Finland
Recent Economic Developments

This paper reviews economic developments in Finland during 1990–95. The paper discusses the domestic economy, public finances, money and credit, and the balance of payments. It reports on the robustness of various inflation indicators, providing background to the process of establishing a monetary policy framework under a floating exchange rate. The paper also reviews possible structural causes for high unemployment and discusses reform proposals. Macroeconomic shocks that triggered the recession are analyzed. The role of financial factors in the transmission of those shocks economy-wide is also discussed.

Abstract

This paper reviews economic developments in Finland during 1990–95. The paper discusses the domestic economy, public finances, money and credit, and the balance of payments. It reports on the robustness of various inflation indicators, providing background to the process of establishing a monetary policy framework under a floating exchange rate. The paper also reviews possible structural causes for high unemployment and discusses reform proposals. Macroeconomic shocks that triggered the recession are analyzed. The role of financial factors in the transmission of those shocks economy-wide is also discussed.

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 1
CHART 1

FINLAND GROSS DOMESTIC PRODUCT, 1986–91

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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

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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 2
CHART 2

FINLAND CONTRIBUTIONS TO REAL GDP GROUTH, 1986–94

(In percent)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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

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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 3
CHART 3

FINLAND HOUSEHOLD SAVING AND INDEBTEDNESS RATIOS, 1985–94

(In percent)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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

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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)

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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

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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

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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 4
CHART 4

FINLAND LABOR MARKET, 1985–94

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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)

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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 5
CHART 5

FINLAND INFLATION, January 1989 – June 1995

(Annual percentage change)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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 6
CHART 6

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

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

Source: OECD Economic Outlook, June 1995.
CHART 7
CHART 7

FINLAND CENTRAL GOVERNMENT FINANCES, 1985–95 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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 8
CHART 8

FINLAND CENTRAL GOVERNMENT BUDGET, 1988–95 1/

(In billions of Fmk)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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)

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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

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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/

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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)

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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.

Specified New Expenditure Cuts Envisaged in the 1996 Budget

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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/

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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 9
CHART 9

FINLAND GENERAL GOVERNMENT FINANCES, 1988–95 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

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/

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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)

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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/

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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/

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 10
CHART 10

FINLAND EXCHANGE RATES, January 1990 – June 1995

Citation: IMF Staff Country Reports 1995, 104; 10.5089/9781451813111.002.A001

Sources: Bank of Finland; and IMF, International Financial Statistics and unit labor cost data server.
CHART 11