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Statement by Ms. Meyersson, Executive Director for Finland and Mr. Miettinen, Advisor to Executive Director, May 21, 2014

Author(s):
International Monetary Fund. European Dept.
Published Date:
May 2014
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We would like to start by conveying our authorities’ gratitude to staff for the detailed discussions during the Article IV consultations and for the thorough analysis of the Finnish economy. An independent analysis of our economic policies and challenging economic situation is particularly welcome at the current juncture. The Finnish authorities agree on balance with the findings presented in the staff reports. While there are some differences about the timing and composition of fiscal measures aimed at securing fiscal sustainability in the long run, many of staff’s recommendations are in line with the policies that are being implemented.

Recent Economic Developments and Outlook

Finland’s economic performance was strong from 2000 until 2008, but the financial crisis hit the country hard. Finland’s economy plummeted in 2009 by 8.5 percent, but recovered well during 2010 and 2011. The Finnish economy contracted again in 2012 and 2013 due to weak demand and the prolonging of the euro area sovereign debt crisis. The latest decline has pushed unemployment in Finland above 8 percent. After falling two years in succession, GDP is expected to gradually return to growth. According to the Ministry of Finance’s latest forecast, Finnish GDP is expected to post growth of 0.5 percent in 2014. In 2015, GDP growth will pick up to 1.4 percent, and be increasingly broadly-based.

The factors underlying the weaknesses of the Finnish economy are well captured in the staff report and some of them are of fundamental nature. As pointed out by staff, labor productivity has been poor since the financial crisis. Part of the reason for this lies in the declined contribution of high-productivity sectors to total output. Return to sustainable growth and elimination of a significant sustainability gap, estimated by the Ministry of Finance to be 3 percent of GDP, requires timely implementation of major structural reforms.

The outlook in Europe, Finland’s principal export market, is now brighter than in the past few years, which will boost Finnish companies’ export demand. The last round of wage negotiations produced a moderate wage increases that marks the first step towards regaining lost competitiveness. Maintaining moderation in wage agreements is an essential part of restoring Finnish competitiveness also in the longer term. As a result of the agreed wage developments, real earnings are projected to decline. This results in weak domestic demand which is expected to pick-up only in 2016 in the Ministry’s latest forecast.

Despite the recent positive trend in the global economy and the improved outlook in the domestic economy, the risks in the outlook are still predominantly to the downside. The authorities agree with staff that delays in the recovery of the Finnish trading partners pose a risk to export-led growth projections. In particular, spillover effects from the crisis in Ukraine and recession in Russia will exert downside risks to Finland’s expected recovery.

One of the most significant domestic challenges is to improve the efficiency of the labor market. Population ageing coupled with the mismatch problems in the labor market may become a real obstacle to growth.

Macroeconomic policies and the reform agenda

The long-run challenges of the Finnish economy and public finances are clear, and the policies to tackle these challenges mutually acknowledged: bold and rapidly implemented structural reforms are needed to achieve higher growth in the medium to long term.

Regarding the short run, the policy recommendation is not as straightforward. Here the key question is how to sustain economic recovery and promote growth without risking confidence in fiscal stability and sustainability in the long run. The appropriate policy orientation depends on how the risks and benefits of the alternative options are emphasized. Staff’s report emphasizes the short-run risks of fiscal consolidation on recovery. The analysis and recommendation rest, among other things, on staff’s estimates of the size of the output gap and fiscal multipliers which are inherently uncertain. In its recent decisions, the Government has recognised these elements but also taken into account the risks of sharply climbing public debt on fiscal stability.

The Government’s fiscal and economic policy is geared to bridging the sustainability gap in public finances. In the autumn of 2013, the Government announced a new structural policy programme aimed at improving the conditions for economic growth and to close the sustainability gap.

Most of the favourable effects of the reforms on growth and fiscal sustainability will only materialise in the long run. Since this route is considered very slow and if deficits remain significant, there is a risk that state debt will spiral out of control once interest rates return to normal. Reducing central government deficit in a credible way is important to preserving confidence and to preventing a vicious circle of escalating debt in the medium term, before the structural reforms have the chance to make an impact.

The Government decisions in March 2014 on new consolidation measures and their timing take into account these concerns. The growth package, which supports seed financing for innovations and important infrastructure investments, mitigates the negative impact of the consolidation on the economy to some extent in 2015-2016.

The staff report correctly points to structural weaknesses in the Finnish economy. The Government’s structural reform program tackles these weaknesses in five areas: i) improving productivity in the public sector; ii) lengthening working careers; iii) lowering structural unemployment; iv) improving the economy’s growth potential; and v) strengthening local government finances.

Labor market

The social partners are negotiating on the pension reform that aims at increasing the effective age of retirement by a minimum of 1.5 years. The consensus-based decision making regarding this issue has taken some time, and the expectation is to finalize discussions in fall of 2014 to deliver the changes as soon as possible. The government has undertaken measures to reduce unemployment through reforms of the tax and benefit system and intensified active labor market policy. From the beginning of this year, it has been possible to receive some earnings without losing the unemployment benefit or housing allowance. Employment will be actively offered to unemployed by employment offices, and sanctions for persons that do not accept employment will be enacted. As pension reforms are prioritized, some other labor market reforms which staff points to, have received less attention.

The government has already introduced legislation to provide incentives for earlier completion of studies. In addition, more weight is placed on the matriculation examination at the entry into higher education and intakes have been increased to expedite the eventual entry to working life. With the announcement of the latest fiscal policies the government also announced reforms to support new housing investment in the capital region.

Healthcare

A significant part of the public expenditure is spent on healthcare and social services in Finland. In March 2014 the government and the opposition parties agreed on the implementation of a comprehensive reform of social welfare and healthcare services in Finland. The reform will consolidate social welfare and healthcare services into five regions that are large enough to deliver economies of scale. In particular, this reform allows for closing efficiency gaps between specialized care units, more efficient exploitation of new technologies and division of labor between and inside the regions and more efficient control at the national level. The plan is to have this reform in place by 2017.

Local governments

The reform agenda includes measures to strengthen local government finances. A new steering system will be implemented in 2015 that enables better safeguards for the sustainability of municipality finances. The new steering system should ensure that the municipalities’ obligations are consistent with balanced budgets. In addition, the agenda includes measures that improve public service productivity. Municipalities have already embarked on cutting costs and increasing municipality taxes. Some municipal mergers have also taken place.

The extensive reform plan notwithstanding, more work is needed to implement these reforms.

Financial sector policies

The Finnish authorities have drafted a national legislation for implementing the Capital Requirements Directive (CRD IV) in compliance with the Capital Regulations Regulation (CRR). The legislation was sent to parliament in April this year. The draft legislation proposes to fulfill the mandatory requirements of the CRD IV. Staff draws attention to the possibility of regulatory arbitrage and to the current design of the legislation. The authorities are well aware of these concerns and are ready to adjust the legislation if warranted.

In addition to the mandatory criteria, the legislation introduces an adjustable LTV cap to the mortgage markets. There is a provision to use collateral in the calculation of the LTV cap, and this provision, along with the LTV cap itself, can be changed by the Finnish FSA board to be more stringent. The authorities are well aware of the risks related to the mortgage market, and households and banks have been prompted to make stress calculations with higher interest rates. On average, Finnish mortgage LTVs are not alarmingly high, as was also shown in the Nordic Regional Report, but the average masks a concentration of debt to more indebted households. The proposal endows the FIN-FSA board with the necessary tools to address risks in the mortgage market if necessary.

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