Finland
2007 Article IV Consultation: Staff Report; Staff Statement and Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Finland
Author: International Monetary Fund
Publication Date:
06 Aug 2007
eISBN:
9781451813289
ISBN:
9781451813289
Language:
English
Keywords:
ISCR; CR; estimate; projection; wage; wage growth; terms of trade; output gap; fiscal policy; staff projection; Labor markets; Fiscal stance
Download PDF (559.5 KB)

This 2007 Article IV Consultation highlights that growth in Finland has outpaced the euro area average. Inflation is among the lowest in the European Union, and the external current account and general government budget are both comfortably in surplus. The labor market has improved markedly since 2005, with rising participation rates and comparatively strong employment growth. The unemployment rate has dipped below the euro area average, and hovers near estimates of the structural unemployment rate.

Abstract

This 2007 Article IV Consultation highlights that growth in Finland has outpaced the euro area average. Inflation is among the lowest in the European Union, and the external current account and general government budget are both comfortably in surplus. The labor market has improved markedly since 2005, with rising participation rates and comparatively strong employment growth. The unemployment rate has dipped below the euro area average, and hovers near estimates of the structural unemployment rate.

I. Introduction

1. The economic situation remains enviable. Growth has outpaced that in the euro area since the early 1990s, inflation has remained among the lowest in the EU, and the government budget and external current account are both comfortably in surplus. Finland is also near the top of rankings for research and development, innovation, and competitiveness.

2. Nevertheless, significant challenges loom. Exports are growing strongly, having rebounded from a labor dispute-induced fall in 2005, but they remain comparatively concentrated in two sectors: telecommunications and paper products. Demographic pressures are soon to be felt, with the old-age dependency ratio set to rise the most rapidly in the EU. Despite recent pension reforms, the authorities acknowledge in their latest Stability Program that without additional steps the fiscal position is unsustainable. Fast-paced change and increasing international integration in the financial sector open opportunities, but create risks and test supervisory capabilities.

II. Recent Economic Developments

3. The economy surged in 2006, the result of underlying strength and one-off factors. Although the rebound following the 2005 labor dispute in the paper sector is estimated to have added 1 percentage point to growth, underlying activity still expanded by some 4½ percent—about 1 percent above potential (Table 1 and Figure 1). The components of domestic demand made more balanced contributions to growth, with strengthening business fixed investment joining vibrant residential construction in offsetting somewhat the reduced contribution of consumption. Nonetheless, private consumption growth remained solid, as employment gains, income tax reductions, and improving consumer confidence offset the dampening effects of higher interest rates and mounting debt loads. Net exports contributed 2½ percentage points to growth, reflecting buoyant activity in the “neighborhood” (Sweden, Russia, and the Baltics), a rallying German economy, and the paper sector bounceback.

Table 1.

Finland: Main Economic Indicators, 2002–09 1/

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Sources: Ministry of Finance, Bank of Finland; and staff projections.

Projections are staff estimates based on the authorities’ current policy indications.

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

Based on relative normalized unit labor costs.

Figure 1.
Figure 1.

Finland: Growth and Inflation, 2000–08

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Sources: Statistics Finland Eurostat; and IMF staff estimates.

GDP and Demand 1/

(Percent change)

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Sources: Statistics Finland; and staff projections.

A paper sector labor dispute is estimated to have reduced growth by about 1 percentage point in 2005 (most of which was accounted for by a worse contribution of net exports to growth), with offsetting changes in 2006.

Contribution to growth.

4. The labor market is finally benefiting from the cyclical upswing, amid, however, signs of mismatches and related tightening. After some delay, rising employer confidence has boosted job growth, with over 125,000 net new jobs created in the last three years. The unemployment rate mirrors the euro area level, but signs of labor shortages are appearing (e.g., in construction), especially in the booming Helsinki area. Impediments to territorial mobility, worsening skills mismatches, and social insurance features (see below) are hindering further employment gains, and threaten to spur wage pressures, as unemployment is falling below the structural rate (estimated at 7½-8 percent).

Inflation, Labor Market, and Output Gap Indicators

(Percent change)

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Sources: Statistics Finland; and staff projections.

Percent of labor force.

Economy-wide.

A01utfig01

Employment Growth and Unemployment Rates, 2000–2006

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Eurostat.
A01utfig02

Beveridge curve (1975-2006)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Finnish authorities.

5. Inflation has remained muted, aided by exceptional factors now on the wane. Relatively low inflation has been supported by wage moderation in the face of fast productivity growth, as demonstrated by the latest tripartite agreement (for 2005–07) between unions, employers, and the government—struck in part thanks to income tax cuts offered by the government. Furthermore, the 4 percent decline in 2005–06 in the terms of trade has lowered the equilibrium real exchange rate, which, in the absence of nominal depreciation, exerts downward pressure on inflation. However, a number of one-off factors have also contributed, including lower telecommunications tariffs and food prices—the latter associated with increased competition from new foreign-owned retailers. With these effects fading, HICP inflation is creeping up to 1½ percent.

6. Finland’s external competitiveness is solid, but its export base is narrow. With a current account surplus of about 6 percent of GDP and a barely negative net international investment position (accounted entirely for by foreign holdings of volatile ICT shares—mainly Nokia), standard indicators of external competitiveness are comforting (Table 2 and Figure 2), with various real effective exchange rate (REER) estimates broadly unchanged over the past decade (Figure 3 panel 1). The manufacturing unit-labor-cost-based measure has shown the largest improvement. However, capital’s share in this sector in Finland vis-à-vis its trading partners is under greater pressure because of a relatively weaker export deflator (Figure 3 panel 2). This is largely because Finland’s export composition is rather heavily biased towards sectors whose prices are rapidly declining (ICT) or comparatively stagnant (paper products) (Figure 4).

Table 2.

Finland: Balance of Payments, 1999–2012

(In billions of euros)

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Sources: Bank of Finland; and staff projections.
Figure 2.
Figure 2.

Finland: Current Account and Net International Investment Position, 1975–2006

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Sources: IFS; WEO.
Figure 3.
Figure 3.

Finland: Real Effective Exchange Rates, 1995–2006

(1999=100)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Sources: European Commission; and IMF staff estimates.
Figure 4.
Figure 4.

Finland: Export Shares and Terms of Trade

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Sources: OECD STAN database; IFS.

7. The fiscal position improved significantly last year, underpinned by expenditure restraint. The general government surplus of 3¾ percent of GDP—mostly in the pension funds—is the second highest in the EU. With the output gap close to zero, the surplus is almost entirely accounted for by structural factors (Table 3). It benefited from a determined implementation of multi-year central government spending limits, which has permitted income tax reductions without weakening the fiscal position. As a result, the gross debt ratio declined over 2003–6 by over 5 percentage points to below 40 percent of GDP, while assets of the public pension system now approach 70 percent of GDP.

Table 3.

General and Central Government Financial Accounts, 2002–09 1/

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Sources: Ministry of Finance; and staff projections.

On ESA95 basis.

The fall in revenues in 2003 reflects, in part, cuts in some indirect taxes as well as the fading out of one-off factors related to exceptional tax revenues owing to income from stock options in earlier years.

Excludes net interest on government debt and financial assets

Corrected for the influence of the business cycle as measured by the output gap, adjusted in 2005 for a paper sector dispute that was estimated to have reduced output by about 1 percentage point.

One-off factors include exceptional tax revenues owing to income from stock options.

Includes stock-flow adjustments reflecting changes in the portfolio allocation of Finnish pension funds.

General Government Overall Balances

(Percent of GDP)

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Sources: Statistics Finland; Ministry of Finance; and staff projections.

Adjusted in 2005 for a paper sector dispute.

III. Outlook

8. Economic expansion will continue in the near term, albeit at a slower pace. During the mission, authorities and staff anticipated growth at about 3 percent in 2007 and 2¾ percent in 2008. However, data for the first quarter of 2007 and revised quarterly data for 2006 recently released suggest that the momentum of growth in 2007 is significantly higher than expected. Accordingly, staff has raised its growth projection to 4 percent in 2007, still less than in 2006. The bulk of the deceleration is due to the ebbing of an unusually strong contribution from net exports in 2006 (including the rebound from the labor dispute). The contribution of domestic demand is projected to increase by about ½ percent of GDP, with private consumption boosted by strong consumer confidence and employment growth, despite rising interest rates and household debt levels (the latter approaching 100 percent of disposable income). Continuing fast employment growth is likely to tighten the labor market. As the economy is expected to continue to operate somewhat above potential, inflation should creep upwards, although rising interest rates and recent euro strength may have cooling effects.

9. Risks appear balanced for growth but risks that inflation may exceed its projected level prevail. The “neighborhood effect” may not decline as projected, which could sustain a larger contribution to growth from trading partners. Higher-than-anticipated labor force participation rates could emerge and immigration—stimulated by a tightening labor market—might accelerate,1 which would allow for greater growth without engendering wage pressures. On the downside, excessive salary increases could harm external competitiveness and stoke inflationary pressures (the latest authorities’ projection has raised wage growth in 2008 from 3½ to 5 percent). More important, if Russia—as recent reports hint—were to impose a 10-fold increase over the next two years in export tariffs on unprocessed wood, Finland’s paper sector (which accounts for one-fourth of all exports) would suffer.

10. For the medium term, the authorities’ official projections envisaged a further slowdown in growth. The deceleration (to 2¾ percent on average) in 2008–11 would result from lower employment expansion and a resumption of the modest trend decline in productivity growth during 2000–04. Staff concurred with this assessment.

11. Officials, however, thought that GDP could rise much faster if the government implemented bold structural measures. In particular, reforms of labor and product markets could substantially lift potential growth of the economy. While agreeing on the need to deepen reforms, staff cautioned that time and size of any boost to growth from structural measures were uncertain.

12. The authorities regarded competitiveness of the economy as broadly adequate. While wage growth in Finland has exceeded that in the euro area, so has productivity growth, especially in the export-intensive electronics sector. However, the bulk of these gains are shifted to foreign consumers through lower prices, limiting domestic income gains. The terms of trade were anticipated to temporarily improve this year, before resuming their trend worsening thereafter, and strengthening euro area growth was expected also to contribute to a one-off improvement in the external accounts. However, capacity constraints and continued shifting of production abroad were expected to limit export growth below that in foreign markets.

13. Staff concurred, while noting that some measures suggested a significant undervaluation of the real exchange rate. As explained above, standard indicators of external competitiveness are benign. Estimates based on methodologies elaborated by the Consultative Group on Exchange Rate Issues (CGER)—point to a sizable competitiveness margin, with a mid-point of 17 percent2. These estimates should be taken with a larger than usual dose of caution. In light of rapid population aging, Finland needs to build up substantial assets in a short time to pre-fund the associated costs, requiring temporarily large fiscal and current account surpluses. As aging unfolds, the domestic savings rate is expected to decline and these surpluses are anticipated to diminish. The trend worsening of Finland’s terms of trade is also expected to reduce the external surplus. Indeed, these forces may, to some extent, already make their presence felt, as attested by pressures on exporter’s profitability. On balance, therefore, staff felt that the real exchange rate was not significantly undervalued.

Estimates of Competitiveness Margin Using CGER Methodologies

(In percent)

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Source: Fund staff estimates.

IV. Policy Discussions

14. The overarching concern is the risk posed to longer-term growth by rapid aging and the anticipated productivity slowdown. With the fastest population aging in the EU and attendant fiscal costs, discussions focused mainly on medium-term and structural issues. As working-age cohorts are expected to shrink from the end of this decade, increasing the employment rate and supporting faster gains in productivity throughout the economy will be key for future growth prospects. Above all, this requires improving the lackluster productivity record of the sheltered sectors (agriculture, utilities, and trade), as the contribution from high technology industries—facing falling prices and stiffer competition in world markets—declines. The adaptation of the economy to the challenges of aging and diversification needs support from the rapidly evolving financial sector, which must cope with the spread of innovative technologies or products and deepening international integration, raising issues about internal risk management and cross-country supervision.

Long-Term Scenario

Prospects for labor force participation/employment and productivity growth imply a significant drop in income per capita growth.

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Sources: WEO; Finnish Stability Program 2006.

GDP per employed.

Change in the share of population 15–64 years.

Employed as a share of population 15–64 years.

A01utfig03

Old-age Dependency Ratios and Population Indices, 2005–50

(Population in 2005 = 100)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Eurostat.

15. Against this background, the discussions focused on three priorities:

  • craft tax and public expenditure policies that promote continued economic expansion while ensuring fiscal sustainability,

  • reform the labor and product markets in order to enhance utilization of soon-to-be shrinking human resources and contribute to greater competition in sheltered sectors,

  • maintain financial sector stability.

A. Fiscal Policy

16. The authorities acknowledged that, based on official macro projections, the government’s program for 2008–11 implies a sharp deterioration of the fiscal position. Specifically, the general government surplus would decline by about 2 percent of GDP over 2008–11, owing mainly to a front-loaded rise in expenditure. Modest cuts—generally backloaded—in personal income taxes, VAT on food, and inheritance taxes are also envisaged, only partially compensated by increases in excises on energy, alcohol, and tobacco. The central government (CG) balance would worsen by 1½ percent of GDP and turn a deficit by 2010.

Finland: Government Financial Operations, 2006–11

(In percent of GDP)

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Source: Ministry of Finance; and staff estimates and projections.

Based on the authorities’ medium-term scenario, including the Ministry’s June economic projections, adjusted for the staff’s macroeconomic projections.

17. Officials did not dispute the staff’s view that under current policies the long-term fiscal position is unsustainable (Box 1). Taking into account the new government’s plan reducing the overall surplus to about 2 percent of GDP by 2011, in an otherwise “passive” projection the additional public spending associated with population aging eventually generates ever-growing deficits and debt. Ministry of Finance officials recognized that the general government primary balance in 2011 and beyond should be uniformly higher by around 2 percent of GDP than in the passive-scenario path to maintain long-term fiscal sustainability, at least through 2050.

18. The authorities, however, were confident that higher growth associated with structural reforms could avert the fiscal deterioration. Notably, the CG surplus of about 1 percent of GDP achieved in 2006 could be maintained through 2011 with GDP growth of 3½ percent, almost 1 percentage point above the average rate currently projected. Staff warned against relying on optimistic revisions to growth projections to discount the fiscal loosening, as the reforms had yet to be identified and implemented and their impact on growth verified. The authorities vowed to implement flexibly planned spending hikes and tax reductions, so as to limit risks to inflation and the fiscal position, if higher sustainable growth were not achieved.

19. Staff also saw a need for tighter fiscal policy for cyclical reasons. Continuing strong growth—positive output gaps are expected in both 2007 and 2008 and labor markets are tightening—points to the advisability of withdrawing some fiscal stimulus. The authorities stated that the fiscal stance would be appropriately corrected should signs of overheating arise.

20. The authorities noted that reducing Finland’s relatively heavy tax burden could lessen economic distortions. Taxation of earned income is particularly steep: the average and marginal rates for the average wage earner exceed 40 and 50 percent, respectively. Such large tax wedges introduce significant distortions in the labor market. Coupled with a high effective minimum wage, they discourage employment of low-skilled workers and lead to inefficient do-it-yourself practices. Thus, a lowering of income taxes was likely to boost employment and output. Staff concurred but stressed that tax cuts, albeit justified, demanded commensurate spending reductions not to undermine sustainability.

21. It was acknowledged that adjustment efforts ought to concentrate on expenditure restraint. The general government expenditure-to-GDP ratio is high—and projected to increase further owing to population aging. The authorities noted that the medium-term budget framework was already postponing several investment projects to limit spending growth. Nonetheless, they also deemed essential some increase in spending in the short term, including to honor electoral promises of sizable pay increases for health workers.

Long-Term Fiscal Sustainability

“Passive” simulations of the general government (GG) position for 2007–50 raise sustainability concerns. The staff’s baseline projection reflects stated policy intentions of the new government for 2008–11. After that, following the authorities’ recent Stability Program, it assumes that the primary-revenue-to-GDP ratio remains constant throughout the period, with pension contributions increasing (by about 2 percent of GDP) but other taxes decreasing correspondingly. Age-related expenditure surges by about 6 percent of GDP, only in small part compensated by declines in education and unemployment spending. The GG balance slips into a deficit, reaching 8% percent of GDP by 2050. And starting with net assets of about 20 percent of GDP, the GG ends with net liabilities. Although characterizing the risks to fiscal sustainability as “low,” the European Commission also notes that a sustainability gap emerges based on the authorities’ long-term projections.

The sustainability gap is estimated at about 2 percent of GDP. This is the permanent adjustment of the GG primary balance, with respect to the “passive” scenario, needed to achieve the net assets targeted for 2050 by the authorities’ stability program—46 percent of GDP. The staff’s “active” scenario assumes that measures are taken to fill this gap.

Nevertheless, some further adjustment after 2050 is needed to stabilize debt fully. Staff projections indicate that improving the primary balance by approximately 1 percent of GDP more would be enough to stabilize net debt (alternatively the rate of return on gross assets could be raised by 1 percentage point). Otherwise, even in the “active” scenario, net assets (although still higher than now in 2050) would decline indefinitely.

A01ufig01

Long-Term Fiscal Projections, 2005–50

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Sources: Ministry of Finance; and IMF staff estimates.1/ Based on the new government’s announced economic strategy’s surplus target for 2008–11, and Stability Program projections thereafter. Other assumptions include: average real GDP growth at 1.9 percent till 2020, and 1.4 percent thereafter; real interest rate at 3 percent; employment rate increasing to 74 percent by 2030 (from about 69 percent in 2006); labor productivity growing by 2 percent up to 2020, and by 1.7 percent thereafter.

22. The authorities viewed enhancing the efficiency of government as the best way to restrain spending. Studies suggest that expenditure could be more efficient, particularly in higher education and health care—with some indicating that Finnish combined expenditure efficiency is somewhat below the OECD average (Figure 5). Thus, sizable spending savings would be feasible without jeopardizing the quality of services. The authorities concurred, but pointed out that the low population density limited economies of scale. They also agreed that recourse to domestic or international benchmarking could help identify best practices and stated that CG employment was already planned to be reduced through attrition. It was noted that greater use of contracting out, outsourcing, and well-designed public-private partnerships could stimulate efficiency and moderate cost inflation. More frequent resort to—and a rebalancing of—user charges for local services would also strengthen market incentives for consumers and suppliers.

Figure 5.
Figure 5.

Finland: Public Sector Efficiency Measures, 2000 1/

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Afonso, Schuknecht, and Tanzi (2005)1/ Production frontier analysis. Measured relative to the most efficient country (with a score of 1.0), the input efficiency indicates how much less input a country could use to achieve its current output (e.g., 0.6 indicates that it could achieve the same output with only 60 percent of current inputs); the output efficiency indicates how much less output a country is producing (e.g., 0.8 indicates that it is producing only 80 percent of output with the same input as the most efficient country). Input is public expenditure as a percent of GDP; output is a composite public sector performance indicator comprising seven public goods and services.
A01utfig04

Government Efficiency, 1995 - 2005

(2000 = 100)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Statistics Finland.

23. Officials were open to improvements in the design of the multi-year spending ceilings in order to contain expenditure growth. The government has committed to new expenditure ceilings until its term expires in 2011, based on the same principles as in the previous legislature, but with a larger contingency reserve and more flexible carry-over rules. Although broadly effective in curbing CG expenditure growth, the limits have not dented the high level of public spending. One problem lies in step increases in outlays decided by incoming governments when setting the new ceilings. Others arise from the generous cost deflator used in establishing the annual ceilings3 and the incomplete coverage of the ceilings. Accordingly, staff recommended using the GDP deflator or the CPI, which would impose more stringent ceilings, thereby providing incentives to increase productivity and reduce costs. In addition, the spending rule could be extended to local governments (LGs) (see below). It was understood that these technical measures could help reduce expenditure growth, but a more substantive impact on spending trends required changes in underlying policies.

24. The authorities agreed that instilling greater budgetary discipline at the local level was a key challenge. Municipalities—the main providers of education, health care, old-age care, and other social services, with total outlays of about 17 percent of GDP and three-quarters of public employment—have experienced a rapid rise of recurrent spending and employment as well as worsening efficiency in recent years. These pressures are expected to mount with population aging. The authorities expect to generate savings from merging municipalities and coordinating provision of services. Staff recommended extending the expenditure ceilings to LGs, sanctioning their inclusion by a “domestic stability pact” with CG transfers used as enforcement mechanism. In addition, caps on LG income taxation (offset as needed by greater reliance on property taxation) might place limits on the growth of revenues which to some extent is fueling LG spending. The authorities explained that they were considering strengthening the existing agreement with the association of LGs to harden budget constraints, but interfering with the constitutionally protected autonomy of municipalities was politically difficult.

A01utfig05

Government Consumption and GDP

(2000 = 100)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Statistics Finland.
A01utfig06

Government Expenditure Shares, 1997–2006

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Statistics Finland.
A01utfig07

Government and Total Employment

(2000 = 100)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Statistics Finland.

B. Structural Policies

Labor market

25. There was consensus on the need to pursue several complementary strategies to raise activity and employment rates. Specifically, the authorities:

  • plan to increase substantially targeted wage subsidies, to boost employment at the low end of the labor market. They also noted that the decision to forgo centralized wage bargaining this year—which may presage its phasing out—could spur wage and regulatory flexibility.

  • have recently created Labor Force Service Centers to reinforce activation of hard-to-place unemployment benefit recipients. To the same end, a 2006 reform made municipalities financially responsible for half of the cost of unemployment assistance and created obligations for beneficiaries. Furthermore, Public Employment Services intend to sign action plans with all young unemployed within the first three months of benefit recipiency to find active alternatives to passive entitlement. Finally, a profiling system for job seekers will be phased-in.

Labor Market Issues

Finland lags behind its peers in labor-market performance. While unemployment has been more than halved since the recession of the early 1990s and the employment rate has risen to 68½ percent at end-2006, the latter is still below other Northern European countries (Figure 6). Furthermore, the shares of long-term unemployed and disabled are quite high.

Problems are particularly acute for young and elderly workers. Finland’s generous welfare system, including highly subsidized education, delays the entry of younger workers into the labor force, and provides unwanted pathways to early exit for older workers (Figures 7–9). Even after the 2005 reform, unemployment benefits can be extended above the standard 500 days for those aged 57 and over. And the disability scheme now allows to consider also “social grounds” when claiming benefits. Thus the employment rate of older workers, at 53 percent, is below that of other Nordic countries. The employment rate for young workers, at less than 40 percent in 2005, compares unfavorably with rates above 60 percent in Denmark and the Netherlands, and is also below the OECD average (43 percent). Part of the explanation lies in prolonged entitlement to generous student allowances (up to €700 a month) supplemented by guaranteed loans and no tuition fees: with 9% years of expected education for the 15–29 year old, Finland is an OECD outlier.

A01ufig02

Nonemployment and Unemployment Benefit Recipiency Rates

(As a percentage of working-age population, 2002/2004)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

The wage-setting system, associated with generous benefits, has not helped price-in young and elderly workers, nor the low-skilled. While the economy-wide wage agreements have served to maintain overall wage moderation, they have also resulted in salary compression, with a high effective minimum wage. Furthermore, the high replacement ratio of unemployment and other social benefits often leads to high effective marginal tax rates which discourage work resumption.

Figure 6.
Figure 6.

Finland: Labor Market Developments, 1990–2006

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: OECD.
Figure 7.
Figure 7.

Finland: Selected Labor Market Characteristics, 1980–2004

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: OECD; and Carcillo and Grubb (2006).
Figure 8.
Figure 8.

Finland: Selected Labor Market Characteristics

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: OECD.1/ ALMP: active labor market programs.2/APW: average production wage, UB: unemployment benefits, IW: in-work benefits, SA: social assistance, HB: housing benefits, FB: family benefits, IT: income tax (net of any tax benefits), SC: employees’ social security contributions.
Figure 9.
Figure 9.

Finland: Wage Compression and Low-Skilled Employment

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Sources: OECD, Miminum Wage and Taxing Wages database; OECD.1/ The costs of labor is the sum of wage level and the corresponding social security contribution paid by employers for a single worker. The minimum cost for younger workers includes exceptions by age or by contract.

Staff argued that, these valuable efforts notwithstanding, further scope for activation existed, notably of recipients of unemployment and disability benefits. Tightening access to early retirement, together with less generous student allowances, would also be useful (Box 2). The stressed that state enterprises were generally run as private entities and thus government ownership did not affect adversely efficiency. Nevertheless, it was not disputed that competition could be enhanced through further selective privatization, restraining local monopolies, and strengthening non-discriminatory third-party access to network industries. In addition, liberalizing shop opening hours and more flexible zoning laws could boost competition in wholesale and retail trade, while reforming agricultural support (which exceeds CAP-based levels) should increase efficiency and lower food prices. The authorities contended, though, that these measures were politically controversial and could only be implemented gradually.

C. Financial Sector

26. The financial system appears sound and well supervised. Banks are profitable and well capitalized. Returns on equity are generally high, with low cost ratios. Capital adequacy ratios are well in the double digits, with sizable financial “buffers,” albeit slowly decreasing owing to the higher credit base. While lending margins have declined with increased competition, bank profits have risen with growing fee income and the expansion of lending portfolios—especially household mortgages. Bank of Finland (BoF) estimates of several stability indicators also point to the good position of the banking sector (Table 4).

Table 4.

Finland: Indicators of Financial Vulnerability, 2000–06

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Sources: Bank of Finland; The Finnish Bankers’ Association; Financial Supervision Authority; Statistics Finland; and Fund staff estimates.

Euro-denominated lending only, which accounted for about 98 percent of total lending in 2000.

Loans are defined as the sum of claims on credit institutions, the public, and public sector entities.

2006 data are for June.

Average lending rate minus average deposit rate.

2001 adjusted for large intrafinancial conglomerate transactions.

Liquid assets are defined as the sum of bills discounted by the central bank, debt securities, and the balance sheet item “liquid assets.”

27. Supervisors closely monitor mortgage lending practices, but were confident that developments in the equity and housing markets were broadly benign. Although household and corporate debt levels remain comparatively low, the authorities noted that household debt is relatively concentrated among younger borrowers, raising concerns about commercial banks’ regard for repayment ability and undue reliance on collateral. Nevertheless, debt servicing expenses are historically low, as household net wealth and disposable income have improved strongly in recent years. House prices, while also rising rapidly, have grown less than in most advanced economies, with BoF analyses not detecting bubbles, except possibly in some Helsinki neighborhoods. Equity prices have increased by more than 50 percent since the beginning of 2003, creating some risk of reversal. However, BoF estimates suggest that stock market valuations do not deviate from fundamentals.

28. Supervisors confirmed that the system can withstand considerable disruptions. New stress tests undertaken jointly by the BoF and bank supervisors (FSA)—assuming a marked economic recession and a sizable drop in housing and equity prices—show that banks’ profitability would be hard hit, but remain positive, and the impact on their capital position would also be manageable. While the authorities’ stress tests are of high quality, staff recommended to improve them further by assessing the impact on the balance sheets of banks: (i) of the same shocks in different years; and (ii) of cross-border contagion, using extreme observations in market-based indicators.

29. The authorities agreed that regulation and supervision of cross-border institutions pose considerable challenges. The recent sale of Sampo’s banking operations—the country’s third largest—to the Danish Danske group has left Finland with the second highest share in the EU15 of foreign-owned banking system assets—70 percent compared to an average of 25 percent. In this connection, both BoF and FSA acknowledged that, while regional supervisory cooperation through memoranda of understanding (MoUs) is generally effective, it has not been tested under crisis conditions. Thus the authorities’ efforts focus, at both the Nordic and European levels, on (i) harmonizing supervisory cooperation on major cross-border groups4 (including the coordination of deposit guarantee schemes) and (ii) defining ex-ante rules and intervention procedures, in particular to minimize conflicting interests in case of financial crises (e.g., rules to determine when a subsidiary is of systemic importance and for burden-sharing for intervention in systemic institutions). Supervisors also confirmed their intention to work closely with market participants and foreign supervisors to improve supervision of an increasingly cross-border “infrastructure” (e.g., merged stock exchanges in the Nordic/Baltic area).

30. Implementation of European directives is proceeding apace. The capital requirements directive (based on Basel II) came into force in February 2007, but banks can delay its application to 2008. To limit temporarily the possible acceleration of lending from the capital “freed” by risk-based determination of capital, the FSA has required banks that choose the internal-ratings-based approach not to reduce for 2008 and 2009 their capital to less than 90 and 80 percent respectively of that prescribed under Basel I. The financial markets directive (MiFID) will be enacted in November 2007. Finland is planning to merge the FSA with the insurance supervisor in 2009, reflecting the growing bundling of activities by financial institutions.

V. Staff Appraisal

31. Finland’s recent economic performance is enviable. Finland has consistently exhibited higher growth and lower inflation than most other EU countries, while the budget and external current account have attained sizable surpluses. Finland also excels in innovation and business environment rankings.

32. Competitiveness of the Finnish economy is also broadly appropriate. Though some measures suggest that the real effective exchange rate may be undervalued, the rising old-age dependency ratio and declining terms of trade, as well as pressures on exporters’ profitability, probably mean that competitiveness margins are moderate. Moreover, the external current account surplus is expected to diminish over the medium to long term. The relatively strong external position at present is also the result of fiscal and structural policies that are generally desirable from a long-term perspective.

33. The authorities nonetheless face considerable challenges. A tightening labor market threatens a build-up of wage pressures. Owing to demographic pressures and sluggish productivity in sheltered sectors, growth is likely to decline, while—despite substantial reforms to the pension system in recent years—the fiscal position remains unsustainable from a longer-term perspective. Increasing international integration, together with technological and organizational changes in the financial sector, improve efficiency, but complicate supervision.

34. Fiscal tightening is advisable both to ensure long-term sustainability and from a cyclical perspective. To maintain an adequate net asset position of the general government at least through 2050, the noninterest balance must improve by about 2 percent of GDP relative to the authorities’ projected path. Some withdrawal of fiscal stimulus is also called for because economic activity is somewhat above potential and the labor market is tight. Otherwise, excess demand could translate into inflationary pressures. A general government surplus of about 4 percent of GDP, only slightly above the 2006 level, would be an appropriate target in both 2007 and 2008.

35. Therefore, the authorities’ recently adopted budget framework for 2008–11 is insufficiently restrained. Indeed, current projections imply a large fiscal loosening. The authorities are confident that stronger-than-projected growth, aided by as yet unspecified structural measures, could help maintain fiscal surpluses approximately at the current level. However, relying on the assumption of a sizable pick-up in growth is risky. Measures to boost productivity and employment should be implemented promptly and their effects on growth assessed before raising spending or cutting taxes.

36. With taxes and expenditures high, fiscal adjustment should focus on spending restraint, facilitated by enhancing its efficiency, particularly at the local level. Sizable savings would then be feasible while maintaining the quality of services. This calls for: benchmarking to identify best practices; redesigning the multi-year expenditure ceilings and extending them to local governments; greater recourse to outsourcing, public-private partnerships, and user charges; and reform of intergovernmental relations to tighten municipal budget constraints.

37. Improved utilization of labor resources, especially older workers and the young, is fundamental for future growth. Increased wage differentiation to help “price-in” those with low skills would be useful. Similarly, an increase in tertiary education fees (while maintaining financial aid to the truly needy), limits to the amount and duration of grants, and greater reliance on student loans could lower the time to graduation of students and accelerate their entry into the labor force. For the elderly, consideration should be given to reduce the scope of early retirement, increase use of activation requirements, and tighten control on access to these benefits. Tax and benefit policies ought to be revised to increase the relative returns from employment, thereby alleviating “poverty-trap” effects.

38. Strengthening competition in product markets to spur productivity would complement labor market reform. Productivity can be enhanced, especially in the sheltered sectors, through further privatization, restraining local monopolies, and promoting non-discriminatory third-party access to network industries. In addition, more regulatory flexibility in the trade sector and reform of agricultural support should increase competition and efficiency.

39. The financial system is sound and well supervised, but enhanced cross-border supervision of financial institutions and infrastructure is key to preserve stability. Rising foreign ownership in the banking sector poses considerable challenges for regulation and supervision, highlighting the urgency to nurture cooperation between home and host supervisors, especially to prepare for financial crises. Moreover, supervisors have to step up their cooperation with market participants and foreign supervisors to control the systemic risks associated with the spread of new technologies or products and with cross-border financial infrastructure.

40. Finland’s data are adequate for surveillance.

41. It is proposed that the next Article IV consultation be held on the 12-month cycle.

Table 5.

Finland: Recent Fund Staff Recommendations and Implementation 1/

article image
Figure 10.
Figure 10.

Finland: Product Market Rigidity 1/

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: OECD Going for Growth 2007.1/ Covers competition-restraining regulation in energy, transport and communications sectors, where 1 indicates the highest level of rigidity.
Figure 11.
Figure 11.

Finland: Selected Product Market Indicators, 2005

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Eurostat.
Figure 12.
Figure 12.

Finland: Telecommunication Charges, 2005

(10 minute calls)

Citation: IMF Staff Country Reports 2007, 279; 10.5089/9781451813289.002.A001

Source: Eurostat.
1

Finland liberalized immigration from the new EU member states more than a year ago.

2

These analyses are discussed in Methodology for CGER Exchange Rate Assessments, IMF, 11/8/06, http://www.imf.org/external/np/pp/eng/2006/110806.pdf

3

The spending rule is defined in real terms, based on a public spending deflator, which tends to grow faster than the CPI or the GDP deflator and accommodates increases in wages and other government costs.

4

In particular, concerning other Nordic countries, supervision of Nordea is conducted according to the supervisory college model following an agreement with the Swedish authorities, which stipulates joint inspection and complete information sharing. An agreement is under discussion with Denmark to supervise jointly the activities of Sampo-Danske.

Same Series

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Cover IMF Staff Country Reports
Finland: 2007 Article IV Consultation: Staff Report; Staff Statement and Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Finland
Author: International Monetary Fund
Volume/Issue:
Volume 2007: Issue 279
Publisher:
International Monetary Fund
ISBN:
9781451813289
ISSN:
1934-7685
Pages:
52
DOI:
https://doi.org/10.5089/9781451813289.002