## _cr10273

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---

### Economic situation and outlook
- GDP fell almost 8 percent in 2009—the worst in the euro area—reflecting adverse trade and financial international spillovers.
- Real GDP (percent change): 2007: 4.9; 2008: 1.2; 2009: -7.8; 2010 (proj.): 1.2; 2011 (proj.): 2.0.
- Components of demand (percent change):
  - Consumption: 2007: 2.7; 2008: 2.0; 2009: -1.3; 2010 (proj.): 1.5; 2011 (proj.): 1.6.
  - Private consumption: 2007: 3.4; 2008: 1.7; 2009: -2.1; 2010 (proj.): 1.6; 2011 (proj.): 2.0.
  - Gross fixed capital formation: 2007: 10.6; 2008: -0.2; 2009: -13.4; 2010 (proj.): -2.5; 2011 (proj.): 3.5.
- Net exports contribution to growth (percent): 2007: 1.2; 2008: 0.3; 2009: -1.8; 2010 (proj.): 1.1; 2011 (proj.): 0.2.
- Inflation, labor market, and output gap indicators:
  - Harmonized CPI: 2007: 1.6; 2008: 3.9; 2009: 1.6; 2010 (proj.): 1.4; 2011 (proj.): 1.8.
  - GDP deflator: 2007: 3.3; 2008: 1.4; 2009: 0.6; 2010 (proj.): 1.7; 2011 (proj.): 2.0.
  - Employment (percent change): 2007: 2.0; 2008: 1.6; 2009: -2.9; 2010 (proj.): -1.7; 2011 (proj.): 0.4.
  - Unemployment rate (percent of labor force): 2007: 6.8; 2008: 6.4; 2009: 8.3; 2010 (proj.): 8.8; 2011 (proj.): 8.7.
  - Labor compensation (economy-wide, percent change): 2007: 4.7; 2008: 5.2; 2009: 2.4; 2010 (proj.): 2.7; 2011 (proj.): 2.8.
  - Unit labor costs (economy-wide, percent change): 2007: 1.0; 2008: 5.4; 2009: 6.8; 2010 (proj.): -0.3; 2011 (proj.): 1.2.
  - Output gap (percent of potential): 2007: 5.4; 2008: 4.3; 2009: -4.3; 2010 (proj.): -3.7; 2011 (proj.): -2.9.
- Domestic demand contracted less than exports because generous pay raises supported private consumption but eroded external competitiveness.
- Activity resumption projected subdued for 2010–11; growth mildly negative in both 2009Q4 and 2010Q1 (a technical double dip).

### Financial sector: resilience, risks, supervision
- System overview:
  - Banks are majority foreign-owned, highly concentrated, conservative, and have limited exposure to opaque structured products or risky regions.
  - Banking system weathered global turmoil relatively well, supported by healthy capital buffers and prudent management.
- Asset quality and profitability:
  - Nonperforming loan rate: 2008: 0.5 percent; 2009: 0.7 percent.
  - Bank profits plunged in 2008–09 but remained positive.
- Capital and liquidity:
  - Tier 1 CAR declined slightly in 2008 then improved in 2009.
  - Equity and near-equity funds accounted for 92 percent of regulatory capital.
  - Liquidity: wholesale liquidity tightened somewhat; liquidity buffers relatively low (Finland ranks fourth lowest out of 26 for the cash and trading assets ratio).
- Insurance and pensions:
  - Financial condition recovered in 2009; solvency ratios improved as equity prices recuperated.
  - Authorities amended solvency regulations for employee pension institutions, boosting long-term investments until end-2010.
- Stress tests and risks:
  - Stress tests benign but identify credit, liquidity, and concentration as sources of risk.
  - Staff warns banks to avoid higher-risk activities such as unexpectedly strong mortgage lending amid surging home prices.
- Supervision and crisis management:
  - Need to boost effectiveness for large cross-border institutions and mitigate too-big-to-fail risks.
  - Authorities broadly endorsed EU and Basel initiatives but expressed concerns about burden sharing and impact on funding and credit.
- Staff view: continued prudence and improvements to supervision are needed.

### Fiscal position, short-term stance, and policy recommendations
- Fiscal deterioration and outlook:
  - General government headline balance: 2008 surplus 4 percent of GDP → 2009 deficit 2½ percent of GDP.
  - Large increase in budget deficit in 2009–10 reflects substantial discretionary stimulus and the cyclical downturn.
  - Authorities contemplate fiscal tightening in 2011 of 1½ percent of GDP.
- Staff advice:
  - With negative output gaps through 2014, advise a measured pace of consolidation unless robust growth emerges.
  - Recommended consolidation: start in 2011 with a measured structural adjustment of ¾ percent of GDP; beyond 2011, about ½ percent of GDP per annum on average to close sustainability gap by 2020.
  - Prioritize expenditure containment and tax base broadening.
- Key fiscal figures (percent of GDP, staff table):
  - Total revenue: 2008: 53.6; 2009: 53.2; 2010: 52.6; 2011 (Staff): 54.0.
  - Total expenditure: 2008: 49.5; 2009: 55.6; 2010: 56.7; 2011 (Staff): 56.3.
  - Fiscal balance: 2008: 4.1; 2009: -2.4; 2010: -4.1; 2011 (Staff): -2.2.
  - Primary balance: 2008: 5.6; 2009: -1.0; 2010: -2.8; 2011 (Staff): -0.8.
  - Structural balance (percent of potential GDP): 2008: 1.7; 2009: 0.1; 2010: -1.5.
  - General government debt (percent of GDP): 2009: 44.0; 2010: 49.9; 2011: 52.0.
- Short-term 2010 measures: cuts in labor income taxes; expansion of social benefits; investment; transfers/subsidies/tax allowances for businesses.
- Staff cautions on composition: only about one-third of discretionary expansion for 2009–10 (~3½ percent of GDP) is temporary; remainder may add about 2 percent of GDP permanently to structural deficit.

### Long-term fiscal sustainability and recommended measures
- Sustainability gap:
  - Staff estimate increased from "1½–2½ percent of GDP" in SR2008 to "about 6 percent of GDP" (evaluated as of 2011).
  - Staff indicates adjustment slightly higher than ½ percent of GDP per annum could close the gap by 2020.
- Aging pressures:
  - Expected aging-related spending increase: 5½ percent of GDP over 2011–60 on account of pensions, health- and old-age care.
  - ECFIN baseline: aging pressures add "6.4 percent of GDP" (2007–2060); pension: "3.3 percent of GDP"; long-term care: "2.6 percent of GDP"; health-care: "1 percent of GDP".
- Measures to achieve sustainability:
  - Expenditure retrenchment should carry the brunt.
  - Pension reforms: raise effective retirement age, lower accrual rates, tighten early retirement access.
  - Health and long-term care: increase user fees; tighten entitlements; productivity increases; benchmarking.
  - Local government reform: reduce reliance on corporate taxes; consider ceiling on municipal income tax rates; mergers to improve efficiency.
  - Revenue-side focus: base broadening; shift from labor to consumption and property taxation; reduce number of reduced VAT items; consider raising property taxation; curtail mortgage interest deductibility.
- Pace and flexibility:
  - Staff recommend measured consolidation beginning 2011 (¾ percent of GDP) and average ½ percent per annum thereafter to 2020; allow flexibility to delay headline adjustment in exchange for structural measures that improve long-run sustainability.

### Structural reforms, exit strategy, and growth prospects
- Structural reforms:
  - Boost labor participation, increase competition in services, foster innovation, reform tertiary education financing, and improve public productivity (municipal mergers, outsourcing).
  - Measures to expand labor participation: tax incentives, intensified training, reduce pipelines to early retirement.
- Exit strategy:
  - Crisis support measures designed with sunset provisions; many initiatives expire or have expired (e.g., guarantees and capitalization facilities).
  - Exit includes repayment of resources received by distressed nonfinancial companies and gradual downsizing of temporary employment support programs.
- Potential output and medium-term outlook:
  - Potential growth expected around 1½ percent over the medium term.
  - Permanent decline in level of potential output—7 percent by 2015 relative to no-crisis path.
  - Medium-Term Macroeconomic Framework (selected annual values):
    - Real GDP growth: 2009 -7.8; 2010 1.2; 2011 2.0; 2012 2.0; 2013 2.1; 2014 2.1; 2015 2.1.
    - Output gap (percent of potential GDP): 2009 -4.3; 2010 -3.7; 2011 -2.9; 2015 0.0.
    - Consumer price inflation (annual average): 2009 1.6; 2010 1.4; 2011 1.8.
    - Employment growth: 2009 -2.9; 2010 -1.7; 2011 0.4.
    - Unemployment rate: 2009 8.3; 2010 8.8; 2011 8.7.
    - General government balance (percent of GDP): 2009 -2.4; 2010 -4.1; 2011 -2.2.
    - General government debt (percent of GDP): 2009 44.0; 2010 49.9; 2011 52.0; 2015 65.8.

### Household, corporate, and credit-market developments
- Household balance sheets and interest rate risk:
  - Financial assets of households almost returned to pre-crisis level.
  - Household debt, especially mortgages, has grown; high proportion of loans with floating interest rates and shortened repricing maturities shift interest rate risk to households.
  - Household loan servicing capacity declined; increasing problem loans.
- Residential and commercial real estate:
  - Real home prices stagnant in 2008–09 after over 30 percent appreciation in 2000–07; started ascending fast again late in prior year.
  - Office rents fell by more than 10 percent in 2009; Finland’s CRE vulnerability high compared to Nordic peers.
- Corporate balance sheets and funding:
  - Firms entered crisis with solid balance sheets but vulnerabilities rose.
  - 2008: short-term loans to nonfinancial companies increased as firms turned to banks.
  - 2009: corporations tapped international bond and syndicated loan markets; medium and large firms increased borrowing from pension funds; small firms relied on public funding (Finnvera).
  - Payment defaults and bankruptcies rose steeply in the slowdown but began decelerating; expected default-frequency indicators improving.
- Financial Conditions Index (FCI) and credit-market imbalances:
  - FCI reached -0.91 in Q4 2008; raised to near 0 during Q3 2009.
  - Staff estimates cumulative negative direct contribution of prevailing financial conditions to 2008–09 growth at 1½–2 percentage points.
  - Credit stock peaked Q3 2008 then decreased; second half of 2009 saw excess demand turn to credit contraction which had practically disappeared by end-2009.
  - VAR and VEC analyses do not identify a robust long-run relationship between credit and GDP or investment; a positive but relatively weak relationship detected between private consumption and credit (estimated elasticity close to 0.25; cointegration not significant at 5 percent; Johansen trace p-value at rank 1 = 0.1059).

### External vulnerabilities and cross-border spillovers
- Trade shock and export composition:
  - Finnish merchandise trade decreased approximately by one third in 2009 relative to 2008.
  - Exports concentrated in telecommunications (TLC) and capital goods (sensitive to world investment collapse) and in paper (trend decline).
  - At least two-thirds of exports highly sensitive to world investment collapse or in trend decline.
- International financial exposures (September/December 2009 / end June 2009 figures presented):
  - Total foreign claims (Immediate Borrower Basis, end December 2009): US$ 217.60 Billion (100.00%).
  - Total international claims: US$ 96.11 Billion (44.17%).
  - By maturity (Immediate Borrower Basis): up to and including one year: US$ 35.60 Billion (16.36%); over one year up to two years: US$ 7.00 Billion (3.22%); over two years: US$ 36.30 Billion (16.68%).
  - By sectors: Bank: US$ 23.93 Billion (11.00%); Public sector: US$ 23.19 Billion (10.66%); Non-bank private sector: US$ 48.26 Billion (22.18%).
  - Local currency positions of reporting banks' foreign offices with local residents: Claims US$ 121.49 Billion (55.83%); Liabilities US$ 87.15 Billion (40.05%); Net risk transfers: -0.25.
  - Total foreign claims (Ultimate Risk Basis): US$ 217.35 Billion.
- Spillover simulation results (staff calculations):
  - A more pessimistic scenario of 10 percent default rate across Europe, US, or Japan could reduce credit availability by approximately one third and produce losses for banks up to 5 percent of GDP.
  - Selected simulation results (Shock Origin, Magnitude, Deleveraging Need (%), Finnish Lenders' Losses (% GDP), Impact on Credit Availability (%)):
    - Europe, magnitude 10: Deleveraging Need 35.4; Finnish Lenders' Losses 3.8; Impact on Credit Availability -28.7.
    - Europe and US, magnitude 10: Deleveraging Need 57.7; Finnish Lenders' Losses 5.0; Impact on Credit Availability -37.6.
    - Europe, US and Japan, magnitude 10: Deleveraging Need 58.6; Finnish Lenders' Losses 5.0; Impact on Credit Availability -37.9.
    - Germany, magnitude 10: Deleveraging Need 0.0; Finnish Lenders' Losses 0.1; Impact on Credit Availability -1.0.
    - Germany, magnitude 25: Deleveraging Need 0.0; Finnish Lenders' Losses 0.3; Impact on Credit Availability -1.2.
- Concentration:
  - Foreign claims originate in a few European countries (e.g., Sweden associated with almost 50 percent of certain claims); foreign banks account for about two-thirds of Finnish banking system assets.

### FSSA Update, supervision, and regulatory recommendations
- FSSA and supervisory findings:
  - Credit quality identified as a key challenge; NPLs low relative to most EU economies but could rise with higher interest rates and unemployment.
  - Four largest banking groups account for 94 percent of total banking assets.
  - Stress tests find system resilient to adverse shocks; main risks: credit, contagion, concentration, and liquidity.
  - Low liquidity buffers and reliance on wholesale funding remain vulnerabilities.
- FSSA recommendations and supervisory enhancements:
  - Enhanced monitoring of mortgage practices and household debt service; compile mortgage portfolio and LTV ratio information.
  - Strengthen top-down stress testing with bank-by-bank macro-financial impact modeling.
  - Improve synergies between Bank of Finland research, financial stability divisions, and the FSA.
  - Use more granular information and include non-bank financial sector and cross-border linkages in systemic risk assessment.
  - Introduce a special resolution regime for banks and financial groups to facilitate prompt intervention and broaden options for allocating losses to the private sector.
  - Strengthen guidance on mortgage LTV ceilings and borrower repayment capacity testing (suggested stress at 6 percent interest).
  - Step up vigilance on liquidity risk and banks’ funding profiles.
- Authorities’ concerns:
  - Worry that EU burden-sharing may not cover smaller Nordic institutions active in Finland; may seek moderation of regulatory tightening given heavy reliance on wholesale funding.
- Supervisory actions:
  - FSA guidance: abstain from granting mortgages with LTV ratios higher than 90 percent; assess borrower capacity to repay at an interest rate of at least 6 percent.

### Key quantitative highlights and selected risks
- Recession and recovery:
  - GDP fell by -7.8 in 2009; projected growth 2010–15: 1.2, 2.0, 2.0, 2.1, 2.1, 2.1.
- Fiscal deterioration and debt:
  - General government gross debt: 2007: 35.2; 2008: 34.2; 2009: 44.0; 2010: 49.9; 2011: 52.0.
- Households and corporate indebtedness:
  - Total household debt (percent of GDP, selected): 2005: 44.0; 2006: 47.1; 2007: 48.2; 2008: 50.6; 2009: 56.7.
  - Debt-to-income ratio: 89.1; 96.5; 101.0; 103.1; 105.1 (series provided).
- Banking sector indicators (selected):
  - Non-performing loans/total loans (in percent): 0.27; 0.26; 0.28; 0.50; 0.70; 0.76 (as of March 2010).
  - Regulatory capital as percent of risk-weighted assets: 17.2; 15.1; 15.1; 13.6; 14.5; 14.5.
  - Equity/total assets (in percent): 9.9; 9.8; 8.3; 7.4; 6.4; 6.2.
- External position:
  - Current account (percent of GDP): 2000–08 around 4 percent; plunged to 1¼ percent in 2009; projected to recover to about 2 percent in 2010–11; medium-term expected to stabilize around 2 percent.
  - NIIP projections: series shows improvement toward positive territory by 2015 (Table 1 NIIP: -29.6 -8.1 -10.6 -7.3 -3.9 -0.7 2.5 5.8 9.0).
- Risks to the outlook:
  - Main risk categories: (i) lending and financial conditions including asset prices; (ii) domestic and external demand; (iii) size/effect of monetary and fiscal policy measures.
  - Overall risks unusually uncertain but roughly balanced with pronounced dispersion.
- Policy priorities:
  - Near term: consolidate financial-sector health, monitor bank risk-taking, address profitability, credit quality, and low liquidity buffers, balance fiscal support and prevention of continuous budget worsening.
  - Longer term: strengthen financial stability, ensure fiscal sustainability, advance structural reforms to boost potential output, improve cross-border supervision and crisis management for systemic institutions.

*Italic: Executive Summary and selected sections from IMF staff report _cr10273 (Article IV Consultation informational annex and FSSA Update) as provided in the source PDF.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Economic situation and outlook
- GDP fell almost 8 percent in 2009—the worst in the euro area—reflecting adverse trade and financial international spillovers.
- Real GDP (percent change): 2007: 4.9; 2008: 1.2; 2009: -7.8; 2010 (proj.): 1.2; 2011 (proj.): 2.0.
- Components of demand (percent change): Consumption 2007: 2.7; 2008: 2.0; 2009: -1.3; 2010 (proj.): 1.5; 2011 (proj.): 1.6. Private consumption 2007: 3.4; 2008: 1.7; 2009: -2.1; 2010 (proj.): 1.6; 2011 (proj.): 2.0. Gross fixed capital formation 2007: 10.6; 2008: -0.2; 2009: -13.4; 2010 (proj.): -2.5; 2011 (proj.): 3.5.
- Net exports contribution to growth (percent): 2007: 1.2; 2008: 0.3; 2009: -1.8; 2010 (proj.): 1.1; 2011 (proj.): 0.2.
- Inflation, labor market, and output gap indicators:
  - Harmonized CPI: 2007: 1.6; 2008: 3.9; 2009: 1.6; 2010 (proj.): 1.4; 2011 (proj.): 1.8.
  - GDP deflator: 2007: 3.3; 2008: 1.4; 2009: 0.6; 2010 (proj.): 1.7; 2011 (proj.): 2.0.
  - Employment (percent change): 2007: 2.0; 2008: 1.6; 2009: -2.9; 2010 (proj.): -1.7; 2011 (proj.): 0.4.
  - Unemployment rate (percent of labor force): 2007: 6.8; 2008: 6.4; 2009: 8.3; 2010 (proj.): 8.8; 2011 (proj.): 8.7.
  - Labor compensation (economy-wide, percent change): 2007: 4.7; 2008: 5.2; 2009: 2.4; 2010 (proj.): 2.7; 2011 (proj.): 2.8.
  - Unit labor costs (economy-wide, percent change): 2007: 1.0; 2008: 5.4; 2009: 6.8; 2010 (proj.): -0.3; 2011 (proj.): 1.2.
  - Output gap (percent of potential): 2007: 5.4; 2008: 4.3; 2009: -4.3; 2010 (proj.): -3.7; 2011 (proj.): -2.9.
- Domestic demand contracted much less than exports because generous pay raises supported private consumption but led to erosion of external competitiveness (external competitiveness still described as adequate).
- Activity resumption is projected to be subdued for 2010–11, with growth remaining well below potential; growth was mildly negative in both 2009Q4 and 2010Q1 (technically a double dip recession).

### Financial sector: resilience, risks, and supervision
- The financial sector weathered the global turmoil relatively well, supported by healthy capital buffers and prudent management in a stern regulatory and supervisory environment.
- Banking system characteristics and performance:
  - Banks are majority foreign-owned and highly concentrated, follow a conservative business model, and have limited exposure to opaque structured products or risky regions.
  - Profitability and asset quality deteriorated in the turmoil:
    - Nonperforming loan rate increased to 0.7 percent in 2009 from 0.5 percent in 2008.
    - Bank profits plunged in 2008–09 but remained positive, reflecting rising loan losses and declining net interest income amid rapidly falling loan rates.
  - Capital ratios:
    - After declining slightly in 2008, the Tier 1 capital adequacy ratio (CAR) improved in 2009 owing to partial portfolio reallocation toward less risky assets and expiration of some transitional additional capital requirements.
    - Equity and near-equity funds accounted for 92 percent of regulatory capital.
  - Liquidity:
    - Wholesale liquidity tightened somewhat; interbank markets were not frozen at the crisis peak.
    - Banks benefited from a shift from mutual funds into bank deposits.
    - Liquidity buffers are relatively low (Finland ranks fourth lowest out of 26 for the cash and trading assets ratio per EU Banking Stability report p. 52).
- Insurance companies and pension funds:
  - Financial condition recovered in 2009 after sharply weakening in 2008; solvency ratios improved as equity prices recuperated and the slide in interest rates halted.
  - Authorities amended solvency regulations for employee pension institutions, boosting their long-term investments until end-2010 to avoid forced sale of shareholdings.
- Stress tests and identified risks:
  - Stress tests of the banking system are benign but identify credit, liquidity, and concentration as sources of risk.
  - Staff warned banks to be cautious in engaging in higher risk activities, such as unexpectedly strong mortgage lending amid recently surging home prices.
- Supervision and crisis management:
  - Officials agreed on the need to boost effectiveness of supervision and crisis management for large cross-border institutions and to mitigate too-big-to-fail risks.
  - Authorities broadly endorsed EU and Basel initiatives to reform supervision and regulation, while expressing concern about burden sharing arrangements and the impact on bank funding and credit.
- Staff view: continued prudence and improvements to supervision are needed.

### Fiscal position and policy recommendations
- Consensus that the fiscal position has weakened considerably and early credible adjustment is required.
- The large increase of the budget deficit in 2009–10 reflects substantial discretionary stimulus as well as the cyclical downturn; staff views the relaxation as appropriate, but notes the fiscal sustainability gap has risen substantially.
- Authorities contemplate ambitious fiscal tightening in 2011 of 1½ percent of GDP.
- Staff advice:
  - With negative output gaps forecast through 2014, staff advised a more measured pace of consolidation unless clear evidence emerges of more robust growth.
  - Beyond 2011, authorities broadly supported staff’s recommended aim to close the sustainability gap by 2020, with focus on expenditure containment and tax base broadening.
- Related fiscal indicators and developments (selected):
  - Table references and analytical note: Analytical Note 5 addresses Long Run Fiscal Sustainability in Finland, with sections on recent fiscal developments and outlook, deterioration of fiscal sustainability, and measures to achieve sustainability.

### Structural reforms and exit strategy
- Further structural reforms would alleviate adverse impacts of the crisis and population aging on growth, and facilitate fiscal consolidation.
- No major structural actions were envisaged before the 2011 general election.
- Exit strategy considerations are discussed in the report’s sections on Policy Discussions and Exit Strategy (Section II, parts C and D).

### Cross-border spillovers and external vulnerabilities (Box 1 highlights)
- Extensive trade linkages deepened the severity of the global crisis in Finland; Finnish merchandise trade decreased approximately by one third in 2009 relative to 2008.
- Export composition and concentration:
  - Exports concentrated in telecommunications (TLC) and capital goods—highly sensitive to the world investment collapse—and in paper, which is in trend decline.
  - At least two-thirds of exports are highly sensitive to the world investment collapse or in trend decline.
- International financial exposures:
  - Finnish banking system has a relatively high share of foreign claims, especially in Western Europe, increasing susceptibility to deteriorating conditions abroad; diversification diminishes risks from a localized financial shock.
  - Finnish banks' foreign claims (September 2009, USD Billion / Share (%)):
    - Total foreign claims (Immediate Borrower Basis): 216.8 / 100.
    - Total international claims: 100 / 46.1.
    - By maturity: Up to and including one year 31.6 / 38.6; Over one year up to two years 7.3 / 8.9.
    - By sectors: Bank 27.2 / 27.4; Public sector 22.8 / 23.0; Non-bank private sector 49.2 / 49.6.
    - Local currency positions of reporting banks' foreign offices with local residents: 116.8 / 53.9.
    - Net risk transfers: -0.5.
    - Total foreign claims (Ultimate Risk Basis): 216.3.
- Spillover simulation results (staff calculations based on BIS and IFS data):
  - A more pessimistic scenario of 10 percent default rate across Europe, US, or Japan could reduce credit availability by approximately one third and produce considerable losses for banks, up to 5 percent of GDP.
  - Selected results (Shock Origin, Magnitude, Deleveraging Need (%), Finnish Lenders' Losses (% GDP), Impact on Credit Availability (%)):
    - Europe, magnitude 10: Deleveraging Need 35.4; Finnish Lenders' Losses 3.8; Impact on Credit Availability -28.7.
    - Europe and US, magnitude 10: Deleveraging Need 57.7; Finnish Lenders' Losses 5.0; Impact on Credit Availability -37.6.
    - Europe, US and Japan, magnitude 10: Deleveraging Need 58.6; Finnish Lenders' Losses 5.0; Impact on Credit Availability -37.9.
    - Germany, magnitude 10: Deleveraging Need 0.0; Finnish Lenders' Losses 0.1; Impact on Credit Availability -1.0 (and alternative magnitude 25: Deleveraging Need 0.0; Finnish Lenders' Losses 0.3; Impact on Credit Availability -1.2).
    - Results for other partner countries are reported in Box 1 and indicate varying but generally manageable direct losses, with concentrated foreign claims implying asymmetric spillovers (e.g., Sweden most affected by a Finnish default scenario).
- Foreign claims on Finnish banks are significant and foreign banks’ share of the Finnish banking system accounts for about two-thirds of its assets, originating in just a few European countries.

*Executive Summary from _cr10273 - EXECUTIVE SUMMARY*

### 7.      Household balance sheets are rallying, but risks have increased, in particular

### 7.      Household balance sheets are rallying, but risks have increased, in particular

### Household balance sheets and interest rate risk
- Financial assets of households have almost returned to pre-crisis level.
- Household debt, especially mortgages, has grown stimulated by low rates.
- The proportion of loans with floating interest rates is very high, and repricing maturities have shortened—shifting significant interest rate risk from banks to households.
- Household loan servicing capacity has declined, leading to increasing problem loans.

### Residential and commercial real estate
- Real home prices:
  - Remained stagnant in 2008–09 after having appreciated by over 30 percent in 2000–07.
  - Started to ascend fast again at the end of last year; staff and other analyses show prices broadly in line with fundamentals, but the sudden acceleration in the last six months points to increasing hazards if the trend continues.
- Commercial real estate (CRE):
  - Office rents fell by more than 10 percent in 2009.
  - Finland’s vulnerability in CRE is high compared to Nordic peers.

### Corporate balance sheets and funding
- Firms entered the crisis with solid balance sheets, but vulnerabilities have risen.
- During 2008 capital market turmoil:
  - Short-term loans to nonfinancial companies increased significantly as firms turned to banks for funding.
- In 2009:
  - Corporations tapped international bond and syndicated loan markets; the stock of bank loans slightly decreased.
  - Medium and large firms increased borrowing from employee pension funds at relatively high cost.
  - Small enterprises faced tighter collateral requirements and increasingly tapped public funding sources like Finnvera.
- The activity slowdown led to a steep rise in payment defaults and bankruptcies; these are now decelerating and expected default frequency indicators have been improving lately.

### Financial conditions, FCI, and credit market imbalances
- Staff estimates using a Financial Conditions Index (FCI) put the cumulative negative direct contribution to 2008–09 growth of prevailing financial conditions at 1½–2 percentage points.
- Lower short-term interbank and corporate loan interest rates since late 2008 are increasingly compensating other adverse financial variables.
- The influence of banking sector conditions (distance-to-default indicator) is approaching levels comparable to the crisis of the early 90’s.
- Credit market imbalances:
  - After peaking in Q3 2008, the stock of credit began to decrease amidst a noticeable credit contraction.
  - Since the second part of 2009 the disequilibrium reflected an excess demand.

### Fiscal developments and contingent operations
- The general government (GG) headline balance moved from a surplus of 4 percent of GDP in 2008 to a deficit of 2½ percent of GDP in 2009.
- The deterioration reflected substantial structural loosening and automatic stabilizers.
- The structural primary surplus declined by 1¾ percent, to 1½ percent of GDP in 2009.
- The 2009 budget made available funds (about ½ percent of GDP) to inject loans and capital into distressed nonfinancial companies; these operations are classified as below-the-line, assumed to be recouped as the economy recovers.

### External position and competitiveness
- The current account (CA) surplus:
  - Hovered around 4 percent of GDP during 2000–08.
  - Plunged to 1¼ percent of GDP last year amid collapsing exports.
  - Projected to recover to the 2 percent of GDP range during 2010–11.
  - In the medium term, expected to stabilize around this level, with old-age pre-funding boosting the savings rate despite continuing terms-of-trade erosion.
- CGER competitiveness margin estimates range from 16 to 4 percent depending on method; macroeconomic balance approach gives -12.4, external sustainability -4.3, equilibrium REER approach 15.8. Memorandum items:
  - Current account balance (percent of GDP) 2009: 1.4
  - Current account balance (percent of GDP) 2015: 1.9
  - CA Norm (macroeconomic balance approach): -1.0
- Two adjustments reduce measured undervaluation substantially: including expected Finnish population evolution and using Finland-only time series increase CA norm to +¼ and +½ percent of GDP respectively, lowering undervaluation to about 7½ percent and about 6 percent.

### Macro outlook and medium-term projections
- Growth projections:
  - 2010: real GDP growth expected to attain 1¼ percent.
    - Domestic demand expands moderately; unemployment anticipated to hit 8¾ percent.
  - 2011: growth projected to speed up to 2 percent.
    - Authorities’ projection: real GDP expanding by 2½ percent.
- Inflation and labor:
  - Inflation likely to decline as a sizable output gap restrains price and salary increases.
  - Labor market expected to lag activity pick-up.
- Potential growth and output level:
  - Potential growth expected to stay at around 1½ percent over the medium term.
  - Permanent decline in the level of potential output—7 percent by 2015, when the output gap is anticipated to close.
- Medium-Term Macroeconomic Framework (selected annual values):
  - Real GDP growth: 2009 -7.8; 2010 1.2; 2011 2.0; 2012 2.0; 2013 2.1; 2014 2.1; 2015 2.1
  - Output gap (percent of potential GDP): 2009 -4.3; 2010 -3.7; 2011 -2.9; 2012 -2.2; 2013 -1.4; 2014 -0.7; 2015 0.0
  - Consumer price inflation (annual average): 2009 1.6; 2010 1.4; 2011 1.8; 2012 1.7; 2013 1.7; 2014 1.7; 2015 1.7
  - Employment growth: 2009 -2.9; 2010 -1.7; 2011 0.4; 2012 0.4; 2013 0.4; 2014 0.2; 2015 0.1
  - Unemployment rate: 2009 8.3; 2010 8.8; 2011 8.7; 2012 8.4; 2013 8.1; 2014 7.9; 2015 7.8
  - Current account balance (percent of GDP): 2009 1.3; 2010 1.8; 2011 1.8; 2012 1.7; 2013 1.7; 2014 1.8; 2015 1.8
  - General government balance (percent of GDP): 2009 -2.4; 2010 -4.1; 2011 -2.2; 2012 -2.6; 2013 -3.0; 2014 -3.1; 2015 -3.0
  - Primary balance (percent of GDP): 2009 -1.0; 2010 -2.8; 2011 -0.8; 2012 -0.9; 2013 -1.1; 2014 -0.9; 2015 -0.8
  - General government debt (percent of GDP): 2009 44.0; 2010 49.9; 2011 52.0; 2012 55.5; 2013 59.1; 2014 62.5; 2015 65.8

### Risks to the outlook
- Overall risks are unusually uncertain but roughly balanced.
- Main risk categories around the central projection:
  - (i) lending and financial conditions, including asset prices;
  - (ii) domestic and external demand;
  - (iii) size/effect of monetary and fiscal policy measures.
- Upside and downside risks from these factors are deemed equally probable, but with unusually pronounced dispersion.

### Policy discussions and recommendations
- Near-term priorities:
  - Consolidate restoration of financial sector health and economic growth.
  - Monitor banks for incentives to engage in higher-risk activities amid competition and difficult operating environment.
  - Address bank profitability decline, credit quality deterioration, and low liquidity buffers given high reliance on wholesale funding.
  - Balance fiscal support for activity with prevention of continuous budget worsening.
- Longer-term priorities:
  - Strengthen financial stability, ensure fiscal sustainability, and advance structural reforms to boost potential output.
  - Given most of the banking system comprises large entities in foreign hands, focus on supervision and crisis management for systemic cross-border institutions, mitigation of too-big-to-fail risks, and prompt intervention in distressed institutions.
  - Monitor implications of EU and Basel initiatives to reform supervision and regulation.
  - Implement gradual and credible fiscal adjustment to restore sustainability.
  - Pursue structural reforms to alleviate crisis and population-aging impacts on growth and facilitate fiscal consolidation.

### Maintaining financial stability (summary)
- Bank support actions during the crisis were broadly appropriate and consistent with other industrialized countries.
- Enlargement of deposit insurance aligned with EU-wide measures.
- ECB liquidity extension on full allocation basis supported financial stability.
- Guarantees for bank liabilities and capitalization facilities were designed with sunset provisions and aimed at a "fix-it-and-exit" approach; these facilities have now expired.

*Source: IMF staff report (section titled "7.      Household balance sheets are rallying, but risks have increased, in particular").*

### 19.      Officials and the FSSA Update report

### 19.      Officials and the FSSA Update report

### Banking sector risks and profitability
- Credit quality was established as a key challenge which may hurt banks’ profits.
- NPLs remain lower than in most EU economies but could increase, particularly if higher interest rates and unemployment complicate debt service of households.
- Authorities considered more important the growth risk of reduced consumption owing to the need to raise household savings to service mortgages.
- Expanding loan-loss provisioning together with low interest margins and sluggish lending to corporations, reflecting a slow recovery, would put pressure on banks’ profitability.
- Improvements in cost efficiency will be crucial to sustain profits; Finnish banks compare well with peers.
- Heightened risk aversion in the wake of the Greek crisis could push up funding costs and complicate access to bank financing.

### Capital adequacy and stress tests
- There was agreement that banks’ capital buffers are sufficient to withstand fairly adverse shocks.
- Stress tests indicate the banking system is resilient to a variety of blows covering credit, exchange rate, and market risk.
- Tests determined that credit is the main source of risk, especially for small banks, together with contagion, owing to the high degree of concentration of the sector.
- Officials argued that although the increase in commercial property value has been one of the highest in the euro area during 2004–07, the small proportion of lending to that sector reduces the impact on banks.
- Low liquidity buffers and reliance on wholesale funding expose banks to significant risk.
- Regulatory capital adequacy of the four largest banking groups, however, would not be impaired, even in a combination of severe downturns in the domestic and global economy.
- The four largest banking groups account for 94 percent of total banking assets.
- The FSSA Update report identified possible improvements in stress testing and financial stability analysis, including:
  - Enhanced monitoring of mortgage practices and household debt service.
  - Compiling information and reporting on properties’ mortgage portfolio and loan-to-value ratios.
  - Strengthening top-down stress testing by modeling the impact of macro-financial variables on a bank-by-bank basis.
  - Fostering synergies between the BoF research and financial stability divisions and the FSA.
  - Using more granular information and including all non-bank elements of the financial sector and cross-border linkages to ameliorate systemic risk assessment.
- Note: Updated Committee of European Banking Supervisors (CEBS) stress tests will be published in July. FSA stress tests were published in English for the first time in June following the FSAP update recommendation.

### Regulation and supervision
- Supervisory and crisis management frameworks for systemic cross-border institutions are key issues for Finland given a banking system with large subsidiaries of big foreign banks.
- Authorities intend to increase the effectiveness of supervision vis-à-vis foreign banks’ branches and pursue clear agreements on specific information to be distributed by home supervisors through efficient communication channels.
- With several institutions of systemic importance, measures to contain the too-big-to-fail risk—including at the regional level, should EU-wide agreements be delayed—were considered important to mitigate potential contagion.
- Safety net and crisis management arrangements face important challenges, both cross-border and domestic; operational aspects of the deposit insurance fund need to be enhanced.
- Authorities broadly endorsed EU and Basel initiatives to reform supervision and regulation but expressed concerns about the impact on burden sharing and banks:
  - They strongly support a model in which the European System of Financial Supervision would be granted incisive supervisory powers, clear responsibilities, and appropriate resources, in the context of a broader framework clarifying fiscal responsibilities of member states.
  - Authorities worry that under current EU proposals, burden-sharing may cover only very large banks (EU-systemic institutions) based in major member countries and not extend to smaller, locally-systemic, Nordic institutions active in Finland; prior understandings are required that burden-sharing will apply to large Nordic banks.
  - Because Finnish banks rely markedly on wholesale funding and corporate deposits, new capital, liquidity, and leverage requirements could hit the system hard and excessively constrain credit, as shown in an FSA study; authorities may seek to moderate the tightening of regulatory ratios, possibly with some differentiation depending on the funding structure of banks.
  - Staff argued that authorities should step up their vigilance of liquidity risk.
- Improvements to domestic aspects of bank resolution discussed:
  - The FSSA Update report argued that introduction of a special resolution regime for banks and financial groups would facilitate prompt intervention in case of rapidly deteriorating conditions that threaten financial stability or depositors.
  - The procedure should entail appointment by the FSA of official administrators and be designed to allow timely adoption of debt restructuring measures; alternatively, it could envisage commencement of compulsory liquidation to reduce crisis cost and possible contagion effects.
  - Authorities are exploring these options.
- Supervisors’ recent guidance to banks for dealing with possible higher interest rate conditions is appropriate and could be strengthened:
  - Banks were invited to abstain from granting mortgages with LTV ratios higher than 90 percent.
  - Banks were invited to undertake systematic assessments of borrower’s capacity to repay with an interest rate of at least 6 percent.
  - Staff suggested authorities could consider further tightening of LTV ceilings, possibly making them mandatory, or introducing limits on the mortgage share that can be borrowed at variable interest rates, particularly should the pick-up in housing prices continue.
  - Staff noted borrowing capacity might be overestimated by tests which omit macro feedback loops through income or employment.

### Short-term fiscal policy (2010)
- Amid a massive economic downturn, fiscal policy will continue to be stimulative in 2010.
- The headline fiscal balance is expected to drop by 2 percentage points to a deficit of 4½ percent of GDP, breaching the SGP limits.
- Deterioration primarily reflects further structural loosening of around 1¾ percent of GDP, leading to a cyclically-adjusted primary fiscal deficit in 2010 of ½ percent of GDP.
- Discretionary measures envisage:
  - Cuts in labor income taxes.
  - Expansion of social benefits.
  - Investment.
  - Transfers, subsidies, and tax allowances for businesses.
- The ratio of expenditures to GDP will rise also because of the increases allowed under spending ceilings originally calibrated for a markedly higher nominal GDP.
- The authorities’ cushioning of the impact of the global crisis is appropriate; the expansionary package implemented in 2009–10 is one of the largest in the euro area.
- Staff remarked the package was broadly adequate because stimulative fiscal policy is indicated from a cyclical perspective—given negative output gaps envisaged for 2009–14—and feasible given the comparatively favorable initial public debt burden; rollover risks are limited by the relatively long average maturity of public debt.
- Concerns about composition of fiscal loosening:
  - Only about one-third of the total discretionary expansion for 2009–10 of about 3½ percent of GDP is temporary, implying it will add about 2 percent of GDP to the structural fiscal deficit—though partly consistent with long standing policy goals, such as reducing labor taxation.
- Agreement that budget consolidation should begin in 2011:
  - Staff supported a gradual structural adjustment of ¾ percent of GDP, because it would bring the headline deficit below the SGP ceiling and not jeopardize the recovery.
  - Absence of market pressure associated with financing requirements renders unnecessary larger front-loading.

Key fiscal figures from staff table (percent of GDP)
- Total revenue: 2008: 53.6; 2009: 53.2; 2010: 52.6; 2010 (Staff/Auth.): 52.6; 2011 (Staff): 54.0; 2011 (Auth.): 54.0
- Total expenditure: 2008: 49.5; 2009: 55.6; 2010: 56.7; 2010 (Staff/Auth.): 56.7; 2011 (Staff): 56.3; 2011 (Auth.): 56.1
- Fiscal balance: 2008: 4.1; 2009: -2.4; 2010: -4.1; 2010 (Staff/Auth.): -4.1; 2011 (Staff): -2.2; 2011 (Auth.): -2.1
- Primary balance: 2008: 5.6; 2009: -1.0; 2010: -2.8; 2010 (Staff/Auth.): -2.8; 2011 (Staff): -0.8; 2011 (Auth.): -0.7
- Structural balance (percent of potential GDP): 2008: 1.7; 2009: 0.1; 2010: -1.5
- Structural primary balance (percent of potential GDP): 2008: 3.2; 2009: 1.4; 2010: -0.2
- Memo: Nominal GDP growth (in percent): 2008: 2.6; 2009: -7.2; 2010: 2.9; 2010 (Staff/Auth.): 3.0; 2011 (Staff): 4.1; 2011 (Auth.): 4.3
- Authorities' structural balance (percent of potential GDP): 2008: 2.2; 2009: 0.2; 2010: ...; 2010 (Auth.): -1.7; 2011 (Auth.): -0.1

- Note: Incorporating the authorities' planned measures, but staff's growth forecast. Under staff's recommended structural adjustment the headline deficit for 2011 would be 2.9 percent of GDP.

### 2011 authorities’ target and staff view
- Authorities target corrective measures of about 1½ percent of GDP in 2011, which would reduce the GG deficit to about 2 percent of GDP, well below the SGP limit.
- Authorities signaled energy taxes and pension contributions will be raised in 2011; expenditure ceilings have been tightened implying moderation of current spending.
- Mission argued such a budgetary contraction might be excessive given uncertainties surrounding the recovery, but could be appropriate if growth momentum is significantly stronger than staff anticipates.

### Medium-term fiscal policy and sustainability
- Officials concurred that the long-term GG position has worsened considerably, reflecting the impact of the crisis.
- Crisis effects: sizable structural fiscal relaxation in 2009–10; operations in support of corporations added to public debt; weaker potential output.
- Expected increases in aging-related spending: 5½ percent of GDP over 2011–60 on account of pensions, health- and old-age care.
- Staff estimates that the GG structural primary balance after 2011 consistent with long-term sustainability will need to be permanently higher than in the no-measures path by 5½–6 percent of GDP—the fiscal sustainability gap—in line with the authorities’ own latest estimates.
- The sustainability indicator used is based on the intertemporal budget constraint and is consistent with the S2 measure of the EC.
- The sustainability gap—evaluated as of 2011—has increased from 1½–2½ in SR2008 to 6 percent of GDP now, primarily reflecting a 4 percent of GDP decline in the projected structural primary balance.
- Staff indicated that an adjustment slightly higher than ½ percent of GDP per annum could be desirable and would close the sustainability gap by 2020.
- Authorities broadly endorsed this approach; it is consistent with their medium-term objective under the SGP of ½ percent of GDP structural surplus.
- Fiscal objectives should be pursued flexibly, with the option to delay somewhat the headline adjustment in exchange for structural measures (such as increasing the retirement age) which improve fiscal sustainability but have only a modest short-run impact on the government balance.

### Measures to achieve sustainability
- Consensus that with an already high revenue ratio, there is only limited scope for increases in the tax burden.
- Prevailing tax rates leave little upward room, especially for direct taxes; international tax competition may lead to cuts in corporate taxation.
- Focus on revenue side should be on base broadening and a shift from labor to consumption and property-based taxation, since the latter are generally less distortionary.
- Recent steps in the right direction:
  - Recent reductions in income tax rates.
  - Increase in VAT rates by one percentage point in mid-2010 (the standard rate was 22 percent before the adjustment).
  - Plans to raise energy taxes.
- Authorities are considering further increases in the VAT rates, partly offset by cuts in payroll or income taxes.
- Staff recommended more should be done, including reducing the number of items on reduced VAT rates.
- Property taxation is currently relatively low and could be increased.
- The generosity of mortgage interest deductibility could be gradually curtailed.

*Source: Officials and the FSSA Update report (IMF staff summary).*

### 34.      Therefore, the authorities acknowledged that expenditure retrenchment would

### 34.      Therefore, the authorities acknowledged that expenditure retrenchment would

### Expenditure retrenchment and fiscal measures
- Authorities acknowledged expenditure retrenchment would need to take the brunt of adjustment, reflecting a relatively elevated government footprint and international evidence that expenditure-based consolidations have been more successful.
- Focus areas to reduce fiscal pressures:
  - Reducing the impact of aging on fiscal expenditures.
  - Local government (LG) reform, including increasing effective retirement age.
  - Measures to restrain growth in demand for health- and long-term care (Table 9).
  - Higher tuition fees and a reduction of student grants in favor of loans for tertiary education to generate expenditure savings and create incentives for reducing time to graduation.
  - Efficiency enhancements to reduce government expenditure without jeopardizing public service provision.

### Structural reforms (Section C)
- Authorities confirmed efforts to:
  - Boost labor participation.
  - Increase competition in services.
  - Foster innovation.
- Specific measures and recommendations:
  - Expand labor participation through tax incentives and intensified training.
  - Reform tertiary educational financing to promote earlier employment among youth.
  - Restrict or eliminate unemployment pipelines at the older end of the age spectrum.
  - Boost competition in services (example: liberalizing shop operating hours).
  - Continue programs to improve public productivity through mergers of municipalities and greater use of outsourcing.
  - Enhance research/business cooperation, entrepreneurship, and venture capital to leverage Finland’s sizable R&D investment.
- Political context:
  - Renewed reform momentum is unlikely before the 2011 elections.

### Exit strategy (Section D)
- Mission assessment:
  - Crisis-related measures to support the economy have been adequately designed to facilitate exit.
  - In the financial area, most initiatives are set to terminate at a predefined date, with some having already expired (¶18).
  - Guarantees for bank borrowing have not been issued or called so far and the likelihood of any outflow of public funds in the future appears very low.
- Broader exit elements:
  - Exit strategy encompasses broader fiscal measures taken to support the economy (¶s33–34), including repayment of resources received by distressed nonfinancial companies (¶11) in line with contractual agreements.
  - Program wind-down should accompany revival of financial markets.
  - Envisages gradual downsizing of temporary employment support programs as economic activity strengthens.

### Staff appraisal — macroeconomic outlook and fiscal stance (Section III)
- Economic impact and outlook:
  - Finland experienced the worst recession in the euro area in 2009 owing to high export dependence on deeply affected countries and commodities.
  - Generous pay raises supported consumption but pressured unit labor costs and eroded external competitiveness, which however remains adequate.
  - A subdued resumption of activity is projected for 2010–11, with output anticipated to remain well below potential and inflation to decline while remaining at the euro area average.
  - Risks are balanced but the outlook is unusually uncertain.
  - The crisis has led to a permanent loss of potential output, aggravating long-term fiscal sustainability concerns related to fast population aging.
- Fiscal assessment and recommendations:
  - The large fiscal impulse in 2009–10 is adequate, but composition raises concerns: sizable contribution of recurrent spending and permanent tax cuts to structural loosening could worsen the medium-term deficit if not reversed.
  - Budgetary position has weakened considerably, requiring strong and credible fiscal consolidation starting in 2011.
  - The fiscal sustainability gap is much larger than estimated in recent years due mainly to crisis-induced deterioration in government deficit and debt and potential output.
  - Recommended consolidation trajectory:
    - A measured budget consolidation of ¾ percent of GDP should start in 2011, consistent with bringing the headline deficit below the SGP ceiling.
    - Stronger consolidation could be considered if there is clear evidence of growth resuming more robustly than envisioned by staff.
    - Beyond 2011, an adjustment of about ½ percent of GDP per annum on average would be desirable and close the sustainability gap by 2020.
    - Fiscal adjustment targets for 2012–15 and supporting measures should be a key plank in the program of the government formed after the 2011 elections.
  - Flexibility:
    - Fiscal objectives should be pursued flexibly, with the option to delay the headline adjustment in exchange for structural measures.
- Policy focus:
  - Fiscal adjustment should prioritize expenditure retrenchment and tax base broadening.
  - Limited room to raise tax rates given deadweight losses and international tax competition, with partial exception of the VAT and property taxation.
  - Key expenditure containment measures: pension, health-and old-age care reforms, and overhaul of local government.

### Financial sector assessment and regulatory recommendations
- Financial sector resilience:
  - The financial sector has withstood the world economic crisis owing to a solid capital base and vigilant supervision, but some risks linger.
  - FSSA Update found exposure to opaque structured products or highly vulnerable countries is limited or negligible.
  - Spillover risks are manageable; only rather extreme scenarios induce sizable losses in Finland.
  - Stress test outcomes for the Finnish banking system are benign; largest sources of risk identified as credit, liquidity, contagion and concentration.
  - Adverse cyclical conditions and rise in nonperforming loans are notable; reliance on wholesale funding calls for greater liquidity buffers.
- Policy recommendations:
  - Strengthen bank cost efficiency and avoid excessive risk-taking.
    - Guarantees for bank liabilities and capitalization facilities have been designed to be phased out, which has occurred at end-June 2010, to minimize distortions to competition.
    - Intense competition has reduced banks’ net interest margins drastically; with prospects of higher funding costs, cost reductions will be important.
    - Banks and insurers should be cautious in engaging in higher risk activities (example: sustained low-interest mortgage lending amid surging home prices).
  - Boost effectiveness of supervisory and crisis management frameworks for large cross-border institutions:
    - Need detailed understandings on information to be distributed by home supervisors, especially for branches.
    - If EU-wide resolution framework implementation is postponed, mitigate too-big-to-fail risk through regional agreements at the Nordic level.
  - Other regulatory enhancements proposed:
    - Introduce a bank-specific resolution regime, including broadening options to allocate losses to the private sector.
    - Step up vigilance on liquidity risk, banks’ funding profiles, and the (consolidated) risk profile of complex financial groups active in Finland.
    - Further strengthen analytical frameworks for stress testing and systemic risk assessment.

*Source: _cr10273 - 34.      Therefore, the authorities acknowledged that expenditure retrenchment would*

### 46.      It is proposed that the next Article IV consultation be held on the 24-month

### _cr10273 - 46.      It is proposed that the next Article IV consultation be held on the 24-month

### Economic outlook and projections
- Output (Table 1, Output and demand (volumes)):
  - GDP: 4.9 1.2 -7.8 1.2 2.0 2.0 2.1 2.1 2.1
  - Consumption: 2.7 2.0 -1.3 1.5 1.6 1.5 1.5 1.5 1.5
  - Gross fixed capital formation: 10.6 -0.2 -13.4 -2.5 3.5 3.2 3.7 4.2 4.2
  - Exports of goods and services: 7.9 6.5 -24.3 0.1 4.5 4.0 4.2 4.2 4.2
  - Imports of goods and services: 6.0 6.6 -22.3 -2.3 4.2 3.4 3.3 3.3 3.3
  - Foreign contribution to growth (in percent of GDP): 1.2 0.3 -1.8 1.1 0.2 0.3 0.4 0.4 0.4
- Stocks and statistical discrepancy contribution to growth (in percent of GDP): -0.4 -0.5 -2.1 -0.4 0.0 0.1 0.0 -0.1 -0.1

### Prices, costs, and potential output
- Prices and labor costs (Table 1, Prices, costs, and income):
  - Consumer price inflation (harmonized): 1.6 3.9 1.6 1.4 1.8 1.7 1.7 1.7 1.7
  - GDP deflator: 3.3 1.4 0.6 1.7 2.0 1.8 1.9 2.0 1.9
  - Unit labor cost, economy-wide: 1.0 5.4 6.8 -0.3 1.2 1.2 1.1 0.9 0.8
- Potential output and labor market (Table 1):
  - Output gap (in percent of potential output) 1/: 5.4 4.3 -4.3 -3.7 -2.9 -2.2 -1.4 -0.7 0.0
  - Growth in potential output: 2.6 2.3 0.5 0.6 1.2 1.3 1.3 1.3 1.4
  - NAIRU (in percent): 8.1 8.0 7.9 7.9 7.9 7.8 7.8 7.8 7.8
  - Labor force: 1.0 1.0 -0.9 -1.1 0.3 0.1 0.0 0.0 0.0
  - Employment: 2.0 1.6 -2.9 -1.7 0.4 0.4 0.4 0.2 0.1
  - Unemployment rate (in percent): 6.8 6.4 8.3 8.8 8.7 8.4 8.1 7.9 7.8

### Public finances and proposed fiscal measures
- Main fiscal aggregates (Table 3, Finland: General Government Accounts, 2007–11):
  - Total Revenue: 52.5 53.6 53.2 52.6 54.0
  - Total Expenditure: 47.3 49.5 55.6 56.7 56.3
  - Fiscal balance: 5.2 4.1 -2.4 -4.1 -2.2
  - Primary balance (memorandum): 6.7 5.6 -1.0 -2.8 -0.8
  - Structural balance (in percent of potential GDP): 2.4 1.7 0.1 -1.5 -0.1
  - Gross Debt: 35.2 34.2 44.0 49.9 52.0
- Proposed fiscal measures (Table 9, selected):
  - Further pension reform:
    - Measures: Raising retirement age; Lowering accrual rate for pension benefits; Tightening early retirement.
    - Rationale: Average effective retirement age is about 60; raising it to 67 would suffice to close the sustainability gap. Steps already taken expected to raise effective retirement age by 1½ years by 2025; working groups tasked to formulate proposals to generate a further 1½ years increase by the same date. From 2010 new pensions will be adjusted downward if life expectancy rises.
    - Authorities’ view: Do not dispute need; taking steps; considering measures.
  - Savings in health and long-term care:
    - Measures: Increase in user fees; Tightening entitlements to long term care; Productivity increases; Benchmarking.
    - Rationale: Health-care and long-term care expenditure projected to rise about 3¼ percent of GDP by 2060 with population aging.
    - Authorities’ view: Actively seeking productivity increases; considering user fees and tighter entitlements while emphasizing social service availability.
  - Reform of local government:
    - Measures: Reduce reliance on corporate taxes and enhance reliance on property taxes; Ceiling on municipal income tax rates; Broader competitive bidding; Merger of municipalities.
    - Rationale: Municipal spending grew faster than rest of GG; municipality productivity declined about 10 percent over 2000-08; median municipality population less than 5,000.
    - Authorities’ view: Support in principle but note constitutional autonomy of local authorities makes reforms politically challenging.
  - Improved rate of return on government financial assets:
    - Fact: Gross financial assets totaled about 90 percent of GDP in 2008.
    - Authorities’ view: Considering options to modestly increase returns while limiting risk.

### Financial sector conditions and state interventions
- Financial vulnerability indicators (Table 2, selected, 2005–10):
  - Total household debt (in percent of GDP): 44.0 47.1 48.2 50.6 56.7 ...
  - Debt-to-income ratio: 89.1 96.5 101.0 103.1 105.1 ...
  - Financial assets/GDP (households): 84.4 88.7 86.6 76.3 ... 88.9 ...
  - Non-financial corporations gross debt (in percent of GDP): 55.6 57.6 58 62.6 67.8 ...
  - General government debt (EMU definition, in percent of GDP): 41.7 39.7 35.2 34.8 44.0 ...
  - Banking sector: Outstanding credit to nonfinancial corporations (annual percent change, e.o.p.): 7.8 8.4 12.9 18.8 -4.8 -2.2 1/ (As of April 2010)
  - Non-performing loans/total loans (in percent): 0.27 0.26 0.28 0.50 0.70 0.76 2/ (As of March 2010)
  - Regulatory capital as percent of risk-weighted assets: 17.2 15.1 15.1 13.6 14.5 14.5 2/
  - Equity/total assets (in percent): 9.9 9.8 8.3 7.4 6.4 6.2 2/
- Banking-sector support and interventions (Table 7 and Table 8, selected):
  - Headline support for financial and other sectors (as of July 2010; in percent of 2009 GDP) is tabulated by country and instrument (capital injection, purchase of assets and lending by Treasury, guarantees, liquidity provision by central bank). (Table reproduces country-by-country percent entries.)
  - Kaupthing Bank h.f. Finnish branch failure:
    - The three commercial banks involved and a SPV took over credit claims and other assets of Kaupthing Bank h.f. and settled all the deposit claims in Finland. The State accepted legal-risk indemnity for the banks and SPV for losses from any recovery or insolvency claims relating to the arrangement. The State did not set an upper limit of the indemnity.
- Banking sector diagnostics (figures and text):
  - Key messages: Large presence of foreign banks; high loan-to-deposit ratio; reliance on wholesale funding; loan quality deteriorated at a slow pace; profitability fell sharply; capital adequacy remains high.

### External sector and international investment position
- Balance of payments and external accounts (Table 4, 2005–11, selected):
  - Current account (2005–11): 5.3 7.0 7.6 5.8 2.3 3.2 3.2 (In billions of euros; as a percentage of GDP: 3.4 4.2 4.3 3.1 1.3 1.8 1.8)
  - Exports of goods and services (2005–11): 65.7 75.4 82.3 86.7 61.9 61.9 65.2
  - Imports of goods and services (2005–11): -59.3 -67.6 -73.0 -79.3 -57.2 -57.5 -60.9
  - GDP at current prices (memorandum): 157.3 165.6 179.5 184.2 171.0 176.0 183.2
- Net international investment position (Table 5 and Table 1 entries):
  - NIIP (Table 1, Net international investment position): -29.6 -8.1 -10.6 -7.3 -3.9 -0.7 2.5 5.8 9.0
  - Table 5 (Net International Investment Position, 2001-09, in percent of GDP) shows net position evolving from -82.2 (2001) to -6.7 (2009) in level terms reported there.
- Trade by regions and countries (Table 6, 2009, selected):
  - Total balance value and shares reported; notable entries: Russia imports balance -2,982 mm EUR, value 7,026 share 16.2% change -31; United States exports +1,996 mm EUR, value 1,486 share 3.4% change -20. (Table reports detailed imports and exports by region and country.)

### Market financing and bond markets
- Bond market developments (figures and text):
  - Stock outstanding of bonds by issuer sector (Figure 6): growth since mid-2008 driven mostly by central government and the financial sector; non-financial sector stock practically constant over last decade.
  - Bond financing represents approximately 7% of the credit financing for non-financial corporations.
  - International bond issuance (Figure 5): spike in 2009 when amount of issuance doubled; majority Euro-denominated; proportion of US Dollar issues increased in 2009; proportion of floating-rate bonds very small.
- Interest rates and monetary indicators (Table 1, Money and interest rates):
  - 3-month money market rate 2/: 4.3 4.6 1.2 0.7 ...
  - 10-year government bonds yield 2/: 4.3 4.3 3.7 3.4 ...
  - M3 (Finnish contribution to euro area , growth rate, e.o.p.) 2/: 19.7 5.0 -1.6 -2.1 ...............
  - Finnish MFI euro area loans (growth rate, e.o.p.) 2/: 11.7 11.6 1.7 3.0 ...............
- Exchange rates (period average, Table 1):
  - Euro per US$: 0.73 0.68 0.72 ..................
  - Nominal effective rate (increase in percent): 2.2 2.6 1.3 ..................
  - Real effective rate (increase in percent) 3/4/: 1.4 4.1 5.5 ..................

### Key quantitative highlights and risks (selected)
- Recession and recovery:
  - GDP fell by -7.8 (2009) with a rebound projected thereafter (GDP row: 1.2 2.0 2.0 2.1 2.1 2.1 for 2010–15).
- Fiscal deterioration:
  - General government gross debt rose from 35.2 (2007) to 49.9 (2010) and projected 52.0 (2011) (Table 3 and memorandum items).
- Aging-related fiscal pressures:
  - Health-care and long-term care expenditure projected to rise about 3¼ percent of GDP by 2060.
- Financial sector strengths and strains:
  - High regulatory capital (e.g., 14.5 percent regulatory capital to RWA in 2009/2010) but declining profitability (return on assets: 0.9 1.2 1.4 0.8 0.6 0.7) and rising non-performing loans (0.27 0.26 0.28 0.50 0.70 0.76).
- External position:
  - Current account surplus narrowed (current account as percent of GDP: 3.4 4.2 4.3 3.1 1.3 1.8 1.8) while NIIP improved toward positive territory by projections (Table 1 NIIP series ending 9.0).

*Source: IMF staff report material extracted from the supplied content unit.*

### 1.      As the worst of the global crisis unwinds, there is mounting evidence that the

### _cr10273 - 1.      As the worst of the global crisis unwinds, there is mounting evidence that the

### Overview
- The Finnish financial sector "has acceptably weathered the turmoil" and data show "an incipient improvement in the health of that sector."
- The Financial Stress Index (FSI) peaked during the crisis but "decreased rapidly," reaching values last observed during 2004–05.
- The Finnish financial system "has suffered less distress than the group of advanced economies, and particularly European countries."

### Financial Stress Index (FSI) and Financial Conditions Index (FCI)
- FSI composition: spread between commercial paper and sovereign bonds; beta of the banking sector; term structure of interest rates; volatilities in stock returns and the exchange rate. Larger values indicate increasing distress; zero implies neutral financial conditions.
- FCI construction: VAR-based composite of cumulative impulse responses of real GDP to financial variables (equity returns, HELIBOR, real exchange rate, banks’ distance to default). Individual impulse responses standardized so one unit of the index interprets as an (annualized) change of 1 percent in growth.
- Key FCI observations:
  - FCI reached a negative value of -0.91 during Q4 2008.
  - FCI "raised rapidly to reach a neutral value close to 0 during Q3 2009."
  - A positive value of the index implies the aggregate effect of variables is an increment in economic growth.
- Main contributors to growth in 2009:
  - "The positive impulse of monetary policy" via low interest rates.
  - Low interest rates "have more than compensated" negative effects from banking and external sectors and, to a lesser degree, the stock market.
- Banking sector risk in 2009:
  - "Increase of the negative contribution to growth coming from the banking sector during 2009."
  - This negative contribution "has now approached levels comparable to those observed in the early 90’s."

### Imbalances in the Credit Market
- Purpose: distinguish rationing origin—supply-side credit crunch (bottleneck in origination, deleveraging, insufficient capital) versus demand-side credit contraction (insufficient appetite for credit).
- Credit supply and demand model variables:
  - Demand: average lending rate, inflation, industrial production, economic confidence index.
  - Supply: total deposits, lending rate, spread between lending rate and short-term funding rate, banking sector share price relative to market average, volatility of banking sector share price, inflation, industrial production.
- Credit market dynamics:
  - Pre-crisis (two years before global financial crisis): stock of credit growing continuously; market imbalances relatively small (generally a credit crunch of less than 2 percent of total credit).
  - After peaking in Q3 2008, the stock of credit decreased until trend reversal in Q1 2010.
  - The change in trend associated with a "noticeable credit contraction," indicating the banking sector was indirectly affected by the global financial crisis and economic contraction rather than being a cause.
  - Second half of 2009: market returned to a credit crunch peaking in September 2009 but "practically disappeared by the end of last year."
  - Possible drivers of reversal: policies reaction to the crisis and positive effects of expansive monetary policy on financial conditions.
- Figure reference: "Credit Market Imbalances" shows Excess demand/supply and Credit in log from 2005Q4 to 2009Q4 with excess demand/supply measured in percentage points.

### Credit Channel: VAR and VEC Evidence
- Methods:
  - Short-run analysis: simple VAR with GDP, investment, private consumption growth explained by changes in credit growth and lags, with employment and foreign demand controls. Quarterly data from Q4 1998 to Q3 2009.
  - Long-run analysis: Vector Error Correction (VEC) to test cointegration between economic activity and credit.
- VAR findings:
  - "Estimated coefficients on credit are not significant in all specifications" (Table 1-1).
  - Adj. R-squared reported: Investment 0.8450, Consumption 0.9597, GDP 0.9828 (Source: IMF staff calculations).
- VEC findings:
  - "Do not identify a long-run stable relationship between investment or GDP growth and credit."
  - "Detect a positive relationship between private consumption and credit but it could be argued that it is relatively weak."
  - Note: "While the estimated individual coefficient is significant and shows an elasticity close to 0.25, the cointegration relationship is not significant at 5 percent."
  - Johansen test notes: "The p-value of the trace statistics at rank 1 is 0.1059."
- Interpretation:
  - Empirical evidence "does not support a significant relationship between credit to the private sector and economic growth."
  - Implication: "the mild credit crunch observed in the last couple of quarters should have only small effects on economic growth."
  - Caveat: econometric results do not rule out all credit channel effects—Freystatter (2010) theoretical general equilibrium model finds a positive relationship between external credit and GDP via an external finance premium mechanism.

### Conclusions (Section D)
- Summary findings:
  - "The Finland financial sector has successfully endured the indirect effects emerging from the recent global financial crisis and the decline in economic growth."
  - "The sector does not show major signs of distress."
  - "Financial conditions overall are now contributing to the economy recovery."
- Credit market effects:
  - "The contraction in economic activity resulted in an important credit contraction."
  - Policy measures and improved prospects stabilized credit to the private sector; imbalances created by the crisis "have also disappeared."
- Risks and monitoring:
  - "The credit market does not seem to constitute an important threat to the incipient economic recovery."
  - "The credit channel does not appear to be very significant."
  - Recommendation: "the health of the banking sector should be carefully monitored given an environment of weak economic growth with high unemployment and low interest margins."

### Analytical Note 2: International Trade and Financial Spillovers — Key Findings
- Trade shock during 2009:
  - "Total trade has decreased approximately by one third in comparison with the previous year."
  - Table 2-1 highlights trade by region/country (2009): Total imports 1,646 mm EUR, exports 43,250 mm EUR, total change -31 (imports mm EUR change -144? — preserve structure as in source table).
  - Selected bilateral changes (from Table 2-1):
    - Europe: imports -1,400 mm EUR share 33,283 77 percent change -30 / exports 31,883 71 percent change -34
    - Russia: imports -2,982 mm EUR share 7,026 16.2 percent change -31 / exports 4,044 9 percent change -47
    - China: imports -1,580 mm EUR share 3,434 7.9 percent change -21 / exports 1,854 4.1 percent change -10
  - "The halving of exports to Russia" cited as an example of vulnerability.
  - "Relatively small exposure to the main emerging market economies could imply that the Finnish economy will benefit little from their already observed recovery."
- International financial exposures:
  - Finnish banks' claims abroad (As of end June 2009) (Table 2-2):
    - All countries USD Billion 125.3 Share (%) 100
    - Western Europe 91.1 Share (%) 72.7
    - Eastern Europe 17.2 Share (%) 13.7
    - United States 4.6 Share (%) 3.7
    - Japan 0.1 Share (%) 0.1
  - Network analysis of default shocks (Table 2-3) — example scenarios and impacts (values as in source table):
    - Shock magnitude denotes percent of claims that default.
    - Scenario: Europe 10 percent magnitude => Deleveraging Need 35.4; Finnish Lenders' Losses 3.8 percent/GDP; Impact on Credit Availability -28.7 percent.
    - Scenario: Europe and US 10 percent magnitude => Deleveraging Need 57.7; Finnish Lenders' Losses 5-? percent/GDP; Impact on Credit Availability -37.6 percent. (Preserve table values as presented.)
    - Scenario: US 10 percent magnitude => Deleveraging Need 0?; Finnish Lenders' Losses 0.8? percent/GDP; Impact on Credit Availability -3.2 percent. (Preserve table formatting and values as in source.)
  - Interpretation of network analysis:
    - "In general, we find small effects owing to defaults in any of the relevant individual countries with the exception of the US."
    - Even the US case "are not sizable unless we assume a rather extreme scenario of a 25 percent average default rate in all private claims."
    - A more pessimistic scenario of a 10 percent default rate across Europe, US and Japan "could reduce credit availability by approximately one third and produce losses of up to 5 percent of GDP."
- Foreign claims in Finnish banks:
  - "Total foreign claims in Finnish banks are almost equally divided between purely international claims and local currency positions of reporting banks’ foreign offices."
  - "Half of international claims have long term maturities (greater than one year)."
  - Concentration:
    - "Claims originate in a few European countries (for instance, Sweden is associated with almost 50 percent of these claims)."
    - Network simulation of a 5 percent default in private claims in Finland: Sweden suffers biggest effects (up to 1.5 percent of GDP), Denmark approximately 0.5 percent of GDP, followed by United Kingdom, Netherlands, Germany and Switzerland with less than (values as in source).

*Source: IMF staff calculations, analysis prepared by Mauro Roca.*

### 0.5 percent of GDP) (Figure 2-1).

### _cr10273 - 0.5 percent of GDP) (Figure 2-1).

### Finnish Banks Claims Abroad (Immediate Borrower Basis, end December 2009)
- Total foreign claims: US$ 217.60 Billion (100.00%)
- Total international claims: US$ 96.11 Billion (44.17%)
- By maturity:
  - Up to and including one year: US$ 35.60 Billion (16.36%)
  - Over one year up to two years: US$ 7.00 Billion (3.22%)
  - Over two years: US$ 36.30 Billion (16.68%)
- By sectors:
  - Bank: US$ 23.93 Billion (11.00%)
  - Public sector: US$ 23.19 Billion (10.66%)
  - Non-bank private sector: US$ 48.26 Billion (22.18%)
- Local currency positions of reporting banks' foreign offices with local residents:
  - Claims: US$ 121.49 Billion (55.83%)
  - Liabilities: US$ 87.15 Billion (40.05%)
  - Net risk transfers: -0.25
- Total foreign claims on an ultimate risk basis: US$ 217.35 Billion
- Source: BIS.
- Note: International claims are also "cross border claims in all currencies and local claims in non-local currencies".

### Lenders’ Losses due to Finnish Default (Figure 2-1)
- Map legend for 5 percent default scenario:
  - [0,.005]
  - (.005,.5]
  - (.5,1]
  - (1,1.5]
  - No data

### Analytical Note 3: The Crisis and Potential Output in Finland — Key Findings and Projections
- Importance:
  - Accurate potential output assessment is critical for near-term monetary and fiscal policy and long-term sustainability of public finances and asset prices.
- Channels through which the crisis could reduce supply potential:
  - Labor:
    - Rising unemployment could pause or reverse prior trend declines in the NAIRU.
    - Participation rates may decline due to discouraged worker effects or early retirement.
  - Capital:
    - Capital accumulation will slow with the fall in investment and higher obsolescence amid restructuring and firm closures.
    - Higher uncertainty and risk aversion could increase borrowing costs and credit constraints.
    - Higher public debt could put upward pressure on interest rates; higher future tax burdens may reduce incentives to work and invest.
  - Total factor productivity (TFP):
    - TFP growth had been declining prior to the crisis, possibly reflecting declining competitiveness as wages grew robustly.
    - Reduced investment (including in intangibles and R&D), greater obsolescence of capital, and greater regulation may reduce innovation.
    - Offsetting: firms may restructure and enhance efficiency.
- Offsetting effects on potential output:
  - Fiscal stimulus will cushion slowdown and raise infrastructure expenditure.
  - Reduced wealth might induce greater labor market participation.
  - Crisis could facilitate political consensus for structural reforms (example: Finland 1990–93).
- Evidence from studies:
  - OECD: crisis likely to reduce potential output by around 2–3 percent in the OECD.
  - European Commission and IMF: potential output level losses of 2¼–6 percent for the euro area over the medium term.
- Staff baseline for Finland:
  - Potential growth in the medium term is lower than pre-crisis levels, largely reflecting adverse demographic change.
  - Investment and TFP growth projected to return close to pre-crisis levels as restructuring ends and risk aversion declines.
  - Labor contribution to potential growth projected to rise from -¾ percent in 2010 to just above zero over the medium term (below the average of ¾ percent for 2000–07).
  - Working age population projected to shrink from 2010 onwards; higher participation rates assumed to partly offset shrinkage.
- Estimates and methodology:
  - Primary method: production function approach (PF) — baseline projection.
  - Comparative method: HP filter with standard parameter (HP-100) and alternative (HP-RU); HP filter extended using baseline forecast through 2015 to address end-point problems.
  - PF yields pre-crisis potential growth estimates generally higher than HP filter.
  - Recent pre-crisis potential growth seems to be around 2½ percent (down from previous estimate of 3¼ percent in 2008 Staff Report).
- Quantitative staff projections:
  - Crisis reduces the overall level of potential output by around 7 percentage points (relative to no-crisis scenario) by 2015.
  - Potential growth in 2015 projected to be about ½ percentage point lower as a result of the crisis.
  - Projections depend critically on future paths of labor, capital, and TFP.
- Risks:
  - Downside: structural unemployment could be higher if consolidation raises tax wedges.
  - Upside: deeper structural reforms could stimulate more-rapid potential growth.

### Table 3-1 and Figures — Selected Numeric Entries (growth, potential growth, output gaps)
- Actual/projected Real GDP growth entries (selected ranges shown in source table):
  - 1990-1995: -0.4
  - 1996-2001: 4.4
  - 2002-2007: 3.4
  - 2008-2011: -0.8
  - 2006: 4.4
  - 2007: 4.9
  - 2008: 1.2
  - 2009: -7.8
  - 2010: 1.2
  - 2011: 2.0
- Production Function potential growth series (selected):
  - 1990-1995: 1.3
  - 1996-2001: 3.6
  - 2002-2007: 2.6
  - 2008-2011: 1.1
  - 2006: 2.7
  - 2007: 2.6
  - 2008: 2.3
  - 2009: 0.5
  - 2010: 0.6
  - 2011: 1.2
- HP-100 potential growth series (selected):
  - 1990-1995: 2.6
  - 1996-2001: 3.3
  - 2002-2007: 2.5
  - 2008-2011: 1.3
  - 2006: 2.1
  - 2007: 1.8
  - 2008: 1.5
  - 2009: 1.3
  - 2010: 1.1
  - 2011: 1.1
- Output gap estimates and figures presented in source show divergence across methods (PF, HP-100, HP-RU, OECD, EC).

### Analytical Note 4: External Competitiveness — Key Findings
- Context:
  - Global recession caused a large shock to international trade, complicating competitiveness assessment for Finland.
  - Multi-year wage negotiations for 2007–10 concluded at an economic peak; raised wage/productivity differentials disproportionally in nontradable sector, potentially spilling to tradables.
- Indicators and trends:
  - Standard REER measures are mixed but generally point to modest recent deterioration.
  - From early 2000s, indicators moved broadly sideways; compared to 2007, economy-wide REER indicators suggest some decline in competitiveness.
  - Tradable-based REER indices deteriorated only marginally.
  - ULC-based measures (general and tradables) increased more than price-based ones, suggesting profit margins may be under pressure.
- Exporter profitability:
  - Worsened; ratio of ULC-based to price-based REERs used as profitability proxy shows increases in relative labor shares over last five years.
  - Interpretation cautioned due to lagged labor bill responses under multi-year wage agreements.
- Merchandise export market shares:
  - Trending downward over last twenty years in both world trade and EU, reflecting secular decline in export prices for communications equipment and forestry/paper and increasing outsourcing.
  - Services exports share of GDP rising, indicating a shift to higher value-added activities.
- CGER (Consultative Group on Exchange Rate Issues) panel-based estimates of competitiveness margin:
  - Macroeconomic balance approach: -12.4 (level relative to equilibrium in percent; minus indicates undervaluation)
  - External sustainability approach: -4.3
  - Equilibrium real exchange rate approach: -15.8
  - Note: margin range of 4.3 to 15.8 percent depending on method (text notes margin estimated in range of 4.3 to 15.8 percent).
- Memorandum items:
  - Current account balance (percent of GDP):
    - 2009: 1.4
    - 2015: 1.9
    - CA Norm (macroeconomic balance approach): -1.0
- Interpretation and robustness checks:
  - The large real undervaluation from the equilibrium real exchange approach driven mainly by relative increase in Finland’s government consumption/GDP ratio (largely due to massive decline in nominal GDP in 2009), causing equilibrium REER to appreciate markedly while measured REER appreciates marginally.
  - Panel results may understate idiosyncratic Finnish characteristics; incorporating long-horizon dependency ratios for all countries increases Finland’s CA Norm to 0.25 percent of GDP and reduces undervaluation to 7.5 percent.
  - Time series re-estimate of CA norm (macroeconomic balance approach) increases CA norm to 0.6 percent of GDP, implying undervaluation of 6.2 percent.
  - Conclusion: undervaluation is smaller than suggested by the standard macroeconomic balance approach once country-specific factors are considered.

### Analytical Note 5: Long Run Fiscal Sustainability in Finland — Recent Developments, Outlook, and Projections
- Summary conclusion:
  - Marked deterioration in fiscal sustainability; sustainability gap much larger than previously estimated.
- Fiscal developments (2008–2009):
  - Headline balance declined from a surplus of 4 percent of GDP in 2008 to a deficit of 2½ percent of GDP in 2009.
  - Deterioration reflected structural loosening and automatic stabilizers.
  - Expenditure rose by 6 percent of GDP (broad-based increases; social benefits rose 2¾ percent of GDP).
  - Revenues declined by ½ percent of GDP (decline of 1 percent of GDP in tax revenue mostly offset by increases in social contributions).
  - Structural balance estimated to have declined from a surplus of 1¾ percent of GDP in 2008 to near zero in 2009.
  - Public debt rose by 9¾ percentage points to 44 percent of GDP in 2009 (after declining continuously since 2003).
- 2010 outlook:
  - Further fiscal deterioration expected.
  - Headline fiscal balance expected to decline by 1¾ percentage points to a deficit slightly above 4 percent of GDP, breaching the SGP limits, primarily reflecting substantial discretionary stimulus.
  - Expenditure expected to increase by 1¼ percent of GDP; revenues expected to decline by ½ percent of GDP (led by further declines in direct taxes).
  - Overall discretionary stimulus estimated at 1½ percent of GDP for 2010.
  - Estimated decline in structural primary balance in 2010: 1½ percentage points to a deficit of ¼ percent of GDP (reflects stimulus measures).
- Authorities’ consolidation plans for 2011:
  - Plans to begin consolidation in the 2011 budget as global recession abates.
  - Signaled measures: raise energy taxes and employee and employer contributions to employment pension starting in 2011.
  - Full-year effect of a one percentage point increase in VAT rates from July 1, 2010, will help improve revenues for 2011.
  - Revenue and expenditure assumptions for 2011:
    - Revenues expected to rise by 1½ percent of GDP.
    - Expenditures expected to decline by ½ percent of GDP.
    - Overall fiscal balance expected to improve by two percentage points to 2¼ percent of GDP.
    - Structural improvement of about 1¼ percent of GDP.

*Italic: IMF staff report content as provided in the source PDF.*

### 5.      As a result, the starting point to assess sustainability is markedly worse than

### _cr10273 - 5.      As a result, the starting point to assess sustainability is markedly worse than

### Fiscal sustainability has deteriorated
- Staff and authorities previously projected a structural surplus of 2 percent of GDP in 2010 in the 2008 Stability Program; staff’s latest projection is 3½ percentage points of GDP worse than that projection.
- Staff’s estimate of the sustainability gap increased from "1½–2½ percent of GDP" in the 2008 Article IV consultation to "about 6 percent of GDP".
- Staff’s estimate is:
  - ½ percentage point higher than the authorities’ latest estimate.
  - About 2 percentage points higher than the European Commission’s 2009 estimate.
  - Significantly below the OECD estimate of "8 percent of GDP".

### Aging-related expenditure projections (2007–60)
- ECFIN baseline estimate: aging pressures are estimated to add "6.4 percent of GDP" to fiscal expenditures in Finland (2007–2060).
- EU median comparison: median of "5.3 percent of GDP" across the European Union.
- Composition of Finland’s increase:
  - Pension expenditure: "3.3 percent of GDP"
  - Long-term care expenditure: "2.6 percent of GDP"
  - Health-care expenditure: "1 percent of GDP"
  - Reduced education expenditure: "0.3 percent of GDP"
  - Reduced unemployment-benefit expenditures: "0.2 percent of GDP"
- Alternative ECFIN scenarios: increase in aging-related expenditures could vary between "5.8 and 7.4 percentage points of GDP":
  - Worst case: "zero immigration"
  - Best case: "higher employment rate"

### Sustainability indicator and gap (methodology)
- Sustainability indicator: based on the general government intertemporal budget constraint (same approach as the EC’s S2 sustainability indicator).
- Sustainability gap definition: the constant change to the primary balance (in percent of GDP), over an infinite horizon, such that the intertemporal budget constraint is satisfied.
- Starting year (period 0) for staff’s analysis: "2011".
- Formula variables explicitly noted: S0 (sustainability gap in percent of GDP in period 0), r (discount rate), g (GDP growth rate), D0 (initial debt stock in percent of GDP in period 0), Pt (primary surplus in percent of GDP in period t).

### Projected fiscal outcomes absent and with adjustment
- Absent corrective measures (no measures scenario):
  - Public debt projected to rise to "over 400 percent of GDP by 2060".
  - Structural primary deficit excluding property income projected to increase by "5 percentage points to 9 percent of GDP".
  - Overall fiscal deficit deteriorates by "22 percentage points to 26 percent of GDP".
- Immediate full adjustment:
  - Gross debt driven to zero by "2024".
  - Notable buildup of government assets thereafter to defray long-run aging costs.
- Phased adjustment over 10 years (with front-loading):
  - Requires structural measures totaling "6½ percent of GDP" for sustainability.
- Delaying onset of adjustment by 10 years:
  - Requires structural measures totaling "7 percent of GDP" for sustainability.
- General relationship: "slower adjustment is associated with a higher path for public debt."

### Measures to achieve sustainability — revenue side
- Total fiscal stimulus for 2009–10: "about 3¼ percent of GDP"; only about one-third temporary — implying about "2 percent of GDP" permanently added to the structural fiscal deficit absent corrective measures.
- With a high revenue ratio, scope for further increases in the tax burden is limited; recommended focus:
  - Base broadening.
  - Shift from labor taxation to consumption and property based taxation.
- Specific measures noted:
  - Recent reductions in income tax rates.
  - Planned increase in VAT rates by "one percentage point in mid-2010".
  - Plans to raise energy taxes.
  - Reduce number of items on reduced VAT rates.
  - Increase property taxation to reduce municipalities’ reliance on cyclical corporate taxes.

### Measures to achieve sustainability — expenditure side
- Expenditure measures must carry the brunt of adjustment.
- Focus areas:
  - Reducing the impact of aging on fiscal expenditures (pensions, long-term care).
  - Overhaul of local government where expenditures have risen fastest.
  - Possible reduction in generosity of social and unemployment benefits.
  - Tuition fees and reduction of student grants in favor of loans at tertiary education level to generate savings.

### Pension-specific reforms and labor-force measures
- Decomposition findings: pension pressures arise from a pronounced increase in the old-age dependency ratio, partly offset by tightening eligibility rules.
- OECD estimate cited: average effective retirement age "about 60"; raising it to "67" would be sufficient to close the sustainability gap (noted as very challenging).
- Further pension-savings options:
  - Lowering the accrual rate for pension benefits (especially for parental leave, unemployment, education).
  - Tightening access to early retirement via disability or unemployment.
- Disability pension context: number of persons on disability pension estimated at "about 9 percent of the labor force".
- Authorities’ planned measures:
  - Measures already taken expected to raise the average effective retirement age by "1½ years by 2025".
  - Working groups tasked to formulate reforms to generate a further "1½ years increase by 2025".
  - From "2010 onward" new pensions adjusted downward by a life expectancy coefficient.

### Long-term care and local government reforms
- Long-term care spending increase for Finland is "well above the median for the EU".
- Municipal spending has grown faster than other parts of general government.
- OECD estimate: municipality productivity declined by "about 10 percent over 2000–08"; productivity declines most marked in social work and health.
- Municipal tax behavior: several municipalities implemented additional significant tax hikes in "2010".
- Identified problems: soft budget constraints and reliance on buoyant, highly cyclical corporate taxation enabling expenditure growth.

### Municipal reform recommendations
- Harden municipal budget constraints and reduce revenue cyclicality.
- Reduce reliance on municipal corporate taxes; offset with higher property taxation or central government transfers.
- Consider a ceiling on municipality income tax rates and restraint in growth of central government transfers.
- Broaden scope for competitive bidding for provision of municipal services to generate cost savings.
- Efficiency gains via municipal mergers, given median population of municipalities is "less than 5,000".

### Public asset management
- Gross financial assets totaled "about 90 percent of GDP in 2008".
- Substantial portions of these assets are low-yielding due to a cautious investment approach.
- Recommendation: adopt an asset management strategy to modestly increase returns and help close the sustainability gap.

### Pace of consolidation and plausible adjustment path
- Government’s stated objective: reduce both the output and fiscal sustainability gaps; intention to delay consolidation until "2011" implies a zero short-run weight on the sustainability gap.
- Staff present illustrative optimal fiscal adjustment paths under a quadratic loss function; structural primary balance in "2010 = -0.2 percent of GDP".
- Structural primary balance targets:
  - To close sustainability gap after 10 years: "6.2 percent of GDP".
  - To immediately close sustainability gap: "5.9 percent of GDP".
- Fiscal multiplier assumed: "0.6".
- Output gap in "2010 = -3.7 percent of GDP".
- A "plausible adjustment" corresponds to variable weights that close the sustainability gap by "2020" with some front-loading to strengthen credibility.

*Source: Staff Report for the 2010 Article IV Consultation—Informational Annex, European Department, July 29, 2010.*

### Annex II. Finland: Recent Fund Staff Recommendations and Implementation 1/

### Annex II. Finland: Recent Fund Staff Recommendations and Implementation

### Implementation — Labor Market Policy
- Recommended: wage bargaining system needs to allow for greater flexibility in wage setting.
- Recommended measures: ease labor market mismatches, reduce structural unemployment, induce earlier entry into the labor force, and further curtail various "pipelines" to early labor force departure.
- Implementation and developments:
  - Centralized wage bargaining has not been used for the last two wage rounds.
  - In 2007–09 wage increases exceeded productivity growth; recent agreements are much more moderate and flexible (including one-year wage agreements in some cases).
  - Labor market mismatches persist, especially given the recent downturn.
  - Policy actions taken:
    - Expanded training opportunities.
    - Mobility subsidies introduced.
    - Development of vocational education.
    - General cuts in labor tax rates, with additional specific reductions targeted for older, less productive workers.
    - Tax incentives and subsidies created for labor-intensive services, home care and service work.
    - Labor force service centers established for the hard-to-employ.
  - Specific extension: tax reductions have been extended notably to young labor market entrants.

### Past Staff Recommendations — Fiscal Policy
- Staff view (pre-implementation): overall fiscal position under current policies remains unsustainable despite previously sizable general government surplus and comparatively low debt ratio.
- Recommended focus:
  - Once recovery is firmly underway, take measures to attain sustainability.
  - Efforts should focus on expenditure restraint, especially at the local level.
  - Consider broadening the tax base and hiking indirect and property taxes.
  - Raise efficiency of public services.
  - Potentially revisit pension system parameters.
- Developments and implementation:
  - Economic downturn produced a large fiscal deficit reflecting cyclical effects and discretionary policy measures, worsening the "sustainability gap."
  - Significant pension reforms adopted in 2005; a life expectancy adjustment applied from the beginning of the referenced year.
  - No specific new pension-parameter measures proposed; a working group is exploring steps to extend the average working life by 3 years by 2025.
  - Reform implementation delayed until after the 2011 elections.
  - Measures to improve expenditure efficiency introduced, with greater success at the central government level.
  - Intergovernmental financing rules are being revised and measures to encourage municipal mergers have been adopted.

### Statistical Issues and Data Adequacy (As of June 28, 2010)
- General assessment: 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 for central government operations.
  - A data ROSC was electronically published on October 31, 2005.
- Table highlights (dates are "Date of latest observation" / "Date received"):
  - Exchange Rates: 06/28/10 / 06/28/10 — Frequency: D / Reporting: D / Publication: D.
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities: 03/10 / 05/08 — M / M / M.
  - Reserve/Base Money: 05/10 / 06/10 — M / M / M.
  - Broad Money: 04/10 / 06/10 — M / M / M.
  - Central Bank Balance Sheet: 05/10 / 06/10 — M / M / M.
  - Consolidated Balance Sheet of the Banking System: 05/10 / 06/10 — M / M / M.
  - Interest Rates: 06/28/10 / 06/28/10 — D / D / D.
  - Consumer Price Index: 05/10 / 06/10 — M / M / M; Data quality methodological soundness: O, O, O, O; accuracy/reliability: LO, O, LO, O, O.
  - Revenue, Expenditure, Balance and Composition of Financing — General Government: 2009 / 03/10 — A / A / A; methodological soundness: LO, LO, LNO, O; accuracy/reliability: LO, O, O, O, O.
  - GDP/GNP: Q1 2010 / 06/10 — Q / Q / Q; methodological soundness: O, O, O, O; accuracy/reliability: LO, O, LO, O, O.
  - Gross External Debt and International Investment Position: latest observation 04/08 / 06/08 — M / M / M.
- Footnote clarifications include definitions for frequencies and the meaning of methodological soundness and accuracy assessments (O = fully observed; LO = largely observed; LNO = largely not observed; NO = not observed).

### Statement by the IMF Staff Representative (August 25, 2010) — Key Revisions and Fiscal Projections
- National accounts revisions:
  - Real GDP decline for 2009 revised to 8 percent (was previously estimated at 7.8 percent).
  - Revisions for 2007–08: higher growth in 2007 largely offset by lower expansion in 2008.
- Fiscal projections revised down for 2010–12 due to better-than-expected H1 2010 outturn:
  - Corporate tax receipts in 2010 significantly higher than anticipated; social contributions overperformed; unemployment-related expenditures lower than planned.
  - Staff projects the deficit for 2010 at 3.4 percent of GDP (instead of the previous 4.1 percent of GDP).
  - General government deficit projections for 2011 and 2012 lowered by about ½ percent of GDP, to 1.8 percent of GDP and 2 percent of GDP, respectively.
  - Fiscal sustainability gap expected to be reduced to 5–5 ½ percent of GDP.
- Policy context:
  - On July 13, ECOFIN opened an excessive deficit procedure for Finland.
  - With revised fiscal prospects, the headline deficit can be brought within the 3 percent of GDP SGP threshold in 2011 even without additional measures owing to more favorable cyclical conditions.
  - Staff advice: pace of budgetary consolidation in 2011 should be moderate.

### Public Information Notice — Executive Board Conclusions (September 2, 2010; Article IV Consultation concluded August 25, 2010)
- Background and outlook:
  - Finland experienced the worst recession in the euro area in 2009, with GDP collapsing by 8 percent in 2009.
  - Growth: projected to expand by 1¼ percent in 2010 and around 2 percent in 2011; outlook unusually uncertain.
  - Employment and inflation:
    - Unemployment rate rose from 6½ to 8¼ percent during 2008–09.
    - Labor market expected to lag activity pick-up, with unemployment hitting 8 3/4 percent in 2010 (text shows "8 3  4  percent" in source — interpreted as unemployment hitting 8 3/4 percent in 2010).
    - Inflation turned down markedly in 2009 but has outpaced the EU average since late 2008, partly due to generous multi-year collective wage agreements in 2007 that were generally in excess of productivity gains.
  - External competitiveness: deteriorated recently but remains adequate.
- Fiscal developments:
  - General government headline balance went from a surplus of 4 percent of GDP in 2008 to a deficit of 2½ percent of GDP in 2009.
  - Headline fiscal balance expected to drop to a deficit of 3½ percent of GDP in 2010, breaching the Stability and Growth Pact limits.
  - Deterioration primarily reflects further structural relaxation of around 1 percent of GDP implying only a small structural primary fiscal surplus in 2010.
- Financial sector:
  - Banking system weathered turmoil well due to healthy capital buffers and prudent management.
  - Profitability and asset quality deteriorated but capital coverage remained well above regulatory minima.
  - Insurance companies and pension funds recovered in 2009 after weakening in 2008.
- Executive Directors’ assessment and recommendations:
  - Commended authorities for strong policies that mitigated the crisis impact.
  - Urged vigilance in the financial sector: improve bank cost efficiency, prevent excessive risk taking, limit liquidity and funding risks.
  - Importance of strengthening cross-border supervision and crisis management arrangements; welcomed Nordic-Baltic Stability Group.
  - Fiscal stance: supported ongoing stimulatory fiscal policy during the downturn, but called for strong and credible consolidation starting in 2011.
    - Some Directors supported the authorities’ plans for a relatively large fiscal adjustment in 2011.
    - Other Directors favored a more moderate pace of consolidation in 2011 to balance restoring fiscal sustainability and allowing recovery to continue.
  - Medium-term: endorsed gradual closing of the sustainability gap by 2020.
    - Fiscal adjustment should focus on expenditure restraint; efforts could also broaden the tax base (including higher property and indirect taxes) and reduce items on reduced VAT rates and other special treatments.
    - With aging pressures, necessary measures include increasing effective retirement age, enhancing public service efficiency, and containing demand for services.
  - Labor market and structural reforms:
    - Encouraged limiting transition to early retirement via unemployment and disability, boost youth employment, increase competition, and foster research and entrepreneurship.
  - Competitiveness: stressed wage increases should be commensurate with productivity growth going forward.

### Selected Economic Indicators (as presented)
- Real economy:
  - GDP (change in percent): 2008 = 0.9; 2009 = -8.0; 2010 1/ = 1.2; 2011 1/ = 2.0.
  - Harmonized CPI (change in percent) 2/: 2008 = 3.9; 2009 = 1.6; 2010 1/ = 1.4; 2011 1/ = 1.8.
  - Unemployment rate (in percent) 2/: 2008 = 6.4; 2009 = 8.3; 2010 1/ = 8.8; 2011 1/ = 8.7.
  - Gross national saving (in percent of GDP): 2008 = 24.9; 2009 = 18.9; 2010 1/ = 19.3; 2011 1/ = 19.1.
  - Gross domestic investment (in percent of GDP): 2008 = 21.8; 2009 = 17.5; 2010 1/ = 17.8; 2011 1/ = 17.6.
- Public finances (general government, in percent of GDP):
  - Overall balance: 2008 = 4.1; 2009 = -2.4; 2010 1/ = -3.4; 2011 1/ = -1.8.
  - Primary balance: 2008 = 5.6; 2009 = -1.0; 2010 1/ = -2.1; 2011 1/ = -0.4.
  - Gross debt (Maastricht definition): 2008 = 34.2; 2009 = 44.0; 2010 1/ = 50.0; 2011 1/ = 52.2.
- Money and credit (end of year, percentage change):
  - M3 (Finnish contribution to euro area) 3/: 2008 = 5.0; 2009 = -1.7; 2010 1/ = -0.8.
  - Finnish MFI euro area loans 3/: 2008 = 11.6; 2009 = 1.7; 2010 1/ = 4.5.
- Interest rates (year average):
  - Three-month money market 4/: 2008 = 4.6; 2009 = 1.2; 2010 1/ = 0.8.
  - Ten-year government bonds 4/: 2008 = 4.3; 2009 = 3.7; 2010 1/ = 2.9.
- Balance of payments (in percent of GDP):
  - Trade balance: 2008 = 3.7; 2009 = 2.3; 2010 1/ = 1.9; 2011 1/ = 1.8.
  - Current account: 2008 = 3.1; 2009 = 1.3; 2010 1/ = 1.5; 2011 1/ = 1.4.
- Fund position (as of end-June 2010):
  - Fund holding of currency (in percent of quota) = 77.3.
  - Holdings of SDR (in percent of allocation) = 101.1.
  - Quota (in millions of SDRs) = 1263.8.
- Exchange rate:
  - Regime = Euro.
  - Present rate (August 5, 2010) = US$1.32 per euro.
  - Nominal effective exchange rate (increase in percent) 5/: 2008 = 2.6; 2009 = 1.3.
  - Real effective exchange rate (increase in percent) 5/6/: 2008 = 4.1; 2009 = 5.5.
- Sources stated: Finnish authorities; International Financial Statistics; and IMF staff estimates.
  - Notes: 1/ IMF staff estimates and projections, unless otherwise indicated. 2/ Consistent with Eurostat methodology. 3/ For 2010, annual change through April. 4/ For 2010, data are for April. 5/ For 2009, data are for first 10 months. 6/ Based on unit labor costs.

### Statement by Finland’s Executive Director and Senior Advisor (August 25, 2010) — Authorities’ View
- Authorities’ summary:
  - Acknowledged candid dialogue with staff and welcomed staff analysis and recommendations.
  - Noted Finland's economy was hit very hard in 2009; GDP plummeted by 8 percent in 2009.
  - Assessed that the worst is over and gradual recovery is under way.
  - Noted significant stimulus measures were made possible by preceding fiscal surpluses and contributed to a better-than-projected employment situation despite deep recession.
  - Firms preferred temporary lay-offs over permanent dismissals to retain skilled labor given anticipated future labor shortages due to the age profile of the population.
  - Recognized that long-run potential output growth may have been lowered due to the deep recession and that the trend level of output has most likely been reduced.
  - Shared staff’s concern about fiscal sustainability in view of rapid population aging and pressures on health care, pension and old age care funding.

*Italic: Source — _cr10273 - Annex II. Finland: Recent Fund Staff Recommendations and Implementation 1/_ (PDF chapter content provided).*

### 4. Finland's financial system was naturally affected by the global turmoil, but financial

### _cr10273 - 4. Finland's financial system was naturally affected by the global turmoil, but financial

### Financial system stability — overview and key concerns
- The financial sector is well regulated and supervised and the banking sector is resilient to common adverse shocks.
- Overall picture of the Finnish financial sector is reassuring: banks endured the financial crisis well in international comparison mainly due to adequate capital reserves and conservative management practices.
- Main concerns raised:
  - Profitability: exceptionally low net interest margins leading to a squeeze on banks’ profitability.
  - Liquidity and funding risks.
  - Insurance companies and pension funds suffered due to a large drop in equity prices during the financial crisis, though the situation has improved with equity market recovery.
- Supervisory context:
  - Banking system is significantly foreign-owned and concentrated, making effective cross-border supervision of utmost importance.
  - Room for strengthening regulatory and supervisory frameworks remains; cross-border supervision at Nordic and EU level would benefit from closer cooperation.
  - Supervisory colleges have been established for financial groups operating in Nordic countries to support joint monitoring of risks and improved information sharing and reporting.
  - Authorities support harmonization of regulation, supervision, and bank resolution frameworks at European and global level.
- Regional cooperation:
  - In August, the Nordic and Baltic authorities concluded a MoU to further strengthen cross-border cooperation for financial groups and relevant infrastructure.
  - The MoU includes a preliminary framework for discussing eventual burden sharing agreements for jointly agreed crisis management actions related to regional financial groups.

### Recent economic developments and outlook
- Growth and activity:
  - Return to growth during Q2, fuelled mainly by recovery of exports and private consumption.
  - Authorities’ forecast: real GDP expected to grow by 1.5 percent in 2010 and by 2.5 percent in both 2011 and 2012.
  - Staff view is slightly less optimistic than the authorities’ forecast; mounting upside risks to the authorities’ GDP forecast for 2010 and 2011 are noted given recent data.
- External sector and industry:
  - Stronger than expected recovery of world trade and economic activity has started to feed into the Finnish economy.
  - The volume of industrial output is now about 15 percent higher than a year ago.
  - New orders have increased rapidly during the past few months.
  - Quarterly growth of exports was 13 percent in Q2.
  - Merchandise export market shares have trended downwards; external competitiveness has deteriorated since the last Article IV discussions.
  - In 2008 and 2009, unit labor costs increased faster than in any other Euro area country, at twice the pace of the Euro area average.
  - Increase in labor costs driven by high pay rises negotiated in 2007 for a three-year period that were not adjusted downwards when the business cycle turned.
- Domestic demand and labor market:
  - Consumer confidence and employment improved during the summer, pointing to a pick-up in private consumption.
  - Employment situation remained better than anticipated during the downturn partly because temporary lay-offs did not turn into dismissals.
  - Number of unemployed continued to decline during the summer.
  - Seasonally adjusted unemployment rate: 8.2 percent in June compared with 8.9 percent at the turn of the year.
  - Housing: signs that housing construction is recovering rapidly based on a pick-up in housing permits; commercial real estate not yet robust.
  - Real house prices have rebounded strongly and are at record high levels that call for monitoring; authorities share staff’s concern about hazards if the accelerated trend continues.
- Inflation and external balances:
  - In 2011, exports and imports are forecast to grow steadily; trade and current accounts will remain in surplus.
  - National consumer price inflation is forecast to accelerate to 2.5 percent next year partly due to the rise in indirect taxes and past hikes in import price levels.

### Fiscal policy, developments, and consolidation measures
- Pre-crisis and crisis fiscal positions:
  - General government surplus was 4.2 percent of GDP in 2008.
  - Deterioration in public finances was around 7 percentage points relative to GDP in 2009.
  - Deterioration particularly apparent in central government accounts.
  - Automatic stabilizers were allowed to operate; discretionary stimulus measures (bringing forward public investment, cutting taxation, facilitating funding for businesses) adversely affected general government financial position.
- Near-term fiscal outlook:
  - Authorities expect the general government deficit to deepen to 3.2 percent of GDP (latest official forecast).
  - With resumption of growth, tightening of taxation, and increase of social security contributions, the general government’s fiscal position will start improving in 2011 though still remain in deficit at 1.3 percent of GDP.
- Consolidation measures taken/announced:
  - Both the general and reduced value-added tax rates were raised by one percentage point at the beginning of July 2010.
  - Government’s 2011 budget proposal includes an excise duty on sweets, expansion of the excise duty on soft drinks as of 1 January 2011, and increases in energy taxes from the beginning of 2011.
  - Government respected central government expenditure ceilings set at the beginning of the government term.
  - Despite measures, the budget proposal ends with a borrowing requirement of around 8.5 billion euro.
  - Authorities view fiscal stance as turning from expansionary to restrictive next year and see a slightly tighter fiscal stance warranted for 2011 than staff recommended, given improving cyclical situation and sizeable sustainability gap.
- Structural fiscal sustainability and reforms:
  - Sustainability gap estimated to have increased substantially to over 5 percent of GDP.
  - Authorities are committed to fiscal consolidation as reflected in the 2011 budget proposal.
  - Measures introduced in recent years include reforms to increase effective retirement age, further mergers of municipalities, increasing upper and lower real estate tax rates, measures to raise productivity of public services, and raising user fees on public services.
  - Government target: implementation of measures aimed at extending working careers by three years by 2025.
  - Structural reform of municipalities and public services aims to develop production practices, strengthen financial basis of service provision, enhance public sector productivity, and reallocate labour.
  - Particular future attention will be paid to developing the productivity of municipal services.

### Labor and product market reforms
- Authorities share staff’s view on the need to continue reforming labor and product markets.
- Measures underway or proposed:
  - Speeding up entry into tertiary education and shortening time spent in studies.
  - Reforms in preparation in the Ministry of Education and Culture, including reforming the financial support system to give more incentives for organizers of education and students to graduate.
  - Introduction of tuition fees and user fees for public services have been widely discussed but face opposition and are unlikely to be imposed in the near future.
- Pension and labor participation issues:
  - Increasing need to raise effective retirement age is widely acknowledged.
  - Financing of earnings-related pension system needs to be secured by an increase in pension contributions that is not too high so as to hamper employment and growth.
  - Working careers need to be extended sufficiently to support pension financing.
  - Authorities share concern relating to the unemployment and disability pipelines.
- Structural measures already implemented:
  - Liberalization of shop opening hours and municipal mergers have already been implemented in part.
  - Number of municipalities reduced from over 400 to some 300 over the past decade; additional mergers expected.
  - Broad acceptance of need to increase competition in services, public administration, and local governments, but building consensus takes time.

### Financial sector policy recommendations and supervisory actions
- Authorities value staff’s FSSA Update assessment and will consider recommendations carefully.
- Specific supervisory and regulatory actions/concerns:
  - FIN-FSA has urged stress testing with interest rates at 6 percent on new mortgages at variable short rates and limits on the LTVs used in new mortgages.
  - Authorities have repeatedly voiced concern to the financial community and mortgage borrowers about low net interest margins.
  - Cross-border supervision: establishment of supervisory colleges for Nordic financial groups; home and host supervisors participate and focus on joint risk monitoring and improved information sharing.
  - Authorities support harmonization of regulation, supervision, and bank resolution frameworks at the European and global level.

*Source: _cr10273 (IMF staff report)*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr10273.pdf_