Finland
Staff Report for the 2012 Article IV Consultation
Author: International Monetary Fund
Publication Date:
31 Aug 2012
eISBN:
9781475506006
ISBN:
9781475506006
Language:
English
Keywords:
ISCR; CR; deficit; current account statistics; staff appraisal; Finland; revision; potential GDP; output gap; fund staff calculation; interest rate; GDP deflator; Europe
Download PDF (3.7 MB)

The paper is an account of Finland’s unexpected upcoming deceleration in the economy at the end of 2011 and later. The deleveraging of the financial sector and the debt crisis made the nation fear an inevitable recession. To sustain this vulnerable situation, due attention was given to short-term growth and long-term challenges. Banks were encouraged to build up capitals and toughen bank decrees. Plans were made to multiply labor power and productivity. At the end of the paper, the Board welcomed the commitment of the state in improving and safeguarding the financial sector.

Abstract

The paper is an account of Finland’s unexpected upcoming deceleration in the economy at the end of 2011 and later. The deleveraging of the financial sector and the debt crisis made the nation fear an inevitable recession. To sustain this vulnerable situation, due attention was given to short-term growth and long-term challenges. Banks were encouraged to build up capitals and toughen bank decrees. Plans were made to multiply labor power and productivity. At the end of the paper, the Board welcomed the commitment of the state in improving and safeguarding the financial sector.

Introduction

1. Despite strong fundamentals and a track record of good policies, Finland’s near-term outlook is threatened by intensifying external strains. Activity in the EA is set to contract in 2012 on the back of the protracted sovereign debt crisis, financial sector deleveraging, and additional fiscal consolidation in several European countries. Spillovers to Finland already have been significant, given its highly open economy and trade and financial linkages with Europe, and, as a result, growth decelerated at the end of 2011. Though activity in the first quarter was slightly stronger than expected, growth is projected to slow significantly in 2012. Thus, the key immediate policy concern is to cushion the downturn, while mitigating financial, fiscal, and structural vulnerabilities.

2. Downside risks prevail. A further deterioration of financial market conditions could have severe negative spillovers for Finland. Increased concern about fiscal sustainability in the EA, forcing additional front-loaded fiscal tightening, would dampen further the prospects for near-term recovery. In case of a strong intensification of the EA crisis, leading to heightened financial stress and associated deleveraging, a sharp recession would be inevitable.

3. The Finnish economy also faces important longer-run challenges. Rapid aging and slowing productivity, coupled with recent cost pressures that have eroded competitiveness, threaten longer-term growth and fiscal sustainability. Growing financial integration in Europe and complexity create new risks and test supervisory abilities.

Recent Economic Developments and Outlook

A. Recent Developments

4. The Finnish economy rebounded robustly in 2010, but stalled at the end of 2011. Following the steep (almost 8½ percent) real GDP decline of 2009, domestic demand surged strongly in 2010, propelled by rising consumer confidence and renewed wage growth, leading to a rapid recovery in activity. However, exports, which had collapsed more than 20 percent in 2009, never regained their previous vigor. As the sovereign debt turmoil in the EA intensified in the second half of 2011, dwindling demand from trading partners dragged the economy to a standstill in late 2011. For the year as a whole, domestic demand prevented a sharper weakening of growth, which reached almost 3 percent. (Table 1, Figure 1). Though activity in the first quarter of 2012 turned out slightly stronger than expected, weak investment continued to point to a deteriorating growth outlook.

Table 1.

Finland: Macroeconomic Framework, 2009–17

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Sources: Bank of Finland, International Financial Statistics, Information Notice System, Ministry of Finance, Statistics Finland, and Fund staff calculations.

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

Fiscal projections include measures as specified in the Government Program.

Adjusted for interest expenditure.

2012 data are from June 29.

CPI-based real effective exchange rate.

Figure 1.
Figure 1.

Finland: Real Sector Developments, 2007–12

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Eurostat, Finnish Authorities, Haver Analytics, and Fund staff calculations.1/ Percent.2/ Percent balance indicates the percentage of respondents reporting an increase minus the percentage of respondents reporting a decrease.
uA01fig01

Capital Ratios

(Percent, data at end-2011Q4)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

* Data at end-2011Q2; ** Data at end-2011Q3.Sources: IMF Financial Soundness Indicators and Fund staff calculations.

5. The labor market slowly improved, while inflation decelerated. The unemployment rate rose about 2½ percentage points during 2008–09 to an 8¾ percent high, but well below Okun’s law predictions thanks largely to labor hoarding. It then declined modestly during the subsequent recovery, ending the first quarter of 2012 at around 7½ percent, with subdued growth prospects constraining firms’ willingness to hire. Harmonized consumer price inflation, which had exceeded that of the EA since late 2010 reflecting cost pressures and a value-added tax (VAT) increase, started to come down in the second half of 2011, reaching just above 2½ percent at year-end, in line with EA inflation (Figure 2).

Figure 2.
Figure 2.

Finland: Labor Market and Inflation, 2007–12

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Eurostat, Finnish Authorities, and Fund staff calculations.1/ Core inflation is defined as headline inflation excluding energy and seasonal food.
uA01fig02

Finland: Okun’s Law, 1980-2010

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: IMF World Economic Outlook and Fund staff calculations.

6. The banking system has remained generally sound despite mounting EA turbulence, but vulnerabilities persist. (Table 2; Figures 3–4).

Table 2.

Finland: Indicators of Financial Vulnerability, 2005–12

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

As of March 2012.

As of December 2011.

As of April, 2012, change since April, 2011.

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

Average of margins (average lending rate minus average deposit rate) on loans to non-financial corporations and households for deposit, commercial, cooperative, and savings banks, and foreign branches.

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

Figure 3.
Figure 3.

Finland: Financial Sector, 1998–2011

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Bank of Finland, DataInsight, ECB Data Warehouse, FSI database, Haver Analytics, and Fund staff calculations.1/ The average discrepancy is a simple average of the difference in margins in the euro area and Finland for long-term loans to nonfinancial corporations and households.
Figure 4.
Figure 4.

Finland and Selected Countries: Financial Position, 2004–11

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Bank of Finland, European Central Bank, and Fund staff calculations.1/ Non-weighted net position of the eurosystem.2/ Percent of quarterly GDP.

  • The capital adequacy ratio (CAR) stood at 14¼ percent at end-2011, well above regulatory standards. At 13½ percent at end-2011, the core Tier 1 capital ratio was unchanged from a year earlier, though it remains higher than in European peers.

  • The non-performing loan (NPL) rate, at ½ percent in March 2012, remains low. However, the NPL to capital ratio, at 5½ percent in Q411, increased slightly relative to one year earlier due mainly to an uptick in troubled loans to households and, to a lesser extent, to corporations.

  • Profitability has deteriorated amid weakening interest income and increased competition for retail business. Return on assets dropped further during 2011, to ½ percent in Q112.

  • Large foreign exposures subject Finnish banks to spillover and deleveraging risks owing to the financial sector strains in the EA (Box 1). In addition, the Finnish banking sector is highly concentrated, with a majority of assets controlled by subsidiaries of foreign Nordic banks, and heavily dependent on wholesale funding. This heightens the vulnerability to a short-term funding shortfall and spillovers from a possible worsening of the EA crisis (AN1 1). Moreover, the net external position of Finnish banks has deteriorated over the past year, reflecting both higher foreign exposure and greater dependence on foreign funds.

uA01fig03

Financial Stress Index, 2006-2012 1/

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Cardarelli, R., S. Elekdag, and S. Lall (2009), “Financial Stress, Downturns, and Recoveries,” IMF Working Paper, WP/09/100 and Fund staff calculations.1/ The financial stress index is a composite of the spread between commercial papers and sovereign bonds, the beta of the banking sector (from a CAPM), the term structure of interest rates, and volatilities in stock returns and in the exchange rate. Large values imply higher distress. A value of zero indicates neutral financial conditions.
uA01fig04

Bank Rollover Requirement, 2012-13

(Billions of euro, LHS; percent of debt, RHS)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Dealogic and Fund staff calculations.

7. The insurance and pension fund sectors are weathering well the ongoing crisis, but not without suffering losses.

  • The deep economic downturn combined with the low level of interest rates and highly volatile equity and bond markets led to reduced solvency margins for insurers in 2010–11. However, at 3¾ and 4 times the regulatory requirement for nonlife and life insurance respectively, such margins remain high relative to European peers. Investments of Finnish insurers returned a loss just shy of 2 percent at end-2011.

  • Compared to other European countries, Finnish pension funds have given preference to equity over debt instruments in their portfolios. Hence, tumbling share prices during the height of the crisis caused deeper losses, from which pension funds are still healing.

8. Household indebtedness has surged. Household debt as a share of disposable income increased sharply during the past decade, rendering household balance sheets riskier. With mortgages overwhelmingly of the floating-rate variety, decline in interest rates and longer repayment terms have lowered borrowing costs. In addition, banks have first charge at default and full recourse against borrowers. Thus, default rates have remained low. Unlike other EA countries, mortgage growth in Finland has been stable throughout 2011, exceeding the EA average by about 4 percentage points. The share of highly indebted households, likely to face heightened repayment problems in 2012 as unemployment increases again, is rising.

uA01fig05

Household Saving and Debt, 2000-11

(Percent of disposable income)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Statistics Finland and Fund staff calculations.
uA01fig06

Selected Countries: Household Debt, 2010

(Percent of disposable income)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Haver Analytics and Fund staff calculations.

Finland: Cross-Border Spillovers1

Finland’s financial and trade linkages to the other Nordics make it sensitive to growth slowdowns in the region. Although Finland’s trade pattern across countries is relatively diversified, its financial linkages are more concentrated in the Nordics. Foreign direct investment in Finland is dominated by Sweden with close to 60 percent of the total for Finland. Similarly, cross-border banking flows are dominated by Sweden and other Nordic countries.

A diversified trade pattern and limited exposure to countries with large consolidation plans help limit spillovers from fiscal consolidation in the euro area. Despite notable consolidation plans in some of its trading partners, the impact on Finland’s growth in 2012 and 2013 from worldwide consolidation will likely be low. Simulation results imply that domestic consolidation plans are likely to generate a more significant drag on GDP with a likely reduction in 2012 of ¼ percentage point, while foreign consolidation will reduce output growth by around 0.1 percentage points in 2012 and 2013.

uA01fig07

Comparison - Export Market Destinations, 2011

(Percent of total merchandise exports)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: IMF Direction of Trade Statistics and Fund staff calculations.
uA01fig08

Contribution to Growth from Global Fiscal Consolidation, 2011

(Percentage points)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Direction of Trade Statistics, World Economic Outlook and Fund staff calculations.

While bank exposure to high spread countries is very limited, significant linkages with banks in Sweden and Denmark make Finland susceptible to shocks in these countries. The claims of Finnish banks on the three program countries Greece, Ireland, and Portugal are very limited so that the direct impact from a default on 50 percent of the outstanding sovereign claims would entail no notable losses to Finnish banks. Further, losses would remain small even if Finnish banks lose 30 percent of their asset value in the three program countries. Claims on Sweden and Germany are more relevant and a 10 percent haircut on these assets reveals a more severe loss of around 2 and ½ percent of GDP, respectively.

Spillovers to Finland from International Banks’ Exposures

(As of September 2011)

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Sources: RES/MFU Bank Contagion Module based on BIS, ECB, and IFS data.

Magnitude denotes the percent of on-balance sheet claims (all borrowing sectors) that default.

Deleveraging need is the amount (in percent of Tier I capital) that needs to be raised through asset sales in response to the shock in order to meet a domestic banking sector Tier I capital asset ratio of 10 percent, expressed in percent of total assets and asuming no recapitalizations.

Reduction in foreign banks’ credit to Finland due to the impact of the analyzed shock on their balance sheet, assuming a uniform deleveraging across domestic and external claims.

Greece, Ireland, Portugal, Italy, Spain, France, Germany, Sweden, and the United Kingdom.

Considerable risk stems from a growth slowdown in Sweden or a simultaneous growth slowdown in the rest of the euro area. Multi-country VAR analysis suggests that a negative growth shock in Sweden of ½ standard deviation in 2012 alone could lower GDP growth in Finland by about 0.1 percentage point in 2012 and above ½ percentage point in 2013 compared with the current baseline. A shock to all euro area members (excluding Finland) could lower Finnish GDP growth by more than ½ percentage point in 2013.

uA01fig09

Output Growth Comparison: Sweden 2012 Shock

(Percent)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.
uA01fig10

Output Growth Comparison: Euro Area Wide 2012 Shock

(Percent)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: OECD, Poirson and Weber (2011), World Economic Outlook, and Fund staff calculations.
1 See AN 1.

9. Real estate prices are at historically high levels but broadly in line with fundamentals. After moderate retrenchment in 2009, house prices recovered the pre-crisis growth path and according to some indicators real house prices and credit are above their long-run trend (Box 2). Nevertheless, the increase in housing prices exceeded income growth only marginally in recent years, suggesting the absence of major real estate bubbles (AN 2). The fall in rental rates for office space in 2011 is likely the harbinger of a modest price correction for commercial real estate, particularly with banks tightening lending policies.

uA01fig11

Real House Price Growth, 2001–12

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: OECD and Fund staff calculations.
uA01fig12

Growth of Mortgage Loans, 1999–2012

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: European Central Bank, Haver Analytics, and Fund staff calculations.

10. The fiscal position deteriorated sharply during the acute 2009 recession, and, while consolidation has begun, the costs of population aging loom large. Reflecting both automatic stabilizers and discretionary stimulus, the general government (GG) headline balance deteriorated by 7 percent of GDP in 2009, spawning a deficit of about 2¾ percent of GDP in 2009–10 (Tables 3–4, Figure 5). In 2011, the budgetary stance tightened by about 1 percent of GDP in structural terms. This followed from a hike in energy taxes and the full-year impact of a 1 percentage point raise in the standard rate of VAT to 23 percent in mid-2010, while, on the expenditure side, the stimulus measures started to be phased out. Nonetheless, with weaker-than-projected growth, the headline deficit stood at around ¾ percent of GDP and gross debt continued to increase, ending 2011 at close to 49 percent of GDP. Meanwhile, population aging remains a challenge for long-term fiscal sustainability, with associated GG costs estimated at 6½ percent of GDP per annum by 2016 (AN 6 and ¶31). Related to below-the-line operations, Finland has secured collateral for its financial assistance to some debtor countries through the EFSF.

Table 3.

Finland: General Government Statement of Operations, 2007–13

(In percent of GDP, unless otherwise indicated)

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Sources: International Financial Statistics, Government Finance Statistics, Eurostat, Ministry of Finance, and IMF staff estimates.

Adjusted for interest expenditure.

Defined as the negative of net financial worth.

Table 4.

Finland: General Government Integrated Balance Sheet, 2005–10

(In percent of GDP)

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Sources: Global Insight, Government Finance Statistics, and Fund staff calculations.
Figure 5.
Figure 5.

Finland and Selected Countries: Fiscal Sector, 2006–12

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: DataInsight, Finnish Ministry of Finance, Statistics Finland, and Fund staff calculations.1/ Percent of GDP.2/ Adjusted for interest expenditure.
uA01fig13

General Government Balances, 2007–12

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: World Economic Outlook and Fund staff calculations.
uA01fig14

Aging-Related Expenditure: Different Scenarios, 2008–60

(Percent of GDP)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: DG ECFIN: The 2009 Ageing Report and Fund staff calculations.

Finland: Macro-Financial Linkages1

Financial variables have strengthened the economic recovery but support is fading.

The low interest rate environment and the improvement in the situation in the banking sector in 2010 have stimulated demand for mortgage loans and housing prices. This in turn strengthened household asset positions, which underpinned robust private consumption growth. The recovery lost steam as asset markets started to deteriorate and the outlook clouded over, slowing investment in residential property and consumption growth.

The historic relationship between credit, housing, and output growth is strong in Finland, making output susceptible to negative shocks in real estate and credit markets. Vector Autoregressions (VARs) suggest that a negative shock to credit availability of 5 percent could be associated with a reduction in output by ¼ to ½ percent after one year and 1 to 1¾ percent after 2 years. Housing prices would be lower by ¼ to 2½ percent in the first year and 2¼ to 2¾ percent in the second year. At the current level of output, housing prices and credit are above their long-run trend.

The credit market is broadly in equilibrium and major disruptions from the credit market to economic growth are less likely. Credit demand declined with economic prospects. With the relative resilience of the banking sector to the woes in the euro area, the impact on credit provision has been limited. Thus, there has been little misalignment in the credit market throughout the earlier phases of the crisis and the recovery phase.

uA01fig15

Financial Conditions Index, 2000Q1-2011Q4

(Percentage points of y/y real GDP growth)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: Cardarelli, R., S. Elekdag, and S. Lall (2009), “Financial Stress, Downturns, and Recoveries,” IMF Working Paper, WP/09/100 and IMF staff calculations.
uA01fig16

Finland: Credit to Households and Output Developments, 1990-2011Q1

(Logs)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: National authorities and Fund staff calculations.
uA01fig17

Finland: House Prices and Output Developments, 1990-2011Q1

(Logs)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Sources: National authorities, OECD, and Fund staff calculations.
uA01fig18

Finland: Excess Supply/Demand for Credit, 2000Q2-2011Q3

(Percentage by which demand exceeds supply)

Citation: IMF Staff Country Reports 2012, 253; 10.5089/9781475506006.002.A001

Source: Fund staff calculations.
1 See AN 2.

11. Previous large current account surpluses have waned, suggesting that competitiveness, while still adequate, has eroded. With the collapse in exports of 2009 and a renewed slowdown in trading partner growth at end-2011, the current account turned from a 2½ percent of GDP surplus in 2008 to a ¾ percent of GDP deficit in 2011. Exports, which in 2008 accounted for more than 45 percent of GDP, have now fallen below the 40 percent mark (Tables 5–7, Figures 6–7). Additionally, Finland has continued to lose export market share (Box 3). Nonetheless, econometric estimates do not suggest misalignment. On balance, in staff’s view, competitiveness remains broadly satisfactory, though margins have been eroded and it may become a concern should current trends continue. While the authorities share this assessment, they highlight that most of the structural export decline (from outsourcing by the ICT and paper industries) already has taken place, limiting the risks of further deterioration. The relatively robust external position limits vulnerabilities from capital flows, with the net international investment position improving steadily since 2007 and expected to remain comfortable. Both assets and liabilities have been rising at a strong pace with considerable direct investment net assets, while portfolio and other investment are in net liability.

Table 5.

Finland: Balance of Payments, 2009–17

(In billions of euro, unless otherwise indicated)

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Sources: Bank of Finland, Statistics Finland, and Fund staff calculations.
Table 6.

Finland: Net International Investment Position, 2003–11

(In percent of GDP, unless otherwise indicated)

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Sources: Bank of Finland, Statistics Finland, and Fund staff calculations.