Country Report Finland
The economic outlook for 2014 is weak. Furthermore, Finland has to deal with waning export sectors, a relatively fast ageing population, and private sector indebtedness. That said, Finland’s public finances and banking system are solid, institutions are strong, and the business sector competitive.
Strengths (+) and weaknesses (-)
(+) Competitive business sector and highly educated workforce
Finland ranks third in the Global Competitiveness Index (GCI) 2013-2014 and tops the sub-rankings related to education. This has helped the economy to become the most innovative of the world (GCI). High firm competitiveness has also led to a healthy international creditor position.
(+) Very healthy public finances
Binding expenditure ceilings set at the beginning of each administration’s four-year term prevent the government from running large deficits. Government debt is relatively low, borrowing is based on long-term bonds, bond yields are very low and net public assets are very large.
(+) Strong institutions and qualified government officials
Finland’s institutions belong to those best performing in the world. Public institutions function well and are highly transparent. Moreover, government officials tend to respond adequately to risks and are often able to find multi-party consensus on difficult reforms.
(-) Ageing, rigid labour market and waning export sectors
The population ages rapidly, while labour mobility is hampered and structural unemployment high. Finland’s export market share is briskly deteriorating due to falling structural demand for some of its main products and lost global (price) competitiveness. Part of the production has moved abroad.
1. Weak GDP growth
In 2013, GDP volume contracted by 1.5% after having decreased by -1% in 2012. Domestic demand fell significantly, while net exports contributed positively on the back of slightly positive export demand and a contraction in import demand. The unemployment rate rose from 7.7% in 2012 to 8.2% in 2013. Going forward, the economy is expected to return to minor export-driven growth in 2014, but unemployment will remain invariably high. Moreover, while exports will benefit from the improving external environment, export growth is hampered by the ongoing industrial restructuring. The current account is likely to show a surplus in 2014, after three years of deficit.
2. Household balance sheets stay put, corporate balance sheets slightly weaken
In 13Q3, household debt reached 107% of disposable income and 65% of GDP, both 1%-point higher than a year before. The credit-to-GDP ratio compares well with the eurozone average (figure 1), though debt-to-disposable income is slightly higher; both are lower than in Nordic peers. Meanwhile, household assets rose at a faster pace than debt, leading to net financial assets of 59% of GDP and 96% of disposable income in 13Q3, which is lower than the eurozone averages (136% and 211%, respectively). The net financial position of non-financial corporations weakened over the past year (from -101% in 12Q3 to -113% in 13Q3), mostly due to a reduction in assets rather than an increase in debt. Finnish corporations are slightly less financially healthy than the eurozone average (-100%), but Nordic peers perform worse (figure 1). Due to a deteriorated economic environment, profitability has come under pressure, but the ratio of non-performing loans (NPLs) has remained broadly stable, as it did for household loans. In fact, the ratio of total private sector NPLs even decreased from 0.9% to 0.8% in the first half of 2013. However, payment deadlines have been slightly loosened. Moreover, due to the continuing weak economic environment payment difficulties are likely to increase. A substantial rise in interest rates would also hurt private debt affordability and sustainability as interest rates on about 90% of all outstanding loans are variable.
3. House prices fall, but houses remain overvalued
House prices slightly fell between 2010 and 13Q3 (-6%), but houses are still substantially overvalued (13Q3) according to the price-to-rent ratio which measures the profitability of owning a house (overvaluation of 36% in 13Q3, figure 2). Consequently, the risk of a housing market correction and resulting worsening of bank balance sheets remains present, especially if regulations and (zoning) restrictions which currently inhibit housing supply to keep up with demand were to be loosened. That said, for more than a decade, house prices have broadly risen in line with income growth wherefore they have remained affordable (see price-to-income ratio, figure 2). Besides, stress tests by the IMF suggest that banks would likely be able to absorb the losses from a steep housing price correction. Nevertheless, it could substantially worsen their balance sheets and the government has taken action to tackle the high house prices. For example, the share of mortgage interest that can be deducted from taxable income will be lowered to cool demand.
4. Government reacts to rising public debt
The general budget deficit-to-GDP ratio widened in 2013 to -2% (-1.8% in 2012) on account of weaker economic growth. The debt ratio increased from 53.6% in 2012 to 56.9% in 2013. However, net public assets did also slightly rise over the past quarters and reached 56.7% of GDP in 13Q2. So, despite the minor worsening in the gross public finances, the overall government balance sheet remains very healthy. Nevertheless, the government has announced plans to reverse the upward trend in its debt ratio, as the ratio is expected to surpass the 60% of GDP limit incorporated in Europe’s fiscal rules and the rapidly ageing population lowers medium-term public debt sustainability. The plans aim to reduce the debt stock and boost potential output. Measures have been or will be introduced to limit (local) government deficits, to improve public sector efficiency, to raise employment and participation rates, lengthen working lives, and to improve competition and productivity. In its fiscal plan 2015-2018, the government has revealed its intentions related to spending cuts and tax hikes, and investments to support short-term growth and employment. While the right implementation of all plans could significantly improve public finances, we stress that they are highly ambitious and right implementation is by no means guaranteed, also because details are still missing. Besides, in March, one party left the government over cuts to child benefits and unemployment security, while others have also called to review these measures. In addition, an increase in the (minimum) pension age has been ruled out by other coalition partners. The coalition still holds a majority in parliament, but it has become rather slim (112 of 200 seats).
The government is financially one of the healthiest in Europe as a result of a strong commitment to prudent fiscal policy since the Nordic banking crisis in the early 1990s. Though, a rapidly ageing population until 2035 imposes medium-term (fiscal) challenges (old-age dependency ratio will rise to 41.8% in 2035). Note that Finland does have accumulated relatively large pension assets (around 75% of GDP in 2011, OECD) owing to the obligatory partly-funded statutory employment pensions and the basic state pension which is pension-income tested. Another more short-term challenge concerns the need for Finland to reposition the product focus of its exports and to increase (cost) competitiveness. A combination of falling structural demand for some of its historically main manufacturing products (wood and paper), and increased operating costs in Finland have led producers in these sectors to move abroad. The latter also holds for part of the production in the ICT sector, while another large part has vanished due to Nokia’s lost market share in the telecom industry. The government has already introduced plans to boost competitiveness and find solutions for fading export sectors, but time will have to tell whether they will be implemented rightly and bring the necessary results. Household debt might pose a higher risk to financial stability than the average figure suggests, as only 59% of total households is actually indebted and 10% of all households faces debt of more than three times disposable income. Though, owing to strong regulation since the banking crisis in 1990s the Finnish banking sector is well-capitalized (core tier 1 capital ratio was 15.5% in 13Q1), wherefore it is likely able to cope with periods of stress. Yet, this does not mean it is immune to increased financial sector stress in Europe as it is dependent on wholesale funding and highly integrated with the financial sectors in other Nordic states. But, its exposure to high-risk eurozone countries is low and according to a stress test of the Bank of Finland, the ability of banks to deal with systemic stress has improved between 2011 and early 2013.