Seminar 19.4.2004 at THE NOBEL INSTITUT, Oslo
Ladies and Gentlemen, first of all I would like to thank for this opportunity to give a presentation on the Finnish economy in euro time.
In my presentation to you today I would like to put before you the challenges Finland is faced with in its membership in the EMU – the Economic and Monetary Union.
There are three angles to evaluate the Finnish economy in 'euro time'.
First it can be viewed from the point of entry, i.e. the economic circumstances at that time and the debates regarding our entry.
Then secondly we can look at the current economic situation.
Thirdly we must assess the economic outlook, and there I will take you through some key points of the bank's forecast for the coming 2 years.
Last of all I will conclude by highlighting some potential challenges we have in our economy.
Perhaps a word of caution is needed. We have been a member of the monetary union only 5 years, which may be far too short a time to come to final conclusions on the subject. I will nevertheless try to provide you with an early assessment of Finland's economic performance.
Above all, one issue that I would like to highlight is the fact that Finland does not stand in isolation. When assessing the position we are in and the challenges that lie ahead, we must recall that we are irrevocably linked to the euro and more than ever must see ourselves in a global perspective. Thus, developments of the global economy – not only European but also United States' and Asian economies – should be taken into account when assessing Finland's economic development.
Entering into the monetary union
Without doubt, the Finnish decision to join the monetary union was not motivated by economic considerations alone. Political motives played an important role as well. One of the key expectations was that being part of the 'inner circle' of the European Union would bring with it the chance to maximise Finland's influence in Europe.
Yet, without doubt, economic considerations were crucial and constantly referred to in heated debates on whether or not to join. Finnish monetary policy had traditionally suffered from a lack of credibility, where devaluation was repeatedly used as a means of restoring competitiveness and this was directly reflected in interest rates. Critics blamed this for many of the structural problems the country suffered from, such as large investment rates relative to growth and the chronic weakness of the current account. It was anticipated that monetary policy credibility would strengthen, and that interest rates would be lower and more stable if the country were to join the monetary union. This should in turn enhance investment and economic growth.
However, there were also some concerns expressed regarding losing our independent monetary policy and the possibility for devaluating our currency in case of unforeseen economic adverse shocks. Generally speaking when there are shocks affecting different countries differently, i.e. so called asymmetric shocks, each country can use its monetary policy or exchange rate movements to adjust accordingly. It should be pointed out that most of the studies made before the EMU showed that the economic structure of Finland deviated clearly from the rest of the EU. Therefore the expected difficulty of adjusting to asymmetric economic shocks without national money was considered the main objection to Finland's membership.
Experiences and outcomes of Finland joining the EMU
Looking at Finland's official membership of the EMU at the beginning of 1999, when the union became a reality in the sense of permanently fixed exchange rates and a single monetary policy, we can see – in retrospect – that Finnish monetary policy converged almost completely with that of Germany already much earlier. Inflation fell been below 2% and the floating exchange rate was fairly stable already from 1994 onwards.
Let me remind you of the fact that when Finland joined the euro, the country had just recovered from very severe economic and financial crises. This means that, the effects of our membership are intrinsically mixed with the effects of the crises, such as the significant depreciation of the currency, a sudden increase in government debt, and mergers and acquisitions as well as privatisations in both banking and industry sectors.
The Finnish experience in the early 1990s stood out from similar experiences of its neighbouring Nordic countries; not least because of the coinciding sudden collapse of Soviet export markets which strongly intensified the crises. Over only a few years, our GDP decreased by an unprecedented 10% and unemployment rate increased from below 4% close to a staggering 18%.
While another factor – and one that makes it difficult to isolate the positive effects of the EMU – is the remarkable impact of the so called 'new economy' in Finland. From late 1990s onwards our economic performance has been dominated by the exceptional growth of the high-tech electronics industry led by the success of Nokia. The information and communication technology sector as a whole contributed to a so strong a boom that the effects of the new monetary regime are hard to distinguish from technology-related changes in the economy.
Current economic situation and outlook for the future
Let me now turn to the current economic situation. To a large extent, the expectations we had of the effects EMU membership have, in fact, materialised. Credibility in monetary policy has been achieved as the promise of lower interest rates has become a reality. Although this is, indisputably, partly an international phenomenon, interest rates in Finland have been somewhat lower and more stable than in Sweden and the UK, who both remain outside the monetary union.
In the environment of the common monetary policy, Finnish economic development has clearly exceeded the average of the other Eurosystem members (slide: Total output). This is partly due to a powerful but favourable asymmetric shock in the form of an IT boom that was much stronger in Finland than in the euro area on average. The slide shows also that the euro area is far from being homogenous yet and Germany's economy in particular has been lagging, which has had a downward effect on the area's overall GDP levels.
Without doubt, one essential development has been the increasing level of openness in the economy. This has taken place at several levels as the share of exports in the country's GDP has increased. But the change has been substantial in the financial markets with a very rapid growth in portfolio investments and direct investments. The improvement of the current account is all the more significant, since Finland had not had large current account surpluses for several decades. Moreover, these surpluses have been recorded at a time when economic growth is robust – previously periods of robust economic growth were typically associated with large external deficits.
The increase in foreign direct investment has happened together with a sharp improvement in the profitability of export industries and a decline in their domestic fixed investment. The period has also seen the expansion of Finnish multinational companies on an unprecedented scale. Much of direct Finnish investment abroad has been in the form of takeovers, especially in the forest industries, however there have also been plenty of industrial greenfield projects in foreign markets.
Fundamentally, Finland is in shape. The country's economy is doing well; in fact it is showing higher-than-average results against its fellow euro area members. This is set against the backdrop of a world economic situation which has taken a cyclical change for the better during the course of 2003 with growth being driven by the United States and several countries in Asia. Although recent developments have been favourable, there are still uncertainties about growth continuing over the longer term due to major imbalances in these big economies.
All things considered, Finland has emerged well from the extended international recession. Its balance sheets have remained relatively strong and the prospects for growth in domestic demand in the immediate years ahead appear bright. The Bank of Finland forecasts slightly less than 3% annual GDP growth for the coming 2 years. We foresee that this growth will be sustained by quite strong household consumption, the gradual stimulus to the export sector from the improving world economy and a gradual recovery in investment. We should note that growth will however remain clearly slower than in the late 1990s.
The information technology boom brought with it a remarkable growth in industrial production from the electronics industry (slide: Industrial output in Finland). However, as far as exports are concerned, the electronics industry is still supported by almost equal shares in the export market with the more traditional Finnish strong industrial pillars of the paper and forestry sector as well as the metals industry.
Although it is felt that Finland's exports over the next few years are likely to be rather lacklustre, compared with the brisk pace of the international economy, a 7% growth forecast for export markets is likely to permit healthy growth of as much as 5 to 6% in Finland's export of goods and services.
We foresee that the inflation outlook is probably going to remain subdued. The inflationary pressures on goods and services have eased although housing prices have accelerated, largely as a result of the low interest rates. It is likely that the strengthening economy and continuing low interest rates will keep these housing prices on a gentle upward curve, at least for some time, and we see that there is a clear risk of overheating in the housing market.
The outlook for public finances is stable even though there has been a decrease in general government revenue relative to GDP, partly due to tax cuts, and central government will move slightly into deficit later this year.
Overshadowing all of the positive development is unemployment. The upward turn in the world economy has not yet been reflected in exports and industrial output in the manner expected. In fact, industrial employment has been in decline for almost two years already, and the overall employment rate for 2006 is forecast as being a dismal 68%. The unemployment rate, meanwhile, is falling far too slowly, which can, in turn, have an adverse affect on consumer sentiment.
This brings us to an essential indicator of economic growth – confidence, both industrial and consumer confidence (slides: Consumer confidence and Industrial confidence indicator). In fact, confidence indicators have been good in forecasting growth, since there has been a tight correlation between the confidence expressed and the actual economic development that follows behind. In Finland, confidence indicators are clearly at higher levels than in the euro area.
Apart from the impact of the increased value of the euro, Finnish industry has been hampered by its production structure, which is not oriented towards the growth sectors of world trade. This means that, contrary to expectations, Finland has been slow to benefit from the return to growth elsewhere in the world. There is a clear need for Finnish industry to become more responsive to the global competition.
Downside risks and upside surprises
To recall a point I made earlier – Finland is not an economy in isolation of the global economy – and the sluggish pace of recovery in fixed investment is a key issue facing our industry. A rise in US long-term interest rates and the continued depreciation of the dollar would have a negative effect on the entire world economy.
Another, very different sort of risk to the international economy concerns the low level of interest rates, the present abundance of global liquidity and the opening up of the Chinese economy, where there is an increased danger of over-investment and, by extension, overheating. This could lead to a serious crisis first in China, and repercussions could also be felt in many traditional sectors in the industrialised nations.
Despite this, the tentativeness of the forecast for the world economy also leaves space for positive surprises. If we look for a moment towards the United States we can see that major improvements in productivity and cost savings have enabled companies recently to strengthen their balance sheets considerably. There could, therefore, be a surprise on the way in the shape of a strong recovery in investment.
After these positive conclusions regarding Finland's EMU membership, let me say a few words of caution and explain some of the challenges the Finnish economy will face in the future.
One of the major aspects of the future economic development relates to the fact that, according to demographic forecasts, the Finnish population will be ageing faster in the next couple of decades than that of most other European countries. It has been assessed that there will be a substantial extra burden on public finances in terms of pensions and other expenditures related to an ageing population.
Despite the growth of the economy, employment in the industrial sector has diminished in recent years. We cannot avoid the fact that overall investment activity in Finland has remained low – in fact the flow of direct investment would appear to be more outward than inward – and there has been little increase in the country's productive capacity.
The entry of the ten new member countries into the European Union in two weeks' time will surely intensify the competition for the placement of new factories and jobs. Moreover, the enlargement will undoubtedly intensify tax competition within the European Union – a particular challenge to countries like Finland with high personal and marginal income tax rates.
The response to these global challenges is to increase the dynamism and efficiency of the Finnish economy, have competitive tax rates, place even greater emphasis on research and development, maintain high level of education, and improve the efficiency of its public services. It is obvious that we cannot succeed in the global competition with conventional means like low-costs, natural resources, abundance of work force, etc.
Finland would have to face most of these challenges, regardless of whether it was a member of the euro area or not. However, we believe that EMU membership provides us with a more stable monetary environment and a larger "home market". These characteristics seem to create confidence among business leaders, and even with the man in the street, in their expectations relating to future economic situation.
Ladies and Gentlemen,
having now taken you through our economical experiences in euro time, the key messages that I would like you to take away with you today are
-that the decision to join the single currency has, for the time being, proven to be a sound solution for Finland,
-that we are clearly able to benefit from being members of the euro area, and
-that the Finnish economic outlook is rather bright, yet subject to international economic development.
All in all, Finnish EMU membership seems, at this early stage, to have fulfilled most of its promises and enable Finland to have avoided most of its risks. The structural effects on the economy appear to have been favourable, as predicted. Clearly however, more time has to pass and the performance of the economy over more than one economic cycle has to be observed before any definite conclusions on these issues can be attempted.