## 1. External Sector Assessment

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### Recent developments
- Finland experienced three years of recession; GDP declined by a cumulative 3 percent in 2012–14.
- Unemployment increased to 8.7 percent in 2014.
- Inflation slowed from 2.2 percent on average in 2013 to 1.2 percent in 2014, with end-of-period inflation at 0.6 percent.
- Average headline inflation is expected to fall to 0.0 percent in 2015; average core inflation is forecast at around 0.6 percent.
- Private sector investment declined from 20 percent of GDP in 2007 to 16 percent in 2014.
- The ICT sector declined sharply since 2007, largely due to Nokia’s handset business sale to Microsoft in 2013; the paper industry also saw secular decline.
- Aggregate productivity growth decline is substantially explained by the shrinkage of high productivity industries; longer-term factors include a rapidly aging workforce and slow labor supply growth.
- The current account shifted to persistent deficits since the crisis; nominal exports have fallen more than 10 percent from their peak in 2008 while imports fell 1 percent over the same period.
- Unit labor costs (ULCs) have risen 25 percent since 2007.
- General government deficit widened to 3.3 percent of GDP in 2014.
- Gross debt-to-GDP ratio was just short of the SGP’s 60 percent threshold and staff forecast it to breach it in 2015.
- The European Commission decided not to recommend Finland enter the Excessive Deficit Procedure (EDP) in June based on announced consolidation plans.
- The new coalition government (took office in May) announced a broad structural reform program; the medium-term fiscal plan envisages consolidation worth around 2 percent of GDP over 2016–19.
- Financial sector policy reforms legislated last year, including a new macroprudential policy framework, are being implemented.

### Outlook and risks
- Baseline growth projections: 0.4 percent in 2015 and 0.9 percent in 2016 (down from April 2015 WEO projections of 0.8 and 1.4 percent, respectively).
- Private consumption contributes to 2015 growth, aided by lower inflation and mortgage amortization holidays worth about 0.3 percent of GDP in total.
- Private investment expected to contribute positively in 2016, partly due to investments in new technology in the paper industry.
- Recovery supported by bottoming out of Nokia’s decline and revival of its network equipment business (Nokia announced it will buy Alcatel-Lucent).
- Absent further structural reforms, medium-term growth projected to rise to only 1.6 percent in 2020.
- Output gap projected at -3.2 percent of potential GDP in 2015.
- Unemployment forecast to rise to 9.5 percent in 2015–16 and begin declining in 2017.
- Headline inflation projected to pick up to 1.3 percent in 2016.
- Short-run low inflation could hamper relative price adjustments and contribute to households’ debt burdens.
- Main external risks: weaker-than-expected external demand (Russia, rest of Nordic region, euro area) and financial shocks transmitted via Swedish or Danish banks.
- Domestic risk: procyclical fiscal consolidation weakening the recovery if fiscal multipliers are higher than expected.
- Recent migrant inflows could be positive for labor force growth but have short-run fiscal costs.

### Authorities’ views
- Authorities saw weaker external demand or financial shocks as main risks and agreed such shocks could impair the fragile recovery.
- Authorities noted the drop in exports to Russia last year was sharper than expected and argued further weakening should have a smaller impact.
- Authorities acknowledged fiscal consolidation will negatively impact growth but considered the likelihood of a large impact low, citing:
  - Fiscal multipliers in small open economies are typically small.
  - Share of liquidity constrained consumers is smaller in Finland than most other euro area countries.
  - Interest rates at the zero lower bound are unlikely to affect multipliers in Finland since Finland cannot influence monetary policy independently as a small member of a monetary union.

### Policy discussion
- Primary challenge: revive growth through bold and comprehensive structural reforms, including labor market reforms to address low productivity and labor supply growth.
- Fiscal policy should balance consolidation needs against growth objectives to avoid derailing the fragile recovery.
- Macroprudential policy toolkit and regional cooperation on financial stability should be further strengthened.

### Structural policies: raising Finland’s growth potential — findings
- Total factor productivity (TFP) growth is forecast to be only half its pre-crisis average over the medium-term.
- Reallocation of resources from declining industries to growing ones is critical to restoring growth and raising TFP.
- Impediments to labor mobility include too little affordable housing in Helsinki and limited retraining opportunities.
- Centralized wage setting compresses the wage distribution, constraining firms’ ability to adjust wages and creating a relatively high effective minimum wage that may hinder low-skilled employment and participation.
- Generous unemployment benefits (500 days duration) and wage compression may have discouraged skill development and inter-sectoral labor mobility.
- Labor force growth has fallen sharply due to population aging compounded by a decline in participation rate of 25–54 year olds by 4 percentage points since 2008 and a relatively low participation rate for 65–69 year olds (13 percent versus 25 percent OECD average).

### Planned reforms and measures
- Pension reforms aim to increase the average effective retirement age to 62.4 by 2025 (from 61 years currently).
- Plans to tighten requirements on student aid to reduce very long tertiary study duration and increase labor force participation by younger people.
- Government seeks to reduce unit labor costs via reduction of employers’ social security contributions and unremunerated increases in working hours (modalities under discussion with social partners).
- Intention to increase flexibility of the wage bargaining system at the firm-level; an internal government expert appointed to make specific proposals.
- Reforms to unemployment benefits planned but not to be implemented before 2017.
- Public sector productivity measures include reducing bureaucratic requirements and increasing local governments’ flexibility in service delivery (e.g., easing minimum staff-to-children ratio in day cares).
- Medium-term reform to shift health and social services delivery from municipalities to regional bodies to streamline administration and reap economies of scale.
- Proposal to liberalize shop opening hours to boost retail output and employment.
- Initiatives to reduce administrative and regulatory burdens on business, streamline permitting processes; specifics remain to be detailed.
- Plans to improve financial incentives for collaboration on R&D between universities and firms; concerns exist about planned cuts to public R&D spending overall.
- Measures to stimulate housing construction: easing requirements for state-subsidized housing construction, reducing restrictions on land use, and streamlining permitting and development processes.

### Policy recommendations and caveats (staff)
- Staff welcomed reform intentions but emphasized outcomes depend on precise modalities and implementation; authorities should quickly flesh out reform details.
- Monitor outcomes of increased local government flexibility to ensure service quality is preserved.
- Assess pension reform impact over time to ensure it meets aims.
- Strengthen and expand active labor market programs (ALMP) to increase retraining and skill development; staff concern that planned ALMP funding cuts should be reconsidered.
- Direct investment in affordable housing and related infrastructure in main urban areas to support labor mobility.
- Maintain or increase public investment in R&D and innovation to support private sector TFP growth over the medium-term.
- Further product market reforms possible, including reducing planning restrictions on real estate developments for retail locations to limit barriers to entry and enable economies of scale.

### Structural reforms and labor market (authorities’ decisions and options)
- Authorities agreed with staff on structural challenges and were determined to move ahead with planned reforms.
- Authorities preferred broad consensus with social partners but would take required measures even if consensus could not be secured.
- After efforts to reach a “social contract” on a reduction of unit labor costs failed, authorities introduced proposals to amend legislation governing collective agreements and bypass trade unions.
- Options being explored to increase firm-level flexibility in wage formation within the existing system include adding opt-out clauses to collective agreements.
- The pension reform that comes into force in 2017 was considered sufficient by authorities to put pension expenditure on a sustainable path; authorities will monitor developments and reassess the need for further reforms at five-year intervals.
- On ALMP and R&D spending cuts, authorities indicated scope to cut less effective programs to help satisfy fiscal consolidation needs.

### Fiscal policy: overview, composition, and recommendations
- The long-run fiscal sustainability gap is sizable (estimated at around 5 percent of GDP) and is primarily due to projected aging related spending pressures.
- Public expenditure has already increased 12 percentage points of GDP since 2007.
- After breaching the SGP’s deficit criterion in 2014, fiscal consolidation is needed to bring the deficit back below the 3 percent threshold next year and to put the public debt-to-GDP ratio on a downward path by 2020.
- The new government plans fiscal adjustment of nearly 2 percent of GDP over 2016–19.
- The consolidation path is slightly frontloaded, with more than three fifths of the consolidation occurring in the first two years.
- The proposed 2016 budget envisages consolidation measures worth about 0.6 percent of GDP.

Composition
- Spending reductions account for more than ¾ of the planned consolidation measures over 2016–19.
- Education, foreign aid, and social benefits are targeted for some of the most substantial cuts.
- Despite high and rising unemployment, spending on ALMP will be reduced; planned reforms to unemployment benefits generating savings of 0.1 percent of GDP per year will be delayed to 2017.
- Public investment in new projects (e.g., City Rail Loop in Helsinki) will be reduced; cuts partially offset by increased maintenance of existing infrastructure.
- Local governments will be responsible for about 20 percent of the savings through reduced responsibilities and greater flexibility in service delivery.
- A General Government Fiscal Plan has been introduced that sets medium-term spending and deficit limits on both central and local governments.

Revenue measures
- Budget proposal includes a hike in unemployment insurance (UI) taxes to generate 0.1 percent of GDP per year in 2016–17.
- Other revenue-raising measures for 2016–19 include phasing out tax deductibility of mortgage interest and excise tax increases.
- These measures will be largely offset by lower income, capital, and corporate taxes, including an earned income tax credit increase worth about 0.2 percent of GDP.

Growth package
- A “growth package” is planned to mitigate the adverse impact of consolidation and is worth about 0.7 percent of GDP in total.
- Components: one-off investments in infrastructure maintenance (0.3 percent of 2016 GDP) and other key projects including investments in innovation and digitization of government services.
- Timing and amounts: about 0.15 percent of GDP spent in 2016 and 0.3 percent of GDP spent in 2017 and 2018 each.
- Financing: asset sales, increased dividends from public enterprises, and cuts to new infrastructure projects (the latter reduce the net impact of the package’s infrastructure component by about half).

Staff recommendations on fiscal policy
- Staff supported measures to curb long-term spending pressures but suggested smoothing the pace of consolidation to reduce growth risks.
- Some scope exists for a more even consolidation path within SGP constraints.
- Frontloading some of the spending from the currently backloaded growth package would help reduce effective fiscal consolidation and ameliorate the growth impact; bringing forward planned infrastructure maintenance is feasible.
- If growth is weaker than expected, automatic stabilizers should be allowed to operate and fiscal costs from a significant surge in refugees should be accommodated.
- Composition should be made as growth friendly as possible: shifting tax composition away from direct (income) taxes toward indirect (consumption) taxes is beneficial in the medium- to long-run.
- Delay the planned increase in the UI contribution tax until unemployment is closer to normal levels because it increases labor costs when labor demand is weak.
- Increase spending on ALMP rather than cut it.
- Avoid planned cuts to productive public investment and R&D; staff analysis suggests that for a given amount of consolidation, shifting cuts from public investment and targeted transfers to public consumption and untargeted transfers could reduce negative short-run effects on output by about one third.

Long-run fiscal sustainability and structural reforms
- Pension reforms legislated this year are projected to reduce the fiscal sustainability gap by around 1 percentage point of GDP.
- Taking into account the government’s nearly 2 percent of GDP consolidation effort, closing the remaining 2 percentage points of the gap will depend on the impact of planned structural reforms.
- Reforms to improve cost efficiency of health and social services, including consolidating services provision at the regional level, are critical to containing aging related spending pressures.

Authorities’ views on fiscal policy
- Authorities acknowledged consolidation risks to growth but emphasized need for sufficient buffers to ensure compliance with the SGP and to lock-in savings early to put public debt-to-GDP ratio on a downward path by 2020.
- Timing of growth package spending depends on availability of financing; authorities saw limited scope for frontloading investments.
- Authorities believed negative growth impact from cuts to public investment and R&D would not be as high as literature suggests because infrastructure levels and R&D spending were near the frontier.
- Agreed reforms to improve public sector productivity are critical but noted careful design and implementation will take time.

### Financial sector: stability, macroprudential policy, and recommendations
Findings
- Few indications of imminent domestic financial stability risks: banking system remains profitable and appears relatively well capitalized.
- Non-performing loans (NPLs) remain low at 1.5 percent of total loans, down from 1.8 percent at end-2014.
- Credit to non-financial and housing corporations growing at around 5 percent in 2014 and first half of 2015; household credit growth around 2 percent.
- Household debt ratio has risen to about 120 percent of disposable income.
- Housing market has cooled; average house prices broadly in line with fundamentals.
- Structural vulnerabilities: banking system concentration, regional interconnectedness, heavy reliance on wholesale funding.

Macroprudential and regulatory steps
- Implementation of the Bank Recovery and Resolution Directive (BRRD) in national legislation, establishment of resolution authority and new deposit guarantee and resolution fund are positive steps.
- Act on Credit Institutions introduced macroprudential tools required by CRR/CRD-IV, and a loan-to-value (LTV) ratio cap for new mortgages to apply from mid-2016.
- Independent Board of the Finnish Financial Supervisory Authority (FIN-FSA) established as the macroprudential authority.
- Scope to further strengthen toolkit, including adding a systemic risk buffer (SRB) as recommended by an internal study group.
- Authorities should implement Basel III net stable funding ratio and liquidity coverage ratio requirements as soon as feasible given banks’ increasing reliance on wholesale funding.

Cross-border and regional cooperation
- Single Supervisory Mechanism (SSM) became competent microprudential regulator for the three largest Finnish banks.
- Two of these—Nordea and Danske Bank—are subsidiaries of parent institutions outside the banking union; cooperation on financial stability and cross-border resolution frameworks remains necessary.
- Nordea plans to convert its Finnish subsidiary into a branch; if realized, Finnish authorities must retain capacity to monitor the bank (it accounts for about 30 percent of loans and deposits in the Finnish banking system) for financial stability risk analysis and macroprudential policy formulation.
- Robust cross-border supervisory cooperation on information sharing, depositor protection, and resolution arrangements should be agreed among Finnish, Swedish, and European authorities.

FSAP and authorities’ views on financial policy
- The 2016 FSAP will examine the financial sector and regulatory environment, coordinated closely with the Sweden FSAP.
- Authorities supported introducing an SRB but expected the proposal probably will not be taken up before next year due to other legislative priorities.
- Authorities agreed that deepening regional cooperation is useful in view of Nordea’s conversion plans and were broadly positive on SSM experience, noting a learning curve and increased FIN-FSA workload.

### External sector assessment — key findings and projections (Box 1)
Current account and drivers
- In the decade up to 2007, Finland’s annual CA surplus averaged 5½ percent of GDP.
- Since 2011, the CA has shown a deficit of about 2 percent of GDP.
- The CA deterioration is mainly driven by the decline of Nokia and wood and paper exports.
  - Exports of electrical and optical equipment fell from a pre-crisis peak of 8½ percent of GDP to 3 percent in 2014.
  - Wood and paper exports declined by about 2½ percentage points of GDP since 2002 to 5½ percent in 2014.
- ULCs rose nearly 25 percent since 2007, due to rapid wage increases during 2008–10 and falling productivity from sectoral changes.

Financial account and NIIP
- The CA deficit has been balanced by a surplus in the financial account.
- From 2009–12, positive portfolio debt investments tied to Finland’s "safe haven" status contributed substantially to the financial account surplus.
- In 2014, foreign direct investment gained importance as Microsoft purchased Nokia’s handset business.
- Portfolio inflows will continue to be an important component of the financial account, averaging about 6 percent of GDP per year out to 2020.

Projections and balance-sheet implications (staff projections)
- Trade balance and CA
  - Exports appear to be stabilizing and the trade balance is expected to move back into surplus.
  - The CA balance is expected to improve by a cumulative ½ percent of GDP to -0.2 percent in 2020.
- Net international investment position (NIIP)
  - NIIP forecast to continue deteriorating, from -0.8 percent of GDP in 2014 to -12 percent in 2020.
  - Change in NIIP mostly attributed to net foreign direct investment, which falls by 9½ percentage points of GDP from 2014 to 2020.
  - Net portfolio investment deteriorates slightly, by about ½ percentage points of GDP over the same period.
  - Net other investments (e.g., loans, deposits, and trade credit), though negative, offset some of this decline.
  - Projected valuation effects from exchange rate changes also play a role.
- External debt
  - Gross external debt expected to remain around 220–230 percent of GDP.
  - Net external debt will average around 50 percent of GDP through 2020.
- Assessment of external position
  - Staff views the external position as "broadly in line with fundamentals."
  - EBA analyses suggest the REER was slightly overvalued in 2014; given uncertainty, staff assesses the REER as broadly in line with fundamentals.

### Key quantitative indicators and projections (selected exact values)
- CA balance: -0.9 percent of GDP in 2014 (Table 2 shows -1.8 billion euros, -0.9 percent of GDP), projected -0.2 percent of GDP in 2020.
- NIIP: -0.8 percent of GDP in 2014; forecast to -12 percent of GDP in 2020.
- Portfolio inflows: about 6 percent of GDP per year out to 2020.
- Gross external debt: expected to remain around 220–230 percent of GDP.
- Net external debt: will average around 50 percent of GDP through 2020.
- Electrical and optical equipment exports: peak 8½ percent of GDP pre-crisis to 3 percent in 2014.
- Wood and paper exports: declined by about 2½ percentage points of GDP since 2002 to 5½ percent in 2014.
- ULCs rose nearly 25 percent since 2007.
- GDP growth (volumes, Table 1 projections): -0.4 in 2014, 0.4 in 2015, projected 0.9 in 2016 and 1.2 in 2017.
- Unemployment rate: 8.7 in 2014, 9.4 in 2015, projected 9.0 in 2016 and 8.5 in 2017.
- Output gap (percent of potential output): -3.3 in 2014, -3.2 in 2015, improving to -0.5 by 2020.
- Consumer price inflation (HICP, average): 1.2 in 2014, 0.0 in 2015, projected 1.3 in 2016 and 1.6 in 2017.

### Debt sustainability analysis — baseline, stress tests, and shock scenarios
Baseline and projections
- Public debt rose in 2014, driven by a higher than expected fiscal deficit, and is forecast to exceed 60 percent of GDP in 2015.
- Under the baseline debt to GDP is expected to peak in 2019 and to gradually decline thereafter.
- Baseline macroeconomic assumptions:
  - Real GDP growth: 0.4 percent in 2015; 0.9 percent in 2016; 1.2 percent in 2017; 1.3 percent in 2018; 1.4 percent in 2019; 1.6 percent in 2020.
  - GDP deflator inflation: 0.7 percent in 2015, 1.4 percent in 2016, 1.6 percent in 2017, 1.8 percent in 2018, 1.9 percent in 2019, 2.1 percent in 2020.
  - Effective interest rate: 2.0 in 2015, 1.9 in 2016, 1.8 in 2017, 1.7 in 2018, 1.8 in 2019, 1.8 in 2020.
- Finland’s debt level is expected to breach 60 percent of GDP in 2015, which calls for using the higher scrutiny framework.
- Projected to continue rising until 2019 and remain above 60 percent over the forecast horizon.
- Gross financing needs remain below 15 percent of GDP every year in the baseline scenario.
- Net debt ratio remains negative due to the large stock of pension assets, though the net debt deteriorates more than gross debt rises over time as pension assets are used to pay benefits.

Shock scenarios (selected impacts)
- Real GDP growth shock
  - Growth is one-standard deviation lower than the baseline in 2016 and 2017 (i.e., 3.9 percentage points lower).
  - Inflation is 25 bps lower in 2016 and 2017.
  - Interest rates are higher by 71 bps in 2016 and by 143 bps in 2017.
  - Debt ratio peaks at 82 percent of GDP in 2019.
  - Gross financing need (GFN) exceeds 20 percent of GDP in 2017.
- Primary balance shock
  - Primary balance is 1.6 percentage points of GDP lower than in the baseline in 2016 and 2017.
  - Debt ratio almost reaches 70 percent of GDP in 2019.
  - GFN peaks at 15 percent of GDP in 2017.
- Real interest rate shock
  - Real interest rate is 274 bps higher than the baseline over 2016-20.
  - Debt reaches 68 percent of GDP by 2020.
  - GFN remains below 15 percent of GDP.
- Real exchange rate shock
  - Impact is small: debt ratio only 1 percent of GDP higher than baseline at its peak in 2019.
  - GFN remains almost identical to the baseline GFN.
- Combined macro-fiscal shock
  - Debt ratio rises above 85 percent of GDP by 2020.
  - GFN hits an apex of 21 percent of GDP in 2017.
- Contingent liability shock
  - Contingent liability shock in 2016 equals about 17 percent of GDP.
  - Growth falls as in the real GDP shock scenario.
  - Real interest rate spikes 441 bps in 2016.
  - Debt ratio jumps more than 20 percentage points of GDP between 2015 and 2016.
  - GFN peaks at around 30 percent of GDP in 2016.
  - Debt ratio peaks near 94 percent of GDP in 2019.

Stress-test outcomes and risk benchmarks
- Under the Real GDP growth shock scenario: debt ratio peaks at 82 percent of GDP in 2019; GFN > 20 percent of GDP in 2017.
- Under the Primary balance shock scenario: debt ratio approaches 70 percent of GDP in 2019; GFN peaks at 15 percent of GDP in 2017.
- Under the Real interest rate shock: debt reaches 68 percent of GDP by 2020; GFN remains below 15 percent of GDP.
- Under the Combined macro-fiscal shock: debt ratio > 85 percent of GDP by 2020; GFN apex of 21 percent of GDP in 2017.
- Under the Contingent liability shock: contingent liabilities ≈ 17 percent of GDP in 2016; debt jumps > 20 percentage points of GDP between 2015 and 2016; GFN ≈ 30 percent of GDP in 2016; debt peaks near 94 percent of GDP in 2019.
- Risk assessment benchmarks used: debt burden benchmark 85 percent; GFN benchmark 20 percent of GDP; bond spread benchmarks 400 and 600 bps; external financing requirement benchmarks 17 and 25 percent of GDP; annual change in short-term public debt benchmarks 1 and 1.5 percent; public debt held by non-residents benchmarks 30 and 45 percent.

Policy implications from DSA
- Use higher scrutiny framework given expected breach of 60 percent of GDP in 2015.
- Manage fiscal consolidation to contain long-run aging-related pressures while insulating near-term growth (smooth consolidation, frontload growth-friendly spending where feasible).
- Maintain gross financing needs under risk thresholds and monitor contingent liabilities.

### Risks from euro area developments and other external shocks (selected scenarios and responses)
- Euro area bond / market contagion: Risk level Medium.
  - Finding: Finland could be affected if sovereign and financial sector stress re-emerges across the euro area.
  - Policy response: Full implementation of the macroprudential toolkit; push banks to improve buffers; ECB to provide ample liquidity if stress materializes.
- Structurally weak growth in the euro area: Risk level High.
  - Finding: Finland’s exports are tightly linked to Euro area markets; weak external demand would deepen stagnation.
  - Policy response: Ease the pace of fiscal consolidation; allow automatic stabilizers; focus on structural reforms.
- Political fragmentation / geopolitical risks: Risk level Medium (overall); Low (quantified trade impact).
  - Finding: Russia is Finland’s fifth largest export market; renewed tensions could reduce trade and shave a couple tenths of a percent off GDP growth.
  - Policy response: Short-run allow fiscal policy and automatic stabilizers; medium-run promote export market diversification.
- Adverse house price shock in an interconnected neighboring Nordic country: Risk level Medium.
  - Finding: Household debt is high in the Nordics; two largest Finnish banks are Swedish and Danish; declining demand from other Nordics would lower growth.
  - Policy response: Full adoption of macroprudential toolkit and introduction of the SRB.

### Financial soundness indicators (selected historical figures 2008–2014)
- Total household debt (percent of GDP): 51.7, 58.2, 59.9, 60.1, 62.3, 63.0, 64.5 (2008–2014).
- Total household debt (percent of disposable income): 109.4, 111.8, 113.8, 115.1, 118.1, 118.5, 122.5 (2008–2014).
- General government debt (EMU definition, percent of GDP): 32.7, 41.7, 47.1, 48.5, 52.9, 55.8, 59.3 (2008–2014).
- Total assets (billions of euro): 347.1, 349.1, 418.2, 542.4, 496.2, 455.3, 505.9 (2008–2014).
- Non-performing loans/total loans (percent): 0.4, 0.7, 0.6, 0.6, 0.5, 0.6, 1.8 (2008–2014).
- Regulatory capital as percent of risk-weighted assets: 13.6, 14.6, 14.4, 14.2, 17.0, 16.0, 17.3 (2008–2014).
- Return on equity (percent): 8.4, 6.9, 6.9, 7.6, 8.5, 8.1, 8.2 (2008–2014).
- Use of ECB refinancing (billions of euro): 2.5, 2.7, 0.1, 2.3, 3.7, 2.5, 0.7 (2008–2014).
- Change in housing price index (year average percent): 0.6, -0.3, 8.7, 2.6, 1.6, 1.3, -0.7 (2008–2014).

### Staff appraisal: macroeconomic context and priorities (summary)
- Finnish economy has been in recession for three years with structural and cyclical shocks since 2007: declines of Nokia and the paper industry, weak external demand (euro area and Russia), wage hikes in 2008–10, weak productivity growth, and rapid population aging.
- Current account and fiscal balances deteriorated; 2014 fiscal deficit breached the SGP’s 3 percent of GDP criterion.
- Recovery projected to start in 2015 and gradually strengthen in 2016, but likely slow and subject to downside risks; absent further reforms, growth likely to remain much lower than before the crisis.
- Main challenge is to revive growth by boosting productivity, facilitating reallocation from declining to growing industries, and raising labor participation rates.
- Government structural reform program promising but needs further development and implementation: liberalizing shop opening hours, reducing unit labor costs, increasing flexibility of wage bargaining, curbing long duration of unemployment benefits, and strengthening ALMP.
- Cutting ALMP spending is seen as ill-advised; giving municipalities greater flexibility could improve public sector productivity but outcomes should be monitored.
- Increasing well-targeted R&D spending could raise medium-term growth and plans to cut such spending should be reconsidered.
- Fiscal policy should balance consolidation needs against growth objectives: focus consolidation on items addressing long-term aging-related pressures (health and social services reforms), smooth pace of consolidation, frontload growth package spending, shift cuts away from public investment, delay UI contribution increases until unemployment is lower, allow automatic stabilizers if growth disappoints, and accommodate fiscal costs from refugee surges.

*Source: IMF staff summary from "1. External Sector Assessment" (content unit provided).*

### 1. External Sector Assessment ____________________________________________________________________  17

### 1. External Sector Assessment

### Recent Developments

- Finland experienced three years of recession; GDP declined by a cumulative 3 percent in 2012–14 (Table 1).
- Unemployment increased to 8.7 percent in 2014.
- Inflation slowed from 2.2 percent on average in 2013 to 1.2 percent in 2014, with end-of-period inflation at 0.6 percent.
- Average headline inflation is expected to fall to 0.0 percent in 2015; average core inflation is forecast at around 0.6 percent.
- Private sector investment declined from 20 percent of GDP in 2007 to 16 percent in 2014.
- The ICT sector declined sharply since 2007, largely due to Nokia’s handset business sale to Microsoft in 2013; the paper industry also saw secular decline.
- Aggregate productivity growth decline is substantially explained by the shrinkage of high productivity industries; longer-term factors include a rapidly aging workforce and slow labor supply growth.
- Real GDP developments indexed to 2007Q4=100 show Finland lagging peers (Figure 2 references).
- The current account shifted to persistent deficits since the crisis; nominal exports have fallen more than 10 percent from their peak in 2008 while imports fell 1 percent over the same period.
- Unit labor costs (ULCs) have risen 25 percent since 2007.
- General government deficit widened to 3.3 percent of GDP in 2014.
- Gross debt-to-GDP ratio was just short of the SGP’s 60 percent threshold and staff forecast it to breach it in 2015.
- The European Commission decided not to recommend Finland enter the Excessive Deficit Procedure (EDP) in June based on announced consolidation plans.
- The new coalition government (took office in May) announced a broad structural reform program; the medium-term fiscal plan envisages consolidation worth around 2 percent of GDP over 2016–19.
- Financial sector policy reforms legislated last year, including a new macroprudential policy framework, are being implemented.

### Outlook and Risks

- Baseline growth projections: 0.4 percent in 2015 and 0.9 percent in 2016 (down from April 2015 WEO projections of 0.8 and 1.4 percent, respectively).
- Private consumption contributes to 2015 growth, aided by lower inflation and mortgage amortization holidays worth about 0.3 percent of GDP in total.
- Private investment expected to contribute positively in 2016, partly due to investments in new technology in the paper industry.
- Recovery supported by bottoming out of Nokia’s decline and revival of its network equipment business (Nokia announced it will buy Alcatel-Lucent).
- Absent further structural reforms, medium-term growth projected to rise to only 1.6 percent in 2020.
- Output gap projected at -3.2 percent of potential GDP in 2015.
- Unemployment forecast to rise to 9.5 percent in 2015–16 and begin declining in 2017.
- Headline inflation projected to pick up to 1.3 percent in 2016.
- Short-run low inflation could hamper relative price adjustments and contribute to households’ debt burdens.
- Main external risks: weaker-than-expected external demand (Russia, rest of Nordic region, euro area) and financial shocks transmitted via Swedish or Danish banks.
- Domestic risk: procyclical fiscal consolidation weakening the recovery if fiscal multipliers are higher than expected.
- Recent migrant inflows could be positive for labor force growth but have short-run fiscal costs.

### Authorities’ Views

- Authorities saw weaker external demand or financial shocks as main risks and agreed such shocks could impair the fragile recovery.
- Authorities noted the drop in exports to Russia last year was sharper than expected and argued further weakening should have a smaller impact.
- Authorities acknowledged fiscal consolidation will negatively impact growth but considered the likelihood of a large impact low, citing:
  - Fiscal multipliers in small open economies are typically small.
  - Share of liquidity constrained consumers is smaller in Finland than most other euro area countries.
  - Interest rates at the zero lower bound are unlikely to affect multipliers in Finland since Finland cannot influence monetary policy independently as a small member of a monetary union.

### Policy Discussion

- Primary challenge: revive growth through bold and comprehensive structural reforms, including labor market reforms to address low productivity and labor supply growth.
- Fiscal policy should balance consolidation needs against growth objectives to avoid derailing the fragile recovery.
- Macroprudential policy toolkit and regional cooperation on financial stability should be further strengthened.

### Structural Policies: Raising Finland’s Growth Potential

Findings
- Total factor productivity (TFP) growth is forecast to be only half its pre-crisis average over the medium-term.
- Reallocation of resources from declining industries to growing ones is critical to restoring growth and raising TFP.
- Impediments to labor mobility include too little affordable housing in Helsinki and limited retraining opportunities.
- Centralized wage setting compresses the wage distribution, constraining firms’ ability to adjust wages and creating a relatively high effective minimum wage that may hinder low-skilled employment and participation.
- Generous unemployment benefits (500 days duration) and wage compression may have discouraged skill development and inter-sectoral labor mobility.
- Labor force growth has fallen sharply due to population aging compounded by a decline in participation rate of 25–54 year olds by 4 percentage points since 2008 and a relatively low participation rate for 65–69 year olds (13 percent versus 25 percent OECD average).

Planned reforms and measures
- Pension reforms aim to increase the average effective retirement age to 62.4 by 2025 (from 61 years currently).
- Plans to tighten requirements on student aid to reduce very long tertiary study duration and increase labor force participation by younger people.
- Government seeks to reduce unit labor costs via reduction of employers’ social security contributions and unremunerated increases in working hours (modalities under discussion with social partners).
- Intention to increase flexibility of the wage bargaining system at the firm-level; an internal government expert appointed to make specific proposals.
- Reforms to unemployment benefits planned but not to be implemented before 2017.
- Public sector productivity measures include reducing bureaucratic requirements and increasing local governments’ flexibility in service delivery (e.g., easing minimum staff-to-children ratio in day cares).
- Medium-term reform to shift health and social services delivery from municipalities to regional bodies to streamline administration and reap economies of scale.
- Proposal to liberalize shop opening hours to boost retail output and employment.
- Initiatives to reduce administrative and regulatory burdens on business, streamline permitting processes; specifics remain to be detailed.
- Plans to improve financial incentives for collaboration on R&D between universities and firms; concerns exist about planned cuts to public R&D spending overall.
- Measures to stimulate housing construction: easing requirements for state-subsidized housing construction, reducing restrictions on land use, and streamlining permitting and development processes.

Policy recommendations and caveats
- Staff welcomed reform intentions but emphasized outcomes depend on precise modalities and implementation; authorities should quickly flesh out reform details.
- Monitor outcomes of increased local government flexibility to ensure service quality is preserved.
- Assess pension reform impact over time to ensure it meets aims.
- Strengthen and expand active labor market programs (ALMP) to increase retraining and skill development; staff concern that planned ALMP funding cuts should be reconsidered.
- Direct investment in affordable housing and related infrastructure in main urban areas to support labor mobility.
- Maintain or increase public investment in R&D and innovation to support private sector TFP growth over the medium-term.
- Further product market reforms possible, including reducing planning restrictions on real estate developments for retail locations to limit barriers to entry and enable economies of scale.

_Italic: Source: IMF staff summary from "1. External Sector Assessment" (content unit provided)._

### 17.      The authorities agreed with staff on the structural challenges and were determined to

### _cr15311 - 17.      The authorities agreed with staff on the structural challenges and were determined to 

### Structural reforms and labor market
- Authorities agreed with staff on structural challenges and were determined to move ahead with planned reforms.
- Authorities preferred broad consensus with social partners but would take required measures even if consensus could not be secured.
- After efforts to reach a “social contract” on a reduction of unit labor costs failed, authorities introduced proposals to amend legislation governing collective agreements and bypass trade unions.
- Authorities agreed with staff on the need for more flexibility in collective wage setting but sought to avoid radical changes that could be costly and disruptive.
- Options being explored to increase firm-level flexibility in wage formation within the existing system include adding opt-out clauses to collective agreements.
- The pension reform that comes into force in 2017 was considered sufficient by authorities to put pension expenditure on a sustainable path; authorities will monitor developments and reassess the need for further reforms at five-year intervals.
- On ALMP and R&D spending cuts, authorities indicated scope to cut less effective programs to help satisfy fiscal consolidation needs.

### Fiscal policy: overview and constraints
- The long-run fiscal sustainability gap is sizable (estimated at around 5 percent of GDP) and is primarily due to projected aging related spending pressures.
- Public expenditure has already increased 12 percentage points of GDP since 2007.
- After breaching the SGP’s deficit criterion in 2014, fiscal consolidation is needed to bring the deficit back below the 3 percent threshold next year and to put the public debt-to-GDP ratio on a downward path by 2020.
- The new government plans fiscal adjustment of nearly 2 percent of GDP over 2016–19.
- The consolidation path is slightly frontloaded, with more than three fifths of the consolidation occurring in the first two years.
- The proposed 2016 budget envisages consolidation measures worth about 0.6 percent of GDP.

### Short-term growth risks from consolidation
- Staff projections include the estimated growth impact of consolidation assuming a fiscal multiplier of 0.6—the estimated average over the cycle.
- Under that assumption, the consolidation in 2016 is expected to reduce growth by about 0.3 percentage points relative to the April 2015 WEO projection.
- There is significant uncertainty around multiplier estimates and the growth impact of the consolidation could be larger; impact will also depend on the composition of fiscal adjustment.

### Composition of consolidation measures
- Spending reductions account for more than ¾ of the planned consolidation measures over 2016–19.
- Education, foreign aid, and social benefits are targeted for some of the most substantial cuts.
- Despite high and rising unemployment, spending on ALMP will be reduced; planned reforms to unemployment benefits generating savings of 0.1 percent of GDP per year will be delayed to 2017.
- Public investment in new projects (e.g., City Rail Loop in Helsinki) will be reduced; cuts partially offset by increased maintenance of existing infrastructure.
- Local governments will be responsible for about 20 percent of the savings through reduced responsibilities and greater flexibility in service delivery.
- A General Government Fiscal Plan has been introduced that sets medium-term spending and deficit limits on both central and local governments, but municipalities have substantial fiscal autonomy under the constitution and enforceability is unclear.

### Revenue measures
- Budget proposal includes a hike in unemployment insurance (UI) taxes to generate 0.1 percent of GDP per year in 2016–17.
- Other revenue-raising measures for 2016–19 include phasing out tax deductibility of mortgage interest and excise tax increases.
- These measures will be largely offset by lower income, capital, and corporate taxes, including an earned income tax credit increase worth about 0.2 percent of GDP.

### Growth package
- A “growth package” is planned to mitigate the adverse impact of consolidation and is worth about 0.7 percent of GDP in total.
- Components: one-off investments in infrastructure maintenance (0.3 percent of 2016 GDP) and other key projects including investments in innovation and digitization of government services.
- Timing and amounts: about 0.15 percent of GDP spent in 2016 and 0.3 percent of GDP spent in 2017 and 2018 each.
- Financing: asset sales, increased dividends from public enterprises, and cuts to new infrastructure projects (the latter reduce the net impact of the package’s infrastructure component by about half).

### Staff recommendations on fiscal policy
- Staff supported measures to curb long-term spending pressures but suggested smoothing the pace of consolidation to reduce growth risks.
- Some scope exists for a more even consolidation path within SGP constraints.
- Frontloading some of the spending from the currently backloaded growth package would help reduce effective fiscal consolidation and ameliorate the growth impact; bringing forward planned infrastructure maintenance is feasible.
- If growth is weaker than expected, automatic stabilizers should be allowed to operate and fiscal costs from a significant surge in refugees should be accommodated.
- Composition should be made as growth friendly as possible: shifting tax composition away from direct (income) taxes toward indirect (consumption) taxes is beneficial in the medium- to long-run.
- Delay the planned increase in the UI contribution tax until unemployment is closer to normal levels because it increases labor costs when labor demand is weak.
- Increase spending on ALMP rather than cut it.
- Avoid planned cuts to productive public investment and R&D; staff analysis suggests that for a given amount of consolidation, shifting cuts from public investment and targeted transfers to public consumption and untargeted transfers could reduce negative short-run effects on output by about one third.

### Long-run fiscal sustainability and structural reforms
- Pension reforms legislated this year are projected to reduce the fiscal sustainability gap by around 1 percentage point of GDP.
- Taking into account the government’s nearly 2 percent of GDP consolidation effort, closing the remaining 2 percentage points of the gap will depend on the impact of planned structural reforms.
- Reforms to improve cost efficiency of health and social services, including consolidating services provision at the regional level, are critical to containing aging related spending pressures.

### Authorities’ views on fiscal policy
- Authorities acknowledged consolidation risks to growth but emphasized need for sufficient buffers to ensure compliance with the SGP and to lock-in savings early to put public debt-to-GDP ratio on a downward path by 2020.
- Timing of growth package spending depends on availability of financing; authorities saw limited scope for frontloading investments.
- Authorities believed negative growth impact from cuts to public investment and R&D would not be as high as literature suggests because infrastructure levels and R&D spending were near the frontier.
- Agreed reforms to improve public sector productivity are critical but noted careful design and implementation will take time.

### Financial sector: stability and vulnerabilities
- Few indications of imminent domestic financial stability risks: banking system remains profitable and appears relatively well capitalized.
- Non-performing loans (NPLs) remain low at 1.5 percent of total loans, down from 1.8 percent at end-2014.
- Credit to non-financial and housing corporations growing at around 5 percent in 2014 and first half of 2015; household credit growth around 2 percent.
- Household debt ratio has risen to about 120 percent of disposable income.
- Housing market has cooled; average house prices broadly in line with fundamentals.
- Structural vulnerabilities: banking system concentration, regional interconnectedness, heavy reliance on wholesale funding.

### Macroprudential policy and regulatory steps
- Implementation of the Bank Recovery and Resolution Directive (BRRD) in national legislation, establishment of resolution authority and new deposit guarantee and resolution fund are positive steps.
- Act on Credit Institutions introduced macroprudential tools required by CRR/CRD-IV, and a loan-to-value (LTV) ratio cap for new mortgages to apply from mid-2016.
- Independent Board of the Finnish Financial Supervisory Authority (FIN-FSA) established as the macroprudential authority.
- Scope to further strengthen toolkit, including adding a systemic risk buffer (SRB) as recommended by an internal study group.
- Authorities should implement Basel III net stable funding ratio and liquidity coverage ratio requirements as soon as feasible given banks’ increasing reliance on wholesale funding.

### Cross-border and regional cooperation
- Single Supervisory Mechanism (SSM) became competent microprudential regulator for the three largest Finnish banks.
- Two of these—Nordea and Danske Bank—are subsidiaries of parent institutions outside the banking union; cooperation on financial stability and cross-border resolution frameworks remains necessary.
- Nordea plans to convert its Finnish subsidiary into a branch; if realized, Finnish authorities must retain capacity to monitor the bank (it accounts for about 30 percent of loans and deposits in the Finnish banking system) for financial stability risk analysis and macroprudential policy formulation.
- Robust cross-border supervisory cooperation on information sharing, depositor protection, and resolution arrangements should be agreed among Finnish, Swedish, and European authorities.

### FSAP and authorities’ views on financial policy
- The 2016 FSAP will examine the financial sector and regulatory environment, coordinated closely with the Sweden FSAP.
- Authorities supported introducing an SRB but expected the proposal probably will not be taken up before next year due to other legislative priorities.
- Authorities agreed that deepening regional cooperation is useful in view of Nordea’s conversion plans and were broadly positive on SSM experience, noting a learning curve and increased FIN-FSA workload.

### Staff appraisal: macroeconomic context and priorities
- Finnish economy has been in recession for three years with structural and cyclical shocks since 2007: declines of Nokia and the paper industry, weak external demand (euro area and Russia), wage hikes in 2008–10, weak productivity growth, and rapid population aging.
- Current account and fiscal balances deteriorated; 2014 fiscal deficit breached the SGP’s 3 percent of GDP criterion.
- Recovery projected to start in 2015 and gradually strengthen in 2016, but likely slow and subject to downside risks; absent further reforms, growth likely to remain much lower than before the crisis.
- Main challenge is to revive growth by boosting productivity, facilitating reallocation from declining to growing industries, and raising labor participation rates.
- Government structural reform program promising but needs further development and implementation: liberalizing shop opening hours, reducing unit labor costs, increasing flexibility of wage bargaining, curbing long duration of unemployment benefits, and strengthening ALMP.
- Cutting ALMP spending is seen as ill-advised; giving municipalities greater flexibility could improve public sector productivity but outcomes should be monitored.
- Increasing well-targeted R&D spending could raise medium-term growth and plans to cut such spending should be reconsidered.
- Fiscal policy should balance consolidation needs against growth objectives: focus consolidation on items addressing long-term aging-related pressures (health and social services reforms), smooth pace of consolidation, frontload growth package spending, shift cuts away from public investment, delay UI contribution increases until unemployment is lower, allow automatic stabilizers if growth disappoints, and accommodate fiscal costs from refugee surges.

*Source: IMF staff report content provided in the supplied PDF extract.*

### 39.      Financial sector risks appear contained for the moment, but ensuring robust policy

### 39–40. Financial sector risks appear contained for the moment, but ensuring robust policy frameworks to deal with future risks is key.

### Financial sector assessment and policy recommendations
- Findings
  - Financial sector risks are assessed as "contained for the moment."
  - The development of a macroprudential policy framework last year is identified as "a major positive step."
  - Household debt ratio remains "well below the levels in comparator countries" (see Figure 5 in source).
  - Credit growth has recently slowed and the housing market "has begun to cool off."
- Policy recommendations
  - Strengthen the policy toolkit, particularly by adding a SRB (systemic risk buffer).
  - Further enhance regional cooperation on financial sector issues, including to address issues raised by Nordea’s plans to convert its Finnish subsidiary into a branch.
  - Ensure the authorities have an adequate toolset to contain risks once the recovery gathers steam.
- Operational note
  - It is proposed that the next Article IV consultation with Finland occur on the standard 12-month cycle.

*Source: IMF staff text (paragraphs 39–40).*

### Box 1 — External Sector Assessment: key findings and projections
- Current account (CA) history and drivers
  - In the decade up to 2007, Finland’s annual CA surplus averaged 5½ percent of GDP.
  - Since 2011, the CA has shown a deficit of about 2 percent of GDP.
  - The CA deterioration is mainly driven by the decline of Nokia and wood and paper exports.
    - Exports of electrical and optical equipment fell from a pre-crisis peak of 8½ percent of GDP to 3 percent in 2014.
    - Wood and paper exports declined by about 2½ percentage points of GDP since 2002 to 5½ percent in 2014.
  - ULCs (unit labor costs) rose nearly 25 percent since 2007, due to rapid wage increases during 2008–10 and falling productivity from sectoral changes.
- Financial account and NIIP
  - The CA deficit has been balanced by a surplus in the financial account.
  - From 2009–12, positive portfolio debt investments tied to Finland’s "safe haven" status contributed substantially to the financial account surplus.
  - In 2014, foreign direct investment gained importance as Microsoft purchased Nokia’s handset business.
  - Portfolio inflows will continue to be an important component of the financial account, averaging about 6 percent of GDP per year out to 2020.
- Projections and balance-sheet implications (staff projections)
  - Trade balance and CA
    - Exports appear to be stabilizing and the trade balance is expected to move back into surplus.
    - The CA balance is expected to improve by a cumulative ½ percent of GDP to -0.2 percent in 2020.
  - Net international investment position (NIIP)
    - NIIP forecast to continue deteriorating, from -0.8 percent of GDP in 2014 to -12 percent in 2020.
    - Change in NIIP mostly attributed to net foreign direct investment, which falls by 9½ percentage points of GDP from 2014 to 2020.
    - Net portfolio investment deteriorates slightly, by about ½ percentage points of GDP over the same period.
    - Net other investments (e.g., loans, deposits, and trade credit), though negative, offset some of this decline.
    - Projected valuation effects from exchange rate changes also play a role.
  - External debt
    - Gross external debt expected to remain around 220–230 percent of GDP.
    - Net external debt will average around 50 percent of GDP through 2020.
- Assessment of external position
  - Staff views the external position as "broadly in line with fundamentals."
  - External Balance Assessment (EBA) analyses (CA, REER Index and Level, and External Sustainability) suggest the REER was slightly overvalued in 2014; given uncertainty, staff assesses the REER as broadly in line with fundamentals.
  - The deterioration in the CA was mainly driven by identifiable structural shocks (declines of Nokia and the paper industry) which the EBA CA norm estimate of 0.9 percent of GDP does not well capture.
  - Past estimates indicate the REER went from undervalued to roughly in line with fundamentals.

*Source: IMF staff Box 1 (External Sector Assessment).*

### Recent macroeconomic developments and structural issues
- Real economy and demand
  - Finland "has been in a slump for 3 years" driven by weak domestic and external demand (see Figure 1 in source).
  - Slowing nominal wage growth and rising unemployment have weighed on consumption.
  - Uncertain demand and income prospects have dragged down private investment.
- Prices, wages, and labor market
  - Inflation has fallen in line with the rest of Europe, partly due to falling commodity prices, despite rising unit labor costs which have increased more than peers since the crisis.
  - Wage dispersion is "relatively low" and wages across industries are compressed, which can hamper efficient reallocation of labor.
  - Regional and sectoral concentration of industries contributes to disparate unemployment outcomes.
  - The staff suggests a role for increasing and better targeting ALMPs to boost labor mobility and activation.
- Sectoral shifts and export shares
  - The collapse of Nokia and decline of the wood and paper industry are highlighted as major structural shocks.
  - Finland’s share of EU and world exports has declined (see Figure 3 in source).

### Fiscal and public debt developments (selected numbers)
- Fiscal deterioration and SGP criteria
  - The fiscal position has "slipped into persistent deficit, breaching the SGP 3 percent deficit criterion."
  - Debt ratio expected to breach the 60 percent of GDP SGP criterion this year.
- Key fiscal figures (from tables and figures)
  - Overall balance: Table 1 shows -3.4 in 2015 and projections improving to -1.3 in 2020 (percent of GDP).
  - General government gross debt: 62.3 percent of GDP in 2015 (Table 1) and projected path in tables.
  - Primary balance (adjusted for interest): Table 1 shows -2.2 in 2015 and projects to 0.0 in 2020 (percent of GDP).
  - Structural balance: Table 1 shows -1.0 in 2015 and projects -0.8 in 2020 (in percent of potential GDP).

*Source: Figures and tables in IMF staff text (selected fiscal indicators).*

### Key quantitative indicators and projections (selected exact values)
- Current account and NIIP
  - CA balance: -0.9 percent of GDP in 2014 (Table 2 shows -1.8 billion euros, -0.9 percent of GDP), projected -0.2 percent of GDP in 2020.
  - NIIP: -0.8 percent of GDP in 2014; forecast to -12 percent of GDP in 2020.
- External financing and debt
  - Portfolio inflows: about 6 percent of GDP per year out to 2020 (Box 1).
  - Gross external debt: expected to remain around 220–230 percent of GDP.
  - Net external debt: will average around 50 percent of GDP through 2020.
- Sectoral export shares and ULCs
  - Electrical and optical equipment exports: peak 8½ percent of GDP pre-crisis to 3 percent in 2014.
  - Wood and paper exports: declined by about 2½ percentage points of GDP since 2002 to 5½ percent in 2014.
  - ULCs rose nearly 25 percent since 2007.
- Growth and labor market (Table 1 projections)
  - GDP: -0.4 in 2014, 0.4 in 2015, projected 0.9 in 2016 and 1.2 in 2017 (percent, volumes).
  - Unemployment rate: 8.7 in 2014, 9.4 in 2015, projected 9.0 in 2016 and 8.5 in 2017 (percent).
  - Output gap (percent of potential output): -3.3 in 2014, -3.2 in 2015, improving to -0.5 by 2020.
- Prices
  - Consumer price inflation (HICP, average): 1.2 in 2014, 0.0 in 2015, projected 1.3 in 2016 and 1.6 in 2017 (percent).

*Source: IMF staff tables and narrative (exact values preserved).*

*Source: Excerpts from IMF Finland staff report text and tables in the provided PDF content.*

### 1. Euro area bond

### 1. Euro area bond

### Market contagion: risk and policy responses
- Risk level: Medium.
- Findings:
  - As a euro area member, Finland could be affected if sovereign and financial sector stress re-emerges across the Euro area due to protracted policy uncertainty and/or events related to Greece.
  - Finland is a core euro area member and its sovereign yields generally track German yields.
  - Severe financial market stress could cause bank losses and funding difficulties, which could lead to curtailed lending, with negative effects on growth.
- Policy response:
  - Full implementation of the macroprudential policy toolkit will help reduce vulnerabilities in the medium-run.
  - Banks with potentially significant credit and funding risks should be pushed to improve buffers in the short-run.
  - If financial market stress materializes, the ECB should provide ample liquidity.

### Structurally weak growth in the euro area: risk and policy responses
- Risk level: High.
- Findings:
  - Finland’s exports are tightly linked to Euro area markets.
  - With domestic demand already anemic, external demand will wane further, pushing Finland into a period of economic stagnation.
- Policy response:
  - Ease the pace of fiscal consolidation.
  - If growth prospects continue to deteriorate, allow automatic stabilizers to function.
  - Focus on structural reforms to improve competitiveness.

### Political fragmentation / geopolitical risks: impact and policy responses
- Risk level: Medium (overall); Low (quantified trade impact).
- Findings:
  - Russia is Finland’s fifth largest export market. Negative effects from a renewed increase in geopolitical tensions could spill over through further reductions in trade.
  - Depending on the severity of a downturn in Russia and exchange rate depreciation, the reduction in trade in goods and services could shave as much as a couple tenths of a percent off GDP growth.
- Policy response:
  - Short-run: allow fiscal policy and automatic stabilizers to act as a shock absorber.
  - Medium-run: Promote diversification in export markets, including through support for firms trying to enter new markets.

### Adverse house price shock in an interconnected neighboring Nordic country: risk and policy responses
- Risk level: Medium.
- Findings:
  - Household debt is high in the Nordics due to easy access to credit, low interest rates, and tax incentives for housing.
  - Property prices remain elevated.
  - The two largest banks in Finland are Swedish and Danish.
  - Declining demand from other Nordics would lower growth.
  - Rising non-performing loans and funding costs for Swedish or Danish banks could translate into curtailed lending in Finland, with negative effects on investment and housing.
- Policy response:
  - Full adoption of the macroprudential toolkit and introduction of the systemic risk buffer to bolster the largest banks’ ability to absorb losses.

### Financial Soundness Indicators for the Banking Sector, selected figures (2008–2014)
- Households:
  - Total household debt (in percent of GDP): 51.7, 58.2, 59.9, 60.1, 62.3, 63.0, 64.5 (2008–2014).
  - Total household debt (in percent of disposable income): 109.4, 111.8, 113.8, 115.1, 118.1, 118.5, 122.5 (2008–2014).
  - Financial assets/GDP: 96.1, 112.1, 120.0, 110.4, 116.8, 125.5, 127.5 (2008–2014).
- Non-financial corporations:
  - Gross debt (in percent of GDP): 58.4, 64.5, 67.2, 65.9, 65.8, 66.7, 65.6 (2008–2014).
- Government:
  - General government debt (EMU definition, in percent of GDP): 32.7, 41.7, 47.1, 48.5, 52.9, 55.8, 59.3 (2008–2014).
  - Central government debt (in percent of GDP): 29.8, 37.6, 42.7, 44.7, 48.0, 49.8, 52.4 (2008–2014).
- Banking sector size and funding:
  - Total assets (in billions of euro): 347.1, 349.1, 418.2, 542.4, 496.2, 455.3, 505.9 (2008–2014).
  - Total assets (in percent of GDP): 179.2, 192.8, 223.5, 275.5, 248.3, 224.6, 246.6 (2008–2014).
  - Total deposits (in billions of euro): 109.3, 110.3, 119.1, 130.3, 135.7, 139.4, 140.5 (2008–2014).
  - Total deposits (in percent of GDP): 58.9, 64.1, 66.7, 69.1, 70.9, 68.8, 68.5 (2008–2014).
- Credit growth (selected):
  - Credit to nonfinancial and housing corporations (annual percent change, e.o.p.): 18.2, -5.9, 5.4, 9.1, 4.8, 6.1, 5.1 (2008–2014).
  - Credit to nonfinancial corporations (annual percent change, e.o.p.): 21.5, -9.4, 2.4, 8.3, 2.5, 3.9, 2.1 (2008–2014).
  - Credit to households (percent change, e.o.p.): 8.0, 5.6, 5.8, 5.6, 4.9, 2.2, 1.9 (2008–2014).
  - Housing loans in percent of total lending: 45.0, 47.8, 47.4, 42.1, 42.7, 40.3, 39.3 (2008–2014).
- Asset quality:
  - Non-performing loans (in billions of euro): 0.8, 1.2, 1.2, 1.3, 1.3, 1.4, 4.4 (2008–2014).
  - Non-performing loans/total loans (in percent): 0.4, 0.7, 0.6, 0.6, 0.5, 0.6, 1.8 (2008–2014). 
  - Provisions to non-performing loans (in percent): N.A., N.A., N.A., N.A., N.A., N.A., 70.5 (2008–2014).
  - Household non-performing loans/total household loans (in percent): 0.5, 0.6, 0.5, 0.6, 0.6, 0.7, 1.7 (2008–2014).
- Capital adequacy:
  - Regulatory capital as percent of risk-weighted assets: 13.6, 14.6, 14.4, 14.2, 17.0, 16.0, 17.3 (2008–2014).
  - Regulatory tier 1 capital to risk-weighted assets: 12.5, 13.8, 13.6, 13.6, 16.1, 15.2, 16.4 (2008–2014).
  - Equity/total assets (in percent): 6.2, 6.4, 5.5, 4.4, 4.4, 5.0, 4.3 (2008–2014).
- Profitability and liquidity:
  - Interest rate margin (percentage points, e.o.p.): 2.6, 1.7, 1.7, 1.9, 1.4, 1.5, 1.5 (2008–2014).
  - Return on equity (in percent): 8.4, 6.9, 6.9, 7.6, 8.5, 8.1, 8.2 (2008–2014).
  - Return on assets (in percent): 0.6, 0.4, 0.4, 0.4, 0.4, 0.4, 0.4 (2008–2014).
  - Deposits as percent of assets: 31.6, 31.6, 28.5, 24.1, 27.5, 30.6, 27.0 (2008–2014).
- Use of ECB refinancing:
  - Use of ECB refinancing (billions of euro): 2.5, 2.7, 0.1, 2.3, 3.7, 2.5, 0.7 (2008–2014).
  - in percent of banks total assets: 0.7, 0.8, 0.0, 0.4, 0.7, 0.6, 0.1 (2008–2014).
  - in percent of total ECB refinancing operations: 0.3, 0.4, 0.0, 0.3, 0.3, 0.3, 0.1 (2008–2014).
- Asset prices:
  - Change in stock market index (in percent, e.o.p.): -53.4, 19.5, 18.7, -30.1, 8.3, 26.5, 5.7 (2008–2014).
  - Change in housing price index (in percent, year average): 0.6, -0.3, 8.7, 2.6, 1.6, 1.3, -0.7 (2008–2014).

### Debt Sustainability Analysis — key projections and stress tests
- Recent trend and near-term projection:
  - Public debt rose in 2014, driven by a higher than expected fiscal deficit, and is forecast to exceed 60 percent of GDP in 2015.
  - Under the baseline debt to GDP is expected to peak in 2019 and to gradually decline thereafter.
- Baseline macroeconomic assumptions:
  - Real GDP growth is expected to gradually pick-up, from 0.4 percent in 2015 to 1.6 percent in 2020.
  - GDP deflator inflation declines to a low of 0.7 percent in 2015, is expected to rebound to 1.4 percent in 2016 and rise to 2.1 percent by 2020.
  - Interest rates are expected to remain subdued due to QE and the likely gradual pace of rates rises once monetary policy begins to normalize.
- Debt level assessment:
  - Finland’s debt level is expected to breach 60 percent of GDP in 2015, which calls for using the higher scrutiny framework.
  - Projected to continue rising until 2019 and remain above 60 percent over the forecast horizon.
  - Gross financing needs remain below 15 percent of GDP every year in the baseline scenario.
  - Net debt ratio remains negative due to the large stock of pension assets, though the net debt deteriorates more than gross debt rises over time as pension assets are used to pay benefits.
- Realism of baseline assumptions:
  - Median forecast error for real GDP growth: -1.27 percent (18th percentile).
  - Median forecast errors for the primary balance: -0.03 percent of GDP.
  - Median forecast error for inflation: 0.2 percent.
- Fiscal adjustment:
  - The 3-year average change in the cyclically adjusted primary balance (CAPB) is around 0.5 percent of potential output.
- Stress testing results:
  - Finland’s debt ratio would remain under 100 percent of GDP even in the worst shock scenario examined.
  - For standard macro-fiscal stress scenarios, the debt ratio stays below 70 percent of GDP, except in the real GDP shock scenario.
  - The contingent liability shock scenario causes the largest debt ratio increase, to a peak of around 94 percent of GDP in 2019.

*International Monetary Fund staff analysis as presented in the source document.*

### 6.      The shock scenarios include:

### _cr15311 - 6.      The shock scenarios include:

### Shock scenarios and quantitative impacts
- Real GDP growth shock
  - Growth is one-standard deviation lower than the baseline in 2016 and 2017 (i.e., 3.9 percentage points lower).
  - Inflation is 25 basis points (bps) lower in 2016 and 2017.
  - Interest rates are higher by 71 bps in 2016 and by 143 bps in 2017.
  - Debt ratio peaks at 82 percent of GDP in 2019.
  - Gross financing need (GFN) exceeds 20 percent of GDP in 2017.

- Primary balance shock
  - Primary balance (PB) is 1.6 percentage points of GDP lower than in the baseline in 2016 and 2017.
  - Debt ratio almost reaches 70 percent of GDP in 2019.
  - GFN peaks at 15 percent of GDP in 2017.

- Real interest rate shock
  - Real interest rate is 274 bps higher than the baseline over 2016-20.
  - Debt reaches 68 percent of GDP by 2020.
  - GFN remains below 15 percent of GDP.

- Real exchange rate shock
  - Impact is small: debt ratio only 1 percent of GDP higher than baseline at its peak in 2019.
  - GFN remains almost identical to the baseline GFN.

- Combined macro-fiscal shock
  - Combination of growth and inflation falls, primary balance deterioration, exchange rate depreciation, and interest rate increases relative to baseline.
  - Debt ratio rises above 85 percent of GDP by 2020.
  - GFN hits an apex of 21 percent of GDP in 2017.

- Contingent liability shock
  - Contingent liability shock in 2016 equals about 17 percent of GDP.
  - Growth falls as in the real GDP shock scenario.
  - Real interest rate spikes 441 bps in 2016.
  - Debt ratio jumps more than 20 percentage points of GDP between 2015 and 2016.
  - GFN peaks at around 30 percent of GDP in 2016.
  - Debt ratio peaks near 94 percent of GDP in 2019.

### Selected baseline and scenario assumptions (as presented)
- Baseline projections (selected)
  - Real GDP growth: 0.4 (2015), 0.9 (2016), 1.2 (2017), 1.3 (2018), 1.4 (2019), 1.6 (2020).
  - Inflation (GDP deflator): 0.7 (2015), 1.4 (2016), 1.6 (2017), 1.8 (2018), 1.9 (2019), 2.1 (2020).
  - Primary Balance: -3.1 (2015), -2.7 (2016), -2.6 (2017), -2.2 (2018), -1.6 (2019), -1.1 (2020).
  - Effective interest rate: 2.0 (2015), 1.9 (2016), 1.8 (2017), 1.7 (2018), 1.8 (2019), 1.8 (2020).

- Scenario-specific assumption examples (selected)
  - Real GDP Growth Shock path (Real GDP growth): 0.4 (2015), -3.0 (2016), -2.7 (2017), 1.3 (2018), 1.4 (2019), 1.6 (2020).
  - Combined Shock primary balance path: -3.1 (2015), -5.5 (2016), -8.3 (2017), -2.2 (2018), -1.6 (2019), -1.1 (2020).
  - Contingent Liability Shock primary balance path: -3.1 (2015), -20.2 (2016), -2.6 (2017), -2.2 (2018), -1.6 (2019), -1.1 (2020).
  - Real interest rate effective interest rate example: 2.0 (2015), 1.9 (2016), 2.3 (2017), 2.7 (2018), 3.1 (2019), 3.4 (2020).

### Stress-test outcomes and risk assessment highlights
- Under the Real GDP growth shock scenario:
  - Debt ratio peaks at 82 percent of GDP in 2019; GFN > 20 percent of GDP in 2017.
- Under the Primary balance shock scenario:
  - Debt ratio approaches 70 percent of GDP in 2019; GFN peaks at 15 percent of GDP in 2017.
- Under the Real interest rate shock:
  - Debt reaches 68 percent of GDP by 2020; GFN remains below 15 percent of GDP.
- Under the Combined macro-fiscal shock:
  - Debt ratio > 85 percent of GDP by 2020; GFN apex of 21 percent of GDP in 2017.
- Under the Contingent liability shock:
  - Contingent liabilities ≈ 17 percent of GDP in 2016; debt jumps > 20 percentage points of GDP between 2015 and 2016; GFN ≈ 30 percent of GDP in 2016; debt peaks near 94 percent of GDP in 2019.
- Risk assessment benchmarks and coloring rules (as presented)
  - Debt burden benchmark: 85 percent.
  - Gross financing needs benchmark: 20 percent of GDP.
  - Bond spread benchmarks: 400 and 600 basis points.
  - External financing requirement benchmarks: 17 and 25 percent of GDP.
  - Annual change in short-term public debt benchmarks: 1 and 1.5 percent.
  - Public debt held by non-residents benchmarks: 30 and 45 percent.

### Policy context, fiscal strategy, and reform commitments (selected items from the same content)
- Government consolidation and fiscal targets
  - The government is committed to covering the entire sustainability gap of 10 billion Euros.
  - Consolidation of public finances will halt the increase in the debt-to-GDP ratio by the end of the Government term and reverse the increase in 2021.
  - Consolidation measures include mainly expenditure reductions, excise tax increases, and accelerated removal of mortgage interest rate deductions.
  - The government has proposed a one-off investment package worth 1.6 billion euros.

- Labor market, competitiveness, and social policy measures
  - Target: reduce unit labor costs by 5 percentage points through measures including removal of two public holidays, reductions in paid sick-leave and in holiday allowance, and a cut in public sector annual leave to 6 weeks; measures to remain in force for three years if enacted.
  - Proposal to reduce earnings-related unemployment benefits to 400 days from the current 500 days starting from 2017.
  - Pension reforms will raise the average effective retirement age to 62.4 years old by 2025.
  - Active labor market policy priorities include increased digitalization of public employment services (PES) and enhanced role of private employment services.
  - Housing supply measures in Helsinki metropolitan area to promote labor mobility.

- Structural and public service reforms
  - Social welfare and health care reform (SOTE) aims to reduce the cost of services by 3 billion euros by 2029 (at 2019 prices); estimated impact to sustainability gap: -1.25 percent of GDP.
  - Municipalities’ responsibilities reductions expected to achieve about one billion euros in savings by 2019.
  - Education and R & D cuts noted; authorities expect efficiency gains and closer cooperation between tertiary institutions and business.
  - Emphasis on innovation (bio-economy, clean technologies), digitalization, deregulation, and liberalizing shop opening hours.

### Selected historical and projection indicators (illustrative)
- Nominal gross public debt (percent of GDP): 41.9 (2013), 55.6 (2014), 59.3 (2015), 62.3 (2016), 64.1 (2017), 65.9 (2018), 66.8 (2019), 66.9 (2020), 66.4 (projection series).
- Public gross financing needs (percent of GDP): 7.3 (2013), 8.5 (2014), 9.8 (2015), 11.4 (2016), 11.3 (2017), 13.0 (2018), 10.3 (2019), 8.1 (2020), 8.4 (additional point).
- Real GDP growth historical and projection examples: 1.4 (2013), -1.1 (2014), -0.4 (2015), 0.4 (2016), 0.9 (2017), 1.2 (2018), 1.3 (2019), 1.4 (2020), 1.6 (later projection point shown).
- Inflation (GDP deflator) historical and projection examples: 1.8 (2013), 2.6 (2014), 1.6 (2015), 0.7 (2016), 1.4 (2017), 1.6 (2018), 1.8 (2019), 1.9 (2020), 2.1 (later projection point shown).

*Source: IMF staff.*

### 2014. The FIN-FSA was appointed as the designated macro prudential authority and the

### _cr15311 - 2014. The FIN-FSA was appointed as the designated macro prudential authority and the

### Institutional arrangements and responsibilities
- In 2014, "The FIN-FSA was appointed as the designated macro prudential authority and the FINFSA Board was given the responsibility for macroprudential policy decisions."
- The authorities "support the establishment of a systemic risk buffer."

### Legislative timing and constraints
- "The legislation process would most likely be postponed until next year due to the existing legislation backlog."

### Regional cooperation
- "The authorities see a deepened regional cooperation on financial sector issues of utmost importance between the Nordic and Baltic countries."

### FSAP assessments and expected benefits
- "The authorities appreciate the plan to conduct FSAPs for Finland and Sweden back-to-back in 2016, as these assessments will provide a thorough review of the Finnish financial sector performance and a framework to identify systemic vulnerabilities."
- "The combination of these exercises offers also an assessment of the Nordic financial and insurance institutions and their operating environment."

*Source: _cr15311 - 2014. The FIN-FSA was appointed as the designated macro prudential authority and the*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2015/_cr15311.pdf_