Finland: Staff Concluding Statement of the 2016 Article IV Mission

IMF News, October 4, 2016

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Published: October 4, 2016

Economic situation and outlook

After three years of recession, Finnish economic growth has turned tepidly positive; stronger private consumption and a rebound in private investment have driven modest output growth.
The output gap remains sizable and unemployment high.
Falling food and energy prices have pushed headline inflation below zero and improved the terms of trade, shifting the current account into a small surplus.
The fiscal outturn in 2015 was better than expected and the deficit is back under the Stability and Growth Pact’s (SGP) 3 percent of GDP limit.
Credit growth has slowed, reflecting low demand, but debt levels in the economy have risen since the crisis, increasing vulnerabilities in the nonfinancial private sector.
House price growth has been modest and banks appear broadly sound.

Key projections and near-term dynamics:

Growth projections:
- 0.9 percent in 2016
- 1.1 percent in 2017
- Around 1½ percent over the medium term
Private consumption and investment: expected to be the main drivers of medium-term growth.
Consumption in the short run: weighed down by slower real wage growth, reflecting rising inflation and the Competitiveness Pact.
Net exports: drag should gradually lessen as external demand strengthens and competitiveness improves.
Unemployment: expected to gradually decline.
Inflation: picked up in the first half of 2016 and should continue to rise as the effects of falling commodity prices abate.

Downside risks highlighted:

Weaker-than-expected global growth, especially in advanced Europe, which would constrain exports.
Uncertainty over post-Brexit arrangements could weigh heavier on confidence and investment.
A shock in a Nordic neighbor (e.g., a housing market correction) could spill over via the regionally interconnected banking system and trade links.
Domestically, fiscal consolidation and labor market reforms could weaken the recovery in the near term, despite positive long-run effects.

Structural reform

Reviving growth requires raising productivity and labor participation; deep structural reform is critical.
Recent reforms move in the right direction but require close follow-up and further measures.

Recent and recommended actions:

Competitiveness Pact:
- Expected to reduce relative labor costs in the short term.
- Provides opportunity to make the highly-centralized wage bargaining process more flexible at the firm level and better align wages with productivity.
- Government should closely monitor implementation and take further measures if needed.
Unemployment benefits:
- Reduction of the maximum duration of unemployment benefits to 400 days should help increase labor supply.
- Mission encourages social partners to reach agreement soon on additional activation measures.
Health and social services reform:
- Draft bills constitute major progress toward improving public sector productivity.
- Given complexity, clear and timely communication with stakeholders and regular assessment of progress are critical.

Other priority areas for reform:

Product market reforms:
- Deregulation, especially in the retail sector (tight zoning and planning restrictions) and government-dominated sectors such as rail and postal services, could strengthen competition and yield substantial productivity gains.
- Mission welcomes work on the new transportation code and renewed privatization efforts.
Research and development:
- Substantial reductions in both public and private R&D expenditures in recent years risk weakening the growth outlook.
- Recommendations: reverse cuts to public R&D spending; create stronger incentives for private R&D, such as well-designed and permanent tax credits.
Labor mobility and housing:
- Strengthen active labor market programs (ALMPs) to facilitate transitions of unemployed workers into new jobs and industries.
- Recent efforts to increase affordable housing supply in main urban areas are helpful but may be insufficient.
- Further measures, such as streamlining planning and development processes, would help improve housing supply over the medium term.

Fiscal policy

Fiscal policy should balance long-run sustainability with protecting the recovery.
Aging-related fiscal pressures contribute to a sizable long-run sustainability gap, making structural fiscal adjustment necessary.

Key fiscal facts and recommendations:

Long-run sustainability gap: estimated at about five percent of GDP at the start of the government’s term.
Consolidation is needed in the context of European rules and to address aging pressures.
Recent recalibration of the consolidation path is appropriate:
- An unexpected fiscal overperformance in 2015 allows for a slower pace of adjustment in 2016 and a slightly accommodative fiscal stance in 2017 without jeopardizing the medium-term adjustment goal.
Short-term support measures:
- Consider faster implementation of the remaining growth package spending.
- Improve growth-friendliness of consolidation by reallocating resources toward R&D spending, well-designed ALMPs, and productive public investment, and away from poorly-targeted transfers and tax expenditures.
- If growth disappoints, allow automatic stabilizers to operate fully.
- Use revenue windfalls to lower borrowing needs.
Closing the long-run sustainability gap:
- The earlier-agreed pension reform (effective from 2017) and the government’s consolidation plan are estimated to close just over half of the long-term fiscal sustainability gap.
- Successful implementation of other structural reforms—most notably the reform of health and social services—will be key to closing the remainder of the gap and ensuring public finances are robust to aging-related spending pressures.

Financial sector

The FSAP concluded the financial sector is broadly sound but structural vulnerabilities remain.

FSAP findings:

Strengths:
- Banking system is well capitalized and profitable.
- Immediate financial stability risks appear limited.
- Level of nonperforming loans is low.
Vulnerabilities:
- Finnish banking system is large relative to the economy, highly concentrated, and closely interlinked with Nordic neighbors.
- Low risk weights for mortgages may exaggerate robustness of regulatory capital ratios.
- Banks are relatively reliant on wholesale funding, creating funding liquidity risks.

Policy and supervisory recommendations:

Bank supervision:
- Strengthen ongoing monitoring of banks’ internal risk models by the ECB and FIN-FSA.
- Intensify oversight of banks’ liquidity positions in foreign currencies.
- Introduce liquidity stress tests over different time horizons.
- Increase resources allocated to banking supervision to reflect growth in regulatory complexity and supervision intensity.
Macroprudential policy:
- Expand the set of policy instruments.
- Authorities plan to introduce a systemic risk buffer and a floor for mortgage risk weights—mission welcomes these plans.
- Consider tools based on borrowers’ debt service capacity and loan terms.
- Clarify macroprudential policy mandate of the FIN-FSA.
- Create a household loan registry to facilitate macroprudential policy analysis.
- Establish necessary tools before risks emerge.
Regional cooperation and crisis preparedness:
- Deepen regional cooperation to mitigate risks from regional linkages and Nordea’s conversion from subsidiary into a branch.
- Pending agreement on systemic branches between key supervisors should provide strong data sharing and supervisory cooperation provisions.
- Conduct joint stress tests to capture regional interlinkages, enhance joint crisis planning, run regular crisis simulation exercises, and strengthen collaboration between Nordic macroprudential authorities.
- Formalize domestic inter-agency cooperation on national crisis preparedness and management.

Concluding remarks

Reviving growth remains Finland’s preeminent challenge; raising productivity and labor participation through structural reforms is essential.
Fiscal consolidation should be phased and composed to minimize adverse effects on growth while addressing the sizable long-term sustainability gap.
Financial sector is broadly sound, but further strengthening of supervision, macroprudential tools, and regional cooperation is needed to mitigate future risks.
The mission thanks the authorities and counterparts for warm hospitality and candid, high-quality discussions.

Finland: Staff Concluding Statement of the 2016 Article IV Mission (October 4, 2016)