## _cr0636

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---

### Economic background and policy setting
- Growth outpacing the euro area average; inflation remains low; employment has started to pick up; fiscal surplus remains among the largest in the EU.
- Growth underpinned by productivity gains in the electronics sector led by Nokia.
- Long-term outlook clouded by rapid aging: old-age dependency set to rise most rapidly in the EU.
- Paper industry accounts for 20 percent of merchandise exports; seven–week production shutdown in Q2 2005 cut annual GDP growth by almost 1 percentage point in 2005, with a rebound expected in 2006.
- Mortgage lending grew by more than 15 percent in 2005 and now exceeds 40 percent of bank lending.
- Debt-income ratio risen to levels last seen in the early 1990s; lower interest rates have kept debt servicing burdens significantly lower than in the earlier period.
- House prices have risen moderately, by about 6-7 percent annually over the past three years.
- Estimated general government net financial assets of about 70 percent of GDP at end-2005.
- Multi-year program of tax cuts: corporate income tax reduced to 26 percent in 2005; cuts in personal income taxation and excises.
- Collective wage accord through September 2007 covering around 90 percent of the labor force.
- Pension reform initiated in early 2005 consistent with Fund advice.

### Key macroeconomic indicators (selected years and projections)
- Real GDP: 2003: 2.4; 2004: 3.6; 2005: 1.9; 2006 (est./proj.): 3.5
- Domestic demand: 2003: 2.4; 2004: 3.6; 2005: 1.0; 2006 (est./proj.): 2.8
- Consumption: 2003: 3.5; 2004: 2.8; 2005: 2.9; 2006 (est./proj.): 2.3
  - Private consumption: 2003: 4.4; 2004: 3.2; 2005: 3.4; 2006 (est./proj.): 2.7
- Gross fixed capital formation: 2003: -1.5; 2004: 5.0; 2005: 0.3; 2006 (est./proj.): 2.5
  - Residential investment: 2003: 8.9; 2004: 7.4; 2005: 2.7; 2006 (est./proj.): 3.4
- Net exports (contribution to growth): 2003: -0.4; 2004: 0.4; 2005: 0.9; 2006 (est./proj.): 1.0
- Harmonized CPI: 2003: 1.3; 2004: 0.1; 2005: 0.9; 2006 (est./proj.): 1.5
- GDP deflator: 2003: -0.3; 2004: 0.5; 2005: 0.3; 2006 (est./proj.): 1.3
- Employment: 2003: -0.3; 2004: 0.0; 2005: 1.3; 2006 (est./proj.): 0.6
- Unemployment rate (percent of labor force): 2003: 9.0; 2004: 8.8; 2005: 8.3; 2006 (est./proj.): 7.9
- Labor compensation (economy-wide): 2003: 3.4; 2004: 4.5; 2005: 3.5; 2006 (est./proj.): 3.5
- Unit labor costs (economy-wide): 2003: 0.6; 2004: 0.8; 2005: 2.9; 2006 (est./proj.): 0.6
- Output gap (in percent of potential output): 2003: -0.6; 2004: 0.0; 2005: -0.9; 2006 (est./proj.): -0.2

### Short-term prospects and staff forecasts
- Staff forecast: GDP to grow by 3½ percent in 2006 and around 2¾ percent in 2007.
- Exports expected to lead the recovery, aided by paper industry rebound and improved prospects for the global technology sector.
- Private consumption to continue supporting demand, stimulated by tax cuts, employment gains, low interest rates and robust confidence.
- Inflation projected to rise in 2006–07 toward but remain below the euro area average as higher energy prices transmit through the economy; solid productivity gains expected to keep unit labor costs in check.
- Continued secular fall in terms of trade anticipated for some exports (notably paper and cellphones).
- Risks: prolonged high energy prices, weaker growth in the euro area, sharp appreciation of the euro, and tentative recovery in employment.
- Main domestic uncertainty: tentativeness of the recovery in employment; labor market mismatches (skill and geographic) and rising vacancies could lead to upward wage pressures in some sectors (e.g., construction).

### Fiscal position and public finances
- Central and local governments (percent of GDP): 2003: -0.2; 2004: -0.4; 2005: -1.0; 2006 (est./proj.): -0.9
- Social security (percent of GDP): 2003: 2.5; 2004: 2.3; 2005: 2.8; 2006 (est./proj.): 2.6
- General government overall balance (percent of GDP): 2003: 2.3; 2004: 1.9; 2005: 1.8; 2006 (est./proj.): 1.8
- General government (structural) (percent of GDP): 2003: 2.6; 2004: 1.9; 2005: 2.2; 2006 (est./proj.): 1.8
- Central government finances moved into a deficit of about ½ percent of GDP in 2005; general government surplus largely accounted for by social security funds.
- Stability Program projections (November 2005) envisage a deficit of ½ percent of GDP persisting into 2009.
- Budget for 2006 implies a moderate stimulus of 0.4 percent of GDP stemming from tax cuts.
- General government revenues (percent of GDP): 2005: 49.8; 2006 (proj.): 49.9
- General government expenditure (percent of GDP): 2005: 48.0; 2006 (proj.): 47.8
- Primary balance (percent of GDP): 2003: 2.4; 2004: 2.1; 2005: 1.9; 2006 (proj.): 1.7
- Debt (EMU definition, percent of GDP): 2003: 45.0; 2004: 44.9; 2005: 43.7; 2006 (proj.): 39.9
- Central government balance (percent of GDP): 2003: 0.4; 2004: 0.2; 2005: -0.5; 2006 (proj.): -0.5

### Fiscal policy recommendations and municipal reform
- Near-term objective: restore balance in central and local government finances; officials acknowledged balancing central government finances by 2007 unlikely.
- New system of expenditure ceilings (since 2004) has worked well but could come under strain in 2007.
- Staff urged further expenditure restraint given easy monetary conditions and that the 2006 tax-cut stimulus was not needed.
- Finland has 432 municipalities, average size about 11,000 people.
- Commission expected to submit recommendations by May 2006; legislative changes to take effect from January 2007; options include mergers of smaller municipalities and creation of 20 to 25 new regional entities.
- Recommendations: consider rebalancing public and private provision and financing of social services; consolidation where scale economies exist; use of public-private partnerships in urban areas; reassessment of user charges for less essential services.
- Limited reforms to municipal finances (including abolition of automatic adjustment of state grants when local spending exceeds plans) to take effect beginning 2006.
- Staff analysis suggests additional measures to permanently raise the general government surplus by some two percentage points of GDP would be needed to ensure sustainability; raising labor and product market efficiency could reduce required fiscal adjustment.
- Central government guideline: fill only every other new vacancy within on-budget entities until 2011, implying an average annual reduction of over 2 percent in personnel if attained.

### Pension reform and fiscal sustainability
- Significant pension reform initiated in early 2005: replace standard retirement age of 65 with flexible retirement age ranging from 63 to 68; increased accrual rate for older workers.
- Goal: raise substantially the current effective retirement age of about 59.
- Authorities intend to replace only one of every two expected retirees through 2011 in central government services.
- Pension reform estimated to increase average working career by some 2 to 3 years.
- Staff: reforms encourage longer working lives and limit growth in pension outlays, but further steps are required to assure fiscal sustainability; assess ongoing impact and be prepared for additional revisions.
- Sustainability still likely to require a substantial increase in contribution rates absent other measures.

### Labor market, wage-setting, and active policies
- Recent collective accord ensures wage moderation but is modest progress toward more flexible wage-setting; centralized bargaining solidifies wage rigidities unfavorable to young and unskilled workers.
- Authorities agree wage-setting mechanism needs to evolve to accommodate greater productivity differentials.
- 2006 budget includes a temporary wage subsidy targeted toward low-paid older workers.
- Vacancies have increased sharply despite high unemployment, reflecting skill and geographic mismatches.
- Active labor market policies aimed at retraining older workers; efforts to make more land available for residential development to ease urban housing shortages.
- Authorities extended by two years (to 57) the age at which the long-term unemployed can enter the “unemployment pipeline” to early retirement; unemployment pension to be phased out in 2009.
- Recommended measures: subsidies for lower-skilled older workers if well targeted; temporary active labor market programs; stronger retraining, life-long learning, and measures to improve labor-market matching.

### Demographic transition, scenarios, and long-term growth
- Working-age population anticipated to begin declining at the end of the decade.
- Growth in living standards will increasingly depend on replication of productivity performance of information technology and financial services sectors throughout the economy.
- Recent research suggests an older society is likely to face ageing related stagnation in human capital productivity, especially with rapidly transforming technologies.
- Pessimistic scenario: were recent trends in hours worked and labor productivity to persist, annual GDP growth could well fall to barely 1 percent in the second half of the decade.
- OECD staff estimate: with unchanged productivity, replacing retiring municipal workers would by itself more than double the share of new labor market entrants pre-empted by municipalities from 20 to over 40 percent.
- Need to raise productivity diffusion across sheltered sectors (utilities, transport, retail services, and agriculture) through improved training and strengthened competition.

### Investment, competitiveness, and structural factors
- Investment in equipment and machinery has been lagging; investment rate in Finland has declined, particularly investment in tools and machinery.
- Indicators such as research and development, levels of skill, cost of capital, and external competitiveness roughly on par with Sweden and the United States.
- Finnish financial markets are generally less deep and sophisticated, especially regarding availability of later-stage venture capital.
- Possible cultural factors (social stigma attached to bankruptcy) may weaken entrepreneurial climate.
- Policy emphasis: enhance competition, promote partnerships between business and academia, greater emphasis on life-long learning and retraining, and faster product market deregulation to smooth resource reallocation and technology adoption.

### Financial sector risks and supervision
- Monetary conditions were excessively easy from a Finnish perspective, posing potential financial sector and macroeconomic risks.
- Robust growth in disposable incomes, boosted by tax cuts, may not persist; some households may be basing borrowing decisions on overly optimistic income expectations.
- Increased competition among lenders has lowered lending margins, especially for mortgages, characterized as “loss leaders.”
- Supervisors concerned that lengthening mortgage maturities lock in low profit margins for extended periods.
- Stress tests indicate a supply shock such as a further rise in oil prices would increase loan loss reserves and weaken, but not eliminate bank profits.
- Need for vigilant banking supervision in light of rapid credit growth; recent acquisition of a domestic insurance company by a bank highlights need for close cooperation between respective supervisors.
- Exposure of Finland’s financial parent institutions to risks from rapidly growing balance sheets in their Baltic offspring remains minimal at present.
- Monetary and credit indicators (selected): M3 (Finnish contribution to euro area, growth rate, e.o.p.) 2003: 11.0; 2004: 6.3; 2005: 9.4. Domestic credit (growth rate, e.o.p.) 2003: 7.7; 2004: 8.8; 2005: 14.5.
- Interest rates (year average): three-month money market 2003: 2.3; 2004: 2.1; 2005: 2.1. Ten-year government bonds 2003: 4.1; 2004: 4.1; 2005: 3.4.
- Mortgage lending increased by about 15 percent in 2005.
- Banking sector indicators (selected): non-performing loans/total loans (percent) 2002: 0.5; 2003: 0.5; 2004: 0.3. Capital adequacy ratio 2002: 11.7; 2003: 18.9; 2004: 19.6.

### External position
- Current account balance (percent of GDP): 2003: 4.0; 2004: 4.0; 2005: 2.8; 2006 (proj.): 3.2
- Trade balance (percent of GDP): 2003: 7.9; 2004: 6.9; 2005: 7.6; 2006 (proj.): 8.0
- Net external debt (excluding equity FDI and shares): 2002: -8.1; 2003: -10.6; 2004: -13.3; 2005: -16.1; 2006 (proj.): -18.5
- Net international investment position (percent of GDP): 2002: -12.2; 2003: -0.8; 2004: 3.3; 2005: 7.5; 2006 (proj.): 11.4
- Nominal effective rate (increase in percent): 2003: 4.4; 2004: -0.5; 2005: -0.2
- Real effective rate (increase in percent): 2003: 2.0; 2004: 1.5; 2005: -1.2

### Executive Board views and key policy recommendations
- Strengthen fiscal position: further steps to restrain expenditure to respect the authorities’ medium-term spending rule and meet the goal of balanced central government finances.
- Increase efficiency of public services; complement reorganization and financing reforms with measures to limit demand for public services (including user charges).
- Continue with and deepen pension reform measures to enhance long-term sustainability.
- Labor market reforms: increase flexibility in centralized wage bargaining to reflect productivity differentials and raise low-skilled employment; implement active and well-targeted labor market policies such as employment training.
- Product and financial market measures: further progress on product market liberalization; maintain vigilance over rapid credit growth, especially in mortgages; ensure close supervisory cooperation across the Nordic-Baltic region.
- Overall assessment: policies underpin strong performance; most pressing task is to strengthen fiscal position and continue reforms to cope with an aging population.

_Italic: Source — IMF staff report and Public Information Notice summarizing the 2005 Article IV consultation with Finland._

### 1. Main Economic Indicators, 2002-09....................................................................................

### 1. Main Economic Indicators, 2002-09

### Economic background and policy setting
- Key recent outcomes and structural features
  - Growth outpacing the euro area average; inflation remains low; employment has started to pick up; fiscal surplus remains among the largest in the EU.
  - Growth underpinned by productivity gains in the electronics sector led by Nokia.
  - Long-term outlook clouded by rapid aging: old-age dependency set to rise most rapidly in the EU.
  - Role of paper industry: accounts for 20 percent of merchandise exports; seven–week production shutdown in Q2 2005 cut annual GDP growth by almost 1 percentage point in 2005, with a rebound expected in 2006.

- Selected indicators (2003, 2004, 2005, 2006 est./proj.)
  - Real GDP: 2.4; 3.6; 1.9; 3.5
  - Domestic demand: 2.4; 3.6; 1.0; 2.8
  - Consumption: 3.5; 2.8; 2.9; 2.3
    - Private consumption: 4.4; 3.2; 3.4; 2.7
  - Gross fixed capital formation: -1.5; 5.0; 0.3; 2.5
    - Residential investment: 8.9; 7.4; 2.7; 3.4
  - Net exports (contribution to growth): -0.4; 0.4; 0.9; 1.0

- Inflation, labor market and output gap (2003, 2004, 2005, 2006 est./proj.)
  - Harmonized CPI: 1.3; 0.1; 0.9; 1.5
  - GDP deflator: -0.3; 0.5; 0.3; 1.3
  - Employment: -0.3; 0.0; 1.3; 0.6
  - Unemployment rate (percent of labor force): 9.0; 8.8; 8.3; 7.9
  - Labor compensation (economy-wide): 3.4; 4.5; 3.5; 3.5
  - Unit labor costs (economy-wide): 0.6; 0.8; 2.9; 0.6
  - Output gap (in percent of potential output): -0.6; 0.0; -0.9; -0.2

- Financial and housing developments
  - Mortgage lending grew by more than 15 percent in 2005 and now exceeds 40 percent of bank lending.
  - Debt-income ratio risen to levels last seen in the early 1990s; lower interest rates have kept debt servicing burdens significantly lower than in the earlier period.
  - House prices have risen moderately, by about 6-7 percent annually over the past three years.

- Government finances
  - Central and local governments (percent of GDP): -0.2; -0.4; -1.0; -0.9
  - Social security (percent of GDP): 2.5; 2.3; 2.8; 2.6
  - General government overall balance (percent of GDP): 2.3; 1.9; 1.8; 1.8
  - General government (structural) (percent of GDP): 2.6; 1.9; 2.2; 1.8
  - Central government finances moved into a deficit of about ½ percent of GDP in 2005; general government surplus largely accounted for by social security funds.
  - Estimated general government net financial assets of about 70 percent of GDP at end-2005.

- Policy orientation and recent measures
  - Multi-year program of tax cuts aimed at promoting employment; corporate income tax reduced to 26 percent in 2005; cuts in personal income taxation and excises.
  - Collective wage accord through September 2007 covering around 90 percent of the labor force.
  - Pension reform initiated in early 2005 consistent with Fund advice.

### Short-term prospects
- Growth and inflation outlook
  - Staff forecast: GDP to grow by 3½ percent in 2006 and around 2¾ percent in 2007.
  - Exports expected to lead the recovery, aided by paper industry rebound and improved prospects for the global technology sector.
  - Private consumption to continue supporting demand, stimulated by tax cuts, employment gains, low interest rates and robust confidence.
  - Inflation projected to rise in 2006–07 toward but remain below the euro area average as higher energy prices transmit through the economy; solid productivity gains expected to keep unit labor costs in check.
  - Continued secular fall in terms of trade anticipated for some exports (notably paper and cellphones).

- Risks to the outlook
  - Downside risks include prolonged high energy prices, weaker growth in the euro area, and sharp appreciation of the euro.
  - Main domestic uncertainty: tentativeness of the recovery in employment.
  - Labor market mismatches (skill and geographic) and rising vacancies could lead to upward wage pressures in some sectors (e.g., construction).

### Policy discussions and recommendations
- Main policy priorities identified
  - Reforms of public and social services to raise efficiency given rising demand from aging.
  - Policies to improve functioning of the labor market: boost employment among younger and older workers, reduce mismatches, raise demand for low-skilled labor.
  - Broadening productivity gains: raise diffusion of productivity gains especially in sheltered sectors (utilities, transport, retail services, and agriculture) through improved training and strengthened competition.

A. Fiscal policy and reform of public services
- Near-term objectives and assessment
  - Near-term task: restore balance in central and local government finances; officials acknowledged balancing central government finances by 2007 unlikely.
  - Stability Program projections (November 2005) envisage a deficit of ½ percent of GDP persisting into 2009.
  - New system of expenditure ceilings (since 2004) has worked well but could come under strain in 2007.
  - Budget for 2006 implies a moderate stimulus of 0.4 percent of GDP stemming from tax cuts; staff noted the stimulus was not needed given easy monetary conditions and urged further expenditure restraint.

- Municipal reform and service provision
  - Finland has 432 municipalities, average size about 11,000 people.
  - A commission expected to submit recommendations by May 2006, with legislative changes to take effect from January 2007; options include mergers of smaller municipalities and creation of 20 to 25 new regional entities.
  - Recommendations: consider rebalancing public and private provision and financing of social services; consolidation where scale economies exist; use of public-private partnerships in urban areas; reassessment of user charges for less essential services.

- Fiscal framework reform
  - Limited reforms to municipal finances (including abolition of automatic adjustment of state grants when local spending exceeds plans) to take effect beginning 2006.
  - More far-reaching changes (e.g., shift from cyclical tax bases to property taxes) seen as politically infeasible in near term.
  - Rising municipal employment could undermine fiscal strategy and growth prospects if continued.

- Pension reform and fiscal sustainability
  - Significant pension reform initiated in early 2005: replace standard retirement age of 65 with flexible retirement age ranging from 63 to 68; increased accrual rate for older workers.
  - Goal: raise substantially the current effective retirement age of about 59.
  - Authorities intend to replace only one of every two expected retirees through 2011 in central government services.
  - Staff analysis suggests additional measures to permanently raise the general government surplus by some two percentage points of GDP would be needed to ensure sustainability; raising labor and product market efficiency could reduce required fiscal adjustment.

B. Labor market and bargaining framework
- Wage-setting and employment implications
  - Recent collective accord ensures wage moderation but is modest progress toward more flexible wage-setting; centralized bargaining solidifies wage rigidities unfavorable to young and unskilled workers.
  - Authorities agree wage-setting mechanism needs to evolve to accommodate greater productivity differentials.
  - 2006 budget includes a temporary wage subsidy targeted toward low-paid older workers to reestablish work patterns and on-the-job productivity gains.
  - Officials note limited fiscal room will make it harder to “buy” wage moderation through tax cuts in coming years.

- Labor market mismatches and policies
  - Vacancies have increased sharply despite high unemployment, reflecting skill and geographic mismatches.
  - Active labor market policies aimed at retraining older workers; efforts to make more land available for residential development to ease urban housing shortages.
  - Authorities extended by two years (to 57) the age at which the long-term unemployed can enter the “unemployment pipeline” to early retirement; unemployment pension to be phased out in 2009.
  - Concern that simply replacing retiring municipal workers would generate upward wage pressures and adverse implications for private sector growth.

C. Long-term growth prospects
- Structural challenges and recommended directions
  - Demographics: working-age population anticipated to begin declining at the end of the decade.
  - Need to raise productivity diffusion across sheltered sectors and to pursue mutually reinforcing labor and product market reforms to reduce the need for fiscal adjustment.
  - Policy emphasis on enhancing competition, improving training, and allowing wage-setting to reflect productivity differentials to boost employment and growth.

*Source: _cr0636 - 1. Main Economic Indicators, 2002-09*

### 21.      The discussions also explored the outlook for long-term growth in light of the

### 21.      The discussions also explored the outlook for long-term growth in light of the demographic transition

### Demographic transition and long-term growth
- Growth in living standards will increasingly depend on the extent to which productivity performance of the information technology and financial services sectors can be replicated throughout the economy.
- Recent research suggests an older society is likely to face ageing related stagnation in human capital productivity, especially with rapidly transforming technologies.
- Were recent trends in hours worked and labor productivity to persist, under a pessimistic scenario, annual GDP growth could well fall to barely 1 percent in the second half of the decade.
- OECD staff estimate: with unchanged productivity, replacing retiring municipal workers would by itself more than double the share of new labor market entrants pre-empted by municipalities from 20 to over 40 percent.

### Productivity, investment, and structural factors
- Investment in equipment and machinery, generally a vehicle for introducing new technologies, has been lagging.
- Absence of more widespread productivity gains remains puzzling despite many favorable preconditions.
- Indicators such as research and development, levels of skill, cost of capital, and external competitiveness were roughly on par with those in Sweden and the United States.
- Finnish financial markets are generally less deep and sophisticated, especially regarding availability of later-stage venture capital.
- Some officials believe cultural factors, such as the social stigma attached to bankruptcy, may explain the relatively weak entrepreneurial climate.

### Policy recommendations: product and labor market reforms
- Continued emphasis on labor and product market liberalization is the appropriate policy response.
- Faster pace of deregulation would:
  - Promote smoother reallocation of resources.
  - Assist in the introduction of new products and adoption of new technologies.
- Encourage partnerships between business and academia, including greater emphasis on life-long learning and retraining to improve labor market matching.

### Financial sector issues and supervisory challenges
- Monetary conditions were excessively easy from a Finnish perspective, posing potential financial sector and macroeconomic risks.
- Robust growth in disposable incomes, boosted by tax cuts, may not persist; some households may be basing borrowing decisions on overly optimistic income expectations.
- Increased competition among lenders has lowered lending margins, especially for mortgages, characterized as “loss leaders.”
- Supervisors concerned that lengthening mortgage maturities lock in low profit margins for extended periods.
- Stress tests indicate a supply shock such as a further rise in oil prices would increase loan loss reserves and weaken, but not eliminate bank profits.
- Need for vigilant banking supervision in light of emerging risks from rapid credit growth.
- Recent acquisition of a domestic insurance company by a bank highlights need for close cooperation between respective supervisors.
- The exposure of Finland’s financial parent institutions to risks from rapidly growing balance sheets in their Baltic offspring remains minimal at present.

### Staff appraisal — fiscal sustainability and structural priorities
- Finland’s near-term outlook is favorable: solid growth, sizeable fiscal surpluses, and a skilled labor force provide a strong platform to prepare for the demographic transition.
- Authorities have initiated pension reform, but further steps are required to put public finances on a sustainable footing and enhance growth prospects.
- Recent fiscal trends of concern:
  - Focus on raising employment has come at the cost of a worsening fiscal position.
  - Cuts in personal income taxes (targeted especially toward lower income brackets) have shifted central government finances into deficit without commensurate expenditure restraint.
  - Further steps to restrain spending are required to respect the medium-term spending rule and meet the authorities’ goal of a central government balance.
- Raising efficiency of public services is key:
  - Efficiency of local governments, which provide the bulk of aging-related services, has declined significantly in recent years.
  - Reorganizing responsibilities for provision and financing of public services is timely and welcome.
  - Greater use of benchmarking municipal services, including publishing results, may spur adoption of best practices.
- Limit burgeoning demand for public services:
  - Consider mechanisms to bring demand in line with costs of providing less essential services, including shifts to private providers.
  - Review user charges to reflect changing costs.
  - Given long gestation periods, an early start on these reforms is highly desirable.
- Pension and labor-force measures:
  - Substantial pension reforms underway encourage longer working lives and limit growth in pension outlays, but are insufficient to assure fiscal sustainability.
  - Important to assess ongoing impact of recent measures and be prepared for additional revisions to the pension regime.
  - Efforts should limit early exits from the labor force, including accelerating the phasing-out of unemployment pensions.
- Labor market and wage-setting:
  - Wage bargaining system needs greater flexibility across the economy.
  - Latest accord locks in moderate wage increases over an extended period, aiding competitiveness but at the cost of tax concessions and limited reflection of productivity differentials.
  - The “solidaristic” bargaining model risks leaving a substantial portion of the workforce outside the system, hindering fuller use of labor resources.
  - Measures to ease labor market mismatches and reduce structural unemployment are called for:
    - Subsidies for lower-skilled older workers are welcome if well targeted.
    - Temporary active labor market programs can help promote employment for underutilized segments.
    - Supporting structural measures are essential to achieve ambitious employment goals.
- Competitiveness and institutional issues:
  - High ranking in competitiveness may mask shortcomings in institutions and attitudes.
  - Paucity of investment and lack of strong economy-wide productivity gains raise questions about long-term growth.
  - Enhanced competition would be beneficial, as suggested by Finland’s high price level.
  - Removing impediments to realizing a fuller return on the nation’s human capital wealth is increasingly important as aging reduces effective labor supply.
- Financial system outlook:
  - Financial system is sound and well–supervised, but faces challenges.
  - Heightened competition for market shares increases risk that credit standards could suffer, especially for housing loans.
  - Current low lending margins may constrain future profitability.
  - Growing financial integration in the Nordic-Baltic region underscores the need for closer cooperation between national supervisory authorities.

*Source: _cr0636 - 21.      The discussions also explored the outlook for long-term growth in light of the demographic transition; https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr0636.pdf*

### 35.      It is proposed that the next consultation take place on the standard 12-month cycle.

### It is proposed that the next consultation take place on the standard 12-month cycle.

### Summary of economic outlook and near-term projections
- Growth outpaced the euro area in recent years; GDP change: 2003: 2.4, 2004: 3.6, 2005: 1.9, 2006 (proj.): 3.5 (percentage change).
- Domestic demand: 2003: 2.4, 2004: 3.6, 2005: 1.0, 2006 (proj.): 2.8 (percentage change).
- Harmonized CPI (change in percent): 2003: 1.3, 2004: 0.1, 2005: 0.9, 2006 (proj.): 1.5.
- Unemployment rate (in percent): 2003: 9.0, 2004: 8.8, 2005: 8.3, 2006 (proj.): 7.9.
- Household real disposable income (increase in percent): 2002: 2.3, 2003: 5.5, 2004: 5.2, 2005: 3.9, 2006 (proj.): 2.6.
- Investment and trade dynamics: gross fixed capital formation 2005: 0.3, 2006 (proj.): 2.5 (percentage change); export of goods and services 2005: 7.7, 2006 (proj.): 6.1 (percentage change).
- IMF staff projection note: "Projections are staff estimates based on the authorities' current policy indications."

### Fiscal position, public finances, and structural indicators
- General government (in percent of GDP): revenues 2005: 49.8, 2006 (proj.): 49.9; expenditure 2005: 48.0, 2006 (proj.): 47.8.
- General Government balance (in percent of GDP): 2003: 2.3, 2004: 1.9, 2005: 1.8, 2006 (proj.): 1.8.
- Primary balance (in percent of GDP): 2003: 2.4, 2004: 2.1, 2005: 1.9, 2006 (proj.): 1.7.
- Structural balance (in percent of potential GDP): 2003: 2.6, 2004: 1.9, 2005: 2.2, 2006 (proj.): 1.8.
- Debt (EMU definition, percent of GDP): 2003: 45.0, 2004: 44.9, 2005: 43.7, 2006 (proj.): 39.9.
- Central government balance (in percent of GDP): 2003: 0.4, 2004: 0.2, 2005: -0.5, 2006 (proj.): -0.5.
- Contextual fiscal measures: budget for 2006 includes further cuts in income taxes of about ½ percent of GDP and increased employment subsidies targeted at lower-income workers.
- Authorities’ actions: measures to raise central government efficiency; proposals to reform financing of local governments; pension reforms initiated in 2005 to be phased in over a number of years.

### Labor market and structural employment issues
- Employment and labor force growth: employment change 2002–2006 shows improvement; unemployment rate falling but levels remain high (2005: 8.3 percent).
- Labor market indicators: participation rate stagnant; long-term unemployment remains significant.
- Labor cost and inflation dynamics: unit labor cost, manufacturing changes (2003: -0.4, 2004: -0.1, 2005: 1.9, 2006 (proj.): -0.4); multi-year wage accord combined with productivity growth expected to maintain external competitiveness.
- Policy concerns: job mismatches increasing; risk of sectoral labor shortages; centralized wage bargaining needs greater flexibility to reflect productivity differentials and promote low-skilled employment.
- Recommended labor measures: active and well-targeted labor market policies such as employment training; measures to reduce demand for public services including more effective employment of user charges.

### Financial sector, credit growth, and vulnerabilities
- Monetary and credit indicators (end-of-year growth or averages): M3 (Finnish contribution to euro area, growth rate, e.o.p.) 2003: 11.0, 2004: 6.3, 2005: 9.4; domestic credit (growth rate, e.o.p.) 2003: 7.7, 2004: 8.8, 2005: 14.5.
- Interest rates (year average): three-month money market 2003: 2.3, 2004: 2.1, 2005: 2.1; ten-year government bonds 2003: 4.1, 2004: 4.1, 2005: 3.4.
- Mortgage lending increased by about 15 percent in 2005.
- Banking sector indicators (selected): non-performing loans/total loans (in percent) 2002: 0.5, 2003: 0.5, 2004: 0.3; capital adequacy ratio 2002: 11.7, 2003: 18.9, 2004: 19.6.
- IMF assessment: financial system sound and well supervised, but rapid credit growth and heightened competition among lenders—especially in the mortgage segment—could pose increased risks for credit quality and future bank profitability.
- Supervisory recommendation: maintain vigilance and close cooperation among supervisory authorities in the rapidly integrating Nordic-Baltic region.

### External position and balance of payments
- Current account balance (in percent of GDP): 2003: 4.0, 2004: 4.0, 2005: 2.8, 2006 (proj.): 3.2.
- Trade balance (in percent of GDP): 2003: 7.9, 2004: 6.9, 2005: 7.6, 2006 (proj.): 8.0.
- Net external debt (excluding equity FDI and shares): 2002: -8.1, 2003: -10.6, 2004: -13.3, 2005: -16.1, 2006 (proj.): -18.5.
- Net international investment position (percent of GDP): 2002: -12.2, 2003: -0.8, 2004: 3.3, 2005: 7.5, 2006 (proj.): 11.4.
- Exchange rate and competitiveness: euro per US$ period averages and effective rate movements show a steady real effective exchange rate; nominal effective rate (increase in percent) 2003: 4.4, 2004: -0.5, 2005: -0.2; real effective rate (increase in percent) 2003: 2.0, 2004: 1.5, 2005: -1.2.

### Key policy recommendations and Executive Board views
- Strengthen fiscal position:
  - Directors called for further steps to restrain expenditure to respect the authorities’ medium-term spending rule and meet the goal of balanced central government finances.
  - Increase efficiency of public services; complement reorganization and financing reforms with measures to limit demand for public services (including user charges).
  - Continue with and deepen pension reform measures to enhance long-term sustainability.
- Labor market reforms:
  - Increase flexibility in centralized wage bargaining to reflect productivity differentials and raise low-skilled employment.
  - Implement active and well-targeted labor market policies such as employment training to address mismatches.
- Product and financial market measures:
  - Further progress on product market liberalization.
  - Maintain vigilance over rapid credit growth, especially in mortgages; ensure close supervisory cooperation across the Nordic-Baltic region.
- Overall assessment by Executive Directors:
  - Commended policies underpinning strong performance; noted the most pressing task is to strengthen fiscal position and continue reforms to cope with an aging population.
  - Reassured by authorities’ recognition of need for adaptation and transformation of the Finnish economy.

_Italic: Source — IMF staff report and Public Information Notice summarizing the 2005 Article IV consultation with Finland._

### 1. Recent Economic Developments and Short-Term Prospects

### 1. Recent Economic Developments and Short-Term Prospects

### Recent growth and demand
- GDP growth picked up towards the end of the year after a temporary setback.
- Staff’s forecast of 1.9 percent for last year was likely met.
- Consumption has remained the main engine of economic growth.
- Household confidence remains high and employment prospects are perceived strong.

### External sector and trade composition
- Export growth supported by strong demand for metal industry products.
- The share of imported intermediate products in both output and exports has continued to rise and is now notably high.
- No official statistics on re-exports; in branches such as telecommunication, automobiles and home appliances the share of re-exports is likely quite high.
- Transfer pricing and high import-content complicate evaluation of GDP/output/exports relations.

### Labor market developments
- Jobs created especially in private services and construction; industry hiring again.
- Employment expanding by 2.7 percent year-to-year (December figures).
- Labor supply has increased, especially among age groups over 55.
- Unemployment rate continues to fall; full-year unemployment rate will most likely reach staff’s forecast of 8.3 percent.
- Vacancies have risen lately, especially in domestic trade and services, suggesting skill mismatches remain a problem.

### Inflation and prices
- Rise in consumer prices in 2005 was 0.9 percent.
- 2005 inflation was less than half of what is generally forecasted for the Euro area.
- Consumer price inflation in 2006 is expected to accelerate only slightly.

### Public finances near-term
- Trend in general government finances slightly better than expected in the fall; central government revenue estimates adjusted upwards.
- Preliminary estimates, based on tax accruals until November, suggest a somewhat smaller central government deficit/GDP for 2005 than the 0.5 percent forecast of last September.

### Short-term outlook
- Economic growth projected to rebound strongly this year.
- Growth forecasts of 3.5 percent (this year) and 2.7 percent (next year) are judged quite attainable.
- Price competitiveness vis-à-vis the euro area continues to improve.
- Perceived pick up of economic activity in the euro area and in neighboring key markets, Sweden and Russia, supports the outlook.

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### 2. Fiscal Policy

### Government priorities and tax policy
- Reducing unemployment is a top priority of the Government’s economic policy.
- Multi-year program of tax cuts aimed at promoting employment has come at the cost of a deteriorating fiscal position.
- Staff argues the fiscal stimulus from 2006 tax cuts was not needed given easy monetary conditions; authorities emphasize tax cuts were motivated by structural considerations to improve incentives for labor market participation.
- Authorities assess the fiscal policy stance is turning out to be neutral in 2006.

### Need to restore fiscal balance
- Authorities agree with staff that near-term task is to restore balance in finances of central and local governments.
- Updated Stability Program suggests expenditure pressures from population ageing are likely stronger than previously estimated.
- Need to curb public expenditures and strengthen efficient markets and structural measures to reinforce general government finances.

### Public sector efficiency measures
- Central government guideline: fill only every other new vacancy within on-budget entities until 2011.
  - If attained, implies an average annual reduction of over 2 percent in personnel and — with assumption that output remains unchanged — a corresponding growth in productivity.
- Local government and service structure project started to increase efficiency of service production via administrative changes to improve structures, operating principles, organizations and working procedures.

### Social services provision and user charges
- Staff proposes rebalancing public and private provision of social services and reassessing role of user charges; these issues are under lively debate.
- Private provision already used in local public transportation services and pre-school kindergartens and being introduced elsewhere.
- User charges actively used in most public services, especially local recreational services and, e.g., health services; in public education user charges remain mainly absent.

### Pension reform and ageing
- Pension reform entered into force in 2005 will encourage older workers to stay longer in the workforce.
  - Estimated that the average working career will increase by some 2 to 3 years.
- Sustainability of general government finances will still require a substantial increase in contribution rates, which will incur additional distortionary effects and efficiency losses.
- Urgency of ageing challenge arises because Finland’s baby-boom started early and ended early, so the high tide of population aging sets on about a decade earlier than in most countries.
- Long-term population projections compare favorably with most other developed countries; Finland will face its peak earlier and may offer lessons to other countries.

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### 3. Labor Market Policies

### Wage-setting and flexibility
- Recent wage accord ensures wage moderation but represents only modest progress towards more flexible wage-setting.
- Centralized agreements have limited differentiation of wages by productivity or labor market conditions.
- Higher flexibility in relative wages would help allocate resources more productively and alleviate skill mismatch.
- Recent changes aim to increase scope for local bargaining; changes are modest and scope varies greatly across branches.
- Authorities agree further progress on wage-setting flexibility can be made.

### Fiscal policy and wage moderation
- It may be misleading to characterize multi-year tax reductions as “buying” wage moderation.
- Specifics of tax cuts were often revealed in context of centralized wage negotiations, but overall magnitudes were decided on structural grounds without input of labor market parties.
- Unclear to what extent tax cuts facilitated wage moderation; depletion of fiscal room for further tax cuts does not necessarily entail increased wage pressures.

### Active labor market measures
- Many macro and micro policies implemented to tackle structural unemployment.
- Recent reforms to Public Employment Services aim to produce an appropriate mix of counseling, training and other active labor market measures.
- Structural unemployment likely stubborn; policies must prevent renewal of the “hard core” of unemployment.

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### 4. Financial Sector Issues

### Banking sector profitability and competition
- Current low lending margins may constrain future profitability of the banking sector.
- Low margins signal competition and are welcome; problem arises if competition leads to excesses that undermine financial stability.
- Situation appears reassuring at present.
- Finnish banking and insurance companies experienced robust performance in 2005.
- Stress tests by the Bank of Finland and jointly by the Central Bank and two supervisory authorities suggest the financial system remains sound.

### Household lending and risks
- Authorities share staff’s concern that strong increase in housing loans may be underpinned in part by overly optimistic income expectations and perhaps some loosening of lending criteria, which could lead to loan servicing problems in the future.
- Household sector’s level of indebtedness still remains reasonable by historical comparisons and relative to other developed countries.
- Historical experience suggests mortgage loan losses have been negligible even in extreme stress.
- Households do not appear to pose a significant risk to financial system stability in the near future.

### Longer-term supervisory challenges
- Longer-term risks include structural change within the financial sector and supervisory/regulatory practicalities in an increasingly global operating environment.
- Need for closer cooperation between national supervisory authorities, particularly in the Nordic-Baltic region.
- Similar cooperation needed among national central banks for financial stability functions.

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### 5. Long-Term Challenges

### Investment trends and composition
- Investment rate in Finland has declined, particularly investment in tools and machinery.
- Explanations include shift from machine-intensive paper industry towards knowledge-intensive electronics industry; historical corporate tax system that favored fixed investment until early 1990s; increased R&D activity treated as current spending in national accounts rather than investment.
- Falling investment trend is a concern and reflects globalization and small domestic market; enterprises must seek growth outside Finland.
- Despite advantages, Finland is often not perceived as a sufficiently attractive base to serve global markets by some domestic enterprises.

### Competitiveness and entrepreneurial incentives
- Finland ranks highly in international competitiveness comparisons due to well-educated population, close co-operation between enterprises and universities, well-functioning infrastructure, and a safe and stable society.
- Staff suggests competitiveness ranking may mask shortcomings in institutions and attitudes; authorities do not disagree.
- Welfare state incentive system may have encouraged complacency and risk aversion that hinders entrepreneurial activity; addressing this challenge will take time.

### Human capital and ageing workforce
- Ageing of the Finnish work force risks reducing human capital productivity development amid rapidly transforming technologies.
- Finland is well positioned to respond due to strong education performance.
- Key challenge is adapting successful school methods to training of older workers in companies.

### Structural unemployment and policy focus
- Unemployment has been halved since early 1990s but remains high; much of current unemployment is structural and affects a stable pool of the weakest part of the labor force.
- Policies must focus on preventing renewal of the “hard core” of unemployment; employment and growth policies will remain political priorities.

### Overall assessment
- Finnish economic and social model has served the country well but needs adaptation to ageing and global structural change.
- A gradual transformation towards a more flexible economic model is under way in a generally favorable environment.
- Starting point is favorable, momentum is building, and there are grounds to be optimistic about Finland’s economic performance in the years to come.

*Source: 1. Recent Economic Developments and Short-Term Prospects*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr0636.pdf_