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Public Information Notice (PIN) No. 05/14
February 7, 2005
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431 USA

IMF Executive Board Concludes 2004 Article IV Consultation with Finland

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2004 Article IV consultation with Finland is also available.

On January 28, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Finland.1

Background

The Finnish economy has performed admirably in recent years, but must confront earlier than any other country in the EU the pressures of population aging. The momentum of growth was maintained, despite the receding role of the export-intensive high-technology electronics sector, aided by a strong fiscal stimulus, although unemployment, largely structural, remains high. Nevertheless, inflation is low and the fiscal and external current account surpluses are comfortable. However, longer-term prospects are clouded by the imminent rise in old-age dependency—the most rapid in Europe.

The economy weathered the global downturn relatively well, and in the near-term an improved external climate is expected to strengthen growth. Strong domestic demand, especially private consumption and residential investment, has buoyed the economy, reflecting strong disposable income growth and low interest rates. Increased external demand is expected to make a larger contribution in the near term, with growth averaging 3 percent in 2004-05. Inflation was largely absent in 2004, following sizable excise cuts, and an appreciating euro which tempered the increase in oil prices, but is expected to revert closer to that in the euro area average in 2005. Strong productivity gains have helped contain unit labor costs and maintain competitiveness. A recent centralized wage accord covering a period of 2½ years is expected to ensure continued wage moderation. However, a compressed wage structure and increased labor market mismatches impede employment growth—despite significant cuts in labor taxation (which nevertheless remains comparatively high)—with relatively low labor contributions from both ends of the age spectrum, and from the less skilled. The unemployment rate has remained broadly at 9 percent since 2000.

The fiscal position has rapidly eroded in recent years, but is expected to remain in surplus over the medium term. While the decline in the surplus from 7 percent of GDP in 2000 is partly cyclical, it is also the consequence of a sharp discretionary policy shift, with the structural surplus declining by 3¼ percent of GDP by 2004. The 2005 budget is expansionary, with cuts in corporate and capital taxes, and the beginning of a three-year labor income tax cut following the wage agreement. Nevertheless, the general government fiscal balance is likely to remain at about 2 percent of GDP, as the output gap closes. The government's sizable net asset position, equivalent to some 15 percent of GDP at the end of 2004, is expected to increase further.

Despite the benign short-term outlook, Finland's long-term fiscal prospects are less comforting. Aging-related fiscal pressures are anticipated to occur earlier than in most other EU countries, and to be stronger, reflecting Finland's comprehensive public welfare system. A significant reform of the public pension system has been initiated, aiming to raise the effective retirement age by 3 years from its current level of 59 years. However, the reform, by itself, is insufficient to ensure fiscal sustainability.

Executive Board Assessment

Executive Directors commended the authorities for the impressive strides made by the Finnish economy in recent years, aided by strong productivity gains and a stable macroeconomic policy framework, with low inflation and sizeable fiscal surpluses. Directors noted, however, that employment has remained stagnant, and structural unemployment high. They also underlined that Finland will face the challenge of population aging earlier than any other country in the European Union.

Directors stressed that economic diversification will be important to reduce Finland's vulnerability to downturns in the information and technology sector. Nevertheless, they observed that the economy has weathered the global slowdown relatively well and that growth is set to remain robust in 2005. The recent tax cuts are expected to stimulate employment, and business investment is set to recover after a period of weakness. Although high oil prices and further appreciation of the euro could pose risks to growth, Directors considered these risks to be broadly offset by a likely faster pace of global recovery and strengthening export prospects. As the impact of cuts in indirect taxation and other one-off factors recedes, inflation is expected to revert to the average in the euro area.

Directors noted that while Finland's fiscal position remains comfortable from a comparative EU perspective, the general government surplus has eroded in recent years. They stressed that sizeable fiscal adjustment will be required in the coming years to ensure long-term fiscal sustainability, given the imminent demographic pressures on public finances. Directors therefore recommended that the planned cuts in income taxes over the period 2005-07 be offset by a reduction in public spending, preferably through improved efficiency in the provision of social and welfare services. Such efficiency gains rather than tax increases should be the preferred means of strengthening local government finances.

Directors argued that a holistic approach to structural reforms, setting in train a virtuous circle of stronger employment, growth, and public finances is necessary to address effectively the challenge of aging. Such comprehensive reforms would reduce the required fiscal adjustment. Absent such reforms, the general government would have to run sizable surpluses to ensure fiscal sustainability.

Directors called for policy initiatives to raise the employment rate, especially at both ends of the age spectrum where labor utilization is relatively low. The recent steps to reduce the burden of labor taxation will help promote employment, but may not be sufficient to attain the authorities' ambitious target for raising the employment rate. Welcoming the authorities' intention to reduce employers' social security contributions for low-income workers, Directors called for targeting tax cuts at the lower end of the income scale in order to maximize the beneficial effects on employment. A gradual shift to a more decentralized wage bargaining system would also help ease wage compression and reduce structural unemployment, as would improved training for low-skilled and older workers.

Directors welcomed the significant pension reform being phased in from the beginning of this year as an important step toward ensuring fiscal sustainability. The reform, with commendable features such as an automatic adjustment for rising life expectancy and sharply rising accrual rates, goes some way toward promoting higher labor participation. However, the reform will need to be followed up with further steps, such as closing the so-called "unemployment pipeline," whereby unemployed persons over 57 can claim benefits until age 65. Noting that a consensus for structural reform may become more difficult to achieve in future years, Directors called for early consideration of additional measures and for stepped-up efforts to raise public awareness of the need for faster reform.

In Directors' view, further strengthening competition in product markets would complement efforts to improve labor market efficiency and accelerate the diffusion of productivity gains from the technology sector to the rest of the economy. While commending the progress achieved in recent years in promoting greater competition in sheltered sectors such as communications and retail trade, Directors felt that considerable scope remains to enhance competition in the sheltered sectors, given that the price level is still significantly above the EU average. In this regard, a more proactive stance on foreign direct investment and privatization of public enterprises would be helpful. A reduction in Finland's farm subsidies, which are high by EU standards, would also contribute to raising competition and consumer welfare.

Directors viewed the financial system as sound and resilient to economic shocks, and considered that it is poised to gain from greater European market integration. They noted that growing cross-border financial activity would call for increasingly closer cooperation among Nordic-Baltic financial supervisors.

Directors expressed their appreciation for Finland's strong record of official development assistance (ODA) and the country's support for increased market access for developing countries' agricultural exports through multilateral trade initiatives. They welcomed the 2005 budgeted increase in ODA and the authorities' intention to continue to increase ODA as a percent of gross national income in the future.

It is expected that the next Article IV consultation with Finland will be held on the standard 12-month cycle.



Finland: Selected Economic Indicators


 

2001

2002

2003

2004 1/


Real economy

       

GDP (change in percent)

1.1

2.3

2.0

3.1

Domestic Demand (change in percent)

1.7

1.3

2.1

2.4

Harmonized CPI (change in percent) 2/

2.7

2.0

1.3

0.2

Unemployment rate (in percent) 2/

9.1

9.1

9.0

8.8

Gross national saving (in percent of GDP)

27.7

25.8

24.2

24.3

Gross domestic investment (in percent of GDP)

20.6

19.0

18.5

18.6

         

Public finances (general government, in percent of GDP)

       

Overall balance

5.2

4.3

2.1

2.1

Primary balance 3/

5.9

4.5

2.4

2.1

Gross debt (Maastricht definition)

43.9

42.6

45.5

45.0

         

Money and credit (end of year, percentage change)

       

M3 (Finnish contribution to euro area) 4/

7.7

4.9

7.4

7.3

Total domestic credit 4/

6.5

9.1

11.2

11.7

         

Interest rates (year average)

       

Three-month money market 5/

4.1

3.5

2.3

2.3

Ten-year government bonds 5/

5.0

4.9

4.2

4.0

         

Balance of payments (in percent of GDP)

       

Trade balance

10.4

9.7

9.2

9.4

Current account

7.1

6.8

5.7

5.8

         

Fund position (as of end-November, 2004)

 

Fund holding of currency (in percent of quota)

65.99

Holdings of SDRs (in percent of allocation)

87.89

Quota (in millions of SDRs)

1,263.80

         

Exchange rate

       

Exchange rate regime

Euro

Present rate (December 29, 2004)

US$ 1.3608 per euro

Nominal effective exchange rate (increase in percent) 6/

1.9

1.3

4.4

1.7

Real effective exchange rate (increase in percent) 7/

0.8

-0.9

2.0

-0.3


Sources: Finnish authorities, International Financial Statistics; and IMF Staff estimates.

1/ IMF staff projections, unless otherwise indicated.
2/ Consistent with Eurostat methodology.
3/ Defined as non-interest revenue minus non-interest expenditure.
4/ For 2004, annualized increase to October.
5/ For 2004, monthly average for November.
6/ For 2004, average 12-month increase to October.
7/ Based on unit labor costs. For 2004, average 12-month increase to November.


1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.




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