Finland: 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

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Finland

Context and Background

1. In the past three years, Finland has emerged from a severe downturn. Since 2008, the economy has weathered two recessions; commendably, income inequality remained low through this period, but the prolonged downturn increased unemployment, stressed the public finances, and likely damaged potential growth. Recovery began in 2015, but only this year has the level of real GDP surpassed that seen in 2007.

uA01fig01

Real GDP in Nordic Countries

(Index, 2008=100)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources: Haver Analytics; and IMF staff calculations.

2. Political parties are vying for support ahead of elections next April. Support for left-of-center parties opposing the current right-of-center coalition has increased. However, policy continuity is likely to be preserved following the elections, as there is a broad consensus across the political spectrum on the importance of reforms to boost productivity and maintain fiscal sustainability.

Recent Developments

3. The recovery continues, but is in its late stages. Recent growth has been healthy and wide-spread across sectors, boosted by private consumption and residential investment, supported by fiscal and monetary policies. Labor market outcomes have improved significantly over the past year—participation rates and employment have picked up sharply, while the unemployment rate has fallen to its lowest level since 2011. Consumer and business confidence are at their highest levels in many years, but have both fallen during the year.

uA01fig02

Finland: Employment and Unemployment Rates

(Percent)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Source: Statistics Finland; and IMF staff calculations.Note: Unemployment rate is measured as a share of labor force. Employment and participation rates are measures as a share of working age population.
uA01fig03

Real GDP Growth Contributions

(Percentage points, yoy)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources: Statistics Finland; and IMF staff calculations.

4. There are few signs currently of macroeconomic imbalances. The recent growth— between 2½ to 3 percent y/y for the past 9 quarters—has seen the output gap almost close (Figure 1). Yet costs have been kept in check: after a wage freeze under the Competitiveness Pact, wages (excluding bonuses) have increased over the past year, but nonetheless modestly in most sectors and only 2 percent overall. Inflation pressures remain subdued; headline CPI inflation is currently 1½ percent y/y, despite increases in fuel costs. Credit growth overall is moderate, and the housing market does not show rapid price growth or signs of excessive exuberance (Figure 2).

Figure 1.
Figure 1.

Finland: Economic Developments

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Figure 2.
Figure 2.

Finland: House Prices

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

uA01fig04

Inflation

(Percent, yoy)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources: Haver Analytics and IMF staff calculations.

5. The public finances have improved with the recovery. The overall balance in 2017 was better than staff expected (-0.7 instead of -1.4 percent of GDP), reflecting both improved revenues from higher growth and employment (offsetting lower taxes and social security contributions) and lower spending and expenditures on unemployment benefits. General government gross debt fell slightly, to 61 percent of GDP.

6. The most recent data suggest that the external position is moderately weaker than would be implied by fundamentals and desirable policy settings.

  • The most recent data show substantial downward revisions to the current account balances (especially income balances) in 2016 and 2017, to -0.7 percent of GDP for both years. Through 2018, export market shares have improved slightly, across markets and products, reversing the steady decline since the onset of the crisis. This is consistent with wage moderation that accelerated the depreciation of the ULC-based real exchange rate in 2017 and a recovery in investment by export-oriented firms during the past three years. However, net income flows are negative for the year, as previously, owing to large dividend payments. The net international investment position remained modestly positive in 2017.

  • Staff assess that the external position is moderately weaker than would be implied by fundamentals and desirable policy settings. The current account models indicate that the current account value in 2017 was below its “norm”, implying a real exchange rate overvaluation in the order of 5 to 10 percent. Real exchange rate models give similar results. Preliminary results from those models applied to the projections of current account balances for 2018 indicate that, on the assumption that the trade balance remains modestly in surplus and the income deficit is similar to that in 2017, the external position would also be moderately weaker than implied by fundamentals and desirable policy settings (Annex I: External Sector Assessment). Going forward, demographic pressures (¶8) and future demands on the public finances (¶29) suggest a need to maintain a modestly positive net national savings rate.

uA01fig05

Current Account and Its Components

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Source: Statistics Finland.
uA01fig06

Real Exchange Rate Indices

(index, 2012=100)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources International Financial Statistics: and IMF staff calculations.Note: 2018 values are averages of first two quarters.

7. Two underlying weaknesses remain.

  • Labor market dynamism: Vacancies remain high relative to employment. This might simply reflect limits on how quickly vacancies can be filled, or increased confidence of workers to enter the labor market and hold out for attractive jobs. But job market dynamism—the rate at which new jobs are created and the “churn” of workers relocating across jobs—has not picked up with the recovery (¶34–36 and Figure 4). Consistent with this, value added per employed worker has been slow to recover and is only now at the level seen in 2008.

  • Household finances: Household debt has been increasing steadily (¶12–13). Debt levels (based on lending from banks) remain comparable to the euro area average, and well below those of other Nordic households, but the increase is notable given deleveraging by other sectors while the economy has recovered. When non-bank lending and loans to housing corporations are included, household debt is notably higher. The distribution of household debt has been broadly stable in recent years, but unofficial data indicate new borrowers are taking on more leverage than the average.

Figure 3.
Figure 3.

Finland: Fiscal Developments

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Figure 4.
Figure 4.

Finland: Labor Force Participation and Unemployment

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Outlook and Risks

8. The current cyclical upswing is expected to moderate. GDP growth is projected to be 2.4 percent in 2018 and 1.9 percent in 2019, before reverting to a long-run growth rate of 1¼ percent.

  • Net exports’ contribution to growth would remain slightly positive, albeit tempered by gradually tightening financial conditions, increases in costs, and a gradual slowdown in global growth. Private investment growth is therefore assumed to ease off, after three years of above-trend growth. Nonetheless, private consumption growth is expected to be supported by increases in real wages, the improvement in employment, and easy access to credit, and therefore is assumed to ease only slightly in 2019.

  • Long-run growth is mainly determined by labor productivity growth, which is expected to be around 1½ percentage points, offset slightly by a net employment contribution of -0.2 percentage points, reflecting the assumption of increasing participation rates that only partly compensate for a declining working age population.

  • Inflation is expected to remain low in 2018 and only gradually increase thereafter. The output gap would remain slightly positive for some time, and costs are expected to increase, due mainly to a gradual pickup in wages going forward with modest productivity growth. After the recovery in mark-ups seen over the past two years, firms are expected to absorb much of this pressure by not raising mark-ups further.

  • As was anticipated, the overall fiscal balance is projected to remain in deficit in 2018.1 Revenue measures (including personal income tax cuts and reductions in unemployment contributions) are expected to increase the deficit by about 0.4 percent of GDP, while an almost neutral expenditure budget and favorable cyclical conditions will help contain the deficit expansion to close to 0.3 percent of GDP. Given Finland’s position in the business cycle, this implies a fiscal stimulus of 0.7 percent of GDP.2 However, the fiscal policy stance is contractionary thereafter, on the assumption that the government expenditure ratio declines in line with the government’s consolidation plan, and debt continues to fall.3

  • The current account is projected to improve gradually over the forecast horizon, from a half percentage point deficit in 2018 to a surplus of around one percent of GDP after five years. This projection assumes that Finnish firms’ export market shares—which had seen large declines over the past two decades with, inter alia, the downturns in IT and pulp and paper industries—will be maintained at recent slightly-higher levels, and that the income balance of the current account improves to about zero.4

uA01fig07

GDP Growth, Potential Growth and Output Gap

(Percent of GDP)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources: IMF staff calculations.

9. Risks are mainly external and tilted to the downside (Annex IV: Risk Assessment Matrix):

  • Weaker global growth and trade disruption: The main downward risk is the international trading environment. In addition to the risks from increased protectionism, the economic cycles of important trading partners—notably Germany—show some signs of slowing. Finland’s exports are predominantly directed to Europe, although in terms of value added, the United States is the most important export partner, followed by Russia, Sweden, Germany, China, and the UK. Staff analysis indicates that the direct effects on Finland from additional tariffs on imports on cars and car parts would be small relative to other European countries, but Finnish exports in general would likely suffer to the extent that European demand falters.

  • Financial system exposures: The Finnish banking system is systemically exposed to Nordic economies, especially their housing markets, both directly through asset holdings of its large international banks. Reliance on wholesale funding, including through covered bonds, is also a risk. Sharper-than expected increases in global interest rates, prompted for example by higher- than-expected inflation or the materialization of other risks, could curb domestic consumption and investment.

Domestic risks include:

  • Reforms: Labor productivity and employment growth could slow if reforms to work incentives were to deliver weaker gains than expected. Health and social services reforms (¶30) might stall or fail to deliver the targeted savings, putting the government’s objective of closing the fiscal sustainability gap in doubt.

Authorities’ Views

10. The authorities shared the staff’s assessment of the outlook and risks. The continued strength of Finland’s growth had been encouraging. The output gap has at least closed, and the labor market is tight in some sectors. However, the authorities concurred the cyclical upswing has reached a mature stage and has likely peaked. Recent weak labor productivity growth was a concern. Growth is expected to slow from 2019; views on long-run potential growth ranged from 1 to 1½ percent, but all parties agreed that further increases in participation would likely not be sufficient to offset declining working age population. Aggregate unit labor costs were anticipated to remain in check, limiting cost pressures, leading authorities to expect inflation to rise gently. Risks to the outlook were perceived as stemming predominantly from a further escalation of trade tensions, which could undermine exports and disrupt production and investment, given Finland’s deep integration in global supply chains. The authorities noted that Finland’s overall external position had improved since last year. Based on the data at the time of the Article IV consultation that showed an external trade surplus in 2017, they felt that the real exchange rate was no longer overvalued, partly reflecting the benefits of wage moderation, which had lowered labor costs markedly, particularly in 2017.

Policy Discussions

11. The discussions focused on policies to mitigate risks and to increase growth. The mix of policies affecting aggregate demand going forward is balanced and appropriate. The bigger challenges are to manage risks arising from household finances and a concentrated and interconnected banking system (sections A and B), address long-run demands on the public finances (section C), and improve the efficiency of the labor market (section D).

A. Credit Markets, Real Estate, Borrower Risks, and Macroprudential Policies

12. Credit has expanded moderately overall, but housing corporation loans and consumer credit have been rising more rapidly. Total loan growth to the private nonfinancial sector has remained broadly constant at around 3½ percent for the past five years. Most lending to households has been in the form of secured lending for housing, which has grown around 4 percent. Corporate loan growth has rebounded strongly in the second quarter of the year after a sharp contraction in the second half of 2017. Two lending categories stand out:

  • Loans to housing corporations have been expanding rapidly—above 10 percent—for many years. The drivers—expansion of the housing stock and renovation of rental properties—are healthy. But the shareholders of housing corporations include homeowners, making these de facto indirect loans to households, and households might thereby be tempted to take on more debt than can easily be repaid.5

  • Consumer credit has been increasing steadily—above 7 percent y/y in the second quarter of 2018—and now accounts for 12 percent of aggregate household debt, driven by credit institutions easing lending standards and a rapid increase in non-bank lending. The expansion has been associated with an increase in payment defaults.

uA01fig08

Credit to the Nonfinancial Private Sector

(Yoy growth, percent)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Source: Statistics Finland
uA01fig09

Household Credit Growth, by Purpose

(Percent, yoy)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources: Statistics Finland; Bank of Finland; and IMF staff calculations.Note: Consumer credit includes lending from non-bank financial institution.

13. Household debt has been increasing steadily, despite the increase in real disposable incomes.6 Saving rates are lower than peers, although some of the difference is attributable to Finland’s public pension system.7 Household debt remains lower than Nordic peers, but is expected to increase further. Highly-indebted households (i.e. those with debt greater than four times their income) accounted for over a quarter of borrowing in 2016; preliminary survey data for 2017 indicate that the typical new borrower for housing purchases is taking on leverage of 4½ times income. The share of floating rate loans in household lending is high, exacerbating households’ vulnerabilities to interest rate and/or income shocks, although this is mitigated by the prevalence of mortgages with annuity repayments.

uA01fig10

Household Debt by Purpose

(EUR billion)

Citation: IMF Staff Country Reports 2019, 007; 10.5089/9781484393482.002.A001

Sources: Statistics Finland; Bank of Finland; and IMF staff calculations.

14. Residential real estate markets do not seem overheated overall, but demand still exceeds supply in major metropolitan areas, and commercial real estate may expose the economy to shocks. Housing starts and completions have been elevated, but price increases in greater Helsinki suggest demand still outstrips supply. Across the whole country, house price increases have been modest, especially in comparison to Nordic peers (Figure 2), with house price deflation in regions outside greater Helsinki. Price-to-income and price-to-rent ratios have not risen much during the recent economic recovery. Low and declining yields in commercial real estate suggest relatively high valuations.

15. The authorities have tightened credit policies. A floor of 15 percent on the average risk weight for housing loans took effect in January for institutions using internal risk-based (IRB) models. Effective July, the maximum loan-to-collateral (LTC) ratio for housing loans (excluding loans on first homes) was cut from 90 to 85 percent.

16. The recent tightening is appropriate, but policy could be more effective if the toolkit were modified. Although overall household debt and leverage are not high in comparison with other Nordic countries, there are some cohorts that are increasingly vulnerable to income and/or interest rate shocks—which, in view of the concentration of total lending in real estate (¶20), opens the financial system to risks.

  • The current cap on mortgage loans relative to collateral could usefully be replaced with a cap relative to the value of the property, as is common in other countries.8 And because the underlying problem is more the level of debt than housing valuations, it would be useful for the authorities to have debt-based macroprudential tools (such as debt-to-income or debt-service-to-income caps) at their disposal should leverage become more stretched. Applying such tools well depends on accurate information. Staff supports the recent Justice Ministry recommendation for the establishment of a “positive credit register”—i.e. a database that credit firms and the FIN-FSA could use to obtain real-time information about customers’ debt and income levels. A new challenge arises from non-bank lending, including online platforms such as peer-to-peer lending, which is not being recorded in credit statistics and registers (section B and Box 1).

  • The growing reliance on consumer credit, especially that provided by non-banks and via digital platforms, raises additional concerns. Some of these outlets are not regulated and provide cross-border financing. Attempts were made to circumvent legally-binding interest rate caps, raising the question of whether borrowers—especially those dealing with non-bank lenders—are sufficiently informed about the conditions of their loans. The authorities are amending the legislation on interest rate caps to close loopholes. Additional consumer protection measures are needed and require more data collection, especially on consumer lending provided through digital platforms. Tighter prudential requirements to demonstrate creditworthiness could also be considered.

17. Macroprudential authority tools should not be expected to solve underlying supply problems. The authorities have already implemented measures to expand housing supply in urban areas, including Helsinki. The government provides considerable support for social housing, which should make it easier to move across regions.9 But property taxation could be deterring mobility: recurrent property taxes collected by municipalities tend to be low, with some exceptions, while transaction tax rates are steeper at 4 percent.10

Authorities’ Views

18. The authorities assessed borrower risks to be increasing. Household debt was thought to be already high, with particular risks associated with consumer lending and housing corporation loans. Unsecured consumer lending, especially by non-banks, could be associated with onerous terms and conditions. Similarly, the authorities noted that shareholders in housing corporations might not appreciate the debt that they had in effect taken on. They also expressed concern over the leverage taken on by new borrowers for house purchases. The authorities would prefer the existing lending cap to be expressed as a ratio to value instead of collateral, and argued for the need to expand macroprudential tools to debt-and-income-based measures to better contain the growth in household debt. They emphasized the need for such caps to cover all lenders, not only banks, and include all debt, not only secured lending. They argued for more data, especially on non- bank and foreign lenders (which are not fully captured by credit statistics), and sought a positive credit registry to support monitoring of financial health.

B. Financial System Policies

19. The Finnish financial system is sound. System-wide capital ratios exceed minimum requirements by a clear margin, and leverage ratios have improved to levels above European averages (Table 6). Returns to equity and cost ratios are healthy; profitability has dipped recently, but mainly because of investment (e.g. IT systems). The quality of the loan stock is very good overall, with low levels of NPLs.

Table 1.

Finland: Selected Economic Indicators, 2016–2024

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Sources: Bank of Finland, BIS, International Financial Statistics, IMF Institute, 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 General Government Fiscal Plan.

Adjusted for interest expenditure.

Defined as the negative of net financial worth (i.e., debt minus assets).

CPI-based real effective exchange rate.

Table 2.

Finland: Balance of Payments, 2016–2024

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

Large inward FDI flows in 2014 and 2015 are mainly due to large mergers and acquisitions (M&A) in those years such as Microsoft’s purchase of Nokia’s handset business (worth 2.6 percent of GDP) and various M&A deals in the energy, manufacturing and shipbuilding sectors worth more than 0.5 percentage points of GDP each.

Table 3.

Finland: International Investment Position, 2008–2017

(Percent of GDP)

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Sources: Statistics Finland and Fund staff calculations.Note: Changes to the NIIP since the 2014 Article IV are mainly due to the switch to the BPM6 statistical standard.
Table 4.

Finland: General Government Statement of Operations, 2015–2024

(Percent of GDP, unless otherwise indicated)

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

Adjusted for interest expenditure.

Defined as the negative of net financial worth (i.e., debt minus assets; excludes all pension liabilities).

Table 5.

Finland: Public Sector Balance Sheet, 2010–2017

(Percent of GDP)

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Source: Brede and Henn, forthcoming. “Finland’s Public Sector Balance Sheet: A Novel Approach to the Analysis of Public Finance,” IMF Working Paper.Note: Public sector corporations include the largest 9 enterprises controlled by the Central Government. These account for over 90 percent of assets of Central Government controlled corporations. However, local government controlled corporations are not covered due to data limitations.

This is the net present value of already-accrued liabilities for work performed in the past, based on data (and discount rates) of the Finnish Centre for Pensions (ETK), except for 2016, which are Fund Staff estimates. These pension liabilities represent a contractual obligation to public sector employees. For private sector employees, rules governing the pension system could potentially be altered to change the present value of payouts.

Table 6.

Finland: Financial Soundness Indicators for the Banking Sector, 2012–2018

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

Debt between domestic non-financial corporations is eliminated

Change in definition of NPLs in 2014, Other receivables, undrawn credit facilities and guarantees and other commitments are excluded from the denominator

Average of margins (average lending rate minus average deposit rate) on loans to non-MFIs.

Cash and debt Securities eligible for central bank funding

Sum of main and long-term refinancing operations and marginal facility.