## cr17370

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### Context and background
- Finland’s economic model combines openness and relatively limited state intervention with extensive social insurance mechanisms; a comprehensive welfare state provides social services and transfers and generous unemployment and other benefits, supported by relatively high taxation.
- Sustainability of the model depends on high employment and incomes; the economy faced severe shocks including:
  - decline of the forestry industry and a severe domestic banking crisis in the early 1990s;
  - sharp downturns in the euro area and Russia and the restructuring of Nokia, resulting in a double-dip recession from 2008 to 2014.
- Constraints on recovery prior to 2015 included weak investment, slumping labor productivity, escalating labor costs, and a relatively fast deterioration in export market share.
- Recovery beginning in 2015 has gathered strength, but challenges remain:
  - demographic changes will shrink the working age population and put further demands on the public finances;
  - achieving high employment will be challenged by skill-biased technological change and routinization.
- Recent policy and labor developments:
  - The 2017 Competitiveness Pact implemented a wage freeze in 2017, lowered the labor tax wedge, and decreased public sector holiday bonuses from 2017 to 2019.
  - At sectoral and firm levels wage increases have often not matched productivity changes.
- Focus of the report:
  - Policies to increase resilience, employment, and growth.
  - Selected Issues Papers (SIPs) evaluate pension and aging costs, exports, and the labor market; findings inform recommendations to keep wages in line with productivity and to boost labor supply and productivity.
  - Emphasis on a well-functioning financial system and safeguards, including implications of Nordea’s headquarters move to Finland.
- Political context:
  - The center-right coalition government remains in power; after a fissure in the Finns party in June, the coalition of the Centre and National Coalition parties continues with the breakaway Blue Reform party.
  - The next general election is in April 2019.

### Recent developments — growth, inflation, labor, credit, external
- Growth and demand:
  - GDP growth accelerated to 2.9 percent year-on-year in the first half of 2017, compared with GDP growth of 1.9 percent in 2016.
  - Initial recovery drivers: private consumption and housing investment; more recent drivers: exports and equipment investment.
- Inflation:
  - Inflation in 2016 averaged 0.4 percent; inflation currently remains below 1 percent due to declining wage growth, the Competitiveness Pact, and low trade partner inflation.
- Labor market:
  - Headline unemployment rate stalled at just below 9 percent despite employment growth.
  - Unit Labour Costs index (2010=100) rose earlier but has fallen recently.
  - Wage inflation series show Total, Private Sector, and Central Government for 2015–2017.
- Credit and financial conditions:
  - Total credit is growing in line with nominal GDP; unsecured credit has expanded rapidly since 2016.
  - Household loan growth: 2.4 percent yoy in June.
  - Credit to non-financial corporates: 6.2 percent yoy growth rate in June.
- External sector:
  - Current account deteriorated to -1.4 percent of GDP in 2016 and returned to surplus in early 2017.
  - Both EBA external sustainability and current account models estimate a current account gap of -¾ percent of GDP in 2016; staff assesses the gap to be between -1.6 to 0 percent of GDP.
  - ULC-based REER depreciated by more than the CPI-based REER following recent wage moderation.
- Exports:
  - Goods export volumes picked up after stagnation, driven by petroleum products, chemicals, electrical equipment and machinery.

### Near-term growth outlook and outlook assumptions
- GDP growth projections:
  - 2017: 2.8 percent
  - 2018: 2.3 percent
  - Potential (early 2020s): estimated at 1¼ percent
- Production shock:
  - Production from a new pulp mill boosts growth in 2018 by 0.2 percentage points.
- Inflation projections:
  - 2017: 0.8 percent
  - 2018: 1.2 percent
  - 2021: 2 percent
- Baseline assumptions:
  - Cost competitiveness continues to improve.
  - Labor productivity growth expected to remain around 1 percent, assuming continued wage moderation.
  - Employment rate increases to above 72 percent by 2021, partly driven by higher participation rates as the working age population continues to shrink.
- Staff productivity and employment projections (2016–2021):
  - Real GDP would increase by 10 percent between 2016 and 2021.
  - Labor productivity growth to average 1 percent and converge to 1¼ percent longer term.
  - Employment estimated to rise 3 percent over these years.
  - Employment growth driven by declines in unemployment to a NAIRU of about 7½ percent, and activation of 60,000 inactive persons (half from lower disguised unemployment).

### Risks to the outlook
- Domestic downside risks:
  - Reforms (health and social services, firm-level wage bargaining) might slow or fail.
  - Labor productivity and employment growth could fall short; return to misaligned real wages and productivity would hold back growth.
- External risks:
  - Baseline assumes 4 percent annual growth in external demand; capital goods exports vulnerable to investment demand in key European partners and China.
- Financial vulnerabilities:
  - Banks’ reliance on wholesale funding and close Nordic linkages expose Finland to financial shocks (Federal Reserve and ECB normalization, European bank distress, neighboring-country contagion).
  - Increases in interest rates could dampen consumption growth, especially for highly leveraged households.

### Fiscal policy — recent outcomes, 2018 budget, and staff recommendations
- 2016 fiscal outturns:
  - Fiscal deficit in 2016: 1.8 percent of GDP (budget forecast 2.8 percent).
  - Gross general government debt at end-2016: 63 percent.
- 2017 projection:
  - Staff expects a deficit in 2017 of around 1½ percent of GDP.
  - Improvement partly driven by 0.4 percent of GDP in one-off capital gains tax revenues from a corporate M&A transaction.
- 2018 budget and fiscal stance:
  - 2018 budget implies a procyclical fiscal stance; deficit ¼ percent of GDP higher than in 2017.
  - Further deficit reduction is gradual; debt would only fall below 60 percent of GDP by 2022.
  - Expenditure measures decided in 2017 include increased spending on security, skills and employment (0.1 percent of GDP), reductions to child care fees, increased resources for the employment service, and partial reversal of past R&D funding decreases (together 0.1 percent of GDP).
  - Startup costs for health and social services reform estimated about 0.1 percent of GDP annually.
  - Revenue measures raise the deficit by 0.1 percent of GDP: reductions in unemployment insurance contributions and discretionary personal income tax cuts partly offset by increases in excise taxes on alcohol and fuel.
- Staff analysis on buffers and recommendations:
  - Prudent level of intertemporal financial net worth (IFNW) suggested between 30 and 85 percent of GDP.
  - Health and social security reform (annual savings about 1½ percent of GDP) boosts public sector net worth to around 54 percent of GDP.
  - If the deficit were to almost close by 2020, net worth would improve by another 34 percent of GDP.
  - Government guarantees now exceed 20 percent of GDP; concentration risks need monitoring.
  - Recommendations:
    - Avoid procyclical policy; adopt cyclically-neutral approach (broadly unchanged structural primary balance from 2017 to 2019).
    - Direct any fiscal yield from positive growth surprises to deficit reduction.
    - Consider new measures that durably boost employment and growth (additional R&D spending, well-targeted ALMPs, public investment to fix maintenance gaps).
    - Reorient or streamline subsidies (total about 1½ percent of GDP).

### Long-term fiscal challenges and intertemporal balance-sheet findings (Annex III)
- Demographics and aging costs:
  - Working age population expected to shrink by ¼ percent annually over the next several years.
  - Aging expenses increasing at an annual pace of 0.2 percentage points of GDP for the past decade, largely driven by higher pensions.
  - Aging-related expenditures will continue to increase rapidly until the early 2030s due to escalating health and long-term care spending.
- Static fiscal balance sheet (2016):
  - A Assets: 278.5 percent of GDP
  - B Nonfinancial: 84.6 percent of GDP
  - B Financial: 193.9 percent of GDP
  - C Liabilities: 441.5 percent of GDP
  - o/w General Government Maastricht Debt: 63.1 percent of GDP
  - Existing Pension Liabilities: 301.1 percent of GDP
  - D = A - C Static Net Worth: -163.1 percent of GDP
- Intertemporal Present Value of Future Primary Balances (Percent of GDP):
  - Baseline (based on 2018 budget proposal): 237.8
  - Baseline including Health and Soc. Serv. Reform: 301.5
  - Fiscal Position near Balance by 2020: 271.5
  - Fiscal Position near Balance by 2020 plus Health and Soc. Serv. Reform: 335.5
  - Abandoning fiscal efforts: 201.5
- Intertemporal Net Financial Worth (IFNW) outcomes (Percent of GDP):
  - Baseline (based on 2018 budget proposal): -9.9
  - Baseline including Health and Soc. Serv. Reform: 53.8
  - Fiscal Position near Balance by 2020: 23.9
  - Fiscal Position near Balance by 2020 plus Health and Soc. Serv. Reform: 87.9
  - Abandoning fiscal efforts: -46.2
- Methodological assumptions:
  - Discount rate: 5 percent; inflation rate: 2 percent.
  - Health and social services reform savings: 1.5 percent of GDP, assumed to accrue linearly during 2023-29.
- Policy implication:
  - Under the baseline IFNW remains negative (-9.9 percent of GDP); implementing health and social services reform materially improves IFNW (to 53.8 percent of GDP).

### Labor market structure, mismatches, and policy recommendations
- Key labor market findings:
  - Need for reform to increase wage flexibility at sector and firm levels and boost labor supply from some cohorts.
  - Wage–productivity misalignments at sector and firm levels hinder job matching and macroeconomic adjustment.
  - Evidence of an outward shift in the Beveridge curve indicates increasing difficulties in matching the unemployed to job vacancies.
  - Factor misallocation, especially of labor, has been relatively high.
- Group-specific observations and recommendations:
  - Youth:
    - Working careers start later due to longer study times; authorities adjusting higher education to encourage faster completion and to reduce importance of entrance exams.
    - Vocational education should be made more adaptable and relevant to employers’ needs.
  - Women of child-bearing age:
    - Participation rates low compared to Nordic peers, especially for low-skilled women; high effective out-of-pocket childcare costs because using day care implies giving up a generous home care allowance.
    - Reductions in early childhood education fees for lower-income households in the 2018 budget proposal are a welcome first step.
    - Evaluation of family leave should consider shortening home care allowances in favor of more resources for child care.
  - Older workers:
    - 2017 pension reform increases retirement age from 63 to 65 over the next decade and in line with life expectancy thereafter.
    - Reform may increase attractiveness of extended unemployment as a path to early retirement for those older than 58; closing this possibility would prolong working lives.
    - More intensive targeting of activation policies to older benefit claimants could hold potential.
- Active labor market and unemployment measures:
  - Requirements to accept job offers have been tightened and duration of earnings-related unemployment benefits shortened.
  - Tapering benefits to decline with duration of unemployment could incentivize job search and should be considered.
  - A bill before parliament would cut unemployment benefits by 5 percent for recipients not active in training or having worked at least 18 hours during the previous three months, and would modify benefits to provide more incentives for entrepreneurship and geographic mobility.
  - Resources for employment services remain much lower than in Nordic peers; recent reversals allow quarterly interviews.

### Structural policy priorities
- Product markets: comparatively liberalized; recent reforms include more flexible retail hours, postal services liberalization, opening taxi and rail transport to competition.
- Skills and lifelong learning:
  - Government co-finances three days of job-related training for each worker every year.
  - Authorities focus on lifelong learning and incorporate private sector input in training design.
- Recommendations:
  - Expand firm-level flexibility in collective bargaining to allow wage differentiation between firms.
  - Increase labor utilization via reforms to enhance work incentives, lengthen working lives, and increase labor mobility.
  - Continue reforms to foster skills and training and maintain external competitiveness.

### Banking system vulnerabilities, Nordea relocation, and macroprudential policy
- Banking structural vulnerabilities (2016 FSAP):
  - Reliance on market funding and high regional interconnectedness:
    - "Around 50 percent of bank liabilities in Finland were foreign owned in 2016, and foreign banks accounted for 70 percent of the sector’s assets."
  - Low risk weights on mortgage loans exaggerate capital adequacy.
  - Authorities introduced a minimum risk weight of 15 percent on residential mortgage loans, taking effect in January 2018.
- Aggregate leverage ratio:
  - Increased from 6.5 percent at end 2016 to 8.8 percent in June 2017 due to Nordea’s branchification.
- Nordea relocation implications:
  - Nordea plans to move its headquarters from Stockholm to Helsinki by October 2018.
  - "The Finnish banking sector under supervision will expand from its current level around 120 to over 350 percent of GDP."
  - Policy priorities:
    - Introduce and calibrate a Systemic Risk Buffer (SRB); legislation approved by parliament and expected in 2018.
    - Ensure FIN-FSA has adequate financial and human resources; ECB will rely strongly on FIN-FSA support.
    - Maintain and strengthen regional cooperation and information-sharing; MOUs signed December 2016 to secure reciprocation of macroprudential tools.
    - European progress on a pan-European deposit insurance and strict standards on bail-inable liabilities remains important.
- Household finances and housing:
  - House prices do not show signs of overvaluation; relative to rent and incomes close to long run averages.
  - Real house prices in Helsinki metropolitan area increased gradually since 2012; declined for the rest of Finland.
  - Household saving rates are negative.
  - A large share of mortgage loans is held by highly indebted borrowers: over a quarter of mortgage debt is to mortgagees with debt to income ratios higher than 400 percent.
  - Most mortgages are variable rate loans; about 40 percent of mortgages have contracts that lengthen loan maturity instead of increasing payments.
- Macroprudential recommendations for household sector:
  - Introduce borrower-based measures: caps on loans relative to house values and personal incomes, and debt servicing to income limits.
  - Create a comprehensive credit registry; Ministry of Justice has ordered a study on implementation.
  - Authorities see merit in adding borrower-based measures, particularly a debt-servicing to income limit, and emphasize need for more complete data.

### External position, NIIP, and DSA — key numeric indicators and stress tests
- NIIP and external stocks (end-2016):
  - NIIP declined from a peak of 17 percent of GDP since 2010.
  - Gross assets: 338 percent of GDP.
  - Gross liabilities: 340 percent of GDP.
  - Financial sector accounts for slightly more than half of both external assets and liabilities.
- Current account:
  - CA deficit averaged 1.4 percent of GDP in the last five years and stood at 1.4 percent of GDP in 2016.
  - CA expected to narrow significantly in 2017 and reach balance over the medium term.
- REER and ULC:
  - ULC-based REER depreciated by some 7 percent from 2016Q1 through October 2017.
  - Staff assesses the REER to be between 0 and 5 percent above the level consistent with fundamentals.
- DSA baseline (selected numeric indicators):
  - Public gross nominal debt 2016: 63.1 percent of GDP; projected decline toward 59.9 percent by 2022.
  - Public gross financing needs 2016: 9.3 percent of GDP; 2017: 8.6 percent; 2018: 9.1 percent; 2019: 7.6 percent.
  - Real GDP growth (baseline): 2017: 2.8 percent; 2018: 2.3 percent; 2019: 1.8 percent; 2020–2022: 1.4, 1.2, 1.2 percent respectively.
  - Inflation (GDP deflator, baseline): 2017: 0.6 percent; 2018: 1.3 percent; 2019: 1.7 percent; 2020–2022: 1.9, 2.0, 2.0 percent respectively.
  - Effective interest rate (baseline): 2017: 1.6 percent; 2018–2019: 1.4 percent; 2020–2022: 1.4, 1.5, 1.6 percent respectively.
  - Primary balance (baseline): 2017: -1.3 percent of GDP; 2018: -1.7 percent; 2019: -1.4 percent; 2020–2022: -1.0, -1.1, -1.1 percent respectively.
- Stress test scenarios and outcomes:
  - Real GDP growth shock: one-standard deviation lower than baseline in both 2018 and 2019 (3.6 percentage points lower); debt ratio peaks at 75 percent of GDP in 2019; GFN peaks at 16½ percent of GDP.
  - Primary balance shock: primary balance 1½ percentage points of GDP lower than baseline in both 2018 and 2019; debt remains above 60 percent of GDP throughout (ending at 62¾ percent in 2022); GFN increases by about 3 percentage points during shock years.
  - Real interest rate shock: effective interest rate rises by 1¼ percentage points by 2022; debt 2 percentage points of GDP above baseline in 2022.
  - Combined macro-fiscal shock: debt ratio peaks at 75½ percent of GDP in 2019; GFN rises to 16½ percent of GDP in 2019 and 2020.
  - Contingent liability shock: one-time increase in non-interest expenditures equivalent to 10 percent of banking sector assets (about 22 percent of GDP) in 2018; debt ratio peaks at 89 percent of GDP in 2019; GFN peaks at 27½ percent of GDP in 2018.

### Risk Assessment Matrix — key downside and upside risks and policy responses
- High/Medium downside risks and policy responses:
  - Tighter global financial conditions (Relative likelihood: High; Expected impact: Low/Medium) — Policy: preemptive prudential measures; ECB liquidity if needed.
  - Weaker-than-expected global growth (Relative likelihood: High/Medium for advanced economies) — Policy: allow automatic stabilizers; push productivity-enhancing structural reforms.
  - European bank distress (Relative likelihood: Medium; Expected impact: Medium) — Policy: strengthen regulatory cooperation; apply macroprudential tools; ECB liquidity if needed.
  - Post-Brexit policy/geopolitical uncertainties (Relative likelihood: High; Expected impact: Low/Medium) — Policy: allow automatic stabilizers.
  - Adverse shock in a neighboring Nordic country (Relative likelihood: Medium; Expected impact: Medium) — Policy: enhance regional cooperation; apply macroprudential tools; monitor institutions and supply liquidity if needed.
  - Loss of competitiveness from real wages rising ahead of productivity (Relative likelihood: Medium; Expected impact: High) — Policy: encourage social partners to factor productivity into settlements; progress toward firm-level bargaining flexibility.
  - Postponement/withdrawal from planned reforms (Relative likelihood: Low; Expected impact: High) — Policy: secure support for reform agenda using the recovery window.
- Upside risks:
  - Lower energy prices (Relative likelihood: Low; Expected impact: Medium) — Policy: continue structural reforms; consider short-term fiscal tightening.
  - Stronger-than-expected domestic recovery (Relative likelihood: Medium; Expected impact: Medium) — Policy: accelerate fiscal buffer rebuilding or lower labor tax wedge.

### Staff appraisal and priorities
- Near-term: growth expected to remain strong, with downside risks.
- Structural reforms: notable progress but more needed to boost potential growth; a shrinking working age population constrains medium-term growth to about 1¼ percent unless reforms increase employment and productivity.
- Fiscal: use the recovery to rebuild buffers; any further revenue surprises should be saved or invested in growth-enhancing measures.
- Financial sector: broaden macroprudential toolkit, prepare for Nordea relocation, increase supervisory resources, ensure discretion to set additional capital requirements, and maintain Nordic cooperation.
- Consultation: next Article IV consultation proposed on the standard 12-month cycle.

*Source: FINLAND — INTERNATIONAL MONETARY FUND (2017).*

### 2017. The staff team was comprised of Messrs. Scott (head),

### cr17370 - 2017. The staff team was comprised of Messrs. Scott (head),

### CONTEXT AND BACKGROUND
- Finland’s economic model combines openness and relatively limited state intervention with extensive social insurance mechanisms; a comprehensive welfare state provides social services and transfers and generous unemployment and other benefits, supported by relatively high taxation.
- Sustainability of the model depends on high employment and incomes; the economy faced severe shocks over recent decades, including:
  - decline of the forestry industry and a severe domestic banking crisis in the early 1990s;
  - sharp downturns in the euro area and Russia and the restructuring of Nokia, resulting in a double-dip recession from 2008 to 2014.
- Constraints on recovery prior to 2015 included weak investment, slumping labor productivity, escalating labor costs, and a relatively fast deterioration in export market share.
- Recovery beginning in 2015 has gathered strength, but challenges remain:
  - demographic changes will shrink the working age population and put further demands on the public finances;
  - achieving high employment will be challenged by skill-biased technological change and routinization.
- Recent policy and labor developments:
  - Recent wage moderation and the 2017 Competitiveness Pact have largely restored national competitiveness; at the sectoral and firm levels wage increases have often not matched productivity changes.
  - The Competitiveness Pact implemented a wage freeze in 2017, lowered the labor tax wedge, and decreased public sector holiday bonuses from 2017 to 2019.
- Focus of the report:
  - Policies to increase resilience, employment, and growth.
  - Selected Issues Papers (SIPs) evaluate pension and aging costs, exports, and the labor market; findings inform recommendations to keep wages in line with productivity and to boost labor supply and productivity.
  - Emphasis on a well-functioning financial system and safeguards, including implications of Nordea’s headquarters move to Finland.
- Political context:
  - The center-right coalition government remains in power; after a fissure in the Finns party in June, the coalition of the Centre and National Coalition parties continues with the breakaway Blue Reform party.
  - The next general election is in April 2019.

### RECENT DEVELOPMENTS
- Growth and demand
  - The recovery is strengthening and broadening: GDP growth accelerated to 2.9 percent year-on-year in the first half of 2017, compared with GDP growth of 1.9 percent in 2016.
  - Initial recovery drivers: private consumption and housing investment, supported by the ECB’s accommodative policy.
  - More recent drivers: exports and equipment investment; confidence has rebounded, especially among consumers.
- Inflation
  - Inflation pressures remain weak: inflation in 2016 averaged only 0.4 percent; inflation currently remains below 1 percent due to declining wage growth, the Competitiveness Pact, and low trade partner inflation.
- Labor market
  - Labor market recovery has been slower: despite continued employment growth, the headline unemployment rate has stalled at just below 9 percent.
  - Recent wage moderation and increasing labor productivity have reduced unit labor costs (which had increased substantially after the crisis).
  - Composition of unemployment is shifting favorably; people are re-entering the labor force, including from disguised unemployment (defined as those outside the labor force who would be available for work within a fortnight, but have not looked for work in the past four weeks).
  - Indicators noted:
    - Unit Labour Costs index (2010=100) rose earlier but has fallen recently.
    - Employment growth and unemployment rate movements for 2015–2017 show employment growth alongside stalled headline unemployment.
    - Wage inflation series show Total, Private Sector, and Central Government for 2015–2017.
- Credit and financial conditions
  - Total credit is growing in line with nominal GDP, but unsecured credit has expanded rapidly since 2016.
  - Household loan growth: 2.4 percent yoy in June (household loan growth is well below pre-crisis levels).
  - Credit to non-financial corporates: 6.2 percent yoy growth rate in June.
  - Some SMEs have experienced difficulties accessing finance (Bank of Finland Bulletin 2/2017).
- External sector
  - The current account returned to surplus in early 2017 after deteriorating to -1.4 percent of GDP in 2016 (a deterioration of ½ percent of GDP in 2016 from the prior year), driven by strong import volumes, higher commodity prices, and weak exports in 2016.
  - During the first half of 2017, exports outpaced imports; primary income yielded a larger surplus driven by higher equity investment returns and lower interest payments.
  - Staff assessment of external position in 2016: broadly consistent with medium-term fundamentals and desirable policies; a small competitiveness gap remained (Annex I).
  - Both EBA external sustainability and current account models estimate a current account gap of -¾ percent of GDP in 2016; staff assesses the gap to be between -1.6 to 0 percent of GDP.
  - Recent wage moderation led to a ULC-based REER depreciating by more than the CPI-based REER.
- Exports composition and drivers
  - Goods export volumes have picked up in recent quarters (after a long period of stagnation) driven by petroleum products, chemicals, electrical equipment and machinery.
  - Recovery in exports attributed to stronger demand from trading partners and reductions in ULCs.

### OUTLOOK AND RISKS
- Near-term outlook
  - The recovery that began in 2015 has improved prospects for sustained momentum due to broader contributions from exports and equipment investment.
- Risks and vulnerabilities highlighted
  - Ongoing demographic decline in the working age population and aging-related fiscal pressures.
  - Skill-biased technological change and routinization could constrain employment gains.
  - Firm-level misalignments: wage increases not matching productivity changes at sectoral and firm levels could impair competitiveness.
  - Financial sector risks related to unsecured consumer credit expansion and the implications of Nordea’s move to Finland.
  - External risks: sensitivity to demand in euro area and Russian markets and commodity price swings affecting terms of trade.

*Source: FINLAND — INTERNATIONAL MONETARY FUND (2017).*

### 12.      Growth is expected to remain strong in the near term.

### 12.      Growth is expected to remain strong in the near term.

### Near-term growth outlook
- GDP growth is projected at 2.8 percent in 2017 and 2.3 percent in 2018, before gradually returning to potential (estimated at 1¼ percent) by the early 2020s.
- Production from a new pulp mill boosts growth in 2018 by 0.2 percentage points.
- Improved competitiveness helps further rebalancing toward exports and investment.
- Consumption growth is expected to level off, constrained by moderate increases in purchasing power, increased indebtedness, and a low household savings rate, notwithstanding increasing employment.
- Together with continued corporate deleveraging, credit growth is expected to remain relatively subdued.
- Inflation projections:
  - 0.8 percent in 2017
  - 1.2 percent in 2018
  - 2 percent by 2021

### Assumptions underpinning the baseline projection
- Cost competitiveness continues to improve.
- Labor productivity growth expected to remain around 1 percent, assuming continued wage moderation.
- Employment rate increases to above 72 percent by 2021, partly driven by higher participation rates as the working age population continues to shrink.

### Risks to the projection
- Domestic risks (mainly downside):
  - Necessary reforms might slow or fail, including on health and social services and expanding firm-level wage bargaining.
  - Labor productivity and employment growth could fall short, especially if reforms to enhance work incentives, including to pensions and unemployment insurance, deliver lower gains than expected.
  - A return to widespread imbalances between real wage increases and productivity would hold back growth.
- External risks:
  - Assumes 4 percent annual growth in external demand over the projection period.
  - Finland’s capital goods exports are especially sensitive to investment demand in key European trade partners and China.
- Financial vulnerabilities:
  - Exposure to financial shocks because of banks’ reliance on wholesale funding and close Nordic linkages.
  - Potential triggers include faster-than-anticipated monetary policy normalization by the Federal Reserve and the ECB; European bank distress; contagion from a neighboring Nordic country.
  - Increases in interest rates could dampen consumption growth, especially for highly leveraged households.

### Authorities’ views
- Authorities shared staff’s assessment of the outlook and risks.
- They agreed the external position is broadly in line with fundamentals, but competitiveness remains vulnerable.
- Negative surprises to global investment are viewed as a key risk.
- A sharp fall in house prices in Nordic neighbors could threaten the recovery.

### Productivity and employment assumptions (staff projections)
- Staff project that real GDP would increase by 10 percent between 2016 and 2021.
- This requires:
  - Labor productivity growth to average 1 percent and converge to 1¼ percent longer term.
  - Employment estimated to rise 3 percent over these years, given recent weak response to GDP growth.
  - Employment growth driven by declines in unemployment to a NAIRU of about 7½ percent, and activation of 60,000 inactive persons (half of which could come through lower disguised unemployment).
  - Employment rate would rise closer to Nordic averages, helping offset a declining working-age population.

### Fiscal policy — recent outcomes and near-term outlook
- 2016 fiscal outturns:
  - Fiscal deficit in 2016 was 1.8 percent of GDP, compared with a budget forecast of 2.8 percent, partly because of higher tax revenues but mainly driven by higher discretionary expenditure savings.
  - Gross general government debt started to gradually decrease, to 63 percent at end 2016.
- 2017 projection:
  - Staff expects a deficit in 2017 of around 1½ percent of GDP.
  - Improvement driven by higher revenues (mainly due to higher growth) and 0.4 percent of GDP in one-off capital gains tax revenues from a corporate M&A transaction.

### Long-term fiscal challenges
- Working age population expected to shrink by ¼ percent annually over the next several years.
- Aging-related spending:
  - Aging expenses have been increasing at an annual pace of 0.2 percentage points of GDP for the past decade, largely driven by higher pensions.
  - Aging-related expenditures will continue to increase rapidly until the early 2030s due to escalating health and long-term care spending.
- Authorities estimate that reforms aimed at saving 5 percent of GDP over the long run would ensure long-term fiscal sustainability.
- From 2016 to 2019:
  - Expenditure cuts estimated to yield 2 percentage points, of which slightly more than 1 percentage point has already been achieved.
  - Employment measures, including the Competitiveness Pact and reforms to unemployment benefits, are envisaged to save 1 percentage point.
- Health and social services reform targets annual savings of around 1½ percentage points by 2030.
- Streamlining provision of other public services should save ½ percentage point of GDP.

### 2018 budget and fiscal stance
- The 2018 budget proposal includes growth-enhancing measures but implies a procyclical fiscal stance in 2018 and slower consolidation in the medium term.
- Fiscal stance:
  - The fiscal stance in 2017 is already procyclical, given much stronger growth and the Competitiveness Pact’s tax concessions.
  - The 2018 budget implies a procyclical stance, with a deficit ¼ percent of GDP higher than in 2017 and continued growth above potential.
  - Further deficit reduction is gradual, implying debt would only fall below 60 percent of GDP by 2022.
- Specific measures and revisions:
  - Expenditure measures decided in 2017 include increased spending on security, skills and employment (0.1 percent of GDP), reductions to child care fees, increased resources for the employment service, and partial reversal of past R&D funding decreases (together 0.1 percent of GDP).
  - Startup costs for health and social services reform estimated about 0.1 percent of GDP annually.
  - Revenue measures raise the deficit by 0.1 percent of GDP: reductions in unemployment insurance contributions and discretionary personal income tax cuts are only partly offset by increases in excise taxes on alcohol and fuel.
  - Revenue projections were revised down as wages and salaries and private consumption are expected to grow more slowly than GDP.

### Building fiscal buffers — staff analysis and recommendations
- Staff analysis suggests a prudent level of intertemporal financial net worth would be between 30 and 85 percent of GDP.
- Health and social security reform (annual savings about 1½ percent of GDP) boosts public sector net worth to around 54 percent of GDP.
- If the deficit were to almost close by 2020, net worth would improve by another 34 percent of GDP.
- Government guarantees now exceed 20 percent of GDP, with much of recent increases accounted for by guarantees to the shipbuilding sector; provisioning seems adequate but concentration risks need close monitoring.
- To help rebuild buffers, staff recommend avoiding procyclical policy:
  - A cyclically-neutral approach (broadly unchanged structural primary balance from 2017 to 2019) would help reach fiscal balance earlier than projected, increasing fiscal resilience.
  - Although hard to avoid procyclicality in 2018, any fiscal yield from additional positive growth surprises should be directed to deficit reduction.
  - New measures could be considered if they durably boost employment and growth; examples include additional R&D spending, well-targeted active labor market policies (ALMPs), or public investment to fix maintenance gaps.
- Subsidies total about 1½ percent of GDP and could be reoriented or streamlined; a recent government report found only a small fraction to be growth enhancing.
- Continued monitoring is needed to ensure consolidation programs deliver expected results, noting local governments have already had to substitute measures to reach savings targets for the 2016–19 expenditure cuts.

### Authorities’ fiscal stance
- Authorities remain focused on achieving long-term fiscal sustainability and will continue with the 2016–19 fiscal consolidation program and health and social services reform.
- They recognize potential savings are uncertain, including from largely autonomous local governments, and would consider adjustments to realize planned savings.
- Authorities agreed that saving unexpected revenues would be prudent and emphasized near-term fiscal procyclicality is partly a result of the sudden increase in economic growth.

### Structural policies and labor market
- Structural policies are crucial to ensure sustainability of the social model.
- Product markets are comparatively liberalized and efficient; recent reforms include more flexible retail hours, postal services liberalization, and opening taxi and rail transport to competition.
- Continued reforms are needed to improve labor market outcomes, address aging population challenges, foster skills and training, and maintain external competitiveness.
- Labor market strengths:
  - A well-educated labor force, including in STEM fields.
  - Government-sponsored life-long learning: government co-finances three days of job-related training for each worker every year.
  - Active labor market policies have achieved relatively high unemployment-employment transition rates.
  - Income inequality remains low despite economic shocks.

*Source: IMF staff report (chapter excerpt).*

### 25.      However, labor market outcomes indicate a need for reform to increase wage flexibility at

### 25.      However, labor market outcomes indicate a need for reform to increase wage flexibility at

### Labor market outcomes and need for wage flexibility
- Labor market outcomes indicate a need for reform to increase wage flexibility at sector and firm levels and boost labor supply from some cohorts (Selected Issues Paper: Labor Markets).
- Recent wage moderation and the Competitiveness Pact have helped to regain national competitiveness, which had deteriorated post crisis.
- Efforts under the Competitiveness Pact to formalize a bargaining system incorporating firm-level flexibility have been elusive; it remains to be seen if this year’s uncoordinated sector-by-sector bargaining can deliver progress in this direction (Annex IV).
- Wage determination has shown low flexibility, limiting sectors’ and firms’ ability to respond to heterogeneous shocks and undermining hiring incentives and job-to-job moves.

### Wage–productivity misalignments and job matching
- Misalignments in wages and productivity at the sector and firm levels hinder job matching and macroeconomic adjustment (Figure 9).
- Changes in real wages in individual sectors and firms have in many cases not matched productivity growth.
- Wage misalignments are consistent with lower productivity by undermining hiring incentives and hindering job-to-job transitions, which are relatively low, especially in comparison to Sweden.
- Evidence shows an outward shift in the Beveridge curve, indicating increasing difficulties in matching the unemployed to job vacancies; arguments persist over whether this reveals structural mismatches or insufficient demand.
- Factor misallocation, especially of labor, has been relatively high, including before the global crisis.

### Policy recommendation on collective bargaining
- Collective bargaining should aim to match wage increases to productivity, not only at the national but also the firm level.
- Integrating increased wage variation across sectors and firms into the bargaining process, as in Sweden and Denmark, would help Finland adjust in the face of forces that will reshape labor markets, such as increasing skill requirements and routinization.
- Increased flexibility could help alleviate the very high wage compression at the lower end of the pay scale.
- External competitiveness should be a factor during bargaining; staff does not recommend that wage increases in other sectors mechanically follow those in export-oriented industries.

### Employment levels, participation, and groups needing reform
- Finland’s employment rate is lower than in other Nordic countries; employment is relatively high for ages 40 to 54, but notably lower among the young, women of child-bearing age, and older workers.
- Unemployment rates have been persistently high, even through the pre-crisis boom years.
- Total male participation is lower than the EU average, dragged down by employment of the low skilled.
- Further steps to improve work incentives for these groups are important to offset adverse demographics and the expected reduction in the working age population (¶16).

Key group-specific observations and recommendations:
- Youth:
  - Finns’ working careers start later on average, largely due to longer study times.
  - Authorities are adjusting higher education to encourage faster completion of studies and plan to reduce the importance of entrance exams for university admission to speed transition from secondary to tertiary education.
  - Ongoing reforms should make vocational education more adaptable and relevant to employers’ needs.
- Women of child-bearing age:
  - Participation rates are low compared to Nordic peers, especially for low-skilled women.
  - This is largely driven by a high effective out-of-pocket cost of child care, because using day care implies giving up a generous home care allowance.
  - Reductions in early childhood education fees for lower-income households as part of the 2018 budget proposal are a welcome first step.
  - The ongoing evaluation of family leave should consider shortening home care allowances in favor of more resources for child care.
- Older workers:
  - The 2017 pension reform comprehensively addresses aging pressures on pension spending (¶29) but is also expected to increase the attractiveness of using extended unemployment as a path to early retirement for those older than 58 years.
  - Closing this early retirement possibility would prolong working lives and reap the full benefits of the pension reform.
  - More intensive targeting of activation policies to older benefit claimants could also hold potential.
- Unemployment and activation:
  - Requirements to accept job offers have been tightened and the duration of earnings-related unemployment benefits has been shortened.
  - Tapering benefits to gradually decline with the duration of unemployment, as in many other countries, could incentivize job search and should be considered.
  - A bill currently before parliament would cut unemployment benefits by 5 percent for recipients not active in training or having worked at least 18 hours during the previous three months, and would modify unemployment benefits to provide more incentives for entrepreneurship and geographic mobility.
  - Resources for employment services remain much lower than in Nordic peers and could be increased; previous cuts have been partly reversed, allowing interviews to now be conducted with a quarterly frequency.
  - More progress on zoning issues to alleviate housing bottlenecks near job-rich cities would likely enhance labor mobility and job matching.

### Low-skilled workers and work incentives
- Job opportunities for those with lower skills are diminished by a very compressed distribution of wages at the lower end and overlaps in social benefits often resulting in high reservation wages.
- More attention is needed to expand work opportunities and incentives for the low skilled; disincentives arise from high wage compression, high marginal tax rates, and for some, potential loss of several social benefits.
- The authorities are reviewing social benefits to reduce their overlap and foster work incentives.
- An experiment to gauge the impact of a universal basic income scheme on work incentives is being conducted (Annex V).

### Aging, pension and health/social services reforms
- The 2017 pension reform:
  - Increases the retirement age from 63 to 65 over the next decade and in line with life expectancy thereafter, ensuring complete coverage of future pension liabilities by contributions.
  - Is expected to increase attractiveness of extended unemployment as a path to early retirement for those older than 58 years, which the report flags as an issue to address.
- Health and social services reform:
  - Aims to increase efficiency and competition by reassigning provision from municipalities to newly-defined counties.
  - Implementation has been pushed back by one year, to 2020, to allow further discussion with stakeholders about individuals’ choice of health care provider.
  - It will be important that the bill provide sufficient scope to realize savings while ensuring adequate care.
  - Achieving planned annual savings of about 1½ percent of GDP by 2030 will require continuous close monitoring and preparedness to make adjustments, if needed.
  - Assuming the bill progresses as planned, 18 counties will be established in June 2018 and new county councils will assume their roles by January 2019. Transfer of responsibility for health and social services will occur in January 2020.
  - The central government will wield substantial power over county finances and could ultimately even revoke autonomy of a county if balanced budgets are not achieved.

### Skills, lifelong learning, and structural change
- Finland faces challenges of skill-biased technological change, automation, and routinization; job polarization has continued with high-skill employment increasing and middle-skill jobs declining.
- Finland has retained fewer low-skill jobs relative to peers; sectors with the fastest increases in value added, such as IT, have not been job rich.
- Authorities have responded with far-reaching education reforms to broaden vocational education programs and create research- and internationally-oriented higher education institutions.
- Authorities appropriately focus on lifelong learning to enable workers to adapt to changes and incorporate private sector input in the design of training.

### Authorities’ views
- Authorities agreed that continued structural reforms—especially to the labor market—are vital to generate durable growth.
- The Competitiveness Pact was seen as successful in restoring competitiveness, but if a new wage bargaining model is not formalized, greater firm-level flexibility seems unlikely.
- Increasing labor supply would require additional reforms to those currently in train, given substantial reductions in the working-age population over the next 15 years.
- Localized labor shortages were seen as symptoms of limited labor mobility and skill mismatches, which the government is working to address.
- Determination to finalize ongoing reforms—especially on health and social services—is high, but scope for introducing new reforms during the present government’s term could narrow soon.

### Financial system note
- The financial system is sound overall. Banks are profitable and well capitalized.
- Solvency levels of insurance companies are well above requirements: recent EU-wide stress tests indicate that they would withstand adverse scenarios.
- Greater diversification of investments into equities has boosted pension funds’ earnings, albeit with increased income volatility.

*Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17370.pdf*

### 35.      However, structural vulnerabilities in the banking system require continued close

### cr17370 - 35.      However, structural vulnerabilities in the banking system require continued close

### Banking system structural vulnerabilities
- Two major issues identified by the 2016 FSAP:
  - Reliance on market funding and high regional interconnectedness:
    - "Around 50 percent of bank liabilities in Finland were foreign owned in 2016, and foreign banks accounted for 70 percent of the sector’s assets."
    - High exposure to regional spillover risks, such as reversals in neighboring countries’ housing markets.
  - Risk weights:
    - "Low risk weights used in banks’ internal risk models exaggerate capital adequacy."
    - Aggregate leverage ratio improved (see below), but low risk weights on mortgage loans remain a concern.
    - Authorities introduced "a minimum risk weight of 15 percent on residential mortgage loans, taking effect in January 2018 (Annex VI)."
- Aggregate leverage ratio change:
  - Increase "from 6.5 percent at end 2016 to 8.8 percent in June 2017" was a result of Nordea’s branchification.

### Nordea relocation and implications for supervision and systemic risk
- Key facts and magnitudes:
  - Nordea plans to move its headquarters from Stockholm to Helsinki by October 2018.
  - "The Finnish banking sector under supervision will expand from its current level around 120 to over 350 percent of GDP."
  - "Nordea’s presence will be one of the largest in Europe in terms of home country gross national income."
  - Nordea operated as a subsidiary until end 2016, and as a branch since January 2017.
- Supervisory and macroprudential implications:
  - Capital and liquidity requirements:
    - Introducing a Systemic Risk Buffer (SRB) is important to mitigate long-term risks not addressed by capital requirements common to all banks.
    - "Legislation for the SRB has been approved by the parliament; the law should give the macroprudential authority flexibility to use its judgement, and not tie the setting of the SRB to mechanical criteria."
    - Macroprudential authority should "make the application of the SRB transparent and as predictable as possible, and set it at an adequately high level that reflects the significant systemic risks posed by Nordea’s large size relative to Finland’s economy."
    - "Once Finland introduces the SRB—expected in 2018—it will have the same prudential tools to set capital levels as does Sweden."
    - Note: "the Swedish supervisor has used Pillar 2 capital requirements for macroprudential objectives, which makes comparison with application by the Single Supervisory Mechanism difficult."
  - Resources:
    - Although the ECB would be the direct supervisor of Nordea after the move, increasing the FIN-FSA’s financial and human resources in line with the 2016 FSAP recommendations (Annex VII: FSAP Update) is important because "the ECB will rely strongly on FIN-FSA support."
  - Regional cooperation:
    - "Memorandums of Understanding on prudential supervision of significant branches—signed between the ECB and Nordic supervisors in December 2016—should secure full reciprocation of macroprudential tools applied in different Nordic countries by the FIN-FSA, following Nordea’s move."
    - Maintain current level of information-sharing between the Nordic supervisors when the ECB takes over supervision.
  - European financial architecture:
    - "In the absence of EU-level deposit insurance scheme, the Finnish Deposit Guarantee Fund will assume responsibility for insuring not only domestic deposits but also deposits at Nordea’s foreign branches."
    - Much depends on European authorities to apply strict standards on bail-inable liabilities and to complete the banking union by introducing pan-European deposit insurance, with due regard to reducing risk in euro area banks.

### Household finances, housing market, and borrower vulnerabilities
- House price and market indicators:
  - "House prices do not show signs of overvaluation."
  - "House prices relative to rent and incomes are close to their long run averages."
  - "Real house prices in the Helsinki metropolitan area have increased gradually since 2012, reflecting greater demand, whereas they have declined for the rest of Finland."
- Household vulnerability indicators:
  - "Household saving rates are negative."
  - "Unsecured consumer credit is growing strongly."
  - "A large share of mortgage loans is held by highly indebted borrowers: over a quarter of mortgage debt is to mortgagees with debt to income ratios higher than 400 percent."
  - Most mortgages are variable rate loans; "about 40 percent of mortgages have contracts that lengthening loan maturity instead of increasing payments."
- Macroprudential policy recommendations for household sector:
  - "Additional macroprudential measures for borrowers should be introduced to allow the macroprudential authority to better target household vulnerabilities that are not well covered by existing Loan-To-Collateral limits."
    - Possible measures: "caps on loans in relation to values of houses and personal incomes, and debt servicing to income."
    - Bank of Finland and FIN-FSA are analyzing tools and "plan to propose legislation for additional measures once the SRB is introduced."
  - "A comprehensive credit registry would be particularly helpful to monitor and assess household credit." The Ministry of Justice has ordered a study on implementation.
- Authorities’ views on household measures:
  - Authorities "agree with the characterization of risks to household finances and recommendations for extra tools."
  - They "see merit in adding borrower-based measures to the macroprudential toolkit, particularly a debt-servicing to income limit."
  - They "place particular emphasis on more complete data."

### Staff appraisal and policy priorities
- Near-term growth and risks:
  - "Growth is expected to remain strong in the near term, albeit with downside risks."
  - Finland remains sensitive to growth fluctuations in and financial shocks from neighboring countries.
  - Domestic risk that necessary reforms may stall; job growth could be undermined if imbalances between real wage increases and productivity growth persist.
- Structural reform assessment:
  - "Notable progress has been achieved on structural reforms, but more is needed to boost potential growth."
  - "A shrinking working age population constrains expected medium-term growth to about 1¼ percent, unless more reforms are implemented that increase employment and productivity."
  - Recommended reforms:
    - Expand firm-level flexibility in collective bargaining to allow differentiation between firms.
    - Increase labor utilization via reforms to enhance work incentives, lengthen working lives, and increase labor mobility.
- Fiscal policy:
  - "The recovery presents an opportunity to rebuild fiscal buffers."
  - Budget deficits have been lower than expected, but "debt remains above the SGP benchmark."
  - Health and social services reform is vital to boost public sector productivity and contain age-related pressures, but savings from the reform are uncertain.
  - "Any further revenue surprises should be saved or invested in growth-enhancing measures."
- Financial sector policy priorities:
  - "Financial sector policies should focus on broadening the macroprudential toolkit and preparing for the relocation of Nordea’s headquarters."
  - Implementing the SRB is important; FIN-FSA board should have more macroprudential tools to contain risks to borrowers.
  - Nordea relocation increases importance of:
    - Increasing supervisor resources,
    - Discretion to set additional capital requirements if needed,
    - Close cooperation among Nordic authorities,
    - Further progress in completing banking union in the EU.
- Consultation cycle:
  - "It is proposed that the next Article IV consultation with Finland be held on the standard 12-month cycle."

*International Monetary Fund staff summary based on IMF Country Report text.*

### Box 1. Risk Assessment Matrix

### Box 1. Risk Assessment Matrix

### Downside Risks — High and Medium likelihood events and impacts
- Tighter global financial conditions. Fed normalization and tapering by ECB increase global rates and term premia, strengthen the U.S. dollar and the euro vis-à-vis the other currencies, and correct market valuations.
  - Relative likelihood: High
  - Expected impact if realized: Low/Medium — Adjustments to tighter financial conditions, if there are policy surprises, could be disruptive, leading to impaired asset values and worsening of banks’ liquidity in light of their reliance on wholesale funding. High corporate savings may help buffer the impact on the ongoing recovery.
  - Policy response: Take preemptive prudential measures to reduce financial sector vulnerabilities, monitor risks at individual institutions. If market stress materializes, ECB should supply liquidity.

- Weaker-than-expected global growth:
  - Significant China slowdown
    - Relative likelihood: Low/Medium
  - Structurally weak growth in key advanced economies
    - Relative likelihood: High/Medium
  - Expected impact if realized: High — Weaker growth globally or in Europe would inhibit recovery of Finnish exports, could stall the current expansion in equipment investment and lead to lower output and employment growth.
  - Policy response: Allow automatic stabilizers to operate while making progress on productivity-enhancing structural reforms.

- European bank distress. Financial distress in one or more major banks with possible knock-on effects on the broader financial sector and for sovereign yields in vulnerable economies.
  - Relative likelihood: Medium
  - Expected impact if realized: Medium — Finnish banks’ capital buffers are strong, but they would be affected by bank distress through their heavy on wholesale funding, and their high cross-border integration with other Nordics.
  - Policy response: Increase efforts to strengthen regulatory cooperation and fully apply macroprudential policy tools. If market stress materializes, the ECB should provide liquidity.

- Policy and geopolitical uncertainties associated with negotiating post-Brexit arrangements.
  - Relative likelihood: High
  - Expected impact if realized: Low/Medium — Only 5 percent of Finland’s goods exports going directly to the U.K., but higher trade barriers could disrupt supply chains. Higher uncertainty could negatively impact investment.
  - Policy response: Allow automatic stabilizers to operate if growth decelerates.

- Adverse shock in a neighboring Nordic country, leading to a correction in the housing market, and distress in the financial sector.
  - Relative likelihood: Medium
  - Expected impact if realized: Medium — Lower demand of key trading partners would reduce domestic output and employment. Finnish financial sector would see declining asset quality and funding difficulties.
  - Policy response: Enhance regional regulatory cooperation, and ensure full implementation of macroprudential policy tools, including liquidity measures. Monitor risks at individual institutions, supply liquidity in case of market distress. Allow automatic stabilizers to operate.

- Loss of competitiveness, from real wages increasing ahead of productivity.
  - Relative likelihood: Medium
  - Expected impact if realized: High — Uncoordinated sectoral bargaining could lead to wages becoming misaligned from productivity, as occurred after the GFC, weakening competitiveness and economic growth.
  - Policy response: Encourage social partners to factor productivity into settlements and make progress on inducing firm-level flexibility into collective bargaining.

- Postponement or withdrawal from planned reforms, including the health and social services reform.
  - Relative likelihood: Low
  - Expected impact if realized: High — Abandoning health and social services reforms could jeopardize long-term fiscal sustainability.
  - Policy response: Take actions to guarantee the necessary support for the reform agenda using the window of opportunity afforded by the economic recovery.

### Upside Risks — Low and Medium likelihood events and impacts
- Lower energy prices, driven by stronger-than-expected U.S. shale and/or recovery of oil production in the African continent.
  - Relative likelihood: Low
  - Expected impact if realized: Medium — Lower energy prices would reduce costs of imports, while supporting domestic consumption and production, thus enhancing growth.
  - Policy response: Continue efforts to implement structural reforms and consider more fiscal tightening in the short term.

- Stronger than expected recovery of the Finnish economy.
  - Relative likelihood: Medium
  - Expected impact if realized: Medium — Agents’ high confidence and robust external demand could support a stronger/longer recovery.
  - Policy response: Push forward with productivity-enhancing structural reforms and consider fiscal measures to accelerate rebuilding of buffers or to further lower the labor tax wedge.

### Notes on likelihood and purpose of the RAM
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).
- The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more).
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

*Box 1. Risk Assessment Matrix — IMF staff*

### 2016. Since 2010, the NIIP has declined from a peak of 17 perc

### cr17370 - 2016. Since 2010, the NIIP has declined from a peak of 17 perc

### External position and NIIP
- Since 2010, the NIIP has declined from a peak of 17 percent of GDP, largely owing to the reversal of the current account balance from surplus to deficit.
- Gross external assets and liabilities (end-2016):  
  - Gross assets: 338 percent of GDP.  
  - Gross liabilities: 340 percent of GDP.
- Sectoral composition:  
  - Financial sector accounts for slightly more than half of both external assets and liabilities.  
  - Remaining holdings are largely by nonfinancial corporations and government social security funds.
- Assessment and outlook:  
  - The NIIP is expected to gradually improve over the medium term, consistent with small current account surpluses.  
  - Main vulnerabilities stem from large cross-border exposures of the financial sector, including liquidity risk related to foreign-financed wholesale funding.
- Overall IMF assessment (2016): external position broadly consistent with medium-term fundamentals and desirable policies; NIIP has stabilized from its declining trend.

### Potential policy responses (external/competitiveness)
- Wage policy and labor markets:  
  - Wage restraint is underpinning competitiveness.  
  - Important to increase wage flexibility at the firm level to enhance ability to adjust to future shocks.
- Structural and fiscal policy:  
  - Continue structural reforms to increase productivity and support the recovery.  
  - Ongoing gradual fiscal consolidation is expected to buttress the external balance.

### Current account (CA)
- Background and recent path:  
  - CA turned into deficit in 2011 amid sharp export declines in wood and paper and electronics (Nokia).  
  - CA deficit averaged 1.4 percent of GDP in the last five years and stood at 1.4 percent of GDP in 2016.  
  - Exports recovered strongly in the first half of 2017 across metal, petroleum, chemicals and machinery and equipment.
- Outlook:  
  - CA deficit expected to narrow significantly in 2017 and reach balance over the medium term as exports, external demand and competitiveness strengthen.
- Assessment (EBA and staff):  
  - EBA external sustainability and EBA CA models estimate a CA gap of -¾ percent of GDP in 2016.  
  - This results from a cyclically adjusted CA balance at -1.5 percent of GDP versus a -¾ percent of GDP current account norm.  
  - Taking normal uncertainties into account, staff assesses the CA gap to be between -1.6 to 0 percent of GDP.  
  - Technical note: A standard deviation of 0.8 percent of GDP around the cyclically adjusted CA norm is applied to obtain the CA gap range.

### Real exchange rate (REER) and unit labor costs (ULC)
- Background:  
  - After depreciation in 2010-11, the CPI-based REER has been relatively stable for the last 5 years.  
  - CPI-based REER: appreciated by about 1 percent in 2016 and depreciated by 1 percent in the first half of 2017.  
  - ULC growth exceeded that in Euro area trade partners notably during 2011 and 2012.  
  - ULC-based REER depreciated by some 7 percent from 2016Q1 through October 2017, helped by wage restraint including a 2017 wage freeze and output recovery.
- Assessment (EBA and staff):  
  - EBA regression-based level and index models provide opposing estimates: REER in 2016 was overvalued by 2.9 percent (level model) and undervalued by 1.6 percent (index model).  
  - EBA external sustainability model suggests REER overvaluation of 2.4 percent.  
  - Staff assesses the REER to be between 0 and 5 percent above the level consistent with fundamentals, reflecting a remaining cost competitiveness gap expected to be further closed going forward.

### Capital and financial accounts; reserves
- Financial flows (2016):  
  - Net total financial inflows: 7.4 percent of GDP, driven by portfolio inflows across equities and fixed income instruments of 6 percent of GDP.  
  - FDI outflows and other investment inflows were both on the order of 10 percent of GDP, offsetting each other and reflecting investments by large domestic and foreign firms.
- Assessment:  
  - Finland has a fully open capital account.  
  - Exposed to financial market risks given interlinked regional financial market.  
- FX intervention and reserves:  
  - Background: the euro has the status of global reserve currency.  
  - Assessment: reserves held by Euro area countries are typically low relative to standard metrics; the currency is freely floating.

### Debt Sustainability Analysis (DSA) — key findings and projections
- Public debt and near-term path:  
  - Public debt recorded its first decline since the global financial crisis in 2016 to 63.1 percent of GDP.  
  - Under the baseline, debt is expected to return to levels below 60 percent of GDP by 2022 and continue to decline thereafter.  
  - Given the relatively long average maturity of Finnish public debt, gross financing needs remain below 13 percent of GDP every year in the baseline.
- Public sector assets and net worth:  
  - Public sector financial assets exceeded 190 percent of GDP in 2016 (government pension funds and public corporations).  
  - Static net financial worth is -50 percent of GDP when accounting for already-accrued pension liabilities to public sector employees and -248 percent of GDP if also accounting for liabilities owed to private sector employees.
- Baseline macroeconomic assumptions:  
  - Real GDP growth: 2.8 percent in 2017 and 2.3 percent in 2018, reverting to potential growth estimated at 1.2 percent over the medium term.  
  - Labor force growth: projected at zero over the medium term.  
  - GDP deflator inflation: rise from 0.6 percent in 2017 to 1.3 and 1.7 percent in 2018 and 2019, respectively; thereafter converge toward 2 percent.  
  - Interest rates: expected to remain subdued near term due to QE; pace of rate rises likely gradual when policy normalizes.
- Realism of baseline:  
  - Median forecast errors: primary balance (-0.47 percent of GDP, 54th percentile), inflation (0.18 percent, 62nd percentile).  
  - Median forecast error for real GDP growth has been relatively high at -1.2 percent (25th percentile) due to past volatility including 2009 shock and 2012–14 recession.
- Fiscal adjustment:  
  - Maximum 3-year change in the cyclically-adjusted primary balance (CAPB) is 0.3 percent of potential output.

### Stress testing — scenarios and impacts
- Summary: Finland’s debt ratio remains under 90 percent of GDP even in the worst shock examined.  
- Standard macro-fiscal stress scenarios: debt ratio stays below 65 percent of GDP except in the real GDP shock scenario.
- Scenario outcomes and parameters:  
  - Real GDP growth shock: growth is one-standard deviation lower than baseline in both 2018 and 2019 (i.e. 3.6 percentage points lower). Inflation around 90 basis points lower in these years. Debt ratio peaks at 75 percent of GDP in 2019 and gross financing need (GFN) peaks at 16½ percent of GDP.  
  - Primary balance shock: primary balance is 1½ percentage points of GDP lower than baseline in both 2018 and 2019. Debt ratio remains above 60 percent of GDP throughout (ending at 62¾ percent in 2022). GFN increases by about 3 percentage points of GDP during shock years and remains about 2 percentage points above baseline thereafter.  
  - Real interest rate shock: effective interest rate gradually rises from 2019 to exceed baseline by 1¼ percentage points by 2022; debt would be 2 percentage points of GDP above baseline in 2022.  
  - Real exchange rate shock: no direct impact on debt sustainability since vast majority of debt issuance is in euros and all foreign currency issuance is completely hedged by the Finnish State Treasury.  
  - Combined macro-fiscal shock: growth and inflation fall, primary balance deteriorates, exchange rate depreciates, interest rates rise; debt ratio peaks at 75½ percent of GDP in 2019, GFN rises to 16½ percent of GDP in 2019 and 2020.  
  - Contingent liability shock: contingent liability shock in 2018 equals about 22 percent of GDP; growth falls as in the real GDP shock and effective interest rate rises by 1 percentage point by 2019. Result: debt ratio increases 27 percent of GDP above baseline; GFN peaks at 27½ percent of GDP in 2018; debt ratio peaks at 89 percent of GDP in 2019.
- Note on contingent liability scenario design: assumes a one-time increase in non-interest expenditures equivalent to 10 percent of banking sector assets and triggers growth and inflation shocks described above.

### DSA baseline projections — selected numeric indicators
- Public gross nominal debt (selected years): 2016: 63.1 percent of GDP; projections show decline toward 59.9 percent by 2022 (table summary).  
- Public gross financing needs (selected years): values remain below 13 percent of GDP in baseline; specific table values include 2016: 9.3 percent; 2017: 8.6 percent; 2018: 9.1 percent; 2019: 7.6 percent.  
- Real GDP growth (baseline): 2017: 2.8 percent; 2018: 2.3 percent; 2019: 1.8 percent; 2020–2022: 1.4, 1.2, 1.2 percent respectively.  
- Inflation (GDP deflator, baseline): 2017: 0.6 percent; 2018: 1.3 percent; 2019: 1.7 percent; 2020–2022: 1.9, 2.0, 2.0 percent respectively.  
- Effective interest rate (baseline): 2017: 1.6 percent; 2018–2019: 1.4 percent; 2020–2022: 1.4, 1.5, 1.6 percent respectively.  
- Primary balance (baseline): 2017: -1.3 percent of GDP; 2018: -1.7 percent; 2019: -1.4 percent; 2020–2022: -1.0, -1.1, -1.1 percent respectively.

*cr17370 - 2016. Since 2010, the NIIP has declined from a peak of 17 perc*

### Annex III. Calculating Public Sector Net Worth

### Annex III. Calculating Public Sector Net Worth

### Overview
- Staff constructed a historical time series and projection of Finland’s fiscal balance sheet to comprehensively assess the viability of the fiscal path (Selected Issues Paper: Fiscal Sustainability).
- Analysis distinguishes a static fiscal balance sheet (accounting for assets, public corporations, and pension liabilities relating to work performed in the past) and an intertemporal fiscal balance sheet (adding the present value of future primary balances to capture all future fiscal positions and age-related spending).

### Static fiscal balance sheet — key findings
- The broadest measure of Finland’s static net worth was negative at around -160 percent of GDP at end 2016.
- Negative static net worth can lead to heightened sustainability and rollover risks, unless future fiscal positions are expected to be sufficiently strong to offset.
- Finland’s future fiscal positions would need to be even stronger to address, in addition, increases in health and care expenditures.
- In contrast, accrual of future pension liabilities are projected to be completely covered by contributions under the 2017 pension reform. Therefore, the present value of pension liabilities in the table relate only to work performed until 2016 and are expected to remain broadly constant.

### Static balance sheet values, 2016 (Percent of GDP)
- A Assets 278.5
- B Nonfinancial 84.6
- Financial 193.9
- C Liabilities 441.5
- Financial Liabilities other than Pensions 1/ 140.4
- o/w General Government Maastricht Debt 63.1
- Existing Pension Liabilities 301.1
- D = A - C Static Net Worth - 163.1

Notes on table scope:
- 1/ Includes 65 percent of GDP in debt of public corporations and the Bank of Finland and 12 percent of GDP in general government debt outside of the Maastricht debt definition.
- Present value calculations in the intertemporal analysis exclude payments related to pension liabilities for work performed until 2016.

### Intertemporal fiscal balance sheet — scenarios and IFNW
- The intertemporal fiscal balance sheet adds the present value of future primary balances, thereby capturing all future fiscal positions and age-related spending.
- Under the baseline (based on the 2018 budget proposal’s medium-term framework), intertemporal financial net worth (IFNW) would be -9.9 percent of GDP.
- To withstand a severe macroeconomic shock (of the magnitude of the GFC) with positive IFNW, Finland should target an IFNW of 30–85 percent of GDP.

Present value of future primary balances (Percent of GDP)
- E Present Value of Future Primary Balances 2/
  - Baseline (based on 2018 budget proposal) 237.8
  - Baseline including Health and Soc. Serv. Reform 301.5
  - Fiscal Position near Balance by 2020 271.5
  - Fiscal Position near Balance by 2020 plus Health and Soc. Serv. Reform 335.5
  - Abandoning fiscal efforts 201.5

Intertemporal Net Financial Worth (IFNW) outcomes (Percent of GDP)
- F = D + E - B Intertemporal Net Financial Worth (IFNW)
  - Baseline (based on 2018 budget proposal) -9.9
  - Baseline including Health and Soc. Serv. Reform 53.8
  - Fiscal Position near Balance by 2020 23.9
  - Fiscal Position near Balance by 2020 plus Health and Soc. Serv. Reform 87.9
  - Abandoning fiscal efforts -46.2

Memorandum item:
- Fiscal buffer required to withstand large macro shock with positive IFNW 30 to 85

### Methodological assumptions and projection rules
- Present value calculations assume a 5 percent discount rate and 2 percent inflation rate.
- Primary balance projections beyond 2022 start from a constant primary balance relative to GDP with the only adjustments relating to aging-related expenditures and the implementation of health and social services reform.
- Health and social services reform: 1.5 percent of GDP cost savings are assumed to accrue linearily during 2023-29.
- Present value calculations exclude payments related to pension liabilities for work performed until 2016.

### Interpretation and policy implications
- Static net worth of -163.1 percent of GDP (end-2016) implies substantial balance-sheet weakness that requires strong future primary surpluses to restore sustainability.
- Under the baseline fiscal policy (2018 budget framework) IFNW remains negative (-9.9 percent of GDP), signaling continued vulnerability to large shocks unless policy is tightened or reforms (including health and social services reform) are implemented.
- Implementing health and social services reform materially improves IFNW (to 53.8 percent of GDP under the baseline including reform), indicating the large fiscal significance of such reforms.
- Targeting an IFNW within the 30–85 percent of GDP range would provide a buffer to withstand severe macroeconomic shocks; the lower end (30 percent) would require subsequent consolidation after a shock, whereas the upper end (85 percent) would allow Finland to weather such a shock without post-crisis fiscal consolidation.

*Source: Brede and Henn (2017) and Fund staff projections and calculations.*

### Annex VIII. Past Fund Staff Recommendations and

### Annex VIII. Past Fund Staff Recommendations and Implementation

### Fiscal Policy
- Recommendation: Fiscal adjustment should be well-calibrated to restore long-term fiscal sustainability while minimizing negative short-term effects on output.
- Implementation:
  - The 2018 budget is procyclical, but the authorities continue to implement medium-term consolidation programs to ensure fiscal sustainability.
  - Much stronger-than-expected growth and near-term outlook has substantially reduced concerns related to adverse short-term effects of fiscal adjustment on output.
- Recommendation: Improve growth-friendliness of fiscal adjustment by reallocating resources toward productive public spending, while reducing poorly-targeted transfers and tax expenditures; reverse cuts to public R&D spending and create stronger incentives to private R&D.
- Implementation:
  - Recent initiatives, including the 2018 budget proposal, include growth-enhancing measures:
    - increased spending on skills and employment,
    - reductions to child care fees,
    - partial reversal of past R&D funding decreases;
    - reductions in unemployment insurance contributions and discretionary personal tax cuts,
    - partly offset by increases in excise taxes on alcohol and fuel.
- Recommendation: Ensure that health and social services reforms generate intended improvements in public sector productivity by clear and timely communication with stakeholders.
- Implementation:
  - Transition to the new health and social services system was postponed by a year to 2020 to allow more time for consultations with stakeholders on a key outstanding legislative bill and ensure smooth transition.
- Key fiscal outlook points:
  - Central government tax revenue forecast for 2017 raised by some EUR 1.5 billion (3.4 percent y-o-y growth).
  - Revenue growth expected to slow to about 2 percent in 2018.
  - Debt-to-GDP ratio turned to a downward path in 2016 and robust growth will keep reducing the ratio until 2021.
  - General government net lending remains in deficit; deficit will remain under the EU Stability and Growth Pact’s 3 percent of GDP reference value limit throughout the forecast horizon.
  - Government program to cover a sustainability gap estimated at EUR 10 billion at the start of the Government’s term in spring 2015 by:
    - consolidation measures (EUR 4 billion),
    - structural reforms (EUR 4 billion),
    - measures boosting growth and employment (EUR 2 billion).
  - Social, healthcare, and county reform (SOTE) expected to contain costs by some EUR 3 billion by 2030 relative to no reform.

### Labor Market Policy and Structural Reforms
- Recommendation: Monitor implementation of the Competitiveness Pact, especially provisions on improving flexibility of the wage bargaining system at the firm-level.
- Implementation:
  - All parts of the Competitiveness Pact have been implemented, including reductions in the labor tax wedge and a wage freeze in 2017.
  - Public sector working hours extended; firm-level surveys show about half of private sector firms also extended working hours.
  - Authorities convened a working group between social partners to devise a bargaining model incorporating more firm-level flexibility; discussions were inconclusive. Authorities are closely monitoring whether the ongoing bargaining round will expand firm-level flexibility.
- Recommendation: Strengthen Active Labor Market Policies (ALMPs) to facilitate labor mobility.
- Implementation:
  - Authorities increased the frequency of interviews with unemployment insurance recipients to facilitate job search outcomes and are continuously evaluating effectiveness of ALMPs.
  - Authorities will finalize an evaluation study of ALMPs by the end of 2017.
  - Funding for activation policies will be increased in 2018–19.
- Recommendation: Implement measures to increase affordable housing in urban areas to facilitate labor mobility.
- Implementation:
  - Authorities working with local governments to streamline zoning regulations to foster housing construction in urban areas; housing construction in the Helsinki Metropolitan area has increased but will take time to meet demand.
- Key labor market and structural points:
  - After a prolonged downturn, growth strengthened in the first half of 2017 and is expected to be close to 3 percent in 2017.
  - Contract wage increases agreed in key manufacturing sectors will be around 1.6 percent in both years (next two years).
  - Finland’s employment rate target: raise from 68 percent in 2015 to 72 percent by 2019.
  - Completed reforms include pension reform, reduction in duration of earnings-related unemployment benefit by 100 days, mandatory job search plans and regular interviews, and unemployment insurance system reforms to increase incentives for active job search.
  - Adjustments to maternity and child care benefits, measures to promote faster graduation from tertiary education, and reforms to make short-term/part-time work more attractive.

### Product Market Policy
- Recommendation: Consider reforms to the retail and state-dominated sectors, such as rail and postal services, to increase competition and yield productivity gains.
- Implementation:
  - Postal services opened to competition as of 2017.
  - Authorities announced in August that railways will be liberalized and work is starting.
  - Authorities are considering further privatization of other public corporations.

### Financial Sector Policy and Macroprudential Framework
- Recommendation: Strengthen bank supervision by ensuring effective monitoring of banks’ internal risk models and intensifying oversight of liquidity positions.
- Implementation:
  - Targeted review of internal models (TRIM) was conducted in coordination with the SSM.
  - Authorities introduced a 15 percent minimum risk weight on residential mortgage loans.
- Recommendation: Bolster resources allocated to supervision to reflect growth in regulatory complexity and supervisory intensity.
- Implementation:
  - Authorities are planning to increase FIN-FSA resources, including to ensure adequate capacity after Nordea Group’s forthcoming relocation.
- Recommendation: Enhance macroprudential tools, including instruments based on borrower and loan characteristics.
- Implementation:
  - Legislation for a Systemic Risk Buffer approved by parliament and will take effect in early 2018; authorities exploring options to expand the macroprudential toolkit to include more instruments based on borrower and loan characteristics.
  - FIN-FSA decided to set an average risk weight floor of 15 percent on mortgage loans for IRB banks, coming into force in January 2018.
  - Macroprudential measures already taken include a loan-to-collateral cap on mortgage loans.
- Recommendation: Formalize inter-agency cooperation on national crisis preparedness and management.
- Implementation:
  - Preparation of a MOU between FIN-FSA and FFSA in progress and expected to be finalized by end-2017; FFSA planning a similar agreement with the Bank of Finland.
  - Comprehensive MOUs on prudential supervision of significant branches were signed between Nordic authorities and the ECB in December 2016.
- Key financial stability points:
  - Finnish banking system is well capitalized and profitable but faces structural vulnerabilities: highly concentrated banking sector, reliance on wholesale and external funding, strong regional interconnections, and low risk weights.
  - Household indebtedness at approximately 128 percent of disposable income.
  - Banks’ mortgage lending grown moderately; loans to housing corporations increased relatively strongly; consumer loans increased rapidly from a low base.
  - Positive credit registry under review by the Ministry of Justice.
  - Parliament adopted systemic risk buffer legislation entering into force in January 2018; calibration work underway and application decision rests with the FIN-FSA.
  - Authorities analyzing possible inclusion of borrower-based tools and whether they would apply to non-bank lenders.
  - Authorities concerned about spillover risks from other Nordic countries; Nordea’s plan to relocate its headquarters to Finland increases importance of adequate supervisory resources.
  - Finland participates in the EU’s Banking Union; SSM and SRM play important roles in supervision and resolution.

### Fund Relations and Statistical Issues
- Membership Status: Joined January 14, 1948; Article VIII.
- Quota and holdings:
  - Quota: 2,410.60 SDR Million (100.00 percent of Quota).
  - Fund holdings of currency: 2,174.58 (90.21 percent of Quota).
  - Reserve Tranche Position: 236.02 (9.79 percent of Quota).
  - New Arrangements to Borrow: 156.43 SDR Million.
- SDR Department:
  - Net cumulative allocation: 1,189.51 SDR Million (100.00 percent of Quota).
  - Holdings: 1,120.75 (94.22 percent of Quota).
- Projected payments to Fund (SDR million; based on existing use of resources and present holdings of SDRs):
  - Charges/Interest: 2017: 0.10; 2018: 0.47; 2019: 0.47; 2020: 0.47; 2021: 0.47.
  - Total: 2017: 0.10; 2018: 0.47; 2019: 0.47; 2020: 0.47; 2021: 0.47.
- Exchange Rate Arrangements: Finland’s currency is the euro, which floats freely and independently.
- Article IV Consultation: Finland on the 12-month consultation cycle.
- FSAP Participation: Finland had an FSAP review in 2016.
- Statistical assessment:
  - Data provision adequate for surveillance; quality and timeliness generally very good.
  - Subscriber to SDDS since June 3, 1996; uses SDDS flexibility option for central government operations data.
  - National accounts published according to ESA 2010 since September 2014.
  - Government finance statistics published based on ESA 2010 since September 2014.
  - External sector statistics published based on BPM6 since December 2014.
  - Monetary data for IFS based on ECB framework.
- Key data/timeliness examples (as of October 31, 2017):
  - Exchange Rates: latest observation 10/31/17; Date received 10/31/17; Frequency: D.
  - International Reserve Assets: latest observation 09/2017; Date received 10/2017; Frequency: M.
  - GDP/GNP: latest observation Q2 2017; Date received 09/2017; Frequency: Q.
  - General Government revenue/expenditure/balance: latest observation 2016; Date received 09/2017; Frequency: A.

*Prepared by European Department; content drawn from Annex VIII and associated sections of the staff report.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17370.pdf_