three years. For Finland, the transmission process is reckoned to take 1-2 years (Pikkarainen and Ripatti [1995]).

The MCI will be described in more detail in the next section.

A similar method was applied by McCallum (1990) for growth indicators.

Encompassing tests are conducted pairwise, involving forecast errors from two equations, say, ei and ej. If model i contains information that helps forecasting ej but not vice versa, then model i encompasses model j.

The trade-off of this relation is within the 3 1/2 - 11 range of estimates by Pikkarainen (1993).

Good indicators should also be identifiable by a consistent lag structure across models. The stronger the impact of an indicator, the more reliable becomes the determination of its strongest lags.

Being the price of uncut timber, stumpage prices are an asset price as well as a cost indicator for the wood industry. Increases in stumpage prices, indicating growing production in the wood industry, quickly translate into higher income for the large number of Finnish forest owners as well as higher wage demands in the forest sector. As a result of strong wage-wage links, stumpage prices have in the past been closely related to economy-wide earnings (Spolander [1994]). Ripatti (1995) offers some evidence that they are also related to the inflation rate.

All variables are seasonally adjusted where required, the lower case denoting logarithms.

t-values are reported in brackets.

The debenture yield was tested stationary but is one of the few borderline cases. The co-integration relationship for y and (m3-p) did not hold without MYD being included.

Both m3 and p are integrated of order two whereas (m3-p) is a linear combination that is only integrated of order one.

See also last year’s report on Selected Background Issues (SM/94/219) for a description of structural aspects of the labor markets in Finland.

Although output in the manufacturing sector passed its trough already in 1991, employment picked up with some delay because of annual productivity increases of 11 percent in 1991-93.

These numbers may understate long-term and youth unemployment, because a large number of persons in these groups are enrolled in Government labor market programs.

Union membership amounts to some 80 percent of the labor force, while 57 percent of private sector employees work for organized employers.

Wage drift contributed to 63 percent of overall wage increases between 1990 and 1993 (Chart 27).

Others have criticized, however, that wage moderation did not go far enough (e.g., Koskenkylä and Pekonen [1993]). For example, an agreement envisaging a 5 percent nominal wage reduction collapsed in 1992 after the export sector unions opted out.

Valid reasons are associated with the capacity or conduct of the worker, or with long-run operational needs of the employer.

The wedge is defined as q=(pc/p)[(1+te)/(1tw)] where pc is the consumer price index, p the output price index, te the payroll tax rate, and tw the average income tax rate. The term (pc/p) is referred to as the price wedge, and the second part of q as the tax wedge.

In addition, early retirement schemes were introduced in 1986, and unemployment pensions are being paid to persons aged 60 years or older.

The rise unemployment insurance contributions was the single most important factor behind the increase in the wedge during the early 1990s (Asplund and Kettunen [1994]). Average employer contributions to unemployment insurance went up from 0.85 percent of the wage bill in 1989 to 6.1 percent in 1994; similarly, contributions from insured persons were introduced in 1992 and reached 1.87 percent in 1994.

Training mobility is measured as the share of persons that were trained for an occupation different to their pre-training occupation.

To achieve stationarity, all variables, except for the change in inventories which was included as a ratio to GDP, are in log-differences. The change in inventories includes the statistical discrepancy; in principle, if the statistical discrepancy is small and purely random it could be ignored. In the case of Finland, however, the discrepancy has varied substantially, ranging from negative 5 percent of GDP in the mid-1970s to almost positive 3 percent in the 1990s.

Block exogeneity tests indicate that government consumption and exports can be treated as exogenous to the system. Likelihood ratio tests were used to select a lag length of four for the estimated VAR.

Reflecting their joint dependence on common underlying shocks to the economy, the estimated residuals are positively correlated across equations. We used identifying assumptions along the lines suggested by Blanchard (1993) to isolate the underlying shocks. These “corrected” residuals were virtually identical in size and pattern to the “raw” residuals reported here.

Shocks to imports and change in inventories are not presented in Table 43. For imports, the shocks were not large compared to those experienced by private consumption and nonresidential investment, implying that the movements in imports are well accounted for by the estimated VAR. The shocks to inventory investment are hard to interpret, since inventory investment in our analysis includes the statistical discrepancy.

Given the nonlinear transformation used to make change in inventories a stationary variable, two methods can be used: (i) construct GDP residuals as a weighted average of the residuals obtained for each individual GDP component, with the weights varying over time; (ii) regress the first difference of the logarithm of real GDP on lagged values of its components. The latter approach is used here because it is easier to implement.

Linkages between financial factors and economic activity are reviewed in Calomiris (1993) and Gertler (1988).

In contrast to what the title might suggest, deflation (i.e., a fall in the general price level) is not a necessary condition for the existence of debt-deflation dynamics. What matters is the change in the value of assets relative to the unit of account in which debt contracts are denominated. Also of importance is the difference between the ex ante (expected) real value of debt and the ex post (realized) value.

By mid-1992, the share price index had dropped to almost its 1986 level.

Section IV describes the current situation of the banking sector. The Finnish banking crisis is put into a Nordic perspective in WP/95/61, which examines the banking crises in Norway, Sweden, and Finland.

Moreover, it has been shown that optimal financial contracts often take the form of debt contracts since those are in general less costly to monitor (Townsend [1979], and Winton [1993]).

In Finland, this is reflected by the fact that the Finnish financial system is largely bank-dominated.

Corporate debt rose from the equivalent of 70 percent of GDP in 1988 to about 85 percent in 1991, at the same time as the market capitalization of the Helsinki Stock Exchange dropped from 30 percent of GDP to 12 percent. These data would suggest that--as a rough approximation--the market value of corporate net worth dropped from 30 percent of assets to about 12 percent.

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