Public Information Notice No. 97/12

Press Information Notice: IMF Concludes Article IV Consultation with Finland

July 23, 1997

The IMF Executive Board on July 14, 1997 concluded the 1997 Article IV consultation¹ with Finland.

Background

After a pause during the second half of 1995, caused by the economic slowdown in Western Europe, output growth resumed at a brisk pace in early 1996. Initially, the acceleration reflected the buoyancy of domestic demand, as private expenditure was spurred by easy monetary conditions, the trend decline in the indebtedness ratios, and renewed confidence in sustainable economic growth. Further momentum was added later by the pick up in production of outward-oriented industries, including the key forestry sector, reflecting improved economic conditions in Europe and some competitiveness gains. Despite the cyclical upturn and the overall stability of participation rates, the unemployment rate edged down only slightly (to some 16 1/4 percent).

Price performance has been excellent. The moderate wage increases agreed in the Fall of 1995, the restraining effect of unemployment on the wage drift, and cuts in employers' social security contributions, moderated the growth in unit labor costs. With capacity utilization still not a binding constraint, increased demand was met by increased production, and profit margins remained broadly stable in most sectors, at the high level reached in 1995. Thus, despite some increases in energy import prices, inflation lingered in the 1/2-1 1/2 percent range for most of the year.

In spite of weak international paper and pulp prices and the related terms of trade loss, the external current account surplus remained sizable (3 3/4 percent of GDP). Exports accelerated gradually during the year as conditions in Europe improved and the drop in forestry prices gradually revived demand. The external net debt-to-GDP ratio continued declining, but remained unusually high for an industrial country.

Fiscal policy was tightened significantly in 1996. At the inception of its mandate in early 1995, the government enacted a fiscal consolidation program aimed at restoring confidence in central government solvency, and, more specifically, at reversing the increase in its debt-to-GDP ratio before the 1999 general elections. The program's strategy centered on a freeze of expenditure and the use of the revenues from the recovery to lower the deficit. This strategy yielded a sizable drop in the central government deficit in 1996 (from 9 1/2 percent of GDP in 1995 to 7 1/4 percent), but the debt ratio continued rising. General government finances also improved, with the deficit-to-GDP ratio only marginally above the Maastricht threshold of 3 percent, and the debt-to-GDP ratio remaining under 60 percent.

Monetary policy remained geared to the inflation target of 2 percent introduced in 1993. The moderate wage settlements of the Fall of 1995, fiscal consolidation, and the weakening of aggregate demand in 1995 led the Bank of Finland to relax the monetary stance as of the last quarter of 1995. This relaxation was well accepted by financial markets: the markka remained broadly stable against the ECU and the differential between Finnish and German long-term interest rates fell to a historical low. Monetary policy reached a turning point in October 1996 when the markka joined the Exchange Rate Mechanism (ERM) of the European Monetary System. The parity matched the average at which the markka had traded in 1995-96. Following the ERM entry, except for a week in January 1997 when the authorities were confronted with a surge of speculative capital inflows, the markka has remained fairly stable.

The favorable outlook is expected to continue in 1997. Growth of output is projected to be robust, supported by both domestic and external demand. As the output gap shrinks, inflation may pick up somewhat, but should remain well below the authorities' inflation target. External balances will remain strong. However, unemployment is projected to decline only slowly.

Executive Board Assessment

The stability-oriented policies pursued in the last few years had yielded important results: output was rising rapidly, the external accounts were strong, inflation remained low, and fiscal consolidation was proceeding well. That improvement had allowed the markka's successful entry into the ERM and augured well for Finland's participation in EMU. However, Directors noted that unemployment remained high, and that reducing it remained a priority, requiring not only a continuation of cautious macroeconomic policies but also comprehensive structural reforms.

Directors commended the authorities for their policies of fiscal consolidation, notably the significant reduction in the fiscal deficit during 1995-96. Such a reduction had contributed to restoring confidence in the economy, and had facilitated the easing of monetary policy, thus paving the way for the recovery of private domestic demand. Directors agreed with the authorities' recognition that further fiscal consolidation was pressing in order to create room for counter-cyclical fiscal policy, especially to deal with idiosyncratic shocks in the context of EMU, and given the fiscal pressures arising from demographic factors. Directors therefore supported the authorities' intention to aim for stricter fiscal targets than required by the Maastricht Treaty. They welcomed the pursuit of tight expenditure policies at the state level in 1997, which should result in a further fall in the fiscal deficit in the current year.

Directors welcomed the authorities' intention to pursue their strategy of strict expenditure control in 1998. Noting the need to consolidate public finances further, Directors generally thought that there was little scope to cut taxes in 1998 unless those cuts were matched with expenditure cuts. Indeed, signs of a possible pickup in inflation--such as the rapid increase of some asset prices--could warrant a tightening of policies. That would need to come in good measure from fiscal policy, given the more limited degree of monetary independence arising from Finland's ERM participation.

Directors noted that structural factors had played an important role in the increase in and persistence of unemployment during the 1990s. In particular, Directors observed that high labor taxes, especially at lower income levels, and generous welfare benefits remained major impediments to a faster decline of unemployment. Thus, they called for further and more significant steps in those areas, including through a thorough reform of the unemployment benefit system.

Directors welcomed the entry of the markka into the ERM, and were of the view that the parity at which the markka had entered the ERM appeared broadly in line with macroeconomic fundamentals. They emphasized that limited monetary and exchange policy independence arising from ERM and the prospective loss of independence under EMU would require increased flexibility in fiscal policy and in the wage determination process. The wage negotiation round expected in the fall--the first since ERM entry--would provide an important test of the extent to which the social partners would adjust to the exigencies of a more rigid exchange rate environment.

Regarding financial sector developments, Directors welcomed the further improvement in the financial accounts of the Finnish banking system. They noted that further progress would require a stable macroeconomic environment and a continuation of the restructuring policies implemented by banks in the last few years.

Directors welcomed the increase in official development assistance in 1996 and encouraged the authorities to restore it to its traditionally generous level.