Public Information Notice No. 99/95

Public Information Notice: IMF Concludes Article IV Consultation with Finland

October 18, 1999

On October 8, 1999, the Executive Board concluded the Article IV consultation with Finland.¹

Background

Finland's economy has made a strong recovery from the deep recession that began in the early 1990s. Spurred by a devaluation of the markka, growth was predominantly export-driven, and the external current account shifted from a deficit of over 5 percent in the early 1990s to a surplus of the same magnitude in 1997/98. In this setting, prudent macroeconomic policies brought public finances from a deficit of 7 percent of GDP in 1993 to a surplus in 1998, and reduced the public debt ratio to less than 50 percent of GDP.

Since mid-1998, activity has been underpinned by robust domestic demand. Private consumption has grown firmly, supported by rapid employment growth. Fixed investment decelerated only slightly, with services and construction expanding strongly. After slowing somewhat toward the end of 1998, industrial output growth picked up in the first half of 1999, spurred by the excellent performance of the electronics industry. Wage rates rose moderately by an average of 3½ percent in 1998 and slightly less in the first half of 1999, and the unemployment rate has recently dropped below 10 percent. Twelve-month CPI inflation, after falling to ½ percent at the beginning of the year, is running at 1¼ percent. Despite a weakening of exports during the second half of 1998--with the impact of the emerging market crisis being felt both directly and through weaker EU activity--the current account surplus remained above 5 percent of GDP, with competitiveness currently strong.

Monetary and financial conditions are currently fairly accommodative relative to Finland's advanced cyclical position. By mid-1999, nominal short-term interest rates were some 100 basis points lower than a year earlier, and real rates, deflated by the 12-month CPI inflation, recently touched new lows. Bank lending accelerated sharply over the past year. Finland's real effective exchange rate appreciated somewhat in late 1998, but the weakening of the euro in the first half of 1999 reversed that trend. Real estate prices have continued to rise, with wealth effects supporting consumption and residential investment. Stock prices have risen more sharply, although the related wealth effects may be less pronounced given high foreign ownership.

The 1999 budget extended the process of fiscal consolidation, while providing for some reduction in taxes on labor income. With economic activity strong and tax revenue buoyant, the general government surplus is set to reach some 3 percent of GDP. The improvement in the cyclically-adjusted primary balance is estimated to be on the order of 1 percent of GDP, providing an offset to the relative ease of monetary conditions.

With recent reforms in the labor market and a significant rise in employment over the past few years, the unemployment rate has declined strongly--but it remains high. Recent measures to strengthen incentives in the labor market included some tightening of unemployment benefit eligibility; enhancement of training programs; and improvements in the flexibility of working-time arrangements, especially for small and medium-sized enterprises. A suspension of inflation indexation for unemployment benefits and a reduction in personal income taxes have increased the gap between net labor income and net benefits, but important incentive problems remain. The employment rate, at some 65 percent, is not impressive by international standards, and structural unemployment among the low-skilled and in the northern and eastern regions is very high, despite relatively strong regional mobility.

With world trade projected to accelerate later this year, and the macroeconomic policy stance broadly neutral, solid economic growth should continue. The latest surveys confirm that corporations are now expecting somewhat stronger export growth, after a sluggish performance in the first half of the year, while consumer confidence has remained buoyant. Overall, GDP growth is expected to be in excess of 3½ percent in 1999, and close to 4 percent in 2000.

Executive Board Assessment

Executive Directors commended the authorities for their impressive conduct of macroeconomic policies in recent years, notably their sustained success in restraining public expenditure. These policies had set the stage for Finland's strong economic growth, as well as its entry into the euro area as a founder member. Nevertheless, Directors noted that structural challenges remained in the public finances and the labor market. To raise the growth of output and employment, curb demographic pressures on the public finances, and improve the flexibility of the economy under monetary union, they urged the authorities to deepen structural reforms, particularly in the labor market.

Directors judged the current outlook for growth to be favorable. With the economy operating close to potential, Directors viewed euro area monetary conditions as accommodative in relation to Finland's cyclical position. While they did not see an immediate risk of overheating or threats to Finland's very satisfactory competitive position, Directors welcomed the authorities' plans to maintain their modestly restrictive fiscal policy stance through 1999 and 2000. This would also ensure progress toward the medium- and long-term objectives for the public finances. They commended the steps taken to enhance the operation of automatic fiscal stabilizers, and observed that if overheating does occur, fiscal policy should be tightened.

Directors strongly supported the authorities' plans to press forward with public expenditure restraint over the medium term. They believed, however, that additional savings could be achieved in the area of social spending without compromising core objectives--for example, through improved targeting of transfers to those most in need. This would create further scope for a reduction in the heavy tax burden, particularly on labor income, without undermining fiscal consolidation.

Directors considered that the major medium- and long-term policy challenge lay in the demographic outlook. In this connection, they welcomed the recent agreement on reforms that would reduce incentives for early retirement in order to improve employment and growth prospects as well as buttress the long-run fiscal position. Directors urged the authorities to keep under review the impact of these changes and to develop other reforms in the pension system that would encourage people to stay in the work force longer. They also advised strengthening the link between pension entitlements and lifetime contributions, so as to render contributions more like savings than taxes, and thereby enhance incentives to work.

Welcoming the authorities' emphasis on raising employment over the coming years and the recent labor market improvements, Directors emphasized that unemployment was nevertheless still high. They stressed that additional efforts were needed to improve the flexibility of labor and product markets. Further reforms to the unemployment benefits system--supported by active labor market policies--were viewed as a crucial complement to a lowering of taxes on labor income, so as to improve incentives for work and training. Several Directors considered that the emergence of a shortage of skilled labor in certain sectors also called for additional steps toward labor market flexibility. While noting that the centralized bargaining system had been very useful in bringing about rapid disinflation with moderate economic and social costs, Directors considered that greater wage differentiation across firms, sectors, and regions was called for to address persistently high unemployment rates among low-skilled workers and in certain regions. They urged the authorities to continue improving the functioning of product markets through accelerated privatization, deregulation, and a strengthening of the competitive environment.

Directors noted that these structural reforms in public expenditure, pensions, and the labor and product markets would not only enhance the resilience of the economy, but also foster a virtuous circle of higher output and employment, and greater scope to reduce tax rates. Such a broad-based reform strategy is essential to address the demographic shock effectively. As these measures would take some time to have their full effect, Directors urged prompt action in order to take advantage of the favorable near-term outlook for the economy.

In the financial sector, Directors welcomed the progress made in enhancing the efficiency of the banking system, while stressing that globalization and European integration posed growing challenges to institutions and supervisors alike. In light of the booming real estate market in certain growth centers, they advised the authorities to continue monitoring closely the effect of credit growth on the financial sector, and to explore ways to improve the functioning of the real estate market.

Directors noted that Finland's provision of high-quality data on a timely basis facilitated the conduct of effective surveillance.