Statement by Mr. Pösö and Mr. Kraavik on Finland January 26, 2022

On behalf of the Finnish authorities, we thank the mission team led by Wojciech Maliszewski for the candid and constructive discussions and the well-balanced Article IV Report. The mission was conducted under exceptional pandemic circumstances and took place both virtually and in person. The authorities highly appreciate staff’s views on economic context, outlook, risks, and policy priorities, which contribute to the policy debate in Finland. The authorities agree with the thrust of staff’s appraisal and agree that further efforts are required to combat medium and long-term challenges.


On behalf of the Finnish authorities, we thank the mission team led by Wojciech Maliszewski for the candid and constructive discussions and the well-balanced Article IV Report. The mission was conducted under exceptional pandemic circumstances and took place both virtually and in person. The authorities highly appreciate staff’s views on economic context, outlook, risks, and policy priorities, which contribute to the policy debate in Finland. The authorities agree with the thrust of staff’s appraisal and agree that further efforts are required to combat medium and long-term challenges.

On behalf of the Finnish authorities, we thank the mission team led by Wojciech Maliszewski for the candid and constructive discussions and the well-balanced Article IV Report. The mission was conducted under exceptional pandemic circumstances and took place both virtually and in person. The authorities highly appreciate staff’s views on economic context, outlook, risks, and policy priorities, which contribute to the policy debate in Finland. The authorities agree with the thrust of staff’s appraisal and agree that further efforts are required to combat medium and long-term challenges.

Recent Economic Developments, Outlook, and Risks

The Finnish economy has recovered swiftly from the downturn in 2020 and reached the pre-pandemic level of output in the second quarter of 2021. Both fiscal and monetary policy have strongly supported growth, and the recovery has been driven mainly by strong domestic demand. The economy has suffered less from the pandemic than many other countries due to the successful containment of the spread of COVID-19 prior to the latest wave of infections, and the relatively small share of contact-intensive sectors in the economy. On the health front, Finland has undertaken a vaccination campaign with 83 percent of people aged 12 and above being fully vaccinated. This has helped limit the number of hospitalizations, but economic growth is expected to be slow in the first quarter of this year due to the record caseloads caused by the Omicron variant.

The labor market has also recovered briskly. Labor market policies implemented in the early phase of the COVID-19 crisis, including easing the terms of temporary lay-offs and a reduction in employers’ social security contributions, helped to cushion the impact on the labor market. The employment rate reached its pre-pandemic level in late 2021, and unemployment remains only slightly above its pre-pandemic rate. Employment is expected to keep improving, albeit at a slowing pace. Labor shortages, regional and skill mismatches in the labor market, and other production bottlenecks will limit employment and output growth.

The effects of the pandemic are still being felt across the economy, and this includes higher inflation, mostly driven by increases in energy prices. Robust disposable income growth in 2021 and savings accumulated by Finnish households during the pandemic have prompted a strong recovery in demand. In the near term, global supply disruptions and high raw material prices further accelerate inflation. While inflation has turned out to be faster than previously forecast, it is below the euro area average and it is expected to decelerate in the course of this year as many of the factors driving inflation gradually a bate. In the recent collective wage agreements, completed in late 2021 and early 2022, no clear signs of second-round effects of inflation have been observed, suggesting that inflation expectations have remained anchored in Finland.

Although the pandemic continues to overshadow the economic outlook, Finland’s economy is expected to grow at a fast pace in 2022 and thereafter return to the long-term growth trend. Private consumption growth was fast in 2021, and robust growth will continue this year as employment continues to improve and households reduce their savings. Corporate investment growth is expected to pick up significantly in 2022. From 2023 onwards, economic growth will start to slow toward its long-term potential rate, reflecting muted long-term growth prospects caused by an ageing population and slow productivity growth. This year, GDP growth is expected to be 3.0 percent, moderating thereafter to around 1.5 percent.

Risks to the economic outlook are predominantly to the downside. In the short term, the COVID pandemic constitutes the greatest risk. The rapidly deteriorated COVID situation both in Finland and internationally, caused by the Omicron variant, increases the uncertainty of households and businesses, and threatens to slow economic recovery. A prolonged pandemic would have a strong impact on private consumption, especially on the demand for services. Global supply disruptions related to the pandemic, if prolonged and more severe than expected, could also threaten the recovery of exports and growth. On the other hand, the economy could perform better than expected if both investment and household consumption grow faster than currently forecast.

Fiscal Policy

The active fiscal policy pursued by the government and the automatic stabilizers have helped to cushion the pandemic shock and stimulate the economy. Fiscal policy will become less supportive this year as many of the support measures prompted by COVID-19 will unwind, but fiscal policy remains expansionary compared to the pre-pandemic policy stance. The general government deficit will decrease further as economic growth continues to be brisk. The growth of the general government debt-to-GDP ratio will level off only temporarily in 2021-2022 and the debt ratio will once again begin to slowly rise as economic growth decelerates.

In the longer term, the increase in age-related expenditures threatens to push the debt-to-GDP ratio again on a growth path. General government finances will be strengthened through growth, employment, and moderate adjustment measures. The government aims at an employment rate of 75 percent and reversing the growth of the debt ratio in the middle of the decade. In its economic sustainability roadmap, the government has identified the following set of measures to strengthen the sustainability of general government finances: (i) increasing employment and reducing unemployment, (ii) reinforcing the conditions for economic growth, (iii) increasing public sector productivity, and (iv) reforming health and social services.

High level of government guarantees poses contingent liability risks. Contingent liabilities grew strongly in the last decade and they are also highly concentrated. In export financing, the shipbuilding industry accounts for about 50 percent of total exposures. The operations of the state housing fund also involve concentration risks. Significant growth in liabilities, combined with moderate long-term growth prospects, raises concerns about the central government’s risk-bearing capacity. In a comprehensive stress testing scenario, the realization of contingent liabilities would increase government borrowing by EUR 2.1 billion.

The Parliament has approved the total state budget of EUR 64.9 billion for 2022. The budget deficit of EUR 7 billion will be covered by additional borrowing. Due to the recent deterioration of the COVID-19 situation, the government is preparing the first supplementary budget for 2022. The budget proposal would be submitted to the Parliament in the beginning of February.

The spending limits system has been in place since 2004, and it has been an established tool in fiscal policy. The COVID-19 pandemic has led to an exceptional and challenging situation where a number of exceptions have been made to the spending limits. The authorities share staff’s view that uncompromised respect for the spending limits system and the expenditure limit set would enhance fiscal credibility. In December 2021, the Ministry of Finance appointed a working group to comprehensively assess the functioning of the spending limits system and fiscal rules in general and make recommendations for the next parliamentary term. The authorities agree with staff that a spending review could be one possible, however laborious, tool to identify fiscal savings and enhance spending efficiency.

Structural Issues

The government’s objective is to increase R&D expenditure to raise productivity. In December 2021, a parliamentary working group proposed the introduction of a legislative act on the financing of R&D and to draw up a statutory plan for R&D funding that would extend beyond the spending limits period. It also proposed a permanent and more extensive tax incentive for R&D activities. The goal would be to raise public sector R&D expenditure to 1.33 percent of GDP by 2030 under the projected economic development. Reaching the overall 4 percent of GDP target also requires increased investments from the private sector.

The authorities agree that structural reforms could improve the functioning of the labor market. New measures to reach the government’s 75 percent employment target will be announced in February. The proposal to abolish the unemployment tunnel is under preparation as a part of a package for improving employment for senior citizens. Various other early exit options for more experienced workers will remain in place. Going forward, additional analysis of current sickness benefits and rehabilitation process in comparison to peers could reveal untapped potential. While improving employment prospects for women with care responsibilities would boost employment and equality, means and funds for ensuring sufficient access to quality childcare should be considered in an environment where regulatory changes and high demand for qualified staff are generating wage pressures.

The organization of public healthcare and social welfare services will be reformed. Legislation was approved by the Parliament in 2021, and the responsibility for organizing these services will be transferred from municipalities to wellbeing services counties from 2023. The key objective of the reform is to improve the availability and quality of basic public services throughout Finland and curb the growth of general government expenditure after the transition. Counties will receive financing from transfers from central government. Establishing the counties will incur extra costs but it is anticipated that the reform will produce savings in the 2030s.

The authorities agree that a wage bargaining model that provides both macro- and micro flexibility would be beneficial. However, finding concrete means to achieve such a model in the Finnish set-up has not been easy. The means through which the government would be able to further such goals are limited. Moreover, as the effects of micro flexibility and associated higher wage dispersion on productivity are not ex-ante clear in light of theory and the empirical evidence on local bargaining is scarce, it is not straightforward to assess what would be the optimal way to increase micro flexibility from the perspective of aggregate productivity.

Climate Policies

The government works to ensure that Finland is carbon neutral by 2035 by accelerating emissions reduction measures and strengthening carbon sinks in a way that is fair from a social and regional perspective and that involves all sectors of society. Large investments in green transition are in the pipeline and various tax incentives have been put in place, but the authorities agree that more needs to be done to achieve the ambitious target. Staff’s recommendation to increase carbon price in Finland to €125 per ton is interesting, but it remains unclear whether a single European country with a rather significant effective level of taxation could implement such a reform for every sector. For example, the authorities have reservations about the recommendation of taxing fuels used for domestic power production as the economic and climate effects may not be beneficial due to risks of carbon leakage within the Nordic electricity market or to other countries. Also, unilateral increase of domestic carbon prices for emissions in manufacturing processes, especially steel production, cement, and oil refining, would entail a risk of carbon leakage. Such proposals are also not included in the European Commission´s latest proposal to reduce net greenhouse gas emissions and similar principles of taxable base of energy taxation are widely used around the world and in reference countries. The authorities consider that more analysis on the sectoral level impact of these reforms is needed as well as discussion on the background of the current structures and the tax treatment of these sectors in reference countries.

The concept of feebates is interesting, but the recommendation, so far, is highly theoretical from the implementation perspective and the benefits are unclear for various reasons. From the energy taxation perspective, it is likely that the recommendation would not be compatible with the current, or the proposed, EU Energy Taxation Directive and EU state aid legislation. Also, a tax- neutral feebate system might not bring about more or better incentives for purchasing low emission cars compared to the current car taxation. It seems likely that the result of the reform would decrease prices of high emission cars and increase prices of plug-in hybrid electric vehicles. Moreover, it is still unclear, and seems unrealistic, how this concept could be implemented in practice, for example, how the appropriate industry-wide average energy consumption rate could be set for the sales of energy-consuming products, such as refrigerators, air conditioners, and industrial machinery, especially in a country of a size like Finland.

Financial Sector Stability

The banking sector has remained resilient and banks have been able to support the real economy throughout the pandemic. The resilience has been supported by extensive post-GFC regulatory and supervisory reforms, solid pre-pandemic asset quality, strong profitability, relatively modest recession, and a wide range of support measures, including fiscal, supervisory and macroprudential relief measures. Asset quality has deteriorated only modestly during the pandemic. Also, most of the repayment holidays granted at the onset of the pandemic have expired without signs of asset quality deterioration. The main systemic vulnerabilities in Finland continue to be structural in nature, such as a large and concentrated banking sector, exposures concentrated to real estate sector, regional interconnectedness, high reliance on market funding, and high and increasing household indebtedness. Some of the vulnerabilities have increased during the pandemic.

Digitalization continues to shape banks’ business models and competitive environment. Several banks are undergoing digital transformations and large IT modernization projects with front- loaded costs. Digitalization has made banks more vulnerable to cyber risks and cross-border financial flows expose banks to possible ML/TF risks. Competitive pressure from new players is rather limited so far, with FinTech activity largely concentrated in payment services and crypto assets.

High and growing household indebtedness remains a medium-term structural vulnerability for the financial system and the real economy. Household indebtedness has continued to grow during the COVID-19 pandemic, mainly driven by mortgage loans and slower growth in income, while before the pandemic it was more driven by housing company loans and consumer credit. As the sources and purposes of new debt may change over time, it would be important to ensure an equal regulatory treatment of different forms of debt. House prices have increased more rapidly in large cities than in the rest of the country, and the overall growth has remained moderate in international comparison.

A complete set of national borrower-based macroprudential measures are deemed necessary. In particular, to prevent an excessive increase in household indebtedness, income related borrower-based measures, like DTI/DSTI, would be warranted. Maturity limits for housing loans and several tools to address risks in construction finance or housing company loans are proposed, but the government has announced that they will not proceed with the introduction of a binding DTI. However, the FIN-FSA has the option of issuing recommendations on income-related measures to help prevent an excessive increase in household indebtedness. The introduction of binding income-related borrower-based measures will be reassessed when the new credit registry is operational in 2024.

Experience implies that more broad-based criteria for applying the countercyclical capital buffer are well-motivated. The use of the buffer in a more responsive and cyclical manner would strengthen its preventive role and it would enable a swift response to situations where cyclical buffer releases are needed. During the pandemic, bank lending in Finland was supported by removing the systemic risk buffer for all Finnish credit institutions, while countries with a positive countercyclical buffer responded by removing this buffer. The introduction of a positive neutral countercyclical capital buffer would, however, require legislative changes.

Macroprudential toolkit must evolve further. Specific instruments should be developed to tackle risks created by exposures to commercial real estate. Enhancing the macroprudential framework beyond banking using activity-based regulation is also important. The systemic relevance of the activities in question should direct the prioritization of regulatory efforts in securities markets, insurance, and infrastructure. Introducing a common framework for payout restrictions in crisis situations, as currently discussed at the EU level, would however require further analysis regarding the costs and benefits of such a framework.