## _cr0939

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### Executive summary — economic situation and near-term outlook
- Real GDP growth (2005–2009 proj.): 2.8, 4.9, 4.5, 2.1, 0.6.
- Growth slowed sharply after a robust 4½ percent in 2007; spillovers from the global turmoil are adversely affecting activity and may weaken the financial system.
- Inflation and labor market:
  - Inflation surged to 4.7 percent in September, greatly exceeding the euro area average.
  - Unemployment increased to 6.5 percent in September; Harmonized CPI (2005–2009 proj.): 0.8, 1.3, 1.6, 4.0, 2.5.
  - GDP deflator (2005–2009 proj.): 0.4, 1.3, 2.9, 3.3, 2.0.
  - High wage increases and disappointing decentralized wage negotiations raise the risk of persistent inflation and competitiveness erosion.
- External sector:
  - Current account surplus hovered around a sizable 4–4½ percent of GDP in 2006–07 and is projected to remain broadly unchanged in the near term.
  - CGER competitiveness margin (average): 7 percent (Macroeconomic balance approach-7.3; External sustainability approach-4.0; Equilibrium real exchange rate approach-9.3).

### Fiscal policy — cyclical stance, medium-term sustainability, and recommendations
- Recent fiscal metrics:
  - General government (GG) surplus: 5¼ percent of GDP in 2007; projected some 4¾ percent of GDP in 2008.
  - General government debt fell to 35 percent of GDP in 2007.
  - Pension fund assets: almost twice as large as government debt (2007).
- Cyclical stance and staff advice:
  - From a cyclical perspective, a fiscal structural loosening is warranted, but effectiveness in Finland’s small, open economy would be limited absent an EU-wide fiscal package.
  - Authorities confident an EU-coordinated budget expansion is possible; loosening should be designed to minimize damage to long-term fiscal sustainability.
- Medium-term sustainability:
  - A permanent improvement in the structural primary balance after 2011 of at least 1½ percent of GDP is required.
  - Staff recommended filling the fiscal gap as early as possible once the economy recovers.
  - Adjustment should rely mainly on expenditure restraint and improved efficiency; tax reform and higher pension fund yields can help.
  - Government plans to lower labor taxation are appropriate; staff advised against cutting the food VAT rate.
- Staff projection (percent of GDP, 2007–2011):
  - Overall balance: 5.3, 4.7, 2.7, 2.4, 2.0.
  - Primary balance: 4.8, 4.1, 2.0, 1.6, 1.1.
  - Overall structural balance: 4.8, 4.5, 3.4, 3.4, 2.7.
  - Primary structural balance: 4.3, 3.9, 2.7, 2.6, 1.9.
- Staff recommendation (percent of GDP, 2007–2011):
  - Overall balance: 5.3, 4.7, 2.7, 2.6, 3.2.
  - Primary balance: 4.8, 4.1, 2.0, 1.8, 2.3.
  - Overall structural balance: 4.8, 4.5, 3.4, 3.6, 3.9.
  - Primary structural balance: 4.3, 3.9, 2.7, 2.8, 3.1.
- Design of stimulus — staff guidance:
  - Use measures that reduce economic distortions or can be implemented swiftly and clawed back quickly.
  - Preferable measures: rapidly implementable infrastructure projects (e.g., public support of social housing construction projects) and earned-income tax cuts to promote labor force participation.

### Economic outlook and near-term projections (section 9)
- Growth projections:
  - Growth projected to decelerate to about 2 percent in 2008 and further to ½ percent in 2009.
  - Staff estimates cumulative direct impact of financial tightening on 2008–09 growth at ¾ percentage points.
  - Baseline GDP growth (Bank of Finland sensitivities): 2009 = 0.6; 2010 = 1.6.
- Inflation projection:
  - Inflation expected to peak at about 4 percent in 2008, before falling back in 2009; aided by a late-2009 cut in food VAT.
- Domestic demand drivers:
  - Lower activity among major trading partners, Russian export tariffs on roundwood, sluggish employment growth, erosion of real disposable income, higher debt servicing, and falling consumer confidence will constrain consumption.
  - Gross fixed capital formation (2005–2009 proj.): 3.5, 4.7, 8.5, 0.0, -4.5.
- Risks (equal upside and downside probability; unusually pronounced dispersion):
  - Lending conditions or housing and equity prices; oil prices; external demand spillovers; the value of the euro; labor market developments.
- Quantified sensitivities (deviation from baseline, full year effects; percentage points):
  - A 1 percentage point increase in lending risk premia: 2009 = -0.9; 2010 = -0.5.
  - A 1 percentage point fall in external demand: 2009 = -0.4; 2010 = -0.2.
  - A 10 percentage point rise in oil prices: 2009 = -0.2; 2010 = -0.1.
  - A 1 percentage point appreciation of the euro: 2009 = -0.2; 2010 = -0.2.
- Output gap turns negative in 2009.

### Financial sector stability, vulnerabilities, and policy responses (sections 24 and Appendix I)
- Overall assessment:
  - Banks largely sheltered from the turmoil so far; key financial stability indicators remain quite healthy: returns on equity and capital-adequacy ratios are high; loan-loss and cost ratios are low.
  - Some 60 percent of banking assets are foreign-owned.
  - Helsinki stock prices: about 55 percent off their late-2007 peak; about 60 percent of total capitalization held by nonresidents.
- Stress tests and scenarios (2008 central bank exercise assumptions):
  - Severe decline in GDP growth for 2008-10.
  - Unemployment rate jumps to above 10 percent by 2010.
  - 3-month Euribor rises to 5.7-5.8 percent over 2008-10.
  - Home prices decline in 2008-10 between 6-10 percent annually.
  - 32 percent decline in stock prices in 2008, modest recovery only in 2010.
  - Result: profitability would decline, but no bank would impair its capital adequacy under these scenarios.
- Mortgages, household debt, and consumer lending:
  - Total household debt (in percent of GDP, 2003–08): 37.6 40.6 45.1 46.7 48.1 ...
  - Debt-to-income ratio (2003–08): 73.5 79.2 89.6 97.2 102.7 ...
  - House price rise has been less worrisome than in other countries; household net worth is robust; debt servicing historically low.
  - Rising household debt, softer house prices, and high loan-to-value lending to young borrowers are monitoring priorities.
- Funding, covered bonds, and securitization:
  - Covered bonds or securitization remain rare; mortgage-covered bonds can be issued only by dedicated mortgage banks; only two banks have set up such special vehicles.
  - Staff recommended considering relaxing restrictions on mortgage-covered bond issuance and supporting securitization through voluntary industry-led standardization.
- Policy measures enacted (in line with euro area agreements):
  - Raised deposit insurance to €50,000.
  - Announced a €50 billion fund to guarantee rollover of term debt issued by banks (subject to compensation on commercial terms and maximum maturity of five years).
  - Proposed a bank recapitalization fund of €4 billion.
  - Staff urged prompt passage of related legislation and implementation without distorting competition.
- Insurance and pension sectors:
  - Insurance solvency dropped significantly after steep market declines in 2008; minimum solvency ratios met but margins declined.
  - Pension funds: reforms in 2005 improved long-term stability; authorities target raising long-term real return on pension fund assets from 3 percent to 4 percent a year (raising it to 4 percent would reduce the GG deficit in 2050 by 3 percentage points of GDP).
  - Supervisory emphasis on integrating insurance and banking supervision and vigilance over financial conglomerates.

### Financial-real sector linkages and empirical findings (Appendix I)
- Financial cycle:
  - The financial cycle has turned; tightening in financial conditions in 2007–08 is estimated to reduce real GDP growth in 2008–09 by about ¾ percentage point.
- VAR-based Financial Conditions Index (FCI):
  - FCI negative in 2002–03, positive from early 2004 to late 2007, re-entered negative territory in 2008.
  - 2008 deterioration owed mainly to higher interest rates, lagged real exchange appreciation, and reversal of earlier stock price gains.
- Disequilibrium credit model:
  - Lending to non-financial enterprises accelerated to about 21 percent at end-September 2008, from about 8 percent at end-2006.
  - Estimated credit supply in 2008 was above model-predicted levels; excess demand present in 2002–05 largely disappeared by 2008.
- Impact of credit on GDP:
  - Regression evidence: coefficients on loan supply growth are consistently small and not statistically significant.
  - Selected OLS and IV results (∆y on ∆l; Obs. 63):
    - Table A1 (OLS): ∆l_t: Coefficient -0.07, Std.Error 0.04, t-value -1.82; ∆l_t-1: Coefficient 0.07, Std.Error 0.03, t-value 2.07.
    - Table A2 (IV): ∆l_t: Coefficient 0.00, Std.Error 0.05, t-value 0.08.
  - Interpretation: bank loan growth had limited measured impact on output growth in recent periods; interbank rate effects and other financing channels are important.
- Conclusions and monitoring priorities:
  - Financial conditions tightened and are estimated to reduce GDP growth in 2008–09 by about ¾ percentage point.
  - Evidence does not point to supply-side banking problems as the principal source of tightening; Finnish banks remain well capitalized with maintained access to interbank markets.
  - Monitor closely: lending growth, bank profitability, liquidity conditions, loan losses, capital adequacy, insurance and pension solvency, household leverage, mortgage concentration, and funding market developments.

### Structural reforms, demographics, and long-term growth
- Demographic challenge:
  - Rapid population aging and slowing productivity weigh on growth and fiscal sustainability.
  - Population aging’s fiscal impact: 5½ percent of GDP of additional annual expenditures by 2050, mostly on healthcare and pensions.
- Policy priorities:
  - Increase labor force participation (especially with a working-age population set to decline).
  - Increase competition in “sheltered” sectors (agriculture, utilities, and trade) to stimulate productivity.
  - Improve pension fund management and consider a defined-contribution option while preserving minimum means-tested pensions and a DB component up to a societal replacement rate target.
- Labor market reforms under consideration:
  - Working committee to submit proposals by early 2009 to raise the effective retirement age; proposals include restricting the unemployment pipeline (early retirement from age 57), tightening disability pension access, and strengthening early medical and vocational rehabilitation.
  - Marginal rate for the average wage exceeds 40 percent (source statement); lowering labor taxation is prioritized to promote employment.
- Efficiency measures:
  - Recommendations: benchmarking, increase recourse to user charges, contracting out, outsourcing, and well-designed public-private partnerships—especially in elderly care and childcare.
  - Staff counseled adopting CPI-based indexation for central government transfers to local governments and strengthening expenditure ceilings for LGs.

### Revised staff projections and updated developments (Statement by IMF Staff Representative, January 30, 2009)
- Recent macro developments:
  - Seasonally adjusted output fell by 1.6 percent year-on-year in October 2008.
  - Industrial production plunged by about 10 percent year-on-year in November 2008; new manufacturing orders down by one-third.
  - Consumer confidence in December dropped to its lowest level since the early 1990s.
  - Staff pared down the estimate of 2008 GDP growth to 1½ percent.
- Revised staff projections:
  - 2009 GDP growth: -1 percent.
  - 2010 GDP growth: 1¼ percent.
- Fiscal and policy response:
  - Government discretionary loosening estimated at about 1¼ percent of GDP; headline surplus projected to decrease to 1¼ percent of GDP in 2009.
  - Discretionary stimulus to date: 1.2 percent of GDP; total budgetary impact (including automatic stabilizers): roughly 2 ½ percent of GDP.
- Financial sector update:
  - Banks’ capital adequacy remains well above minimum levels; no use of government guarantees for debt issuance nor government-funded recapitalization needed as of the statement.
  - Lending conditions tightened; credit growth remained robust through October 2008.

### Article IV consultation timing and final messages
- Next Article IV consultation: to be held on a 24-month cycle; rationale: Finland described as non-systemic with stable conditions and without outstanding Fund credit or pressing policy issues of broad interest.
- Key messages from Executive Board (Public Information Notice):
  - Support for coordinated EU-wide short-term fiscal relaxation while safeguarding long-term fiscal sustainability.
  - Preserve budgetary margins to allow for possible fiscal interventions to recapitalize financial institutions.
  - Expenditure restraint and efficiency improvements are the lynchpin of long-term fiscal adjustment.
  - Maintain vigilance over financial sector risks and strengthen cross-border supervisory cooperation.

*Source: _cr0939*

### Executive Summary

### Executive Summary

### Economic situation and near-term outlook
- Growth slowed sharply after a robust 4½ percent in 2007; Real GDP growth series reported: 2.8, 4.9, 4.5, 2.1, 0.6 (2005–2009 proj.).
- Spillovers from the global turmoil are adversely affecting activity and may weaken the financial system.
- Inflation and labor market:
  - Inflation surged to 4.7 percent in September, greatly exceeding the euro area average.
  - Unemployment increased to 6.5 percent in September; staff projections show unemployment rates and labor indicators (Harmonized CPI: 0.8, 1.3, 1.6, 4.0, 2.5; GDP deflator: 0.4, 1.3, 2.9, 3.3, 2.0 for 2005–2009 proj.).
  - High wage increases and disappointing decentralized wage negotiations raise the risk of persistent inflation and competitiveness erosion.
- External sector:
  - Current account surplus hovered around a sizable 4–4½ percent of GDP in 2006–07 and is projected to remain broadly unchanged in the near term.
  - Box 1 CGER assessment: average competitiveness margin of 7 percent (down from a mid-point of 17 percent last year).

### Fiscal policy — cyclical and medium-term
- Cyclical stance:
  - From a cyclical perspective, a fiscal structural loosening is warranted, but its effectiveness in Finland’s small, open economy would be limited absent an EU-wide fiscal package.
  - Authorities were confident that an EU-coordinated budget expansion is in the cards; agreement that loosening should be designed to minimize damage to long-term fiscal sustainability.
- Medium-term sustainability:
  - A permanent improvement in the structural primary balance after 2011 of at least 1½ percent of GDP is required.
  - The fiscal gap should be filled soon once the economy recovers for intergenerational equity and to reduce the needed adjustment.
  - The authorities concurred that, with comparatively high spending, adjustment should rely mainly on expenditure restraint and improved efficiency; tax reform and higher pension fund yields can help too.
  - Government plans to lower labor taxation are appropriate; staff advised against cutting the food VAT rate.
- Recent fiscal metrics:
  - General government (GG) surplus surged to 5¼ percent of GDP in 2007, buoyed by expansion and strong property revenues.
  - GG surplus is projected to contract to some 4¾ percent of GDP in 2008 because of slowing growth, tax cuts, and higher expenditures related to sizable wage raises.
  - GG debt fell to 35 percent of GDP in 2007, with pension fund assets almost twice as large.

### Financial sector stability and risks
- Overall assessment:
  - Banks have been largely sheltered from the turmoil so far, but the impact of a weakening economy on bank profitability and non-performing loans must be monitored closely.
- Key findings:
  - Exposure to U.S. subprime assets, U.S. GSEs, and Lehman is minimal; main problems related to two Icelandic banks’ small local operations have been resolved.
  - CDS spreads for the biggest banks widened and remain volatile but stayed consistently below those of European peers.
  - Key financial stability indicators remain quite healthy: returns on equity and capital-adequacy ratios are high; loan-loss and cost ratios are low (Table 5, Figures 3–4).
  - Liquidity tightened but the domestic interbank market did not freeze in 2008; banks gained some deposits from mutual funds in a flight to safety.
  - Some 60 percent of banking assets are foreign-owned, posing challenges for cross-border supervision.
  - Helsinki stock prices are about 55 percent off their late-2007 peak, with some 60 percent of total capitalization held by nonresidents.
  - Housing prices have risen more moderately than in many European economies and have slightly declined in real terms in 2008.
- Vulnerabilities highlighted:
  - Rising household debt, softer house prices, and developments in funding markets may become a concern.
  - Softer economic growth, reduced non-operating and fee income, and rising funding costs herald lower profitability and higher loan losses (albeit from healthy levels).
  - Household and nonfinancial corporation balance sheets remain strong, although household debt has risen sizably and enterprise profitability is squeezed by rising labor costs and energy and commodity prices.
  - Insurance and pension companies have suffered significant losses owing to the plummeting capital markets; while minimum solvency ratios are met, margins have declined considerably, underscoring the need to step up vigilance over financial conglomerates.
- Policy responses supported by staff:
  - Steps to guarantee bank debt renewal and recapitalize banks, if needed.
  - Efforts to improve European coordination and harmonization in deposit insurance and cross-border financial supervision.
  - Supervisors underscored the need to step up vigilance of financial conglomerates.

### Structural reforms and long-term growth
- Challenge:
  - Rapid population aging and slowing productivity weigh down on growth and fiscal sustainability.
  - Population aging’s fiscal impact is large: 5½ percent of GDP of additional annual expenditures by 2050, mostly on account of healthcare and pensions.
- Policy priorities:
  - Increase labor force participation (especially given a working-age population set to decline).
  - Increase competition, especially in “sheltered” sectors of the economy (agriculture, utilities, and trade), to stimulate productivity.
  - Improve pension fund management to help cope with aging.
  - Authorities receptive but emphasized need to move cautiously in socially sensitive areas.
- Progress and gaps:
  - Structural progress continues but at a slower pace; reforms led to sizable employment gains in recent years and unemployment is below the EU average.
  - Employment rates for the elderly and youth lag behind other Nordic economies; productivity growth has been sluggish in sheltered sectors and declining in local government social services.
  - Steps in 2007–08 mainly implemented previously adopted measures; further activation of the labor force and measures to stimulate competition are needed.

### Key statistics and indicators (preserved as reported)
- Real GDP growth (2005–2009 proj.): 2.8, 4.9, 4.5, 2.1, 0.6.
- Consumption (2005–2009 proj.): 2.9, 3.1, 2.7, 2.6, 0.9.
- Private consumption (2005–2009 proj.): 3.3, 4.1, 3.2, 3.0, 0.9.
- Gross fixed capital formation (2005–2009 proj.): 3.5, 4.7, 8.5, 0.0, -4.5.
- Net exports contribution (2005–2009 proj.): 2/ -1.1, 2.0, 1.1, 1.4, -0.1.
- Harmonized CPI (2005–2009 proj.): 0.8, 1.3, 1.6, 4.0, 2.5.
- GDP deflator (2005–2009 proj.): 0.4, 1.3, 2.9, 3.3, 2.0.
- Employment (2005–2009 proj.): 1.5, 1.8, 2.0, 1.3, -0.5.
- Unemployment rate (2005–2009 proj.): 8.4, 7.7, 6.8, 6.4, 6.8.
- Labor compensation (2005–2009 proj.): 3.8, 2.9, 3.5, 5.5, 4.8.
- Unit labor costs (2005–2009 proj.): 2/ 2.4, -0.3, 1.2, 4.6, 3.6.
- Output gap (2005–2009 proj.): -1.5, 0.0, 1.3, 0.4, -1.6.
- General government surplus: 5¼ percent of GDP in 2007; projected some 4¾ percent of GDP in 2008.
- General government debt: fell to 35 percent of GDP in 2007.
- Pension fund assets: almost twice as large as government debt (2007).
- CGER competitiveness margin estimates: Macroeconomic balance approach-7.3; External sustainability approach-4.0; Equilibrium real exchange rate approach-9.3 (average reported as 7 percent).
- Helsinki stock prices: about 55 percent off their late-2007 peak.
- Banking sector foreign ownership: some 60 percent of banking assets are foreign-owned.

*Source: _cr0939 - Executive Summary*

### 9.      The economy is slowing in 2008–09 amid dwindling domestic demand and a

### _cr0939 - 9.      The economy is slowing in 2008–09 amid dwindling domestic demand and a

### Economic outlook and near-term projections
- Growth projections:
  - Growth is projected to decelerate to about 2 percent in 2008 and further to ½ percent in 2009, owing mainly to lingering effects of the global turbulence.
  - Staff estimates a cumulative direct impact of financial tightening on 2008–09 growth at ¾ percentage points.
- Inflation projection:
  - Inflation is expected to peak at about 4 percent in 2008, before falling back in 2009, as the pass-through of earlier food and fuel price surges (and excise hikes) fades, aided by a late-2009 cut in food VAT.
- Domestic demand drivers:
  - Lower activity in a number of major trading partners will reduce export expansion; Russian export tariffs on roundwood are an additional negative factor.
  - Sluggish employment growth, erosion of real disposable income by higher inflation, higher debt servicing, and falling consumer confidence will constrain consumption.
  - Capital formation is projected to brake for cyclical reasons: tightening profit margins, worsening expectations, and rising financing costs.

### Risks to the outlook and spillover impacts
- Main risks identified (equal upside and downside probability; dispersion unusually pronounced):
  - Lending conditions or housing and equity prices affecting domestic demand.
  - Oil prices.
  - External demand spillovers.
  - The value of the euro.
  - Labor market developments (sharp inflation acceleration may trigger cost pressures and erode competitiveness; poorer employment prospects could dampen that concern).
- Quantified sensitivity to selected shocks (deviation from baseline projections in percentage points, full year effects; source: Bank of Finland):
  - Baseline GDP growth: 2009 = 0.6; 2010 = 1.6
  - A 1 percentage point increase in lending risk premia: 2009 = -0.9; 2010 = -0.5
  - A 1 percentage point fall in external demand: 2009 = -0.4; 2010 = -0.2
  - A 10 percentage point rise in oil prices: 2009 = -0.2; 2010 = -0.1
  - A 1 percentage point appreciation of the euro: 2009 = -0.2; 2010 = -0.2
- Output gap:
  - Accordingly, the output gap turns negative in 2009.

### Financial conditions and real-sector linkages
- Financial cycle assessment:
  - The financial cycle seems to have turned, which is estimated to reduce GDP growth in 2008-09 by about 3/4 percentage point.
  - A disequilibrium model suggests there is no “credit crunch” in Finland.
- Financial Conditions Index (FCI) contributions (illustrative):
  - Components include stock market returns, real effective exchange rate, three-month HELIBOR, distance-to-default, and overall FCI.
  - Both the level of the FCI and the direction of recent changes have implications for economic activity (example: a value of 1 means the total impulse of financial conditions to GDP is one percentage point, annualized).

### Longer-term challenges: demographics and productivity
- Demographic and productivity trends:
  - Trend productivity growth is declining in Finland, while imminent population aging will shrink working-age cohorts.
  - Raising the employment rate and stimulating productivity—especially in the service sector—are key for long-run growth and competitiveness.
- Long-term decomposition (as presented):
  - Productivity growth line: "Productivity growth 1/2.62.01.82.11.9" (as in source).
  - Demographic contribution line: "Demographic contribution 2/0.0-0.10.0-0.8-0.5" (as in source).
  - Employment rate contribution line: "Employment rate contribution 3/1.80.40.70.20.0" (as in source).
  - Resulting GDP per capita growth line: "GDP per capita growth4.52.32.51.41.4" (as in source).
- Long-term scenario conclusion:
  - Prospects for labor force participation/employment and productivity growth imply a significant drop in income per capita growth.

### Fiscal policy: stance, projections, and staff recommendations
- Recent and planned fiscal easing:
  - Following substantial improvement in GG structural balances during 2004–07, the 2009 budget and accompanying medium-term plan envisage a decline in the structural primary surplus of 2 percent of GDP from 2008 to 2011.
  - A fiscal impulse equivalent to about 1 percent of GDP is estimated for 2009 alone, with further cuts on labor taxes at the beginning of next year (brought forward for cyclical reasons), and a reduction in the VAT rate on food from 17 to 12 percent in October 2009.
- Staff view on stimulus:
  - Staff saw merit in the relaxation envisaged by the authorities as part of an EU-wide fiscal stimulus package, recognizing scope for discretionary budgetary impulse given negative output gaps for 2009–12.
  - Staff cautioned that effectiveness of demand-enhancing measures in Finland’s small, open economy would be limited if done in isolation, especially with a tight labor market.
  - Staff warned potential overestimation of potential output (time-series methods do not allow for structural breaks) and urged preserving some budgetary margins in case fiscal interventions for bank recapitalization are required.
- Fiscal projections (Staff Projection and Staff Recommendation tables, percent of GDP; as in source):
  - Staff Projection (2007–2011): Overall balance 5.3, 4.7, 2.7, 2.4, 2.0; Primary balance 4.8, 4.1, 2.0, 1.6, 1.1; Overall structural balance 4.8, 4.5, 3.4, 3.4, 2.7; Primary structural balance 4.3, 3.9, 2.7, 2.6, 1.9.
  - Staff Recommendation (2007–2011): Overall balance 5.3, 4.7, 2.7, 2.6, 3.2; Primary balance 4.8, 4.1, 2.0, 1.8, 2.3; Overall structural balance 4.8, 4.5, 3.4, 3.6, 3.9; Primary structural balance 4.3, 3.9, 2.7, 2.8, 3.1.
- Long-term sustainability gap:
  - To ensure sustainability, the GG structural primary balance after 2011 should be permanently higher than in the current policies path by 1½–2½ percent of GDP—the fiscal sustainability gap.
  - Staff recommended filling the gap as early as possible once the economy recovers to limit required tightening and for intergenerational equity.
- Design of stimulus:
  - Stimulus should minimize negative impact on long-term budget position: rely on actions that reduce economic distortions or can be implemented swiftly and clawed back quickly.
  - Preferable measures: rapidly implementable infrastructure projects (e.g., public support of social housing construction projects) and earned-income tax cuts to promote labor force participation.

### Expenditure efficiency, taxation, and structural fiscal measures
- Expenditure management and efficiency:
  - Expenditure restraint is the lynchpin of adjustment; containment of government spending is a priority given high expenditure-to-GDP ratio and aging pressures.
  - Productivity increases in health and long-term care of ½ percent a year (achieved in some OECD countries) would lower significantly projected rises in spending.
  - Available data suggest room for improvements in the efficiency of health spending; public productivity has declined since the late 1990s, especially in education, health, and social services, all provided by local governments (LGs).
  - Recommendations to improve efficiency: domestic and international benchmarking; increase recourse to user charges; encourage contracting out, outsourcing, and well-designed public-private partnerships—especially in institutional and home-care for the elderly and day-care for children.
- Local government fiscal discipline:
  - Staff counseled adopting CPI-based rather than cost-based indexation for central government transfers to LGs and strengthening agreement with LG association to extend expenditure ceilings to LGs; authorities were skeptical about LG willingness to accept these changes.
- Tax reform:
  - Authorities committed to lowering taxes on labor and the VAT rate on food; staff concurred that moderating labor taxes should boost labor participation and growth.
  - Staff advised against the VAT cut on food because VAT is among the least distortionary taxes and revenue losses must be minimized for sustainability’s sake; staff argued the Finnish VAT base should be broadened given special treatments for a relatively large share of goods and services.
  - Staff noted property taxation is comparatively low and should be increased; officials explained sizable rises would be unpopular and require LG agreement.
- Pension fund returns:
  - Authorities target increasing the long-term real return on pension fund assets from the 3 percent assumed in the baseline to 4 percent a year; raising it to 4 percent would reduce the GG deficit in 2050 by 3 percentage points of GDP.
  - In 2007, investment guidelines for pension funds were eased; staff proposed additional steps.

### Structural reforms and labor market
- Labor market and social security reforms under consideration:
  - Authorities considering reforms to increase the still low effective retirement age; a working committee will submit proposals by early 2009.
  - Early proposals aim to: (i) restrict use of the unemployment pipeline (which in practice provides early retirement from age 57), stepping up activation measures for the older unemployed; (ii) tighten control on access to disability pensions; and (iii) strengthen early medical and vocational rehabilitation.
- Taxation and incentives:
  - Lowering labor taxation is prioritized to promote employment and labor force participation; marginal rate for the average wage exceeds 40 percent (source statement).
  - Broadening less distortionary tax bases and improving pension asset management can support fiscal sustainability.

*Source: IMF staff report chapter provided in content unit _cr0939 - 9.*

### 24.      While confirming the resilience of Finnish banks to market turmoil so far, the

### _cr0939 - 24.      While confirming the resilience of Finnish banks to market turmoil so far, the

### Financial sector resilience and risks
- Finnish banks have shown resilience to market turmoil so far, but authorities identified concerns.
- Risks relating to toxic assets, derivatives, liquidity, or off-balance-sheet exposure appear moderate.
- Indirect effects through the real economy:
  - Lower growth → less profitability and higher non performing loans.
- Additional risk channels to monitor:
  - Losses on group insurance and asset management activities.
  - Banks’ global operations, especially in the Nordic-Baltic region, as potential sources of unexpected contagion.
- Supervisory emphasis:
  - Monitor insurance capital and cover ratios closely and ensure proactive recapitalization where necessary.

### Mortgages, household debt, and consumer lending
- Authorities are vigilant about mortgages and consumer lending given the run-up in household debt.
- Positive indicators:
  - House price rise has been less worrisome than in other countries.
  - Households’ net worth is robust.
  - Debt servicing is historically low.
- Concerns:
  - Slowing economy and higher unemployment may be a bigger concern than current household balance-sheet weaknesses.
  - Supervisors stressed alert scrutiny of weakening home prices and credit risks in specific sectors such as high loan-to-value loans to young borrowers.

### Funding, covered bonds, and securitization
- Diversification of banks’ wholesale funding was seen as a positive development.
- Despite a sound mortgage portfolio, covered bonds or securitization remain rare.
  - Mortgage-covered bonds can be issued only by dedicated mortgage banks; only two banks have set up such special vehicles.
- Staff recommendation:
  - Consider relaxing the provision restricting mortgage-covered bond issuance.
  - Support development of securitization through voluntary industry-led standardization and facilitating dialogue between banks and potential investors.
- Authorities and staff agreed on gradualism due to unfavorable market conditions and the need for market participants to acquaint themselves with new instruments.

### Policy measures to buttress the financial sector
- In line with euro area agreements, Finland took the following measures:
  - Raised deposit insurance to €50,000.
  - Announced a €50 billion fund to guarantee the rollover of term debt issued by banks (subject to compensation on commercial terms and with maximum maturity of five years).
  - Proposed a bank recapitalization fund of €4 billion.
- Staff urged:
  - Prompt passage of related legislation and regulations.
  - Implementation of measures without distorting competition among Finnish banks.

### Stress tests and assumptions
- Central bank stress tests (2008 exercise) indicate banks can withstand fairly adverse shocks; profitability would decline, but no bank would impair its capital adequacy.
- 2008 Main Stress Test Assumptions:
  - a severe decline in GDP growth for 2008-10
  - a jump in unemployment rate to above 10 percent by 2010
  - a rise in 3-month Euribor to 5.7-5.8 percent over 2008-10
  - declines in home prices in 2008-10 ranging between 6-10 percent annually
  - a 32 percent decline in stock prices in 2008, modest recovery only in 2010
- Identified improvements for future tests:
  - (i) Cover more thoroughly market risks, such as valuation losses, counterparty risks, risk concentration, and strategic risks relating to liquidity and new capital issuance.
  - (ii) Integrate more completely the insurance sector.
  - (iii) Explore procyclicality implicit in capital adequacy measures under Basle II.

### Insurance, pensions, and related vulnerabilities
- Insurance sector:
  - Solvency levels were strong and improving until mid-June 2007, but dropped significantly after the steep market declines in 2008.
  - Premium growth leveled off in 2007, with falling premia in the life segment in recent years.
  - Authorities’ concerns: (i) impact of insurers’ potential problems on related groups; (ii) possible saturation of the life market.
- Pension funds:
  - Appear in good financial health.
  - 2005 reforms improved long-term stability but linked benefits to life expectancy and increased risk-sharing by employees.
  - Officials expressed interest in exploring:
    - Gradually raising funding levels and introducing a defined-contribution (DC) component option—while preserving an adequate minimum means-tested pension and defined-benefit (DB) component up to a replacement rate target determined by societal preferences on intergenerational risk sharing.
    - Integrating administration and investment functions across funds, notably those of local and central governments.
    - Fine-tuning solvency regulations to reflect better the PAYG nature of the pension system.

### Cross-border supervision and regulatory cooperation
- Authorities committed to strengthen cross-border supervision.
- Proposed actions and priorities:
  - Merge the Financial Supervisory Authority and the Insurance Supervisor to improve efficiency and effectiveness.
  - Clarify supervisory and fiscal responsibility of home-host authorities in crisis resolution.
  - Use supervisory colleges for both subsidiaries and significant branches.
  - Improve harmonization and clarity about operation of deposit insurance schemes, especially after recent expansion.
  - Develop common criteria for intervention in troubled institutions.
  - Move towards a more integrated European supervisory structure, at least for major cross-border institutions.

### Structural policies, fiscal outlook, and staff appraisal
- Structural policy priorities:
  - Labor and product market reforms to stimulate growth, especially with working-age population set to decline after 2010.
  - Enhance labor force activation measures and competition in product markets to raise productivity.
  - Address lack of wage differentiation—social partners considering linking wage negotiations more closely to productivity increases.
- Fiscal stance and recommendations:
  - Cyclical: fiscal structural loosening is warranted, but should avoid damaging the long-term budget position; relaxation in the 2009 budget is suitable in the context of joint EU action.
  - Measures should reduce distortions (e.g., labor-income tax cuts that promote labor force participation) or be swiftly reversible.
  - Preserve budgetary margins to allow for possible fiscal interventions to recapitalize distressed financial institutions.
- Long-term fiscal sustainability:
  - A permanent improvement in the structural primary balance after 2011 of at least 1½ percent of GDP is needed to stabilize net public debt in light of the budgetary costs of aging.
  - The bulk of the needed adjustment should rely on containment of spending; suggestions include benchmarking, user charges, contracting out, outsourcing, and well-designed public-private partnerships.
  - Tax recommendations:
    - Lower earned income taxes can promote higher labor force participation if accompanied by broadening the base of less distortionary levies, especially the VAT.
    - Cutting the VAT rate on food is not advisable.
    - Increase property taxation, which is low in international comparison.
  - To lift long-term returns on pension assets, consider a defined contribution pension option and a greater degree of funding.

### Summary of immediate monitoring priorities
- Monitor closely:
  - Lending growth, bank profitability, liquidity conditions, loan losses, and capital adequacy.
  - Rising household debt, softer house prices, mortgage concentration in weak borrower segments, funding market developments, and the impact of a weakening economy on bank profitability and non-performing loans.
  - Insurance and pension company solvency and potential contagion to banks in financial conglomerates.
- Support prompt passage of legislation for guarantees and recapitalization, and implement measures without distorting competition.
- Strengthen cooperation with supervisors abroad and pursue greater harmonization of deposit insurance and intervention criteria.

*Source: _cr0939*

### 43.      The next Article IV consultation will be held on a 24-month cycle. Finland is a

### _cr0939 - 43.      The next Article IV consultation will be held on a 24-month cycle. Finland is a

### Article IV consultation timing
- The next Article IV consultation will be held on a 24-month cycle.
- Rationale: Finland is described as a non-systemic country, with stable economic and financial conditions, and without outstanding Fund credit or pressing policy issues of broad interest to the Fund membership. Hence, the authorities agreed to move consultations to a 24-month cycle, with an interim staff visit.

### Macroeconomic outlook and projections
- Growth expectation (text figure caption): "Growth is expected to slow to some 2 percent this year, and to only 1/2 percent next year,..." 
- GDP (annual percent change, 2004–11): 3.7 2.8 4.9 4.5 2.1 0.6 1.6 2.7
- Consumption (2004–11): 2.6 2.9 3.1 2.7 2.6 0.9 1.4 2.2
  - Private consumption (2004–11): 3.0 3.3 4.1 3.2 3.0 0.9 1.5 2.4
  - Public consumption (2004–11): 1.8 1.9 0.6 1.3 1.0 1.1 1.3 1.5
- Investment (2004–11):
  - Gross fixed capital formation: 3.6 3.5 4.7 8.5 0.0 -4.5 1.5 2.7
  - Private investment: 3.6 6.3 6.5 8.3 0.3 -5.7 1.0 2.7
  - Public investment: 3.7 -11.0 -6.4 9.4 -0.4 3.5 3.5 2.5
- External sector (2004–11):
  - Exports of goods and services: 8.6 7.0 11.8 8.2 4.0 -0.6 4.6 4.5
  - Imports of goods and services: 7.2 11.8 7.8 6.6 1.2 -0.6 4.5 3.6
  - Foreign contribution to growth (in percent of GDP): 1.0 -1.1 2.0 1.1 1.4 -0.1 0.2 0.5

### Prices, costs, and income
- Consumer price inflation (harmonized, 2004–11): 0.1 0.8 1.3 1.6 4.0 2.5 2.0 2.0
- Core inflation (excluding energy and seasonal food, 2004–08): 0.7 0.5 0.9 1.3 ............
- GDP deflator (2004–11): 0.6 0.4 1.3 2.9 3.3 2.0 0.9 1.4
- Terms of trade (2004–11): 1.3 -0.7 -3.1 -1.4 -2.5 -1.4 -1.5 -1.3
- Unit labor cost, economy-wide (2004–11): 0.3 2.4 -0.3 1.2 4.6 3.6 2.5 1.5

### Labor market and potential output
- Labor force growth (2004–11): -0.2 1.0 1.1 1.0 0.8 0.0 0.0 0.0
- Employment (2004–11): 0.0 1.5 1.8 2.0 1.3 -0.5 0.1 0.2
- Unemployment rate (in percent, 2004–11): 8.8 8.4 7.7 6.8 6.4 6.8 6.8 6.6
- Output gap (in percent of potential output, 2004–11): 1/ -1.1 -1.5 0.0 1.3 0.4 -1.6 -2.3 -1.6
- Growth in potential output (2004–11): 3.3 3.2 3.3 3.2 3.0 2.7 2.3 2.0
- NAIRU (in percent, 2004–11): 8.5 7.9 7.8 7.2 6.6 6.4 6.4 6.4

### Money, interest rates, and external accounts
- M3 (Finnish contribution to euro area, growth rate, e.o.p., 2004–07): 6.3 8.2 8.1 19.7 8.2 .........
- Finnish MFI euro area loans (growth rate, e.o.p., 2004–07): 10.6 12.2 11.5 11.7 13.1 .........
- 3-month money market rate (2004–08): 2.1 2.2 3.1 4.3 4.8 .........
- 10-year government bonds yield (2004–08): 4.1 3.4 3.8 4.3 4.2 .........
- Current account balance (2004–11, in percent of GDP): 6.5 3.6 4.5 4.1 4.0 3.5 2.5 2.4
- Net external debt (excluding equity FDI and shares, 2004–11): -8.2 -5.5 -5.5 -6.8 -10.5 -13.7 -15.9 -17.7
- Net international investment position (2004–11): -10.9 -14.7 -13.4 -28.1 -19.7 -14.8 -10.9 -6.8

### Balance of payments and external projections (2004–13, selected series)
- Current account (in billions of euros, 2004–13): 10.0 5.7 7.5 7.3 7.5 6.8 5.0 5.1 5.1 5.2
- Current account as a percentage of GDP (2004–13): 6.5 3.6 4.5 4.1 4.0 3.5 2.5 2.4 2.4 2.3
- Exports of goods and services (2004–13, percent of GDP): 60.9 65.7 75.5 82.2 86.7 86.2 89.3 94.0 98.8 103.9
- Imports of goods and services (2004–13, percent of GDP): -48.6 -58.8 -67.2 -73.1 -76.9 -77.6 -82.7 -87.4 -92.2 -97.3
- GDP at current prices (memorandum, in billions of euros, 2004–13): 152.3 157.3 167.0 179.7 189.6 194.5 199.4 207.6 216.4 225.6

### Public finances and fiscal stance
- General government (ESA95 basis, percent of GDP, 2004–11):
  - Revenues: 47.0 47.5 47.3 47.3 46.7 45.7 45.4 45.2
  - Expenditure: 44.9 44.8 43.3 41.9 42.0 43.0 43.0 43.2
  - General government balance: 2.2 2.7 4.0 5.3 4.7 2.7 2.4 2.0
  - Gross debt (EMU definition): 44.1 41.3 39.2 35.2 32.4 31.2 29.2 27.8
- Central government (percent of GDP, 2004–11):
  - Revenues: 24.8 24.8 24.3 24.4 24.3 23.3 22.9 22.7
  - Expenditure: 24.4 24.4 23.5 22.3 22.7 23.0 22.9 23.2
  - Central government balance: 0.4 0.4 0.9 2.1 1.6 0.3 0.0 -0.4
  - Gross debt: 40.3 36.8 34.6 30.7 27.5 26.5 25.9 25.3

### Financial sector indicators and vulnerabilities
- Household sector (selected, 2003–08):
  - Total household debt (in percent of GDP, 2003–08): 37.6 40.6 45.1 46.7 48.1 ...
  - Debt-to-income ratio (2003–08): 73.5 79.2 89.6 97.2 102.7 ...
  - Financial assets/GDP (2003–08): 81.5 84.6 93.4 87.3 85.4 ...
- Non-financial corporations gross debt (in percent of GDP, 2003–08): 51.0 50.9 50.9 50.4 50.4 ...
- Government debt (EMU definition, 2003–08): 44.3 44.1 38.2 35.3 31.2 ...
- Banking sector (selected ratios, 2003–08):
  - Non-performing loans/total loans (in percent, 2003–08): 0.48 0.37 0.27 0.26 0.28 0.35 4/
  - Regulatory capital as percent of risk-weighted assets (2003–08): 18.7 19.1 17.2 15.1 15.4 13.5 4/
  - Regulatory tier 1 capital to risk-weighted assets (2003–08): 9.7 16.5 15.0 12.8 11.5 12.2 4/
  - Equity/total assets (in percent, 2003–08): 10.9 9.6 9.9 9.8 8.3 7.4 2/
  - Return on assets (in percent, 2003–08): 0.7 0.8 0.9 1.0 1.2 0.8 4/
  - Change in stock market index (in percent, e.o.p., 2003–08): 4.4 3.3 31.1 17.9 20.5 -50.7 7/

### Policy recommendations and implementation (staff recommendations and progress)
- Fiscal policy
  - Recommendation: Focus on expenditure restraint, especially at the local level; raise efficiency of public services; revisit pension system parameters as necessary.
  - Implementation noted: Significant pension reforms adopted in 2005 with a life expectancy coefficient to be applied from 2009. Multi-year expenditure rule reformed. Intergovernmental financing rules revised; measures to encourage municipal mergers adopted. Greater success in expenditure efficiency at central government level.
- Labor market policy
  - Recommendation: Increase flexibility in wage setting; ease labor market mismatches; reduce structural unemployment; induce earlier entry into labor force; curtail "pipelines" to early labor force departure.
  - Implementation noted: Employment gains exceeded targets; Lisbon employment targets met. Centralized bargaining was not in force in recent wage negotiations. Labor tax cuts implemented, including targeted reductions for older, less productive workers and extensions to young entrants. Tax incentives/subsidies for labor-intensive services and mobility introduced. New Ministry of Employment and the Economy formed. Unemployment pension to be phased out from 2009; "unemployment pipeline" tightened to begin from age 57. Tripartite working group established on "flexicurity"; working group to initiate comprehensive social security reform.
- Competition policy
  - Recommendation: Strengthen competition in product markets, especially sheltered sectors, to boost productivity.
  - Implementation noted: Competition Authority's powers enhanced; working group to review competition legislation formed; research on competition developments launched; Companies and Auditing Acts amended to ease firm creation and reduce administrative burdens; national action plan for better regulation to be introduced; government target to increase R&D to 4 percent of GDP; implementation of the EU services directive began in 2007.
- Financial sector policy
  - Recommendation: Strengthen financial sector stability, improve cross-country supervision, and improve stress testing techniques.
  - Implementation noted: Progress in expanding stress tests; enhanced cooperation with foreign supervisors for foreign-owned Finnish institutions; supervisors working to improve supervision of cross-border infrastructure. Merger of Financial Supervisory Authority and Insurance Supervisory Authority to take effect in 2009.

### Key messages and risks
- Finland moved to a 24-month Article IV cycle given stable conditions and absence of Fund credit or pressing multilateral policy issues.
- Near-term growth slowdown is material: "some 2 percent this year" and "1/2 percent next year."
- Inflation (harmonized) spiked to 4.0 percent in 2007 (in the series shown) before moderating in staff projections.
- External position remains a surplus but is declining relative to earlier ICT-boom levels; NIIP shows a trend improvement but remains negative in the projection period.
- Fiscal position exhibits sizable surpluses in recent years but structural concerns remain; general government balance and gross debt show improving debt ratios alongside reduced fiscal balances in projections.
- Financial sector indicators show manageable non-performing loan ratios and relatively strong capital metrics historically, but vulnerability exists through rising household debt and substantial portfolio/other investment cross-border positions.

*Sources: Ministry of Finance; Bank of Finland; Statistics Finland; Financial Supervision Authority; The Finnish Bankers' Association; IMF staff projections and estimates.*

### Appendix I. Financial-Real Sector Linkages in Finland

### Appendix I. Financial-Real Sector Linkages in Finland

### Executive summary
- Lending to non-financial enterprises accelerated to about 21 percent at end-September 2008, from about 8 percent at end-2006.
- The financial cycle has turned; estimated tightening in financial conditions in 2007–08 is expected to reduce real GDP growth in 2008–09 by about ¾ percentage point (in the absence of further shocks).
- Evidence points to weakened loan demand in 2008 rather than a generalized credit supply contraction: estimated credit supply in 2008 was above model-predicted levels, and excess demand that existed in 2002–05 largely disappeared by 2008.
- Bank lending has had limited impact on GDP growth in Finland according to simple, IV, and VAR estimates; coefficients on loan supply growth are consistently small and not statistically significant.

### A. VAR-Based Financial Conditions Index (FCI)
- Methodology:
  - VAR with Cholesky decomposition on variables (in levels): real GDP (y_t); GDP deflator (def_t); distance-to-default (dtd_t); three-month HELIBOR (R_t); real effective exchange rate (reer_t); and real equity return (er_t).
  - FCI constructed by aggregating impulse responses of GDP to financial variable shocks, using equation (2) as specified in the source.
  - Interpretation: a value of 1 means the total impulse of financial conditions to GDP is 1 percentage point, annualized; a decline from 1 to ½ would be expected to reduce GDP growth by ½ percentage point while still contributing positively.
- Key empirical findings:
  - The FCI was negative in 2002–03, generally positive from early 2004 to late 2007, and re-entered negative territory in 2008.
  - The 2008 deterioration in FCI owed mainly to higher interest rates, lagged effects of real exchange appreciation, and reversal of earlier stock price gains.
  - Changes in interest rates and the real effective exchange rate account for most of the changes in the FCI; the contribution of distance-to-default to the FCI is small.
  - Compared with 2007, financial conditions are expected to reduce growth by about ¾ percent in 2008–09.

### B. Disequilibrium model of supply and demand for credit
- Model specification (general-to-specific yielded):
  - Supply equation (in first differences; variables defined in text):
    - Equation (3) as presented in the source (coefficients preserved in the source format).
  - Demand equation:
    - Equation (4) as presented in the source (coefficients preserved in the source format).
  - Definitions: l_s = loan supply (real); m3 = broad money (real); sp_b/sp = banking sector share price relative to market average; dtd = distance-to-default; y = real GDP; mar = margin; l_d = loan demand (real); i = lending rate (real).
- Main results:
  - Growth in credit supply in 2008 was above the levels predicted by the model.
  - Excess loan demand present in 2002–05 largely disappeared by 2008.
  - Caveats: analysis does not account for other credit channels such as the bond market; aggregate estimation may mask sectoral differences where some enterprises or households may face tighter access.

### C. Impact of credit on GDP growth
- Estimation approaches:
  - OLS regression of output on loans (Table A1).
  - Instrumental variables regression using past values of loans as instruments (Table A2).
  - VAR estimates (Table A3).
- Selected regression results (as reported):
  - Table A1 (OLS Regression of Output on Loans; Obs. 63; R-squared 0.17)
    - ∆y_t-1: Coefficient -0.03, Std.Error 0.13, t-value -0.20
    - ∆y_t-2: Coefficient 0.30, Std.Error 0.11, t-value 2.70
    - ∆l_t: Coefficient -0.07, Std.Error 0.04, t-value -1.82
    - ∆l_t-1: Coefficient 0.07, Std.Error 0.03, t-value 2.07
    - ∆l_t-2: Coefficient 0.00, Std.Error 0.03, t-value 0.05
    - Constant: 0.01, Std.Error 0.00, t-value 3.89
  - Table A2 (IV Regression of Output on Loans; Obs. 63)
    - ∆l_t: Coefficient 0.00, Std.Error 0.05, t-value 0.08
    - ∆y_t-1: Coefficient -0.01, Std.Error 0.13, t-value -0.07
    - ∆y_t-2: Coefficient 0.24, Std.Error 0.12, t-value 1.96
    - Constant: 0.01, Std.Error 0.00, t-value 4.14
    - Note: Past values of loans are used as instruments.
  - Table A3 (VAR estimates; Included observations: 63)
    - Equation system coefficients (∆y, ∆l) reported with standard errors and t-statistics; Adj. R-squared: 0.33 (∆y), 0.39 (∆l); F-statistic 9.65 (∆y), 11.97 (∆l); Log likelihood 243.66 (∆y), 156.91 (∆l).
- Interpretation:
  - Coefficients on loan supply growth are consistently small and not statistically significant, suggesting that bank loan growth has had limited explanatory power for output growth in recent periods in Finland.
  - This result does not contradict the FCI finding that higher interbank rates contributed to reduced GDP growth; interbank rate effects are distinct from aggregate bank lending effects and other financing channels (e.g., bond market) also matter.

### D. Other relevant empirical observations
- Bond issuance (Figure A5): reported quarterly series for Non-financial corporations and Non-bank financial corporations for 2005 Q1 through 2008 Q3 (values shown in chart in source; axis in millions of euro).
- Household vulnerability: gross household debt has risen above disposable income; widespread recourse to floating rates increases vulnerability to adverse shocks, despite currently low debt-servicing costs.

### Conclusions and policy implications
- Financial conditions in Finland have tightened and are estimated to reduce real GDP growth in 2008–09 by about ¾ percentage point, mainly through higher interbank market rates since mid-2007 and lingering real exchange appreciation effects.
- Evidence does not point to supply-side banking problems (such as capital destruction or widespread unwillingness to lend) as the principal source of the tightening:
  - Distance-to-default contributed little to the FCI.
  - Disequilibrium estimates indicate credit supply in September 2008 was above model-predicted levels.
  - Finnish banks are described as well capitalized, with maintained access to interbank markets and a strong deposit base; deposits and corporate lending surged in the first three quarters of 2008.
- Because loan supply alone had limited measured impact on GDP growth, and absent further shocks, Finland may not require a large bank recapitalization package akin to some other developed economies; fiscal stimulus to support growth is also assessed as beneficial for the financial sector.
- Monitoring priorities:
  - Outlook for credit quality remains uncertain as external and domestic demand are expected to decelerate further.
  - Increased household leverage and floating-rate exposure raise vulnerability to adverse shocks even with low current debt-servicing costs.

*Source: Appendix I. Financial-Real Sector Linkages in Finland (IMF staff estimates and analysis) — extracted from the supplied content unit.*

### ANNEX II. FINLAND: STATISTICAL ISSUES

### ANNEX II. FINLAND: STATISTICAL ISSUES (As of December 5, 2008)

### Assessment of Data Adequacy for Surveillance
- General: Data provision is adequate for surveillance.

### Data Standards and Quality
- Subscriber to the Fund’s Special Data Dissemination Standard (SDDS) since June 3, 1996.
- Uses SDDS flexibility option on the timeliness of data on both general and central government operations.
- A data ROSC was electronically published on October 31, 2005.
- Finnish authorities have worked to satisfy the data ROSC mission team’s recommendations in the area of government finance statistics.
  - Increased the detail on revenue and expense classifications, now consistent with both ESA 95 and requirements of Eurostat’s quarterly GFS database, as well as the recommendations of the IMF’s Government Finance Statistical Manual, 2001.

### Table of Common Indicators (selected entries, as of December 5, 2008)
- Exchange Rates: Date of latest observation Nov. 19, 2008; Date received Nov. 19, 2008; Frequency D; Reporting D; Publication D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation Oct. 2008; Date received Nov. 2008; Frequency M; Reporting M; Publication M.
- Reserve/Base Money: Oct. 2008; Nov. 2008; M; M; M.
- Broad Money: Sept. 2008; Oct. 2008; M; M; M.
- Central Bank Balance Sheet: Oct. 2008; Nov. 2008; M; M; M.
- Consolidated Balance Sheet of the Banking System: Sept. 2008; Oct. 2008; M; M; M.
- Interest Rates: Nov. 19, 2008; Nov. 19, 2008; D; D; D.
- Consumer Price Index: Oct. 2008; Nov. 2008; M; M; M; Data Quality – Methodological soundness: O, O, O, O LO, O, LO, O, O; Data Quality – Accuracy and reliability: LO, LO, LNO, O.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation 2007; Date received Mar. 2008; Frequency A; Reporting A; Publication A; Data Quality – Methodological soundness: LO, LO, LNO, O; Data Quality – Accuracy and reliability: LO, O, O, O, O.
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: 2007; Mar. 2008; A; A; A.
- Stocks of Central Government and Central Government-Guaranteed Debt: Oct. 2008; Nov. 2008; M; M; M.
- External Current Account Balance: Sept. 2008; Nov. 2008; M; M; M.
- Exports and Imports of Goods and Services: Q2. 2008; Sept. 2008; M; M; M.
- GDP/GNP: Q2. 2008; Sept. 2008; Q; Q; Q; Data Quality – Methodological soundness: O, O, O, O LO, O, LO, O, O; Data Quality – Accuracy and reliability: LO, O, LO, O, O.
- Gross External Debt: Sept. 2008; Nov. 2008; M; M; M.
- International Investment Position: Sept. 2008; Nov. 2008; M; M; M.

### Statement by the IMF Staff Representative (January 30, 2009) — Economic Developments and Projections
- Recent developments:
  - Seasonally adjusted output fell by 1.6 percent year-on-year in October 2008.
  - Industrial production plunged by about 10 percent year-on-year in November 2008, with a near-collapse in the wood and paper industry.
  - New orders for manufacturing were off by one-third.
  - Consumer confidence in December dropped to its lowest level since the early 1990s.
  - Staff has pared down the estimate of 2008 GDP growth to 1½ percent.
  - The harmonized (HICP) inflation rate declined to 3.4 percent in December 2008.
  - Nominal hourly wages accelerated to 6.7 percent in the third quarter.
- Staff projections (revised):
  - 2009 GDP growth: -1 percent.
  - 2010 GDP growth: 1¼ percent.
  - The revision reflects lower activity among trading partners and reduced domestic demand.
  - External current account surplus in 2009 and the medium term is expected to shrink more than anticipated in the staff report.
- Fiscal and policy response:
  - Government adopted budgetary measures beyond tax cuts included in the draft 2009 budget, raising spending for building construction and renovation, and for infrastructure projects in transport and energy.
  - Overall package of discretionary loosening estimated at about 1¼ percent of GDP.
  - Headline surplus projected to decrease to 1¼ percent of GDP in 2009.
- Financial sector:
  - Banks’ capital adequacy remains well above minimum levels.
  - No use of government guarantees for debt issuance nor government-funded recapitalization needed as of statement.
  - Lending conditions tightened; credit growth remained robust through October 2008.

### Selected Economic Indicators (Staff Report and Revised figures)
- Real economy (GDP change in percent):
  - Staff Report 2008: 2.1
  - Revised 2008: 1.5
  - Staff Report 2009: 0.6
  - Revised 2009: -1.0
  - Staff Report 2010: 1.6
  - Revised 2010: 1.2
- Harmonized CPI (change in percent):
  - Staff Report 2008: 4.0
  - Revised 2008: 3.9
  - Staff Report 2009: 2.5
  - Revised 2009: 1.8
  - Staff Report 2010: 2.0
  - Revised 2010: 1.9
- Gross national savings (in percent of GDP):
  - Staff Report 2008: 26.2
  - Revised 2008: 26.4
  - Staff Report 2009: 25.1
  - Revised 2009: 24.5
  - Staff Report 2010: 24.2
  - Revised 2010: 23.0
- Gross domestic investment (in percent of GDP):
  - Staff Report 2008: 22.2
  - Revised 2008: 22.7
  - Staff Report 2009: 21.5
  - Revised 2009: 22.3
  - Staff Report 2010: 21.7
  - Revised 2010: 22.0
- Public finances (general government, percent of GDP):
  - Overall balance: Staff Report 2008: 4.7; Revised 2008: 4.2; Staff Report 2009: 2.7; Revised 2009: 1.3; Staff Report 2010: 2.4; Revised 2010: 0.9.
  - Primary balance: Staff Report 2008: 4.1; Revised 2008: 3.6; Staff Report 2009: 2.0; Revised 2009: 0.7; Staff Report 2010: 1.6; Revised 2010: 0.0.
  - Gross debt (Maastricht definition): Staff Report 2008: 32.4; Revised 2008: 32.6; Staff Report 2009: 31.2; Revised 2009: 32.0; Staff Report 2010: 29.2; Revised 2010: 30.0.
- Money and credit:
  - M3 (Finnish contribution to euro area): Staff Report 2008: 8.2; Revised 2008: 6.6.
  - Finnish MFI euro area loans: Staff Report 2008: 13.1; Revised 2008: 12.7.
- Interest rates (year average):
  - Three-month money market: Staff Report 2008: 4.8; Revised 2008: 4.6.
  - Ten-year government bonds: Staff Report 2008: 4.2; Revised 2008: 4.3.
- Balance of payments (in percent of GDP):
  - Trade balance: Staff Report 2008: 4.7; Revised 2008: 4.5; Staff Report 2009: 4.1; Revised 2009: 3.1; Staff Report 2010: 3.2; Revised 2010: 2.0.
  - Current account: Staff Report 2008: 4.0; Revised 2008: 3.6; Staff Report 2009: 3.5; Revised 2009: 2.3; Staff Report 2010: 2.5; Revised 2010: 1.0.
- Exchange rate:
  - Nominal effective exch. rate (increase in percent): Staff Report 2008: 0.3; Revised 2008: -0.8.
  - Real effective exchange rate (increase in percent) based on unit labor costs: Staff Report 2008: 1.8; Revised 2008: 0.6.

### Public Information Notice (PIN) — Executive Board Conclusions (February 4, 2009)
- Background and risks:
  - Spillovers from the global turmoil adversely affecting activity and may weaken the financial system.
  - High wage increases raised the risk of a wage-price spiral and could erode competitiveness.
  - Rapid aging and slowing productivity threaten longer-term growth, competitiveness, and fiscal sustainability.
  - Improved pension fund management could help cope with aging; growing financial integration and complexity create new risks and supervisory challenges.
- Short-term outlook and impacts:
  - Growth projected to decelerate to about 2 percent in 2008 and further to ½ percent in 2009 (earlier staff projection).
  - Cumulative direct impact of financial tightening on 2008–09 growth estimated at ¾ percentage points.
  - Inflation rose to 4¾ percent in late 2008.
  - Current account surplus has hovered around a sizable 4–4½ percent of GDP in recent years.
- Fiscal assessment:
  - General government surplus surged to 5¼ percent of GDP in 2007.
  - Recently adopted or anticipated discretionary measures imply a substantial reduction of the surplus, inconsistent with eventual stability of the public-debt-to-GDP ratio.
- Financial sector assessment:
  - Banks largely sheltered from the turmoil; key financial stability indicators remain quite healthy; exposure to “toxic assets” is minimal.
  - With some 60 percent of banking assets foreign-owned, strengthened cross-country supervision is key.
  - Insurance and pension companies suffered significant losses owing to plummeting capital markets, although minimum solvency ratios continue to be met.

### Executive Board Assessment — Recommendations and Policy Guidance
- Fiscal policy:
  - Structural fiscal relaxation warranted in present circumstances as part of a coordinated EU-wide fiscal stimulus consistent with European Council guidelines.
  - Short-term budgetary easing should not adversely affect long-term fiscal sustainability.
  - Use measures that can be implemented rapidly and scaled back once activity rebounds.
  - Once growth resumes, early action should be taken to address long-term fiscal sustainability.
  - Expenditure restraint should be the lynchpin of efforts to achieve fiscal sustainability.
  - Improve expenditure efficiency and consider user fees to moderate demand for public services.
  - Support a shift from labor income to less distortionary taxation to help increase labor force participation.
  - Most Directors considered the planned cut in the value added tax rate on food to be undesirable on efficiency grounds; a few Directors saw merit for equity and as short-term stimulus.
  - Recent easing of pension fund investment guidelines could lead to higher long-term returns and buttress the long-term fiscal position.
- Competitiveness and labor market:
  - Real exchange rate maintains a moderate margin of external competitiveness; competitiveness is adequate but could be undermined if high wage awards in excess of productivity gains continue.
  - Raise labor utilization and productivity growth to support economic growth and fiscal sustainability.
  - Authorities’ intention to raise the still-low effective retirement age welcomed.
  - Shift to less centralized wage bargaining and differentiated wage increases recommended to reflect productivity differentials and stimulate labor force participation while preserving competitiveness.
  - Additional measures urged to enhance competition and productivity in product markets, especially in “sheltered” sectors.
- Financial sector vigilance:
  - Authorities commended for effective supervision; stress tests indicate banks could withstand fairly severe shocks.
  - Urged to remain vigilant to financial sector risks, particularly adverse effects on bank profitability and liquidity through contagion from parent banks.
  - Welcomed steps to guarantee bank debt renewal and to recapitalize banks if needed; urged further enhancements in cooperation with home supervisors of foreign-owned banks.

*Source: _cr0939 - ANNEX II. FINLAND: STATISTICAL ISSUES (As of December 5, 2008) and related sections of the IMF staff report and PIN included in the supplied content.*

### 1. Finland’s outlook as a small open economy is intimately connected with the state of

### 1. Finland’s outlook as a small open economy is intimately connected with the state of

### Recent Economic Developments and Outlook
- Finland’s outlook is closely tied to the international business cycle; a sharp deterioration in the external environment led to a more rapid than expected turnaround in economic activity.
- Close-to-potential GDP growth in the first half of 2008 was followed by a significant slowdown toward the end of 2008.
- A slump in new orders and cancellations of existing orders, coupled with tighter financing conditions, has made industry prospects bleak; a rapid fall in investments, a wave of lay-offs and weakening consumer confidence have followed. The construction sector has been hard-hit by the subdued state of the housing market.
- Authorities’ expectations for 2009: they indicated they expect the Finnish GDP to contract by more than 2 percent in 2009.
- Recovery: a gradual recovery will likely follow the bottoming out of the global downturn.
- Employment:
  - Rapid employment gains stabilized toward the end of 2008.
  - The unemployment rate is now set to rise for the first time in 15 years.
  - Authorities envisage the unemployment rate will climb up to 8 – 9 percent by the end of 2009, compared to just over 6 percent last year.
- Demand composition: the downturn has left growth in public demand as the main driving force in national output; lower global demand, a rise in labour costs from the 2007 wage negotiations and scaling down of forest industry production capacity have produced a discouraging outlook for exporters.
- Investment and consumption: tighter financing conditions and the decline in construction have weighed down investment plans; cuts in industrial output and rising unemployment have eroded consumer confidence and the projected increases in real disposable incomes over 2009-2010 do not fully translate into higher consumption.
- Inflation: after being suppressed for years, inflation accelerated early last year and exceeded the euro area average by mid-2008; with reversal of energy prices and rapid cooling of demand, the pace of increase in consumer prices should fall close to or below 2 percent in 2009 and 2010.

### Financial Sector Developments
- Overall assessment: authorities share staff’s view that the overall situation in the Finnish financial markets is still relatively unproblematic.
- Banks:
  - Banks’ short-term liquidity position is healthy and capital adequacy ratios are on solid levels.
  - The cost of longer-term funding has increased markedly.
  - Banks’ profitability is weakening in line with rapidly slowing growth, falling interest rates and reduced demand for housing loans and financial services in general.
- Policy measures implemented in line with EU principles agreed October 2008:
  - State guarantee scheme (Parliament approved December 2008):
    - Allows adequately capitalised banks to apply for a state guarantee on new short- or medium-term funding of up to 50 billion euros.
    - Scheme is in place until the end of April with an option to extend to the end of the year.
    - Pricing of guarantees will follow the recommendations of the ECB.
  - Precautionary recapitalization proposal (to be presented in early February):
    - Capital provided through subordinated loans and access limited to solvent banks.
    - Total amount limited to 4 billion euros.
    - Interest on the loans is the sum of the state’s five-year funding cost and a 600 basis point overall premium.
    - Interest payments take seniority over dividends.
    - Loan conditions include reporting requirements on the bank’s lending behaviour.
    - Both the state guarantee and the recapitalization schemes entail restrictions to executive pay.
- Corporate sector pressures: worsening financial situation in the corporate sector is putting banks under growing pressure to increase funding especially for large Finnish companies; authorities plan additional actions to alleviate companies’ financing difficulties.
- State pension fund: was granted the right to purchase limited amounts of domestic corporate commercial paper.
- Pension funds outlook:
  - Despite strongly negative returns in 2008, the longer term outlook for the Finnish pension funds remains broadly favourable.
  - 2007 reform of investment guidelines aimed at a gradual 2 percent per annum rise in the pension funds’ portfolio share of equities, which could result in the long-term real return rising to 4 percent a year.
  - Temporary relaxation of the funds’ solvency rules at the end of last year has improved their financial health.
- Supervision: Starting from 2009, the Financial Supervision Authority and the Insurance Supervisory Authority merged into the Financial Supervisory Authority with a mandate over both sectors, enabling more efficient utilisation of expertise and resources.

### Fiscal Policy
- 2009 budget and November 2008 amendments introduced stimulative measures: tax-cuts on labour and pensions; measures to boost infrastructure investment, housing construction and renovation; measures to perk business operating potential and financing options; cut in food VAT (motivated by equity and may boost private consumption).
- Discretionary stimulus to date: 1.2 percent of GDP (in line with the amount agreed under the European Economy Recovery Plan by the European Council in December 2008).
- Total budgetary impact (including automatic stabilizers): roughly 2 ½ percent of GDP.
- Authorities intend to introduce additional fiscal measures in a supplementary budget proposal in early February 2009.
- Fiscal positions and projections:
  - 2008 general government surplus is estimated to have remained above 4 percent of GDP.
  - 2009 will see erosion of the general government surplus due to rapid fall in cyclically sensitive tax revenues, rise in unemployment-related expenditure and expansionary budget.
  - Central government balance will slip into deficit in 2009 for the first time this decade.
  - Local government finances expected to slide from a near-balance to a slight deficit, widening further in 2010.
  - Near-term general government surplus hinges entirely on the employment pension funds.
  - Debt-to-GDP ratio will increase substantially from its 2008 level of 33 percent.
- Long-term sustainability:
  - Authorities concur that the near-term state of public finances is inconsistent with long-term fiscal sustainability, estimated to require a general government surplus of around 4 percent in the medium term.
  - Government will assess in late February whether sufficient provision has been made for the ageing population so that any necessary reforms can be launched by 2011 while it is still in office.
  - Growth in public spending will be curbed by structural measures and enhancements in public sector efficiency via the Government productivity programme and restructuring of municipalities (shift from local government mergers toward reform of service structures).
  - A working group examining possible reforms to the tax system is due to complete its efforts by the end of 2010.
  - Prospect of rising long-term real return on pension fund assets may improve the general government balance in the long run.

### Structural Policies
- Labour market and social security:
  - Authorities concur on need for further labour and product market reforms.
  - Two working groups focus on labour market mismatches and “flexicurity”; Government launched a comprehensive review of whole social security legislation.
  - Committee presented its mid-term report in January 2009.
  - Main elements under consideration: the unemployment pipeline, disability pensions and rehabilitation of workers outside the labour force.
  - Sizeable income tax cuts and targeted increases in appropriations are expected to further improve labour market dynamics.
- Product market reforms:
  - Two working groups examine further product market reforms:
    - “Competition Law 2010” analyzes needs to reform current competition law.
    - “Level playing field” looks into regulations, including tax laws, that are not neutral with respect to private and public sector players in product markets.
  - Both working groups are to reach conclusions this winter.
  - Government has launched a new innovation strategy seeking to enhance the economy’s innovation capacity and identify areas where reforms are necessary.
- Wage-setting:
  - After meagre results from the decentralized 2007 round of wage negotiations, authorities are considering a new structure to improve provision of information on wage and price developments and mitigate leap-frogging between employee groups.
  - Partially owing to the downturn, wage increases from the next round of negotiations in 2010 are anticipated to be modest.

*Source: _cr0939 - 1. Finland’s outlook as a small open economy is intimately connected with the state of*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0939.pdf_