Journal Issue

Finland: 2014 Article IV Consultation—Staff Report; Press Release; and Statement by the Executive Director for Finland

International Monetary Fund. European Dept.
Published Date:
May 2014
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Recent Economic Developments and Outlook

A. Recent developments

1. Finland’s strong recovery from the global crisis was short-lived. After rapid growth in 2010–11, GDP declined by 1 percent in 2012 and by an estimated 1.4 percent in 2013 (Table 1). Unemployment is elevated, at more than 8 percent as more people went without work for longer, and the output gap is sizable, estimated at around 3 percent of potential GDP. Moderating, but still positive, wage growth and higher indirect taxes explain why inflation (2.2 percent in 2013) remained above the euro area average (Figure 2).

Table 1.Selected Economic Indicators, 2010–19
(Percentage change unless otherwise indicated)
Output and demand (volumes)
Domestic demand2.94.2•0.8•
Private consumption3.32.50.3•
Public consumption••
Gross fixed capital formation1.75.8•0.8•4.6•
Change in stocks (contribution to growth in percent of GDP)0.91.5•0.9•
Exports of goods and services7.92.8•
Imports of goods and services6.86.2•0.7•
Net exports (contribution to growth in percent of GDP)0.5•
Prices, costs, and income
Consumer price inflation (harmonized, average)
Consumer price inflation (harmonized, end-year)
GDP deflator0.
Unit labor cost, manufacturing••
Labor market
Labor force••0.6•
Unemployment rate (in percent)
Potential output and NAIRU
Output gap (in percent of potential output)1•2.40.0•1.3•2.9•2.9•2.6•2.0•1.5•0.9•0.4
Growth in potential output0.
NAIRU (in percent)
(Percent of GDP)
General government finances2
Overall balance•2.8•1.0•2.2•2.4•2.4•1.4•0.9•0.4•0.10.1
Primary balance3•1.40.4•0.8•1.1•
Structural balance (in percent of potential GDP)•1.3•1.0•1.5•0.5•
Structural primary balance (in percent of potential GDP)30.00.4•
Gross debt48.849.353.657.059.660.961.461.261.060.1
Net debt (negative of net financial worth)•65.6•54.3•55.4•52.7•49.2•46.6•44.1•42.3•40.6•39.3
Money and interest rates
M3 (Finnish contribution to euro area, growth rate, e.o.p.)
Finnish MFI euro area loans (growth rate, e.o.p.)
3-month Euribor rate (percent)
10-year government bonds yield43.
(Percent of GDP)
National saving and investment
Gross national saving20.019.017.817.018.118.618.919.119.119.1
Gross domestic investment18.420.519.818.718.418.418.518.618.618.6
Balance of payments
Current account balance1.5•1.5•1.4•1.1•
Goods and services balance1.6•0.6•
Net international investment position10.716.217.719.320.922.924.826.728.329.9
Gross external debt189.6216.1231.3240.8245.4248.7249.8250.0249.5248.8
Exchange rates (period average)
Euro per US$0.750.720.780.75
Nominal effective rate (appreciation in percent)•4.50.0•3.32.6
Real effective rate (appreciation in percent)5•5.40.0•2.92.1
Sources: Bank of Finland, International Financial Statistics, IMF Institute, Ministry of Finance, Statistics Finland, and Fund staff calculations.

A negative value indicates a level of actual GDP that is below potential output.

Fiscal projections include measures as specified in the Government Program.

Adjusted for interest expenditure.

2014 data are latest available.

CPI-based real effective exchange rate.

Sources: Bank of Finland, International Financial Statistics, IMF Institute, Ministry of Finance, Statistics Finland, and Fund staff calculations.

A negative value indicates a level of actual GDP that is below potential output.

Fiscal projections include measures as specified in the Government Program.

Adjusted for interest expenditure.

2014 data are latest available.

CPI-based real effective exchange rate.

Figure 1.Recent Developments

Sources: Bank of Finland, CPB World Trade Monitor, Datastream, Haver Analytics, IMF World Economic Outlook, and Fund staff calculations.

Figure 2.Structural Indicators

Sources: Eurostat, Haver Analytics, IMF World Economic Outlook, OECD, Statistics Finland, and Fund staff calculations.

GDP Developments

(Index: 2007Q4=100)

Source: Fund staff calculations.

2. Behind the slowdown is a combination of cyclical and structural factors. The effects from weak domestic and external demand in the wake of the crisis have been exacerbated by the decline in the information and communications technology (ICT) industry and the continuing fall in global demand for traditional exports such as paper and pulp (Figure 1). Longer-term structural factors are also playing a role, including a rapidly aging workforce and declining total factor productivity (TFP) growth. At the same time, the persistently weak growth outlook has affected the confidence of investors, with private sector investment falling from over 20 percent of GDP in 2007 to under 16 percent in 2013. Highly leveraged households (mostly in the form of mounting real estate credit) are contributing little to overall consumption growth.

3. The fiscal deficit has widened and current account surpluses have given way to deficits. Increased social spending and the weaker economy have raised the general government deficit to an estimated 2.4 percent of GDP in 2013 (Table 4). At the same time, the debt-to-GDP ratio is approaching the 60 percent benchmark in 2014 (under the pre-ESA2010 GDP accounting standard). Along with the reduced importance of the ICT sector, the current account surpluses of the late 1990s and early 2000s have disappeared (Table 2). The real effective exchange rate (REER), though somewhat on the strong side, is broadly in line with fundamentals (see Box 1).

Table 2.Balance of Payments, 2010–19(In billions of euros, unless otherwise indicated)
Current account2.7•2.8•2.7•2.1•
(percent of GDP)1.5•1.5•1.4•1.1•
Goods and services2.8•1.1•
(percent of GDP)1.6•0.6•
Exports of goods and services72.977.879.979.479.281.283.585.788.190.5
Imports of goods and services•70.0•78.9•81.0•78.8•79.0•80.3•82.6•85.0•87.5•90.0
Compensation of employees0.
Investment income1.3•0.3•
Current transfers•1.7•1.6•1.3•1.3•1.0•0.6•
(of which, official)•2.0•2.3•1.2•1.2•0.9•0.5•
Capital and financial account•3.58.517.22.10.4•0.7•1.1•1.5•1.5•1.4
Capital account0.
Financial account•3.78.416.91.90.2•0.9•1.3•1.7•1.7•1.6
Direct investment•2.1•1.8•2.6•3.1•2.8•2.6•2.6•2.5•2.3•2.4
In Finland5.
Portfolio investment•
Financial derivatives•
Other investment6.71.49.7•4.4•6.4•7.7•8.2•8.7•8.9•8.9
Reserve assets1.7•0.3•
Net errors and omissions0.8•5.7•
Memorandum item:
GDP at current prices178.7188.7192.4193.4197.9203.0209.8217.2225.3233.7
Sources: Bank of Finland, Statistics Finland, and Fund staff calculations.
Sources: Bank of Finland, Statistics Finland, and Fund staff calculations.
Table 3.Net International Investment Position, 2005–12(Percent of GDP)
Direct investment54.257.861.861.673.979.166.077.6
Equity & investment fund shares29.235.639.039.952.555.647.155.6
Debt instruments25.022.122.821.621.423.618.921.9
Portfolio investment78.9103.0104.167.0106.3121.3103.9128.0
Equity & investment fund shares33.046.349.723.343.155.743.356.5
Debt securities45.956.654.443.763.265.660.671.5
Fin. deriv. (other than reserves)17.917.721.747.748.861.291.172.4
Other investment41.249.952.651.464.377.794.9103.8
Reserve assets5.
Direct investment40.345.451.750.355.157.649.055.4
Equity & investment fund shares21.126.529.124.728.730.827.430.9
Debt instruments19.318.922.725.726.426.821.624.5
Portfolio investment117.7139.3154.485.0116.4117.2100.3126.1
Equity & investment fund shares61.374.593.535.743.541.225.531.2
Debt securities56.464.860.949.472.976.074.894.9
Fin. deriv. (other than reserves)17.417.220.847.647.558.387.267.9
Other investment37.044.646.950.573.089.4105.6118.7
Net International Investment Position•14.6•14.6•30.1•
Direct Investment13.812.310.111.318.821.517.022.1
Portfolio Investment•38.8•36.4•50.3•18.0•
Fin. deriv. (other than reserves)
Other Investment4.•8.7•11.7•10.8•14.9
Sources: International Financial Statistics and Fund staff calculations.
Sources: International Financial Statistics and Fund staff calculations.
Table 4.General Government Statement of Operations, 2010–19(In percent of GDP, unless otherwise indicated)
Tax revenues29.630.830.832.131.932.132.332.432.332.4
Taxes on production and imports13.414.214.414.815.
Current taxes on income, wealth, etc.16.016.416.016.916.516.716.917.117.317.4
Capital taxes0.
Social contributions12.812.713.313.413.613.613.713.613.513.5
Other revenue
Compensation of employees14.514.214.514.714.514.113.813.613.313.2
Use of goods and services11.511.511.812.211.911.911.912.011.911.9
Consumption of fixed capital (CFC)
Social benefits21.020.621.522.623.
Other expense2.
Net acquisition of nonfinancial assets0.
Net acquisition of nonfinancial assets excl. CFC
Consumption of fixed capital (CFC)
Net operating balance•2.5•0.7•1.8•1.8•1.9•1.0•0.6•
Net lending/borrowing•2.8•1.0•2.2•2.4•2.4•1.4•0.9•0.4•0.10.1
Net acquisition of financial assets3.62.23.7
Currency and deposits2.71.3•1.1
Securities other than shares•4.10.9•0.5
Shares and other equity3.80.13.4
Insurance technical reserves0.00.00.0
Financial derivatives0.00.00.0
Other accounts receivable0.70.10.1
Net incurrence of liabilities6.73.35.9
Special Drawing Rights (SDRs)
Currency and deposits0.00.00.0
Securities other than shares6.82.03.4
Shares and other equity0.00.00.0
Insurance technical reserves0.00.00.0
Financial derivatives•
Other accounts payable•
Memorandum items:
Primary balance1•1.40.4•0.8•1.1•
Structural balance (in percent of potential GDP)•1.3•1.0•1.5•0.5•
Structural primary balance (in percent of potentia0.00.4•
Central government net lending/borrowing•5.6•3.4•3.8•3.7•3.5•2.4•2.1•1.5•1.2•1.0
General government gross debt48.849.353.657.059.660.961.461.261.060.1
General government net debt265.654.355.452.749.246.644.142.340.639.3
Central government gross debt44.345.548.850.952.252.351.750.749.648.1
Output gap (percent of potential GDP)•2.40.0•1.3•2.9•2.9•2.6•2.0•1.5•0.9•0.4
Nominal GDP (billions of euros)178.7188.7192.4193.4197.9203.0209.8217.2225.3233.7
Sources: Eurostat, Government Finance Statistics, International Financial Statistics, Ministry of Finance, and Fund staff calculations.

Adjusted for interest expenditure.

Defined as the negative of net financial worth.

Sources: Eurostat, Government Finance Statistics, International Financial Statistics, Ministry of Finance, and Fund staff calculations.

Adjusted for interest expenditure.

Defined as the negative of net financial worth.

Twin Deficits

(Percent of GDP)

Sources: IMF World Economic Outlook and Fund staff calculations.

4. The slowdown has come despite unusually favorable financial conditions, increasing risks to banks. The banking sector, dominated by large Nordic institutions, has been operating in a low interest rate environment, partially linked to Finland’s appeal as a “safe haven.” This has weighed on banks’ margins and increased their exposure to riskier borrowers, especially through housing-related loans. Overall credit has declined with the weak economy, but household debt has continued to grow, reaching 118 percent of disposable income in 2013, more than double the level in the late 1990s (Figure 4). Standard metrics suggest that real house prices are 8.5 percent above fundamentals.1

Figure 3.Fiscal Indicators

Sources: EC AMECO Database, DG ECFIN The 2012 Ageing Report, IMF World Economic Outlook, and Fund staff calculations.

1 The downside risk scenario is an illustrative simulation of the possible growth impact of a frontloaded fiscal consolidation, broadly along the lines of the government’s spending limits decision, but omitting any mitigating factors. A fiscal multiplier of 1 is assumed in the simulation. See Chapter IV of the Selected Issues for details.

Figure 4.Financial Indicators

Sources: European Central Bank, Haver Analytics, IMF Financial Soundness Indicators, OECD, and Fund staff calculations.

5. Structural issues are playing a significant role in the slowdown. In addition to the weakening of traditional industries, falling export shares also reflect a loss in competitiveness linked to high pre-crisis wage growth at a time when labor productivity was deteriorating (Figure 2). The slowdown in productivity predominantly stems from weaker TFP growth caused, in large part, by the fading importance of the ICT sector and the associated decline in patent and innovation activity.2 As a result of this and an aging workforce, potential output growth is estimated to have declined from about 3 percent on average in 1997–2007 to less than ½ percent in 2013.3

Credit Institutions’ Interest Rate Margins in the Euro Area and Finland


Sources: European Central Bank and Fund staff calculations.

Notes: The average discrepancy is a simple average of the difference in margins in the euro area (EA) and Finland for long-term loans to non-financial corporations and households.

6. Policymakers have begun to address these challenges. The government is pursuing an ambitious reform agenda to improve the public finances and strengthen conditions for economic growth, with some measures already in train. Also, long-needed progress is being made towards putting in place a macroprudential policy framework in line with the evolving framework at the European Union (EU) and euro area levels.

B. Outlook and Risks

7. The recovery will be slow. Growth is projected to improve modestly, driven largely by the expected improvement in euro area exports and gradually strengthening investment helped by still low interest rates and building confidence in the recovery. However, in light of the expected slowdown in Russia and the planned fiscal consolidation, the pick-up in growth will be moderate—about 0.3 percent in 2014 and 1.1 percent in 2015. As a result, unemployment will remain high and the output gap will shrink only gradually, with inflation decelerating to about 1.5 percent in 2015.

8. A number of downside risks could further lower growth. Slower-than-expected exports linked to a cooling of global trade, rising geopolitical tensions, or a protracted period of slow European growth could easily derail the recovery. Domestically, high household debt could cause consumers to cut back if interest rates normalized more quickly than expected, for example because of changing global financial conditions. Rapid fiscal consolidation or a less growth-friendly budget composition could further weaken demand. Finally, a financial shock, such as a funding difficulty hitting the large Swedish or Danish banks operating in Finland, could impact financing conditions, with potentially significant consequences for investment and consumption, especially if amplified by a fall in house prices (see also Table 7 with the Risk Assessment Matrix).

Table 5.General Government Balance Sheet, 2005–12(In percent of GDP)
Net worth
Nonfinancial assets
Net financial worth58.669.472.552.362.865.654.355.4
Financial assets107.0115.0113.992.6114.6123.4112.4119.4
Currency and deposits5.
Securities other than shares28.326.323.122.827.322.021.721.9
Shares and other equity55.564.566.844.761.071.361.367.3
Insurance technical reserves0.
Financial derivatives0.
Other accounts receivable/payable4.
Currency and deposits0.
Securities other than shares36.733.929.328.637.443.244.348.2
Shares and other equity0.
Insurance technical reserves0.
Financial derivatives••0.7•0.8
Other accounts receivable/payable4.
Sources: Global Insight, Government Finance Statistics, and Fund staff calculations.
Sources: Global Insight, Government Finance Statistics, and Fund staff calculations.
Table 6.Financial Soundness Indicators for the Banking Sector, 2008–13
Total household debt (in percent of GDP)53.460.662.
Total household debt (in percent of disposable income)109.3111.4113.1115.0117.3117.6
Financial assets/GDP99.9120.0125.9115.4120.8121.2
Non-financial corporations
Gross debt (in percent of GDP)55.560.160.059.860.863.7
General government debt (EMU definition, in percent of GDP)33.943.648.849.353.657.0
Central government debt (in percent of GDP)31.139.444.345.548.850.9
Banking sector
Total assets (in billions of euro)347.1349.1418.2542.4496.2445.4
in percent of GDP186.9202.6234.0287.4257.9226.5
Total deposits (in billions of euro)109.4110.4119.2130.5136.3131.6
in percent of GDP58.964.166.769.170.966.9
Credit to nonfinancial and housing corporations (annual percent change, e.o.p.)18.1•
Credit to nonfinancial corporations (annual percent change, e.o.p.)21.6•
Credit to households (percent change, e.o.p.)
Housing loans in percent of total lending45.047.847.442.142.740.3
Asset quality
Non-performing loans (in billions of euro)
Non-performing loans/total loans (in percent)
Povisions to non-performing loans (in percent)N/AN/AN/AN/AN/AN/A
Household non-performing loans/total household loans (in percent)
Household non-performing loans/total non-performing loans (in percent)157.844.243.547.551.954.5
Capital adequacy
Regulatory capital as percent of risk-weighted assets13.614.514.414.217.015.6
Regulatory tier 1 capital to risk-weighted assets12.513.713.613.616.114.8
Equity/total assets (in percent)
Interest rate margin (percentage points, e.o.p.)
Net interest income (in percent of total income)60.346.744.748.143.840.3
Return on equity (in percent)12.410.
Return on assets (in percent)
Liquid assets/total assets (in percent)
Liquid assets/short-term liabilitiesN/AN/AN/AN/AN/AN/A
Deposits as percent of assets31.631.628.524.127.529.6
Off-balance sheet liabilities/total assets (in percent)13.815.613.610.811.111.8
Use of ECB refinancing (billions of euro)
in percent of banks total assets0.
in percent of total ECB refinancing operations0.
Asset prices
Change in stock market index (in percent, e.o.p.)5•53.419.518.7•30.18.315.9
Change in housing price index (in percent, year average)0.6•
Sources: Bank of Finland, Financial Supervision Authority, Finnish Bankers’ Association, Haver Analytics, Statistics Finland, and Fund staff calculations.

Denominator also includes guarantees.

Average of margins (average lending rate minus average deposit rate) on loans to non-MFIs.

Liquid assets are defined as the sum of cash, claims on central bank payable on demand and debt securities eligible for refinancing with central bank.

Sum of main and long-term refinancing operations and marginal facility.

For 2013, the observation is as of January 2014 (change since January 2013).

Sources: Bank of Finland, Financial Supervision Authority, Finnish Bankers’ Association, Haver Analytics, Statistics Finland, and Fund staff calculations.

Denominator also includes guarantees.

Average of margins (average lending rate minus average deposit rate) on loans to non-MFIs.

Liquid assets are defined as the sum of cash, claims on central bank payable on demand and debt securities eligible for refinancing with central bank.

Sum of main and long-term refinancing operations and marginal facility.

For 2013, the observation is as of January 2014 (change since January 2013).

Table 7.Risk Assessment Matrix(Scale—high, medium, or low)
Source of RisksOverall Level of Concern
Relative LikelihoodImpact if Realized
1. Side Effects from global financial conditions.High
  • Surges in global financial market volatility, especially in wholesale funding, leading to economic and fiscal stress, and constraints on country policy settings, including in Finland, a small open economy that is financially integrated with the large Nordic banking system.

  • Bank losses and funding stress could translate into curtailed lending, with negative effects for investment, consumption, and growth.

  • Policy Response: Reduce vulnerabilities of the financial sector by fully implementing the macroprudential toolkit

2. Protracted period of slow European growth.High
  • Drop in export demand as Finland’s exports are tightly linked to EA markets.

  • With domestic demand already anemic, external demand will wane further, pushing Finland into a period of economic stagnation.

  • Policy Response: Maintain gradual pace of fiscal consolidation

3. Risks to financial stability from incomplete regulatory reforms.Medium
  • Financial instabilities linked to the remaining uncertainties about the design of future regulatory landscape and slow progress in reaching global agreements on effective crisis resolution mechanisms.

  • Bank’s willingness to lend may be affected as well as their cross-border operations and exposure.

  • Policy Response: Move ahead with financial sector reform, including at the EU, euro area, and Nordic level.

4. Adverse house price shock in Finland (or an interconnected neighboring Nordic country).Medium
  • Given high levels of household debt, a drop in house prices would reduce household liquidity and net wealth.

  • The impact of a house price shock would be elevated if it occurred in conjunction with stress in global funding markets (see point 1).

  • The effect to consumption and employment will lower growth.

  • Rising NPLs and bank funding costs could translate into curtailed lending, with negative effects on investment.

  • Policy Response: Full adoption of the macroprudential toolkit.

5. Increasing geopolitical tensions surrounding Ukraine lead to disruptions in financial, trade, and commodity markets.Medium
  • Doubts about whether Ukraine will consistently make timely commercial and financial payments.

  • An increase in geopolitical tensions, including the imposition of additional sanctions.

  • Drop in global and regional trade and financial instability.

  • A slowdown in Russia.

  • Exports to Russia may be affected, with a negative growth impact.

  • Finland is almost entirely reliant on Russian gas, but a supply disruption would be limited in the short-run.

  • Financial linkages with Russia and Ukraine are limited.

  • Policy Response: Proactively seek to diversify export markets and energy sources.

The Authorities’ Views

9. The authorities broadly agreed that the pace of recovery would be moderate and initially fragile. They recognized that the growth path would be very dependent on the external environment, especially the pace of recovery in Europe. Relatedly, the authorities acknowledged the risks to growth from developments in Eastern Europe, as Russia is an important export market and the source of all Finnish gas imports. However, they noted that the planned “growth package” (see below) should mitigate short-term risks while structural reforms should boost medium-term growth and facilitate adjustment, which could lead to export market diversification. Although household debt is still rising as a share of disposable income, the authorities did not think this represented a significant risk to financial stability in the near term. They also felt that the macroprudential policy tools provided in recent draft legislation would help them address future risks in this area.

Policy Discussion

10. Finland remains a high-capacity economy, but raising growth requires reforms. The labor force is highly skilled and firms operate in a reliably favorable business climate. However, a number of well-known obstacles—linked to the shrinking workforce, weakening productivity, and the capacity for structural adjustment—are holding back growth and need to be addressed quickly by structural reforms. In the short- to medium-term, the pace and composition of fiscal consolidation should be designed to protect the fragile recovery. And completing and deploying the full macroprudential toolkit would help guard against domestic and regional financial stability risks.

A. Structural Policies: Restarting the Growth Engine

11. Reforms were at the heart of Finland’s resurgence after the crisis in the early 1990s. The dynamic ICT sector prospered in an environment of strong policies aimed at improving competitiveness through private sector innovation. Reforms linked to EU accession in 1995 added further momentum and opened important export markets. As a result, between 1991 and 2008, Finland closed the labor productivity gap with the best performing OECD countries, mirroring strong TFP developments and a shift in investment from physical capital towards R&D. However, export market shares had already declined prior to the global crisis, along with the fading fortunes of Nokia’s mobile handset business and the global shift from paper to electronic media.

Finland Real Growth

(Percent change)

Sources: Haver Analytics and Fund staff calculations.

12. A number of new structural issues demand attention, particularly in the labor market.

  • Short work careers reduce labor supply. The pension reform of 2005 has created incentives for a longer working life. However the majority of workers retire as soon as they are legally eligible, shrinking the labor force as the population ages. At around 61 in 2013, the average effective retirement age remains considerably lower than in peer economies, despite increases in life expectancy. Projections by the United Nations suggest that life expectancy at birth in advanced economies will improve by 6 years between 2005-10 and 2045-50, lifting the expected retirement duration by 3 years for men and nearly 4 years for women.4 This contrasts with the government’s current plan to increase the effective retirement age by 1.5 years by 2025, suggesting further increases will be needed after 2025.

  • Study times are lengthy. Finnish students take a relatively long time to enter the labor force. This is partly due to cumbersome entrance processes that can delay entering university, followed by long tertiary study times—with less than half of the students completing their degrees in the targeted time. Even though universities rank high against the average of OECD countries, their performance lags behind Nordic neighbors and European top performers.5

  • Wage levels are high relative to productivity. Unit Labor Costs (ULC) are elevated and have risen markedly since the onset of the crisis, reflecting, among other factors, strong wage growth against a background of generous unemployment benefit replacement rates and duration (currently at 500 days) relative to many other OECD economies (Figure 2).

Average Effective Retirement Age, 2007–12

(Years of age)

Sources: OECD and Fund staff calculations

Unit Labor Costs

(Index: 2000=100)

Sources: OECD and Fund staff calculations.

Value of Production, Gross Value Added

(Index: 2007=100)

Sources: Statistics Finland and Fund staff calculations.

13. Low productivity growth points to weaknesses at the sectoral level. To some degree, the secular decline in TFP growth is a consequence of structural change, with manufacturing’s contribution to value added and employment falling, largely due to the reduced importance of Nokia. Although the services sector (e.g., private healthcare, rental/leasing) is growing, its productivity tends to be lower. This is particularly true for Finland’s retail sector, which still faces among the highest regulatory barriers in the EU—for example, from planning restrictions that limit economies of scale and market entry. Despite the introduction of the 2011 Competition Act, retail market concentration remains high. The productivity of Finland’s large public sector has also been declining, notably in the provision of local public healthcare and social services.

14. In response, policymakers have set ambitious goals for reform. In November 2013, the government agreed on a reform program that—in addition to fiscal reforms (see next section)—includes measures to lengthen working careers, reduce structural unemployment, and boost the economy’s growth potential.

  • Social partners, in coordination with the government, are discussing a pension reform that aims to gradually increase the effective retirement by 1.5 years (to a still low 62.4) by 2025. The discussions are to be concluded by end-2014, with implementation starting in 2017.

  • There are plans to streamline university entrance requirements and shorten study times to accelerate the transition into the labor market. The government has already shortened the duration of financial assistance to students (while increasing the level).

  • To encourage labor participation, active job seekers are allowed to earn up to €300 per month without a reduction in unemployment benefits, while employment plans will be monitored more closely. To improve the functioning of the labor market, policies are being developed to encourage job seekers to consider offers across regions, employment services for immigrants, the disabled, and long-term unemployed are being improved, and the child home care subsidy and job alteration leave policies are being amended.

  • At the local government level, some mergers of municipalities have taken place and personnel cuts in 2013 are estimated to have achieved €400 million in annual savings. The plan to consolidate the administration of healthcare and social services under five regional joint municipal authorities has the potential to improve economies of scale in these areas. Detailed measures are to be formulated by summer 2014 and considered by Parliament in the fall, with the operation of the new regional organizations to start in 2017.

15. A rapid and comprehensive implementation of reforms would improve labor market performance. In particular, the pension reform should become effective as soon as possible, preferably even before early 2017. The reform’s impact on actual retirement decisions will require close monitoring, including ensuring that the incentives linking life expectancy and the effective retirement age are working. Reducing unemployment benefits’ duration and replacement rate could add to ongoing initiatives to boost labor market activation by increasing job search incentives.

16. There is scope for additional measures to boost productivity. The efficiency of the provision of public healthcare and social services should be improved. Consolidating administration of these services at the regional level, as recently agreed by the government and other stakeholders, and standardizing data and information systems can be powerful tools in this regard. It is also important to rejuvenate efforts to deregulate Finland’s retail sector, which would improve private sector productivity overall. In addition, steps are required to adjust R&D policies to the post-Nokia era, where innovation and growth might be found in firms outside the existing ICT cluster. In this context, while R&D investment (3½ percent of GDP in 2013) remains high by international standards, it could be better focused to support innovation, especially by young firms (e.g., through well-designed tax credits). Moreover, better aligning research grants with performance, and improving the design of pre-seed and seed stage support schemes may also help.

17. Facilitating adjustment will further support growth. The transition from ICT to other sources of growth will be facilitated by wage agreements that steer average wages in line with productivity, while also offering sufficient flexibility to take into account developments at the sectoral and firm level. Furthermore, reducing the reliance of the economy on the ICT sector by stimulating innovation in other sectors would help improve productivity.

18. Removing obstacles to labor mobility is crucial. Employment protection should not become an impediment to adjustment—for example, in the context of local government reform. In addition, increasing the quantity of affordable housing in urban areas where employment is available will reduce obstacles to job seekers across the country. This requires reducing planning restrictions and increasing competition in the construction sector. Tax incentives can help here as well—for example, by raising property taxes on unused land zoned for development or improving the treatment of income from investment in residential rental property. Finally, the supply of affordable housing can be increased by higher government investment.

The Authorities’ Views

19. The authorities agreed with staff’s assessment of the structural challenges facing the Finnish economy and acknowledged the urgency of structural reforms. They pointed out the measures already introduced as part of the structural reform program announced in the fall of 2013 (see above) that aim to tackle key issues such as labor market participation, retail sector competition, and public sector productivity. While recognizing that further steps will likely be necessary, the authorities also stressed the Finnish tradition of consensus-based decision making as a factor in the speed at which some reforms can be introduced (e.g., pension reform). They noted that one benefit of consensus-based decisions is that they are less likely to be unwound over time. They acknowledged the advantages of broadening the focus of R&D support while pointing out the challenge of determining the appropriate tools to achieve this. The authorities considered the advantages of further labor market reforms, but pointed to the difficulties of implementing measures at the early stage of a recovery while the social partners were engaged in pension reform.

B. Fiscal Policy: Finding the Right Balance

20. Finland’s fiscal position has deteriorated since before the global crisis, largely due to rapid spending growth. Between 2007 and 2013, total expenditure increased by 11.1 percent of GDP, with higher spending on social benefits, public consumption excluding wages (i.e. “intermediate consumption”), and the wage bill accounting for 90 percent of the increase. Spending accelerated even before the crisis, largely due to generous public sector wage increases and rising aging-related spending (e.g., on healthcare), then continued to rise rapidly when the crisis struck (Figure 3). Overall, around 60 percent of the observed spending growth can be associated with structural factors, with the remainder due to the weak economy (e.g., unemployment benefits).

Change in Expenditure and Components, 2007–13

(Percent of GDP)

Source: Fund staff calculations.

21. Slow GDP growth has depressed revenues, exacerbating deficits and prompting the authorities to increase taxes. When the crisis struck in 2009, Finnish real GDP fell by 8.5 percent and revenue declined correspondingly. Despite sizable tax increases—including a VAT rate hike from 23 to 24 percent, increases in energy and excise taxes, and higher local income taxes—which raised the revenue-to-GDP ratio from 53 percent in 2007 to nearly 56 percent in 2013, revenues have fallen behind expenditures. This has caused the fiscal balance to deteriorate (both in headline and structural terms), shifting from consistent surpluses to persistent deficits.

GDP, Revenue, and Expenditures: Real Growth Rates


Sources: Fund staff calculations.

22. Local governments have been the driving force behind many of these developments. Local governments accounted for approximately 70 percent of the increase in public consumption (excluding wages) and wage spending over 2007–13. As a result, over the same period the aggregate local government deficit grew by 0.5 percent of GDP, despite local government tax revenues and central government transfers rising by 1.5 percent and 1.4 percent of GDP, respectively. Local government spending accounts for more than one-third of general government total expenditure, reflecting their large role in the provision of public services (e.g., healthcare), and two-thirds of public investment.

23. General government debt has risen considerably. The public debt ratio grew from 35 percent to 57 percent of GDP between 2008 and 2013 and is close to breaching 60 percent of GDP this year (see the DSA in Annex I). While still well below the average euro area public debt ratio, which exceeds 90 percent of GDP, the higher debt level has reduced buffers to absorb short-term shocks and to smooth aging-related fiscal pressures over the longer term. Population aging and lower trend growth have given rise to a longer-term fiscal sustainability gap, estimated at around 4.7 percent of GDP, mostly driven by higher projected spending on pensions, healthcare, and long-term care.6

General Government Gross Debt

(Percent of GDP)

Sources: Fund staff calculations.

24. Ultimately, it will take both growth and fiscal consolidation to ensure the long-run sustainability of the public finances. Historical experience suggests that growth and fiscal consolidation are the main drivers of successful sovereign debt reductions in advanced economies. However, while fiscal consolidation directly contributes to lower debt, it typically has a negative short-run impact on GDP, thereby (temporarily) directly raising the debt ratio as the denominator falls. Indirectly, lower GDP would also be a drag on revenue, so the improvement in the headline primary balance—and correspondingly in the numerator of the debt ratio—due to the consolidation would be smaller than otherwise. Furthermore, recent research shows that the fiscal multiplier tends to be larger when the output gap is large, as in Finland currently.7

Deviation from Baseline GDP: Adjustment Scenarios


Sources: Fund staff calculations.

Notes: See Chapter IV of the SelectedIssues for details.

25. This suggests a gradual approach to consolidation to protect the fragile recovery. Illustrative simulations show that for the same total adjustment over the 2015–19 period, depending on the multiplier assumptions used, the cumulative output loss would be around 0.5 to 1 percentage points of GDP greater for a frontloaded adjustment than for a phased-in approach.8 Both frontloaded and phased-in adjustments would cause debt to begin falling after 2015, even though by 2019 the debt ratio would be slightly lower under the frontloaded approach due to higher primary surpluses early in the consolidation. In principle, the central government’s well-established spending limits framework—reinforced by the proposed new steering system for local government finances—provides an effective mechanism with which to implement such a phased-in medium-term adjustment plan, while allowing automatic stabilizers to operate should growth underperform. Securing broad-based political support for the plan would further enhance its credibility.

Public Debt: Adjustment Scenarios

(Pecent of GDP)

Source: Fund staff calculations.

Notes: See Chapter IV of the Selected Issues for details.

26. Instead, the government’s recent spending limits decision points to a frontloaded adjustment—mitigated by off-budget measures to support growth. The fiscal stance in 2014 is broadly neutral. But the decision on central government spending limits envisages a consolidation effort of 1.1 percent of (2015) GDP over the 2015–18 period, of which 0.8 percentage points of GDP would fall in 2015. If implemented in the 2015 budget to be submitted to parliament in late-2014, as is assumed in staff’s baseline projection, this would amount to a structural adjustment of about

0.6 percent of potential GDP in 2015. At the same time, the government has announced a “growth package”—worth about around 0.3 percent of GDP—and additional measures that are projected to effectively offset part of the consolidation in 2015, so the net impact on output would be lower than otherwise. The “growth package” aims to use asset sales and higher transfers from state-owned firms to finance additional spending, mostly off-budget, in 2014 and 2015, including for R&D support and one-off public investments, with much of the spending likely to occur in 2015. Among the additional measures are plans to allow pension funds to finance new public housing construction in urban areas starting in 2014, which could boost growth and labor mobility in 2015 and beyond.

27. While difficult to gauge, the overall effect of these measures constitutes a drag on growth in 2015. There is a downside risk that the proceeds from asset sales to finance the “growth package” are lower than expected, which would result in lower spending and less mitigation of the output impact of budgetary tightening. For example, simulations suggest that if none of the mitigating factors discussed above were to materialize, growth in 2015 may be as much as 0.2–0.4 percentage points lower than in the baseline, depending on the size of the fiscal multiplier.9 However, there are also upside risks. The central government’s 2015 budget might entail less tightening than implied by the spending limits decision and local governments’ spending might be reduced by less than currently planned. Finally, even if the size of the overall adjustment is as currently expected under staff’s baseline, the composition of the adjustment measures overall could differ, which would change the growth impact.

28. In the medium term, the right budget composition would support growth. The already relatively high level of taxation—Finland ranks third in the OECD in terms of the general government revenue-to-GDP ratio—would suggest the consolidation should focus on expenditure cuts. However, on current plans, higher taxes would contribute almost half of the envisaged consolidation effort, through a mix of direct and indirect tax increases. This runs contrary to recent efforts by the central government to make Finland’s tax structure more growth friendly. For example, the corporate income tax rate was cut in 2014 from 24.5 to 20 percent—with compensating reforms to dividend taxes that broadened the tax base, as well as increases in energy and excise taxes—which should encourage higher investment over the medium-term. Recent local government tax increases have also mainly been through income taxes instead of property taxes, which tend to have less detrimental growth effects and vary less with the business cycle. Recent estimates suggest that raising the property taxes to the OECD average could generate revenue of about 1 percent of GDP.

29. Successful structural reforms will be important to offset the drag from fiscal consolidation in the medium term. Simulations of the impact of structural reforms on output—based on OECD measures of structural indicators and the gap between Finland and the OECD “frontier” and DSGE model results—suggest that reforms could raise output by between 1 and 3 percent relative to the baseline in 2019.10 This would be sufficient to put debt on a downward path over the medium-term. And the simulations suggest that combining structural reforms with fiscal adjustment would lead to an even faster decline in the debt ratio.

Public Debt: Adjustment and Reform Scenarios

(Percent of GDP)

Source: Fund staff calculations.

Notes: See Chapter IV ofthe SelectedIssues for details.

30. In this context, measures that combine growth-enhancing effects with fiscal savings are particularly effective. Pension reform is a central pillar of the government’s structural reform program agreed in 2013. If executed as planned, it is expected to significantly reduce the sustainability gap over the long term through direct fiscal savings (from the later retirement of public employees) and higher revenues (by increasing labor supply and potential growth). The proposed steering system for local governments’ finances—conceptually similar to the central government’s spending limits framework—should help to contain spending growth over the medium-term. Additionally, local government reforms to improve public sector productivity, such as the consolidation of health and social services administration, should deliver further savings over the medium- to long-run.

The Authorities’ Views

31. The authorities recognize the risks to growth from rapid fiscal adjustment, but ultimately view a potential loss of credibility as more important. They pointed to the difficulty of securing broad-based support for a more gradual consolidation path extending beyond the elections in 2015. They emphasized that their approach would help maintain Finland’s reputation for responsible fiscal management in line with an earlier commitment to put government debt on a downward path. The authorities also stressed the growth-enhancing nature of certain measures in the “growth package” introduced in conjunction with the spending limits decision, which they believe will reduce risks to growth next year. They defended the roughly 50-50 split in spending cuts and tax increases as a key plank in the governing coalition’s agreement. Generally, the idea of substantive property tax reform was not considered politically feasible in the near-term.

C. Financial Policy: Ensuring Stability

32. The Finnish banking system has proven resilient during the crisis, but the low interest rate environment has left its mark on profitability. Banks’ capital ratios declined somewhat in 2013, but remain comfortably above regulatory norms and high relative to many European peers (Table 6). However, with interest rates still at very low levels, the bulk of banks’ income stems from non-interest earnings, including equity investments. At the same time, banks remain highly dependent on wholesale funding, as reflected in a high and rising loan-to-deposit ratio (119 percent at the end of 2013, up from 111 percent in 2012). Nevertheless, the Financial Supervisory Authority (FIN-FSA) considers liquidity buffers adequate and in line with Basel III requirements, at least among the large banks that are active in wholesale funding markets.

33. Domestic asset quality is an area of concern. Nonperforming loans (NPLs) remain low, rising slightly to 0.6 percent of total loans in 2013. But the aggregate measure masks a notable rise in corporate NPLs, which grew by 10.8 percent year-on-year in 2013, while a decline in external assets, primarily reflecting deleveraging within Nordea Bank Finland’s Baltic operations, has helped reduce NPLs overall. Lending to SMEs remains subdued and larger corporates increasingly issue debt amid still favorable capital market conditions.

34. At the same time, household indebtedness continues to rise, helping to boost house prices in certain regions. Household debt as a share of disposable income is around 120 percent, up from just over 100 percent prior to the crisis, with both the level of housing-related credit rising and disposable income declining in the wake of the crisis. The high level of housing-related credit, including that incurred by housing associations, is reflected in elevated house prices, though the level of overvaluation is lower than in other Nordic countries. However, the national average conceals rapid growth in prices in large metropolitan areas (see Box 2).

35. Risks to the Finnish banking system predominately stem from spillover risks due to strong regional interconnections and the dominant role of foreign-owned banks. Nordea Bank Finland and Danske Bank Finland are the largest banks operating in Finland. Although this can provide a degree of stability (e.g., through supportive group level liquidity or capital management), it also means that economic or financial shocks in Sweden and Denmark could cause significant negative spillovers to lending activity in Finland. Moreover, group level policies—such as Nordea’s consolidation of its derivatives business in Finland—complicate the signals from aggregate financial soundness indicators and can result in an undue concentration of risk. While higher interest rates would raise banks’ funding costs and could pose a risk to banks’ net interest income, the impact would likely be limited for income from lending to households, as the bulk of this is via mortgages with adjustable interest rates (see Box 2).

36. The advancing EU regulatory agenda is an opportunity to strengthen Finland’s macroprudential framework. Long-needed progress is underway as some CRD IV/CRR recommendations are being transposed into national legislation under the draft Act on Credit Institutions. The proposed empowerment of the independent Board of the FIN-FSA will create a macroprudential authority effective from mid-2014, with decision-making powers over all adopted instruments. The Board is comprised of representatives from the Bank of Finland, Ministry of Finance, and Ministry of Social Affairs and Health, as well as two independent candidates, all of whom are nominated by the parliament’s Supervisory Board. The represented institutions and independent positions will have permanent voting rights. Importantly, the policy-making process will be supported through surveillance and analysis, provided primarily by the Bank of Finland.

37. Ensuring the full scope and flexibility of macroprudential tools identified by the ESRB are available will be critical to the Board’s effectiveness. Finland lags behind its Nordic peers in legislating a comprehensive set of macroprudential instruments. The current draft legislation incorporates mandatory macroprudential instruments set out in CRD IV/CRR, but only at the minimum standards for each tool and with very limited recourse to others. This unduly restrains the authorities’ capacity to contain mounting risks, respond to shocks, or to fully harmonize regulations with their regional peers and, thus, deter regulatory arbitrage. In this regard, the macroprudential framework can be strengthened in two specific areas:

  • A systemic risk buffer (SRB) should be incorporated into national legislation. Allowing for mandatory additional capital holdings, including in a targeted manner, under the SRB is particularly important given the banking sector’s large size, degree of concentration, extent of cross-border activities, and dependence on wholesale funding.

  • The countercyclical capital buffer (CCB) should not be limited to the minimum mandatory reciprocity threshold of 2.5 percent. Current draft legislation excludes the possibility of requiring additional capital should it be justified by underlying risks. Allowing the full scope of the CCB would empower the Board to guard against large swings in credit, and better ensure regulatory consistency across the region.

Finland: Proposed Adoption of CRD IV and CRR Instruments
MandatoryOptionalFinland to Adopt
CRD Instruments:
Countercyclical Capital Buffer
Systemically Important Institution Buffer
Systemic Risk Buffer
Liquidity Requirements under Pillar II
Other Pillar II
CRR Instruments:
Higher Requirements
(capital, liqudity, large exposures, risk weights)
Higher Real Estate Risk Weights
(or stricter lending criteria)
Higher Average LGDs
LTI, DSTI, LTD limits, and Leverage Ratio
Sources: ESRB, FIN-FSA, and Fund staff.Notes: Loan-to-Income (LTI); Debt-Service-to-Income (DSTI); Loan-to-Deposit (LTD).
Sources: ESRB, FIN-FSA, and Fund staff.Notes: Loan-to-Income (LTI); Debt-Service-to-Income (DSTI); Loan-to-Deposit (LTD).

Nordic Four: Transition to Common Equity Tier 1 Capital Buffer1

(Percent of Risk Weighted Assets)

Sources: FIN-FSA and Fund staff calculations.

1 These data are only representative as they have been compiled from known draft capitalization plansof respective supervisoryauthorities.

38. To reduce risks from elevated house prices, regulators must have the full capacity of tools to contain mortgage lending. Plans to introduce Loan-to-Value (LTV) caps for new mortgages—set at 90 percent for current mortgage holders and 95 percent for first time buyers—should directly reduce demand for a limited portion of loans and help ensure credit quality throughout the cycle. Nevertheless, the provision of collateral—including financial assets, deposits, property, and insurance instruments or state guarantees—against the LTV caps effectively raises the amount of leverage that can be achieved. This practice should be limited to avoid reducing the effectiveness of LTVs and also to maintain the spirit of ESRB recommendations on their use.11

39. A more targeted approach to LTVs, along with more stringent capital measures, could prove highly effective in addressing localized housing pressures. Given the dispersion in regional house prices, the Board should consider enforcing more binding LTVs (e.g., set at 80 percent for current holders and 85 percent for first time buyers) in certain metropolitan areas. This could be achieved by tightening the collateral ceiling, as allowed for in the draft legislation. As a complementary measure, higher mortgage risk weights for banks should also be considered. This would help to limit the supply of housing-related credit when financial stability concerns arise and ensure greater regulatory coherence at the regional level. Finally, the introduction of a national loan registry would facilitate macroprudential monitoring of credit developments.

40. The advancement of the Banking Union should enhance regional supervisory cooperation. It is important to ensure that large regional banks are assessed at the group level during the upcoming Balance Sheet Assessment, including by using like methodologies and independent third party reviews. In support, binding regional agreements on resolution and burden sharing, particularly in the Nordea Crisis Management Group, should be reached without delay. The principles of these agreements should be in line with the Single Resolution Mechanism (SRM) and Bank Recovery and Resolution Directive objectives to facilitate harmonization between Finland and other Nordic countries when the SRM comes into operation. Similarly, once liquidity and funding requirements are fully developed at the EU level, they should be harmonized across the Nordic region to ensure group-level liquidity is adequately defined in branches and subsidiaries.

The Authorities’ Views

41. The authorities acknowledged the importance of more fully implementing CRD IV/CRR, including as a means to harmonize regional frameworks. However, they viewed the outcome of the current draft legislation as pragmatic given the strong capitalization of Finnish banks and lack of consensus on key issues at the European level. They did not exclude further enhancing the macroprudential toolkit in line with European-level progress. The authorities also recognized staff concerns over elevated house prices, but viewed the proposed LTV caps as adequate, particularly given the recent moderation in mortgage lending and overall house prices. The authorities saw some merit in future consideration of more binding LTVs, but noted that this would significantly change the current structure of loan provision. They also broadly agreed with staff on the possibility of using LTVs on a targeted basis to address regional house price pressures, but thought it was necessary to first carefully consider any potential implications.

42. The authorities welcomed progress toward banking union, seeing it as an opportunity to further strengthen regional supervisory coordination. The authorities noted the potential challenges of joint supervision of large banks operating across countries currently outside and inside of the banking union framework. But they also pointed to the tradition of supervisory cooperation in the Nordic region and stressed the role for the existing supervisory colleges, which could help enhance coordination and promote a smooth transition to evolving European regulations.

Staff Appraisal

43. Finland’s recovery from the global crisis was brief. Real GDP dropped by almost 2½ percent during 2012–13, and unemployment has risen above 8 percent. The shortfall in growth, coming at a time when peer economies saw GDP improve and unemployment decline, points to deeper structural problems. Exports suffered from the continued decline of the ICT and paper and pulp industries, but also because Finnish wage costs increased just as labor productivity growth fell. Longer-term factors, such as a rapidly aging workforce, added to the headwinds.

44. The outlook is for slow growth. With the gradually improving outlook for the euro area, external demand is expected to increase over the course of 2014. This should eventually support a rebound in investment, especially if interest rates remain low. However, GDP growth is likely to pick–up more gradually than previously forecast, reflecting recent weak data and trade exposure to Russia, as well as the planned fiscal consolidation. With a still sizable negative output gap, unemployment will decline slowly, while inflation is projected to decelerate to 1.5 percent by 2015.

45. The economic upturn will also likely be fragile. Weaker external demand could easily derail the recovery—for example, because of negative effects from an escalation of geopolitical tensions, or slower euro area growth. Domestically, high, and still rising, levels of household debt could make consumers more cautious to spend if interest rates normalize faster than expected. Finally, the growth outcome could also change with the timing and composition of fiscal adjustment.

46. Bold and rapidly implemented structural reforms are needed to achieve higher medium-term growth. Pension reform to lift the effective retirement age is crucial to avoid declining labor market participation, as is encouraging younger workers to enter the labor market sooner. Plans to improve the productivity of public sector healthcare should be specified and implemented quickly. Boosting retail competition would improve overall productivity in the private sector, while R&D investment can be better focused to support innovation, especially by young firms. In addition, it is important that wage bargaining supports adjustment by steering real wages in line with overall productivity growth, while ensuring sufficient flexibility to accommodate variation at the firm and sectoral levels. Measures to increase the quantity of affordable housing would facilitate labor mobility and matching.

47. Fiscal policy should seek to balance growth and sustainability concerns. The deterioration of the public finances has both cyclical and structural roots. Credible fiscal adjustment over the medium-term—backed by continued broad-based political support—would ensure sustainability and help protect the fragile recovery. The broadly neutral fiscal stance in 2014 is appropriate, and staff simulations suggest that gradually increasing fiscal adjustment in line with the expected strengthening of the economy would minimize the risks to growth. If growth underperforms, automatic stabilizers should be allowed to operate.

48. In contrast, the planned frontloaded adjustment risks slowing the recovery. The recent decision on medium-term spending limits for the central government suggests that the bulk of the fiscal consolidation could come in 2015, when the upturn will still be gathering speed. To reduce the risks to growth, it will be important to steer the discussion of the 2015 budget towards making the composition as growth-friendly as possible—for example, by increasing the contribution from expenditure cuts, while preserving public investment, and shifting the revenue component of the adjustment away from direct taxes towards property taxes. Full and rapid implementation of the government’s “growth package” and measures to enhance housing investment are also crucial.

49. A robust macroprudential framework is crucial to containing financial stability risks. Despite relatively high levels of capitalization, banks remain vulnerable to risks stemming from elevated house prices, high levels of household indebtedness, regional interconnections, and dependence on wholesale funding. Thus, the planned legislation should maintain the full scope and flexibility of the European framework (CRD IV/CRR). This would ensure that the independent Board of the FSA has the capacity to respond to financial stability risks and to work toward full harmonization of macroprudential tools across the Nordic region. The Bank of Finland is well placed to support the new macroprudential policy-making process through surveillance and analysis.

50. It is proposed that the next Article IV consultation with Finland occur on the standard 12-month cycle.

Box 1.Exchange Rate and Current Account1

After widening as Finland lost export market share after the crisis, the current account deficit is now shrinking as external demand improves and domestic demand remains subdued. The current account (CA) deficit improved from 1.4 percent of GDP in 2012 to 1.1 percent in 2013. The move from a pre-crisis CA surplus to recent deficits was driven primarily by a drop in export demand, reflecting the break-up of Nokia, the structural decline in global demand for paper and pulp, and declining competiveness. The recent improvement in the CA deficit stems from slightly better external demand, as well as weak domestic demand due to the persistently low confidence of investors and consumers alike.

Finland’s net international investment position (NIIP) remains positive, at 17 percent of GDP (Table 3). Portfolio debt liabilities have come to dominate capital inflows since 2007. As a result, gross external debt liabilities have doubled relative to GDP (to 240 percent of GDP in 2013), driving up the share of external debt in total external liabilities to 80 percent (from 52 percent in 2007). This is largely due to Swedish and Danish banks funding much of their broader euro area activities through their Finnish operations, as well as “safe haven” flows during the crisis. Comparatively, net external debt is low (26 percent of GDP). The composition of Finland’s external assets has remained remarkably stable over time, with external equity and debt assets accounting for roughly 1/3 and 2/3, respectively, of total external assets.

Estimates of Competitiveness Using EBA Methodologies1
MethodologyCA gap

(percent of GDP)
REER gap

Macroeconomic balance (MB) approach•1.25.0
External sustainability (ES) approach1.9•7.0
Equilibrium real exchange rate approach0.0
Source: IMF staff estimates.

EBA (External Balance Assessment). CA gaps: minus indicates overvaluation. REER gaps: minus indicates undervaluation. REER deviations between -10 and +10 mean the real exchange rate (RER) is close to balance. EBA estimates are based on data available in April 2014.

Source: IMF staff estimates.

EBA (External Balance Assessment). CA gaps: minus indicates overvaluation. REER gaps: minus indicates undervaluation. REER deviations between -10 and +10 mean the real exchange rate (RER) is close to balance. EBA estimates are based on data available in April 2014.

The IMF’s multilaterally-consistent methodologies suggest the real exchange rate remains broadly in line with fundamentals. Recent External Balance Assessment (EBA) estimates are mixed, but, overall, support the view that the real exchange rate is broadly in line with fundamentals and desirable policies. While the Equilibrium Real Exchange Rate approach concludes that the real exchange rate is neither over- nor undervalued, the Macroeconomic Balance approach suggests mild overvaluation and the External Sustainability approach points to the opposite. CGER methodologies also produce a mixed picture, even though the models suggesting overvaluation come out somewhat stronger than the relevant EBA approaches.

Estimates of Competitiveness Using CGER Methodologies1(Percent deviation from levels implied by medium-term fundamentals)
Macroeconomic balance (MB) approach9.4
External sustainability (ES) approach8.8
Equilibrium real exchange rate (REER) approach•3.7
Source: IMF staff estimates.

CGER (Consultative Group on Exchange Rate Issues). A positive current account gap and a negative real effective exchange rate gap indicate undervaluation. International Monetary Fund, 2008, “Exchange Rate Assessments: CGER Methodologies” (available at CGER estimates are based on data available in November 2013.

Source: IMF staff estimates.

CGER (Consultative Group on Exchange Rate Issues). A positive current account gap and a negative real effective exchange rate gap indicate undervaluation. International Monetary Fund, 2008, “Exchange Rate Assessments: CGER Methodologies” (available at CGER estimates are based on data available in November 2013.

1 All results are based on the October 2013 World Economic Outlook, and real effective exchange rate estimates for February 2014.

Box 2.Household Debt and Interest Rate Risk

Retail borrowing rates in Finland are at historic lows. The real average prime bank rate across key lenders is slightly negative, down from around 2.7 percent prior to the crisis. This has cushioned the impact of the economic downturn on households, but it has also facilitated higher household debt, boosted house prices in certain regions, and challenged banks’ profitability. In the context of weak overall growth, this mix raises the risks to both household and bank balance sheets from higher interest rates.

Household indebtedness has increased. A substantial portion of household debt is comprised of variable rate mortgages (largely tied to Euribor), but additional debt is incurred through housing associations. Borrowing by housing associations increased notably early in the crisis with the decline in interest rates, and currently amounts to around €10 billion (or 9-10 percent of total household borrowing). Although mortgage borrowing has cooled over the past year, borrowing through housing associations remains elevated, and whether amortized or pre-paid through personal loans, adds to household debt.

House prices have risen the fastest in metropolitan areas. The pace of house price growth has been pronounced in Helsinki and other highly developed areas despite the crisis, but less so in other regions, especially where there have been declines in manufacturing and industry. Similar dynamics are evident in the relative prices of smaller dwellings compared to larger properties or detached homes, underscoring the upward pressures on house prices in highly populated areas.

Housing Related Credit and Euribor


Sources: Bloomberg, FIN-FSA, and Fund staff calculations.

Notes: HA stands for Housing Associations.

Housing Prices by Region

(Index: March 2010=100, 3-month moving average, old flats)

Sources: Statistics Finland and Fund staff calculations.

Still-growing household indebtedness and concentrated house price pressures underscore risks from a rise in domestic interest rates. Higer interest rates could be driven by a normalization of global monetary policy and/or risks in global funding markets, and would impact the economy through several channels:

  • Mortgage payments by households would rise over time. But the cushion provided by variable mortgage amortization schedules and the prohibition of banks to unilaterally revise lending margins on existing mortgages would limit immediate risks. FIN-FSA stress tests indicate only modest impacts on mortgage serviceability from interest rates rising to as high as 6 percent.

  • SMEs would be affected by rising rates, particuarly given already higher relative impariment levels on bank loans, having negative knock-on effects to employment and household income.

  • Private consumption would be weakened by higher debt servicing costs, amplifying the effects through lower household incomes.

  • House prices would be exposed to a downward correction. Estimates suggest that a 10 percentage point decline in property prices in Nordic countries could reduce GDP by as much as 2½ percent, and private consumption and residential investment by as much as 3½ and 28½ percent, respectively.1

  • Household net wealth would fall with declining house prices, reducing household borrowing capacity through lower collateral valuations and confidence effects.2 Finnish household wealth is high (on par, for example, with Germany), but with a lower share of liquid financial assets. This suggests limited positive income effects from higher interest income streams.

Strong regional bank interconnections underscore potential risks from other Nordic countries. Similar interest rate, or other, shocks in Sweden or Denmark could cause marked revisions in the domestic lending capacity of Noredea Bank Finland and Danske Bank Finland. Given the systemic importance of these banks, the negative effects would be similar to those emanating from within Finland. As an example, the correction in house prices elsewhere in the Nordic region has prompted local affiliates to reduce high loan-to-value lending in Finland.

1 See the IMF working paper by Igan and Loungani, 2012, Global Housing Cycles.”2 See IMF, 2013, Nordic Regional Report.”
Appendix I. Debt Sustainability Analysis

Finland Public Sector Debt Sustainability Analysis (DSA) – Baseline Scenario

(in percent of GDP unless otherwise indicated)

Source: Fund staff calculations.

1/ Public sector is defined as general government.

2/ Based on available data.

3/ Bond Spread over German Bonds.

4/ Defined as interest payments divided by debt stock at the end of previous year.

5/ Derived as [(r - p(1+g) - g + ae(1+r)]/(1+g+p+gp)) times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

6/ The real interest rate contribution is derived from the denominator in footnote 4 as r - π (1+g) and the real growth contribution as -g.

7/ The exchange rate contribution is derived from the numerator in footnote 2/ as ae(1+r).

8/ For projections, this line includes exchange rate changes during the projection period.

9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

Finland Public DSA – Composition of Public Debt and Alternative Scenarios

Source: Eurostat, Finnish State Treasury, Ministry of Finance, Statistics Finland, and Fund staff calculations.

1/ The Baseline is constructed from historical data on debt maturity, currency denomination of debt, and other characteristics of outstanding government debt. Projections are based on financing needs and other related variables from reports of the Swedish National Debt Office and the Ministry of Finance. In the Historical scenario, real GDP growth, the real interest rate, and the primary balance are set to historical averages. In the Constant Primary Balance scenario, the primary balance projection is kept constant at the 2013 Baseline proejction level. The Contingent Liability Shock scenario considers a one-time increase in non-interest expenditures equivalent to 10 percent of banking sector assets. In turn, this results in adverse effects on real GDP growth, which is reduced by 2 standard deviations for 2 consecutive years. The revenue-to-GDP ratio remains unchanged relative to the baseline; the deterioration in the primary balance leads to an increase in the interst rate; and the decline in growth results in lower inflation.

IMF, 2013, “Nordic Regional Report,” describes the underlying methodology.

See Chapter III of the Selected Issues for further details.

See Chapter I of the Selected Issues for a discussion of potential output estimates under a variety of approaches, including the importance of smoothing parameter assumptions for the volatility of potential output growth.

Estimation by OECD in “Economic Survey: Finland 2014.

See OECD, “Economic Survey: Finland 2012.

See Chapter IV of the Selected Issues and “The 2012 Aging Report” from the European Commission for details.

See Abbas and others, 2013, “Dealing with High Debt in an Era of Low Growth,” for an analysis of past episodes of sovereign debt reductions in advanced economies. Chapter IV of the Selected Issues discusses the multiplier issue and the mechanics of how a consolidation’s negative GDP impact can cause the debt ratio to rise in the short-run.

See Chapter IV of the Selected Issues for details.

See Chapter IV of the Selected Issues for details.

See Chapter IV of the Selected Issues for details.

The ESRB recommends LTVs as a means to restrict the quantity of credit relative to the value of the collateral. See “The ESRB Handbook on Operationalising Macroprudential Policy in the Banking Sector” at

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