Public Information Notice No. 98/67

Public Information Notice: IMF Concludes Article IV Consultation with Finland

September 10, 1998

On August 28, 1998, the Executive Board concluded the Article IV consultation with Finland¹.

Background

Finland has grown steadily since mid-1993, the turning point of its deepest recession this century. During the recession—caused by external shocks, the bursting of an asset price bubble, and a loss of competitiveness—output declined by 15 percent, unemployment approached 17 percent, and public and external debt ratios reached record levels. The recovery was underpinned by the 1992 floating of the markka, and gained momentum when domestic demand picked-up in 1994–95.

Economic activity was strong in 1997, as GDP and employment increased by 6 percent, and by 2 percent, respectively. Private consumption and investment were spurred by the improved macroeconomic outlook, relatively easy monetary conditions, and declining household and corporate indebtedness ratios. The recovery of the labor-intensive residential construction and retail trade sectors explains much of the rise in employment. Unemployment fell more rapidly than in recent years, to a still high 12¾ percent in 1997 on an EMU-harmonized basis. In particular, the unemployment rate for young and older workers remained about twice as high as that of other wage groups, and the ratio of long-term unemployed to total reached 30 percent.

CPI inflation edged up, but was still a modest 1¾ percent at end 1997, assisted by a decline in unit labor costs (ULC) as productivity growth outweighed modest wage increases. Finland’s competitiveness was further boosted by the strengthening of the U.S. dollar, with the ULC-based real effective exchange rate depreciating by 5 percent in 1997. In addition to strong competitiveness, the buoyancy of exports reflected sector-specific factors (high world demand for wood and paper, and metal and engineering products), and the 13 percent growth in export volumes lifted the external current account surplus to a record 5½ percent of GDP. Net external debt dropped to 28 percent of GDP, still a high level for an industrial country.

The fiscal strategy begun during 1995—freezing expenditure in nominal terms and using the revenues from the recovery initially to reduce the deficit and, subsequently, also to lessen the tax burden—continued in 1997. As the expenditure ratio dropped (a cumulative 7 percentage points of GDP since 1993), the general government deficit fell to 1 percent of GDP in spite of cuts in taxes. The public debt ratio fell to 55 percent of GDP. As in the past, the strength of general government finances reflected the surplus of the social security accounts (3 percent of GDP in 1997). The central budget deficit, while improving, was still large (4¼ percent of GDP).

Monetary policy was tightened slightly more than in core ERM countries. In September 1997 the Bank of Finland (BoF) raised its main policy rate—the tender rate—by 25 basis points to 3.25 percent, in view of its concerns about the acceleration in asset prices and to send a signal ahead of the nationwide wage agreement of December 1997. The agreement reached was for contractual wage increases of 2½ percent in 1998 and 1½ percent in 1999, and was regarded as moderate, though actual wages may increase faster due to "wage drift". The BoF nudged the tender rate up by an additional 15 basis points in March 1998, noting that inflation in Finland was higher than in the countries likely to be among the first to enter EMU, while Finnish short-term rates were among the lowest (after the October 1997 increase in Bundesbank rates).

These results have paved the way for Finland’s participation in the last phase of Economic and Monetary Union (EMU). An EU member since March 1995, and an ERM member since October 1996, Finland passed all tests for EMU membership with flying colors.

The 1998–99 outlook remains positive. Output growth should moderate from its unsustainable 1997 rate, reflecting some fiscal tightening, the completion of the recent investment cycle in the forestry industry, and the effects of the Asian crisis. However, the momentum of residential investment is strong, and is likely to remain so given the relatively easy monetary stance in the EMU area. Further cuts in labor taxes should sustain consumption in spite of the modest real wage increases expected. The unemployment rate is expected to edge further down, although not as rapidly as in 1997, to 11¼ percent in 1998 and further in 1999. The external current account surplus is projected to remain close to its 1997 level. Inflationary pressures are likely to be restrained by low imported inflation, though ifaggregate demand continued to rise rapidly, wage drift and inflation pressures could build in 1999.

Executive Board Assessment

Directors commended the authorities for their prudent macroeconomic policies, which had paved the way to strong output growth in the context of modest inflation, a large external surplus, and improved fiscal accounts. However, Directors observed that challenges lay ahead, particularly in light of Finland’s upcoming adoption of the euro: fiscal consolidation needed to be continued, with an eye to the sizable demographic shock in the years ahead and the risk of overheating; increased flexibility in fiscal policy and in the labor market was needed to offset the loss of monetary independence related to EMU; and comprehensive structural measures were required to lower the still high—albeit declining—unemployment rate over the medium term. Addressing these structural problems was necessary for enhancing the economy’s production potential.

Directors welcomed the tightening of monetary and fiscal policies since the fall of 1997. In particular, they noted that the marked improvement in the general government balance expected for 1998 and 1999 was consistent with both fiscal consolidation goals and the need to gradually slow down the pace of aggregate demand to more sustainable levels. They supported the authorities’ objective of further strengthening the central budget over the medium term, as this would help offset the prospective erosion of the surplus of the pension fund as a result of the aging of the population. Tackling the latter, however, would also require further pension reform, including measures leading to an increase in the effective retirement age.

While the policy stance appeared at present broadly consistent with the continuation of the current phase of balanced growth, most Directors urged the authorities to remain vigilant, and to tighten fiscal policy further if the risk of overheating mounted. Noting the recent rapid increase in housing prices, Directors welcomed the measures already envisaged in the 1999 budget to dampen demand in the housing market. A prompt fiscal reaction to any emerging inflationary pressures would be especially important in light of the very limited room left for independent monetary action in the run-up to EMU. However, Directors generally did not see a need at the present time to further tighten fiscal policy, given the lack of clear indications that inflationary pressures were mounting and the potential deflationary effects from the financial difficulties in Russia and Asia.

Directors concurred that participation in EMU should be accompanied by more flexibility in fiscal policy and in the labor market. In this respect, most Directors welcomed the strengthening of the automatic stabilizers implied by the recent reform of the financing mechanism of unemployment and pension benefits. Directors also noted that a stronger responsiveness of average wages and wage differentials to cyclical developments would enhance the resiliency of the Finnish economy. While noting the progress in economicdiversification and export markets, Directors underscored that Finland remained vulnerable to idiosyncratic and other shocks. In this regard, they also highlighted the importance of greater flexibility in fiscal policy and further structural reform.

Directors emphasized that, in order to boost employment prospects over the medium term, the economic incentives to demand and supply for labor should be strengthened. In this respect, they commended the authorities for cutting labor taxes further in the 1999 budget, while maintaining a sustained pace of fiscal adjustment. However, they called for additional cuts, as the tax wedge remained high. Directors noted that tax cuts should not delay fiscal consolidation, but should be fully matched by reductions in public expenditure, particularly in transfers to the population, which were very generous, not well targeted, and which reduced the incentives to supply labor. Directors called for a revision of the unemployment benefit system with the goal of reducing the duration of the benefits, as well as benefit abuse.

Directors recognized the continuous strengthening of the banking system since the crisis of the early 1990s, but warned that banking competition in the EMU area was bound to increase. They stressed that maintaining strong, balanced output growth would be essential to the health of the banking system.

Directors welcomed the increase in official development assistance registered in the last few years, and encouraged the authorities to raise it to its traditionally generous level.