Finland -- 2005 Article IV Consultation, Concluding Statement of the IMF Mission
October 25, 2005
1. Finland's economic performance continues to be remarkable on several counts. Economic growth in 2005 is again outpacing the euro area average, despite the temporary setback from the production shutdown in the paper sector. Inflation remains in check, the external position is comfortable, and the public finances are recording a sizeable surplus, which remains among the largest in the European Union. A notable success of the past year has been a long-awaited pick-up in employment. Looking ahead to the rest of this decade and beyond, however, Finland faces major economic challenges that call for timely policy responses. The current benign economic environment should not be allowed to obscure the urgency of these challenges, but instead be seized as an opportunity to forge a national consensus to address them.
2. Prospects for economic growth in 2006 are favorable, aided by the strength of the projected European recovery. Private consumption is expected to continue to sustain domestic demand, stimulated by tax cuts and low interest rates. Private fixed investment is set to continue a gradual recovery that began last year after two years of decline. A smart rebound in exports as the paper sector shakes off the effects of the labor dispute, coupled with the improving outlook for the global technology sector, should help solidify the recovery. All in all, we expect growth in Finland to exceed 3 percent next year. Inflation is projected to rise in 2006 toward, but remain below, the euro area average. The competitive position is expected to remain comfortable, although a further fall in the terms of trade is in the cards.
3. The risks to the forecast for growth are tilted somewhat to the downside. Prolonged high energy prices could dampen confidence at home and growth in export markets. A failure of euro area growth to revive would be a drag on Finnish activity. However, Russia's re-emergence as a strong export market, and the important role of Sweden, the United Kingdom, and China as trading partners, will serve to cushion any adverse impact. An abrupt correction of continued large global imbalances in external positions, with the attendant risk of disorderly movements in exchange rates, also poses a risk. The main domestic uncertainty stems from the still tentative nature of the recovery in employment. If it fails to pick up durably, consumer confidence and growth prospects could be adversely affected.
4. The current fiscal position and performance are broadly satisfactory, especially in the European Union context. The general government surplus is projected at 1¾ percent of GDP this year and next, gross public debt has been reduced to around 40 percent of GDP, and the public sector continues to accumulate net financial assets. The experience of the new medium-term expenditure rule in containing spending pressures has so far been encouraging. The initiation of pension reform earlier this year constitutes an important step toward the goals of promoting higher labor participation among older workers and addressing the long-term demographic pressures on public finances.
5. The authorities' goal of attaining balance in central government finances in 2007 is unlikely to be realized without further efforts at restraining public spending. The general government surplus is now more than accounted for by the surpluses of the social security and pension funds. Cuts in personal income taxes to support employment, targeted toward lower income brackets, while desirable, are largely responsible for shifting the central government finances into a deficit of about ½ percent of GDP this year, the first such red ink in recent years. Additional tax cuts in the context of the wage accord are projected to keep the deficit at the same level as a share of output in 2006, at a time when economic growth is expected to be robust. The goal of a balanced budget would only be realized through further steps to restrain public spending. These would also be required to respect the medium-term spending rule, a recognition reflected in the authorities' welcome plans to improve the efficiency of central government operations.
6. Reforms aimed at enhancing the efficiency of public services are emerging as a key element in preparing for the coming demographic challenge. In this context, apart from the task of raising the effective supply of labor and restraining pension spending, rapid aging will call for meeting the pressures of rising demand for a variety of public services such as healthcare and care for the elderly. Regrettably, the efficiency of spending by local governments, which provide the bulk of health, education and social services, has declined significantly in recent years. Moreover, the large number of government employees expected to retire in the near future will place additional pressures on a shrinking labor pool. The authorities and the population at large increasingly recognize the critical role of reforms in public services for the sustainability of the welfare system, and are currently examining various proposals to reorganize responsibilities for their provision and financing.
7. A pragmatic approach should be adopted to reform the current system for providing social services, with improved efficiency as the paramount objective. Irrespective of the specific model that is ultimately adopted, it would be important to ensure that the new organizational structure focuses on raising efficiency, drawing on international best practices, including wider use of information technologies. It would also be necessary to allow for flexibility and due recognition of the diversity of local circumstances, stemming from factors such as geographical location and population density. Consolidation of activities may be useful in some localities to capture scale economies, while public-private partnerships may induce increased efficiency in more urban areas. As the demand for aging-related services rises, consideration would need to be given to institutional arrangements that would bring demand in line with the costs of providing "non-core" or less essential services, including through a shift to private providers. User charges should be reviewed to reflect changing cost developments. Given the long gestation periods needed for implementing such reforms, an early start would be highly desirable.
8. While efficiency gains will go far in strengthening the fiscal position, ensuring sustainability will require further measures, including revisiting pension system parameters. Finland's extensive social welfare system, combined with its rapidly aging population, places especially heavy pressures on the sustainability of public finances. The substantial pension reforms to be phased in beginning this year go some way toward alleviating these pressures by encouraging longer working lives and limiting the growth in pension outlays. It will be important, nevertheless, to assess the ongoing impact of the measures on sustainability, and remain open to undertaking additional revisions to the pension regime as necessary.
9. The wage bargaining system has served to secure wage moderation, but looking forward, would need to allow for greater flexibility in wage-setting across the economy. The latest accord has succeeded in delivering moderate wage increases and assuring certainty over an extended period, promising a continued favorable competitive position for Finnish industry. The accord has also partially stemmed the process of growing wage compression. Nevertheless, it fails to allow for a fuller reflection of age- and skill-specific variations in labor productivity. It is thus imperative to raise popular recognition that the so-called "solidaristic" bargaining model can be contrary to a broader concept of social solidarity, since it may leave a substantial portion of the workforce outside the system. Moreover, the bargaining system hinders the economy's ability to address the demographic transition by failing to make the fullest use of the nation's labor resources.
10. Wide-ranging measures are also called for to ease growing labor market mismatches and reduce structural unemployment. The sharp rise in vacancies in the recent upswing along with persistent high unemployment suggests a mismatching of skills and opportunities, as well as limited labor mobility between regions and occupations. The authorities' efforts to "price in" labor through subsidies for lower-skilled older workers are welcome if they are well targeted. As important, the temporary active labor market programs can help promote employment opportunities for underutilized segments of the labor force. In addition to these efforts, other supporting structural measures would be essential to achieve the authorities' ambitious goal of a 70 percent employment rate by early 2007.
11. The contrast between Finland's high ranking in competitiveness and the unease about economic prospects suggests deeper underlying shortcomings in institutions and attitudes. Indicators such as the quality of education and skills of the labor force, and investment in research and development place Finland in an enviable position. However, there are valid concerns that these achievements do not seem to be translated into commensurate gains in productivity outside the information and communications technology (ICT) sector. The paucity of investment also does not augur well for future growth. It seems plausible that a combination of a compressed wage structure and a high tax wedge on labor reduces the return to high investment in human capital, preventing the economy from reaping its full benefits in terms of productivity. Finland also appears to display relatively less entrepreneurial activity, as partly reflected in its high price level. However, recent gains in efficiency in telecoms and in retail trade are promising. As aging reduces effective labor supply in the coming years, it would be all the more important to minimize impediments to realizing a fuller return on the nation's human capital wealth.
12. The financial system is sound and well-supervised, but faces some challenges. Several indicators of financial sector soundness suggest that the Finnish system is efficient, competitive, and well supervised. Nevertheless, heightened competition for market shares has increased the risk that credit standards could suffer, especially for housing loans, in the face of sizable increases in house prices. The current low lending margins may also constrain future profitability. While increasing financial integration in the Nordic-Baltic region will allow for greater risk diversification, it also underscores the need for closer cooperation between national, as well as supranational, supervisory authorities.
13. With the transition to an older society occurring here earlier than elsewhere in the European Union, Finland can set an example of timely adaptation of institutions and mindsets to economic change. The authorities should aim at a consensus behind an integrated and bold approach to structural reforms that would initiate a favorable dynamic of higher employment and growth, and stronger public finances. Such a policy agenda would ensure that Finnish citizens continue to enjoy high and rising living standards by sharing in the gains created by a rapidly globalizing world economy.