Public Information Notice No. 06/10

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Finland

February 1, 2006

On January 30, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the 2005 Article IV consultation with Finland.¹

Background

Economic performance in recent years continued to be favorable. Growth has outpaced that in the euro area and is expected to pick up to over 3 percent in 2006. The external current account has remained comfortably in surplus, and inflation has remained below the euro area average. Although the public finances remain in surplus, there has been a weakening in recent years, with the central government accounts shifting into a deficit. Moreover, the imminent rise in old-age dependency—more rapid than elsewhere in Europe—is clouding the long-term outlook for growth and fiscal sustainability.

Economy activity weakened in 2005, primarily due to a major but temporary setback to output as a the result of a labor dispute in the key paper sector. Activity has been underpinned by domestic demand, especially strong private consumption, supported by low interest rates, reductions in income taxation, and buoyant consumer confidence. Growth is projected to rebound strongly in 2006, with a bounce-back in paper exports helping to boost net exports. A decline in private consumption growth is anticipated to be more than offset by a pickup in investment.

Inflation has been very low in the past two years, aided by strong productivity growth and wage moderation. Cuts in some excises, increased competition in some domestic sectors, and low non-fuel import prices have also contributed to keeping inflation in check. Although inflation is expected to rise in 2006 toward the euro area average, the multi-year wage accord, combined with continued productivity growth is expected to maintain external competitiveness. Employment growth has picked up in 2005 after three years of stagnation, driven by public and private services. However, job mismatches are also increasing, and risks of some labor shortages in particular sectors are emerging. Monetary conditions have been very easy, and credit growth has risen markedly, with mortgage lending increasing by about 15 percent in 2005.

Although the general government surplus is estimated at about 1¾ percent of GDP in 2005, its magnitude has declined markedly in recent years, largely the result of cuts in personal income taxation at the central level designed to boost employment, and growing local government expenditures. The central and local governments are now both in deficit, with the general government surplus more than accounted for by pension fund surpluses. The budget for 2006 includes further cuts in income taxes of about ½ percent of GDP and increased employment subsidies aimed at workers at the lower end of the income scale.

The authorities are taking some steps to address the long-term fiscal pressures. Measures to raise central government efficiency are in train. Proposals are also being debated to reform the financing of local governments and restructure their activities to raise efficiency in the provision of public services. Significant pension reforms were initiated in 2005, to be phased in over a number of years.

Executive Board Assessment

The Executive Directors commended the authorities for their consistent implementation of policies that had underpinned Finland's strong economic performance in recent years. Directors noted the record of solid growth and low inflation and expected the short-term outlook to remain favorable, despite some downside risks. They considered that the most pressing task in the period ahead would be to strengthen the fiscal position and continue to implement reforms to cope effectively with the challenges of an aging population. Directors were reassured by the authorities' recognition of the need for adaptation and transformation of the Finnish economy.

Although Finland's overall fiscal position is relatively comfortable, Directors expressed concern about its recent deterioration. Efforts to boost employment through cuts in labor taxation without offsetting reductions in public spending had shifted the central government balance into deficit. While welcoming the tax cuts, Directors called for further steps to restrain expenditure in order to respect the authorities' medium-term spending rule and meet their goal of balanced central government finances.

Directors viewed an increase in efficiency of public services as critical to addressing the imminent demographic challenge. They welcomed the authorities' efforts to reorganize the provision and financing of such services, and suggested that these would need to be complemented by measures to limit demand for public services, including more effective employment of user charges. While Directors welcomed the pension reforms being phased-in, they called for further measures in this area to enhance long-term sustainability.

Directors considered that the centralized wage bargaining mechanism needed a greater degree of flexibility to allow the wage structure to more fully reflect productivity differentials and promote the employment of low-skilled labor. Continued efforts are essential to address growing labor market mismatches and make the fullest use of labor resources, including through active and well-targeted labor market policies such as employment training. Directors also called for further progress on product market liberalization.

Directors welcomed the assessment that Finland's financial system is sound and well supervised. Nonetheless, continued vigilance will be needed in light of the rapid growth in credit and heightened competition among lenders, especially in the mortgage segment, which could pose increased risks for credit quality and future bank profitability. Directors also underscored the importance of close cooperation among supervisory authorities in the rapidly integrating Nordic-Baltic region.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On eturn to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.