2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Finland
2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Finland
Recent Economic Developments, Outlook and Risks
Economic growth has continued for almost three years, fuelled in particular by the recovery in Finnish goods and services exports. Household consumption has also increased, as growth in disposable income and low interest rates have encouraged household spending. Employment growth has exceeded expectations.
The fundamentals for continued economic expansion remain in place. The Competitiveness Pact, which restricted the increase in labor costs, has contributed to improving Finnish companies’ global competitiveness. The Finnish economy will continue to grow, although more moderately than in the past two years and at a considerably slower pace than prior to the financial crisis in 2008. The growth rate will gradually decelerate to its long-term potential rate.
The exceptionally rapid growth in employment witnessed in 2018 will slow down going forward, partly due to labor market mismatches. The number of unemployed is still high in Finland, despite an increase in job openings. Mismatches reflect differences in the supply and demand of labor both geographically and in terms of skills. Certain sectors, such as construction and services, have especially suffered from labor shortages. Job creation is also being constrained by a decline in the working-age population.
Uncertainty surrounding global economic development has increased, and risks to the Finnish economic growth are now clearly tilted to the downside. Exports will continue to grow at a reasonable pace in the baseline scenario, but a realization of the foreseeable risks could cut export growth significantly. This constitutes the greatest downside risk in the immediate years ahead.
Household consumption has exceeded household disposable income in recent years, leading to a rise in household debt levels. Even though household income will grow markedly faster in the forecast period than in the past few years, household indebtedness will likely rise further.
Overall, even though growth in output and employment will continue, the peak of the Finnish economic cycle has been passed. This is partly explained by the slowing down of the global upswing. Going forward, population aging and weak productivity developments will begin to put a further drag on the Finnish growth outlook.
The economic upswing has continued to strengthen public finances. With higher tax revenues, lower unemployment-related expenditures, and some positive one-off factors, the 2018 budget deficit is expected to decrease to EUR 1.25 billion (0.5 percent of GDP). Due to the strong cyclical position, the fiscal stance in 2018 was slightly expansionary. However, the authorities are highly committed to the medium-term consolidation plan implying a contractionary fiscal stance again in 2019. Spending growth will be reined in by the adjustment measures outlined in the Government Program, the impacts of which will be felt gradually, and the fact that the Government’s key projects will no longer boost expenditure in 2019.
The deficit will remain clearly under the EU Stability and Growth Pact’s (SGP) 3 percent of GDP reference value limit throughout the forecast horizon. Public finances are expected to be in balance at the beginning of the 2020s. In addition, it appears that the Government will broadly achieve its own fiscal targets set for 2019 with projections of the general government net lending of -0.4 percent of GDP and the debt ratio of 58.4 percent of GDP.
The debt-to-GDP ratio turned to a downward path already in 2016, falling below the EU SGP’s 60 percent reference value in 2018, and the growth momentum will keep reducing the ratio going forward. In 2018, aided by some positive one-off factors, the central government was able to reduce the outstanding stock of debt (by EUR 0.9 billion) for the first time in 10 years. However, in 2019, the central government debt is expected to grow again by EUR 1.6 billion.
The authorities are well aware of the structural weaknesses in the public finances and concur with staff’s recommendation that the favorable cyclical situation presents an opportunity to rebuild fiscal buffers. Demographic headwinds and increasing age-related public expenditures make building fiscal buffers more challenging. Despite the recent strong economic growth and already implemented consolidation measures, fiscal buffers remain thin.
At the start of the current Government’s term in 2015, it outlined a combination of measures to ensure sustainable growth and public finances. The measures aim at cost savings of some EUR 10 billion and consist of consolidation measures (EUR 4 billion), structural reforms (EUR 4 billion), and measures boosting growth and employment (EUR 2 billion). The fiscal consolidation measures are specified and broadly confirmed, with some risks related to the measures to be implemented by the autonomous municipalities. The bulk of the cost savings from the structural reforms is expected to result from the social and healthcare reform in the long term. Growth and employment have been boosted by the Competitiveness Pact and will be further boosted by measures aimed at improving productivity growth, as well as by shifting taxation from labor to indirect taxation.
Social and healthcare reform
A fundamental reform of the social and healthcare services (SOTE) is necessary due to the demographic headwinds and a lack of equal access to public health and social services. Currently, there are wide differences in the availability, quality, and costs of services between municipalities and regions.
The reform is estimated to bring cost savings. Costs will not be cut from what they are at present, but their future increase is estimated to be curbed by EUR 3 billion by 2029. For this to be possible, health and social service expenditure can only be allowed to grow by 0.9 percent per year, whereas at present they increase by 2.4 percent annually. The cost and efficiency gains are expected to be realized via better integration of both health and social services on one hand, and primary and specialized care on the other hand, as well as by allowing more freedom of choice for customers through increased competition. Moreover, digitalization and technology are expected to yield efficiency gains when effectively and systematically implemented in the counties.
With the help of the cost and efficiency gains, the reform aims to safeguard equal access to social and healthcare services. Another aim of the reform is to create a more harmonious regional administration than at present, which will provide multiple public services. It will clarify public administration by transferring the responsibility for organizing these services from nearly 400 different responsible authorities to 18 autonomous counties with directly elected decision makers.
According to the plan, the regional government, health, and social services reform is due to come into force on January 1, 2021, with the freedom of choice being implemented in stages in 2021–23. The laws will be put to a vote in the Parliament in early 2019 after the final constitutional assessment. The election of the county councils will be held in the fall 2019.
Labor market reforms and competitiveness
The 2016 Competitiveness Pact between the social partners has been successful in lowering unit labor costs and restoring national competitiveness. Its main elements consisted of reductions in employers’ social security contributions, extensions in working time, cuts in public sector holiday pay, and wage freezes in 2017. At the same time, the Government implemented tax concessions to compensate for purchasing power losses.
In addition, as agreed in the Competitiveness Pact, social partners have held discussions to reform the highly-centralized wage bargaining process but with limited success so far. While the outcome of the 2017–18 decentralized, but closely coordinated, wage bargaining round was satisfactory, further progress is needed going forward.
Several labor market reforms have been implemented in recent years, including the pension reform, reduction in the duration of earnings-related unemployment benefit, mandatory job search plans, and regular interviews for all unemployed jobseekers, and reforms to the unemployment insurance system incentivizing active job search and making short-term and part-time work financially more viable. Recently, the Parliament approved a legislative change making hiring and firing easier for smaller firms.
Due to demographic headwinds, a key goal of the current Government has been to raise the employment rate from 68 percent in 2015 to 72 percent by 2019. Aided by the stronger than expected economic rebound, this goal has now been reached as Finland’s seasonally adjusted employment rate rose to 72 percent in November 2018.
The more pessimistic demographic outlook of the latest population forecast, however, strengthened the demographic pressures. The declining birth rate will reduce the working age population in the future, which contributes to the strain on public finances. This emphasizes the need for increasing the employment rate further and implementing structural reforms.
While a lot of progress has been made, further reforms to improve the functioning of the labor market are needed. The authorities continue to work on improving incentives to work by changes to the social benefits. In connection with the SOTE reform, public employment services will be reorganized into the 18 new regional governance structures. Several new measures have been piloted and initiated with the aim of addressing labor market matching problems and new forms of work, with a strong emphasis on digitalization and intelligent matching.
As regards labor mobility challenges, a major obstacle is the lack of affordable housing in growth centers. Housing construction in the Helsinki Metropolitan area has increased significantly in recent years but it will take time to meet the demand for affordable housing. The authorities continue to take measures to deal with the housing situation in growth centers by adjusting zoning rules and building regulations.
Financial Sector Stability
The Finnish financial system continues to be sound with a well-capitalized and profitable banking system. The authorities broadly concur with staff’s conclusions about the key challenges for financial supervision and oversight, including financial sector size, high concentration, strong regional interconnections, and digitalization. Moreover, the low interest rate environment continues to pose challenges for both the banking and insurance sectors.
Nordea’s relocation from Sweden to Finland significantly increased both the size of the Finnish banking sector, to about 375 percent of GDP, and the exposure of the Finnish financial system to other Nordic economies. The authorities have responded to the new challenges by strengthening domestic supervisory resources and making sure that Nordea’s capital requirements are maintained at a sufficient level in the transition period and in the longer term, including a 3 percent systemic risk buffer effective from July 1, 2019. The Single Supervisory Mechanism (SSM) plays a key role in ensuring a consistent application of EU regulations and common supervisory practices across the euro area, while the Single Resolution Mechanism (SRM) works to ensure a consistent approach to banking resolutions. These are important elements in safeguarding the safety and soundness of the Finnish banking system. Moreover, the Nordic-Baltic regional supervisory cooperation, already at a good level in international comparison, continues to function with the ECB and the SRM having taken the lead in the joint supervisory and resolution colleges, respectively. The authorities are committed to continue the joint monitoring of financial stability risks and reciprocation of macroprudential measures.
The authorities share staff’s desire to have further progress in completing the Banking Union, including a common European deposit insurance scheme. However, this is possible only if further progress is made in reducing the risks in the European banking sector.
Household indebtedness stands at historical heights at approximately 128 percent of disposable income. In 2018, loans to housing corporations and consumer loans increased rapidly. High indebtedness and an increased number of consumer payment default entries have prompted a review by the Ministry of Justice on establishing a comprehensive credit registry in Finland with a legislative proposal expected to be issued in 2019.
House price developments have continued to be moderate at the aggregate with increasing divergence across the country. Large regional differences are driven by urbanization and investor demand. Consumer confidence has remained relatively robust implying that household indebtedness may continue to increase adding to the elevated structural vulnerability.
The national macroprudential authority—the FIN-FSA—has taken several measures to safeguard against increasing system-wide risks in the credit market. An average risk weight floor of 15 percent on mortgage loans for IRB banks came into force on January 1, 2018. The loan-to-collateral cap on housing loans was reduced from 90 to 85 percent in July 2018. In June, the FIN-FSA imposed a systemic risk buffer on all Finnish credit institutions and re- examined the institution-specific additional capital requirements on larger credit institutions, which will be binding by July 1, 2019.
The authorities broadly agree with staff on the need to develop and broaden the macroprudential toolkit. They are currently analyzing whether to include additional borrower-based tools into the toolkit and a legislative proposal is likely expected in 2019. They also agree on the need to increase the coverage of data collection among non-bank providers of debt.