Dr Sinikka Salo
Member of the Board
Bank of Finland
Finnish economy – past, present and future challenges
Presentation at the Bank of Lithuania, 3 July 2009
- Slides (PDF)
I was asked to talk about the Finnish economy and the impact of the current global financial and economic crisis on our economy.
To begin with, as a background, I should say that albeit the financial crisis has not had a major impact on the Finnish banks directly, the Finnish economy is of course not immune to its indirect effects, on the contrary. The global recession following the financial drawbacks − tightening of credit availability and loan conditions − is having a severe impact on the open Finnish economy – the share of exports in our GDP is about 45 per cent.
Facts about Finland
Finland is, indeed, a small open economy. As you can notice from the chart, which provides some facts about Finland, our economic base is very much on industry – ICT, machinery, forest industries. The share of industry in gross value added is 32.6% while the respective average figure for the euro area is 26.9%. Finland has benefitted greatly from globalization – and of course now suffers greatly from its back-steps.
I have organised my presentation so that I first give you, as a background, a short history of the Finnish economy commenting economic developments during the past 10-15 years.
I then discuss the current economic situation and outlook for the near term 2009-2011.
Finally, I conclude with discussing some key challenges for the longer-term perspective.
High growth in the latter part of the 1990s
Many factors have influenced the Finnish economy in the past 10-15 years. Certainly the membership in the EU, which took place in 1995 together with Sweden and Austria, as well as membership in the monetary union. Actually the EMU membership had important effects already before it materialized. I think this is a phenomenon seen in all countries with the prospect of joining the EMU. In the case of Finland, expectations of joining the monetary union were fairly firmly established already soon after 1995, and it was clear that these expectations influenced economic policy decisions and private sector behaviour already before membership in the monetary union became a reality.
The hope for improved credibility of monetary policy was clearly there, as Finnish monetary policy traditionally had suffered from a lack of credibility which caused recurrent balance of payment problems and large risk premiums in market interest rates. It was hoped and expected that high credibility of euro area monetary policy would imply lower interest rates, in particular lower and more stable long-term interest rates.
It was also predicted that monetary union would be conducive to wage moderation, because better credibility would lower inflation expectations and therefore imply smaller inflation premiums in wage contracts. In the monetary union, so it was hoped, the wage inflation does not take off as easily as before, as the monetary policy can no more bail out export industries in the event of problems like in the old days characterized by "inflation-devaluation cycles".
It should also be kept in mind that when deciding to join the EU, the country was just recovering from a severe economic and financial crisis which in itself had changed the structure of the economy in several ways. Nokia is a good example: a success story of Nokia mobile phones would presumably have been less impressive, had Finland not become a member of the EU, and in this way become entitled to bigger internal/home markets, as well as EU’s trade policy powers.
To summarize, there was a need and will to conduct sound economic policies, and at the same time to boost economic growth to compensate for the huge loss in the number of jobs and in living standards that had taken place in the beginning of 1990s. And Finland succeeded: in the latter half of 1990s GDP growth in Finland was among the highest in the EU.
At the same time inflation was kept under control. Wage moderation was good in terms of the profitability and external competitiveness of the economy until 2007 − when as a result of overheating of the labour markets, wages rose beyond productivity growth, at the same time when traditional centralized wage bargaining system was given up. All in all, inflation remained reasonable close to 2 % even during the high growth period.
Hit by asymmetric chock when the ICT bubble burst
When assessing the past economic performance of Finland I would also like to draw attention to the issue of asymmetric shocks.
A regime shift from national to common monetary policy may invoke the well-known problem of asymmetric (meaning country-specific) shocks: if the member countries do not fulfil the criteria for an optimum currency area – which Finland and the rest of EU countries obviously do not do – common monetary policy cannot be expected to react to the asymmetric shocks the countries face in a similar way as national monetary policies could. To the extent that national monetary policies or exchange rate movements do in fact facilitate adjustment to asymmetric shocks, a country may have to face more severe economic fluctuations as a result of forsaking its national currency. This question was discussed extensively in Finland and was considered as the main risk for Finland in the EMU, although it was noted that a separate exchange rate policy is also a source of speculative disturbances – several times experienced in Finland – and that this source of shocks would be eliminated in EMU.
Experiences so far are rather positive in this regard and common monetary policy has been reasonably appropriate for the Finnish economy. The problem of asymmetric shocks has not been at the forefront in Finnish economic policy. It seems also, that economic cycle in Finland has recently become more synchronized with the other euro area countries although the amplitude of the cycle in Finland is larger. This is true, in particular, for industrial production.
A test was due in late 2000-early 2001 when Finland was hit by the burst in global ICT stock prices and stagnation of network markets. As you may know, Finland is more dependent on the ICT-sector than the euro area on average (in 2000 the share of Nokia alone was about 5.5% of the GDP volume). It is interesting to compare the recession that followed the ICT crash to the recession in the beginning of 1990s when Finland also was hit more severely by the sudden collapse of trade to the Soviet Union simultaneously with a downturn in other export markets. (The share of Soviet Union in Finnish total exports was in 1990, before the collapse, 13%).
In the recession of early 1990s, the whole economy entered the recession (which turned out to the worst depression in Finland since the second world war) in a situation where the credibility of monetary policy could not be maintained, not even with high real interest rates and real economic costs, as it turned out.
By contrast, in the recession of early 2000s, due to the EMU membership, there was no impact on exchange rates and ECB's rate cuts were supportive also to other sectors of economy. In particular, with low prevailing interest rates households could continue to be confident in maintaining their consumption and housing expenditure. GDP performance was reasonably good in Finland even after the ICT crash. In conclusion, in spite of the exceptionally strong dependence of the Finnish economy on the ICT sector, the ICT shock was not transmitted to other sectors of the economy through destabilizing exchange rate or interest rate reactions.
Current global recession hits exports and investments heavily
Coming back to the current situation, as I already mentioned, Finland has benefitted greatly from globalization. We have internationally strong companies in ICT, but also many investment goods producers. These companies used to heavily rely on global financial markets.
Finland is now suffering greatly from the back-steps of globalisation, in particular as the financial crisis has hit hardest investments and thus exports of investment goods. Also, as financing from overseas has become more difficult, large companies have turned to domestic banks making access to financing more stringent for SMEs, although direct impact of the financial crisis on Finnish banks has so far been rather limited.
Current state of the Finnish economy is showing
- private consumption slowing down
- industrial production falling rapidly
- exports declining heavily
- labour markets deteriorating
Inflation is falling – in particular due to lower energy prices. The latest figure for HICP-inflation from May is 1.5 % p.a. Our public finances are in good shape, but deteriorating.
With regard to financial sector, you should also note that our banking sector is by 70 % (as measured by deposits) foreign-owned (Nordea has its head office in Stockholm, and Sampo-Pankki (as part of Danske) in Copenhagen although Sampo-Pankki and Nordea-Suomi are still in subsidiary formats, i.e. Finnish banks). Thus, of the three major banking groups, only OP-Pohjola is Finnish.
Banks in Finland are not affected directly by the financial crisis, but non- performing assets and impairment losses have increased. Compared to the situation in the beginning of 1990s they still are modest. As the economic situation has weakened, credit risk has increased at the same time as banks’ income has decreased. So far credit losses have been minor. According to the analysis of the Finnish Financial Supervisory Authority (FIN- FSA), the Finnish banking sector remains solid but its profitability has declined and will do so in the coming forecasting period.
Banking sector faces challenges, however. Banks should be able to compensate for the financing gap that has emerged following the drying of other sources of finance, in particular for firms. As I mentioned many companies, in particular larger ones, used to raise finance directly from the global commercial paper market, which is still not functioning well. Consequently, these big companies now have turned to banks for their needs, which causes an increased demand for bank loans, and may be crowding out lending to small and medium sized companies. Therefore, we hope that banks make use of the available means (state guarantees, capital loans), offered them by the government, to strengthen their lending abilities. So far this has not taken place sufficiently.
Economic outlook for Finland 2009-2011
Our latest published forecast for the Finnish economy is from March 2009 It is still relatively up-to-date and gives an idea what is happening in our economy and where we are heading to.
The forecast sees a slowdown of the GDP from the growth of 0.9 per cent last year to -5.0 per cent this year. Growth remains negative also next year turning positive only late in 2010 or 2011. Finnish economy is very dependent on the exports markets and world trade. Our export structure aggravates the situation: Finland’s exports (especially investment goods) drop even more than its markets and will recover slowly with the recovery of world trade.
With regard to near-term economic development, households and their consumption behaviour is a key. According to our projections, in a couple of years the savings ratio of households, currently negative, turns positive as employment starts to decline thus dampening consumption. However, households' real income will increase quite favourably because of generous and long wage agreements combined with tax cuts and declining inflation. Thus, those households who can rely on keeping their jobs, do not need to change their consumption or investment behaviour. Private consumption is, however, forecast to decline this year, and growth turns positive only late this year or next year. Private investment is contributing to growth only in 2011.
Major contributions to GDP growth during the forecast period comes from public sector demand. As a result we will see rapid deterioration of public finances.
In the forecast summary it should be noted that current account surplus prevailing on a high level for a long period will disappear rapidly by 2011.
In my view, it is important to avoid encouraging excessive pessimism, although we have probably not seen the bottom of the crisis yet. There are, however, increasing amount of evidence that the sharpest drop in economic activity and trade flows is over and we are gradually approaching the start of the recovery. In Finland, we still have in our memories the severe crisis of the beginning of 1990s, when our GDP declined by more than 10 per cent in just two years and the unemployment rate rose to about 17 per cent. It is important to point out that forecasts are not pointing to a repetition of that. However, it is necessary that the international policy response to global recession is adequate and cooperative so that the rise of "economic nationalism" and global protectionism are avoided.
Let me conclude my presentation by pointing to two key challenges for the Finnish economy in a somewhat longer perspective after we have surpassed the current crisis period.
The first one is ageing population and the requirements that it sets for financing pension and related costs in the future. It should be noted that very soon, more people exit labour force than enter to labour markets in Finland. As a result, the provision of public services should be made more efficient – there is a huge need to increase productivity in the public sector. It is calculated that if nothing is done there will be a need to increase our already high tax rate by 5 %-points. This would further aggravate and challenge sustainability of public finances in the future.
As a second challenge, I should like to mention the need for producing more high value services. As I showed before, Finland is still excessively an industrialized economy where role of services – albeit having increased during past years - is too small. There is a need to move towards a post industrialized economy, where services play a more significant role.
In Finland – as in all other Nordic countries – a special characteristic of services is the major role of public welfare services (health care and care for children and elderly persons). Almost a quarter of the employment is in the public sector.
Specialization in ICT technology since 1990s was a success story of the Finnish industry. However, the strongest phase of growth seems to be now over. International competition has intensified, and proximity of clients and production costs tend to drive to diversification of production and purchases around the world. It is notable that fabrication of even high value products has been rather easy to transfer to emerging economies, whereas service inputs of production chain – such as head quarter services, R&D-activities − have been more rigid in this sense, at least so far and to the same extent.
It seems that Finland is approaching Sweden, where export share of high technology production is only on the average level in EU despite top-ranking intensity of R&D. It is not that competitiveness of Swedish firms had deteriorated and market shares diminished, but because of transferring production abroad.
In my view, during the following decade, Finnish production hardly can rely on technology industry to the same extent as in the past. Taking into account the above-mentioned limitations the public sector has, this means that production and exports in Finland must increasingly rely on private services. Key role will be played in particular by knowledge-intensive services, such as services for business activities and companies.
Innovative service-providing enterprises making use of high technology have during recent years grown fast in Finland, and the growth is expected to continue (when returning to more normal economic circumstances). The growth will be strengthened not only by global division of work, but also by the fact that industrial companies concentrate on their core knowhow and businesses and outsource other activities to service providers.
In addition, different kinds of immaterial factors, such as delivery times and means, brands and imagoes, as well as maintenance tasks become increasingly important as competing factors. This on its part is supporting demand for business related services.
Services are the key not only for Finland but also for other post-industrialized EU-countries. Expansion of activities to abroad is necessary in particular for service providing companies in small countries to gain scale and scope for efficient production. In this sense the internal markets of the EU are crucial and all efforts should be taken to complete their functioning.