Recent Economic Developments and Outlook

Finland is undergoing an extended period of slow economic growth that is among the weakest on record. GDP in 2015 is projected to be more than five percentage points below the 2008 level, and unemployment figures have risen close to double digits. It is of particular concern that lately the long term and structural unemployment rates have increased rapidly. Finland has experienced several asymmetric shocks that include the decline in two important export industries, deterioration in productivity, rapid rise in unit labor costs, weakness in the main trading partners’ economies and a quickly aging population. These developments are well described in the staff report and the selected issues papers.

The economic projections for Finland envisage only a slow recovery and a continuation of low growth. The risks for the near term are also on the downside. The Ministry of Finance projects close to zero growth for this year and a tepid strengthening of the recovery to an annual 1.3 percent GDP growth in 2016. While domestic consumption will remain weak due to a moderate pick-up in inflation and the fiscal consolidation measures, investment activity should be accelerating due to some large investments that are already under way or in the pipeline in the forestry industry, as well as and in chemical and construction industries. Moreover, the external environment will support growth as many of Finland’s main trading partners are growing reasonably well supported by accommodative monetary policies and low oil prices. The contribution of net exports to growth in Finland will remain weak in 2016, as imports pick up due to investment growth. Also weakness in many emerging markets and continued volatility in financial markets pose risks to the external environment. Recently the wave of refugees to Europe is having its impact on public finances in Finland as well.

Fiscal policy: a balancing act geared to consolidation of public finances and reviving growth

Finland, being a small open economy, is very dependent on exports of both goods and increasingly also of services, and hence the key priority is to maintain competitiveness in global markets. This is also a prerequisite for the sustainability of the Nordic welfare model. The new government is committed to an ambitious reform agenda aimed at raising the employment rate, promoting entrepreneurship, and the long term growth potential. That said, the authorities are fully aware of the urgent need to implement structural reforms in order to revive economic growth and consolidate public finances to a sustainable level. However, most structural reforms will start to have impact only in the medium term, but their implementation is long overdue.

The government is committed to making decisions to cover the entire sustainability gap of 10 billion Euros. The consolidation of public finances will firstly halt by the end of the Government term and then reverse the increase in the debt-to-GDP ratio in 2021. In the short run, the authorities are pursuing a balancing act with necessary consolidation efforts while trying to induce economic recovery. The authorities are determined to preserve the confidence in fiscal stability in Finland and to comply with fiscal rules of the EU. The consolidation measures include mainly expenditure reductions, but will also raise revenue by excise tax increases, and an accelerated removal of mortgage interest rate deductions. At the same time, the income taxes for the low and middle income earners are somewhat reduced in order to promote work incentives. As noted in the staff report, the magnitude of the negative effects from consolidation measures depend on the size of the fiscal multipliers that are highly uncertain. The impact of asylum seekers and refugees is taken into account and the government has already proposed an addendum to the budget to account for the fiscal costs related to the rapid inflow of asylum seekers.

The government’s reform program is supported with a one-off investment package worth 1.6 billion euros that will also off-set some of the negative effects from the consolidation measures. About a third of the package is directed to reducing the infrastructure repair debt and the remainder is devoted to the advancement of the Government’s key projects and reforms.

Structural reforms to be implemented without delay

Closing the competitiveness gap. For a small open economy like Finland, the more rapid increase in unit labor costs in comparison to peers and the persistent current account deficits in the past few years that is forecast to last until 2020 illustrate a deeper structural problem of the economy. Due to the loss of the ICT-intensive export base there was a shift from high labor productivity output to lower labor productivity production that resulted in a loss of competitiveness in the exports sector.

The government’s goal is to reverse the deterioration in the Finnish competitiveness. While the negotiations for a social contract with labor unions and employers’ federations broke down, the government is proceeding with legislative measures to reduce unit labor costs. To regain competitiveness, these measures need to be complemented with a sustained period of very moderate pay increases, and companies and communities need to make individual efforts to improve their efficiency.

The government has prepared a set of measures to reduce the unit labor costs by 5 percentage points while also strengthening the employees’ redundancy security. The proposed measures include a removal of two public holidays, reductions in paid sick-leave and in holiday allowance, and a cut in the public sector annual leave to 6 weeks. The employees’ redundancy security is improved by forcing medium and large companies to provide health benefits for six months, and an option to receive re-employment coaching that is worth the company’s average one-month pay in a layoff situation. These measures would enter into force as mandatory ceilings by the time of the next collective wage bargaining agreement in 2016, if enacted, and they would remain in force for three years. In the meantime, the labor unions and the employer federations continue discussions to find alternative ways to achieve the targeted reduction in unit labor costs.

Labor market reforms. The Ministry of Employment and the Economy is considering proposals that would pave the way for wider use of localized wage agreements and a more flexible use of working-time. The proposals also underline that the employees should have representation in the firm’s decision-making bodies to improve information sharing, transparency and to build trust for the local level wage bargaining. The proposal received mixed reviews by the labor market representatives, but the Ministry will continue to finalize the proposal, which is part of the government’s program to reform the wage bargaining process.

The government has also proposed to reduce the earnings-related unemployment benefits to 400 days from the current 500 days starting from 2017, as part of the fiscal consolidation package and to increase labor supply. On ALMP, the government’s program introduces a project to increase the efficiency of the public employment services (PES). The priorities of the reform are to make full use of digitalization in the PES, to create closer contacts with the employers and to respond to their recruitment needs and to enhance the role of the private employment services. In order to decrease income trap due to a high participation tax rate, from 2014 on, an income of 300 Euros per month is allowed without reduction of unemployment benefits or housing subsidy.

The government program also supports the increase of housing supply in the Helsinki metropolitan area that would promote labor mobility.

Education reform to increase working life/labor force participation. The government has introduced cuts in education and R & D. The latter is not supported by staff, but the authorities see room for a more efficient use of the remaining funding. According to the authorities, the reform program envisages a better cooperation between institutions of tertiary education and business life as well as accelerating graduation and transition to working life, and this would result in savings.

Innovation and deregulation. The reform program gives also special emphasis to development of bio-economy and clean technologies for achieving climate goals and improving export performance. In addition, the program envisages increased use of digitalization and dismantling of unnecessary regulation and zoning restrictions. The changes also aim to promote complementary construction and to significantly increase the supply of both housing and building sites. A proposal to liberalize shop opening hours has already been tabled in the parliament.

Finalizing key reforms in health care and municipalities

The government has indicated that it will reduce municipalities’ responsibilities that would achieve about one billion euros in savings by 2019. The Government’s fiscal plan for 2016-2019 contains a maximum limit of expenditures for the local governments and it includes a number of measures aimed at strengthening local government finances. The government’s social welfare and health care reform work is underway. A draft Government proposal will be circulated for comment in April 2016. The Government proposal will be submitted to parliament in October 2016.

The objective of the reform of social welfare and health care services is to narrow health disparities and manage costs (so called SOTE reform). The current system is fragmented, disintegrated and inefficient. Hence, the reform will be implemented with a complete horizontal and vertical integration of services, and by strengthening the capacity of service providers. The integration is expected to have a significant impact on the sustainability in public finances. With SOTE reform, the Government seeks to reduce the cost of social welfare and health care services by 3 billion euros by 2029 (at 2019 prices). The estimated impact to sustainability gap would be -1.25 percent of GDP.

The new structure for social welfare and health care services will be based on autonomous regions. The service provision is consolidated from municipalities to these larger regions that may also use the private sector in service production. In order to control for the expenditure on social and health care services and enhance efficiency, the possibility of opening up the market (for more) private competition will be explored. Additionally, the details regarding a freedom of choice model will be explored, as well as the legislative amendments required by EU directive on Patient Mobility.

Financial sector stability

The Capital Requirements Directive (CRD IV) was adopted in the Finnish legislation in 2014. The FIN-FSA was appointed as the designated macro prudential authority and the FINFSA Board was given the responsibility for macroprudential policy decisions. The Finnish authorities support the establishment of a systemic risk buffer, but the legislation process would most likely be postponed until next year due to the existing legislation backlog. The authorities see a deepened regional cooperation on financial sector issues of utmost importance between the Nordic and Baltic countries. Finally, the authorities appreciate the plan to conduct FSAPs for Finland and Sweden back-to-back in 2016, as these assessments will provide a thorough review of the Finnish financial sector performance and a framework to identify systemic vulnerabilities. The combination of these exercises offers also an assessment of the Nordic financial and insurance institutions and their operating environment.