COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Finland 2014
Date: 2014-03-05
Institutions: European Commission
Subjects: Euro Group (euro area), Finland, competitiveness, economic growth, industrial restructuring, macroeconomics, stability pact, trade balance













EUR-Lex - 52014SC0089 - EN











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52014SC0089

COMMISSION STAFF WORKING DOCUMENT Macroeconomic Imbalances - Finland 2014 /* SWD/2014/089 final */









Results of in-depth reviews under
Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic
imbalances
Finland continues to experience macroeconomic imbalances,
which require monitoring and policy action. In particular, the weak export
performance during the last years, driven by industrial restructuring, cost and
non-cost competitiveness factors, deserve continued attention. 
More specifically,
high import growth prior to the crisis and subdued exports afterwards explained
the erosion in external balance. However, the current account has stabilised
recently and external sustainability is not a concern. The country continued to
lose export market shares at a fast pace, despite the recovery in world trade.
Finland's integration into global value chains has played a role in the
declining performance of exports, while the industrial restructuring has not
yet been able to make up for the large downsizing of the electronics and
forestry industries. In turn, the adjustment capacity of the economy is
constrained by low productivity and weak competitive pressures in services as
well as increasing costs due to dynamic wage growth and a high
energy-intensity. Exporters have thus been able to sustain price
competitiveness mainly by compressing profit margins, which have limited their
capacity to translate the high innovation potential into new products. Non-cost
factors appear to explain most of the deterioration in competitiveness: a
limited number of large exporting firms selling a narrow product range, a lower
propensity of small companies to export as well as less efficient R&D
spending. In turn, weak investment, a declining working age population and a
significant drop in productivity weigh on potential growth. As regards public
finances, the structural deficit is expected to be slightly above its
medium-term objective in 2014 while, partly due to the unfavourable growth
dynamics, the public debt is projected to increase to above 60 per cent of GDP.
Excerpt
of country-specific findings on Finland, COM(2014) 150 final, 5.3.2014
Executive Summary and Conclusions 7
1.       Introduction  9
2.       Macroeconomic
Developments 11
3.       Imbalances
and Risks 17
3.1.     Current
account balance  17
3.1.1.  Main
developments and savings-investment balances 17
3.1.2.  Net
international investment position and cross-border financial linkages 23
3.2.     Trade
performance and Finland's integration into the global value chain  24
3.3.     Price and
cost competitiveness 31
3.3.1.  Nominal and
real effective exchange rate  31
3.3.2.  Labour costs 33
3.3.3.  Other cost
components and profit margins 40
3.4.     Non-price
competitiveness 45
4.       Policy
Challenges 51
References 53
LIST OF Tables
2.1. Key
economic, financial and social indicators 15
LIST OF Graphs
2.1.     Labour
market 12
2.2.     Dispersion
of regional unemployment rates, selected countries 12
2.3.     Low-skilled
to high-skilled unemployment gap, selected countries 13
2.4.     Part-time
employment in total employment, selected countries 13
3.1.     Decomposition
of external position (current and capital accounts) 17
3.2.     Average
annual growth of domestic demand, exports and imports of goods 19
3.3.     Terms of
trade, selected countries 19
3.4.     Terms of
trade, selected products 19
3.5.     EMS in
selected countries (index) 19
3.6.     Contribution
to EMS growth  20
3.7.     Energy
trade balance, selected countries 20
3.8.     Current
Account financing  20
3.9.     Decomposition
of change in current account balance (2007-12) 21
3.10.   Net
Lending/Borrowing by Sector 21
3.11.   Savings and
investment by sector 21
3.12.   Gross capital
formation by type  22
3.13.   Investment
excl. construction, selected countries 22
3.14.   Decomposition
of NIIP  23
3.15.   Decomposition
of rate of change of NIIP  23
3.16.   NIIP by
sector 24
3.17.   Geographical
and sectoral composition of nominal rate of change of goods exports 25
3.18.   Destinations
of exports of goods (2011), selected countries 25
3.19.   Composition
of goods exports (current prices) 25
3.20.   Shares in
exports and imports of goods in the BRICs 26
3.21.   Share of
high-tech exports, selected countries 26
3.22.   Low-tech
exports, selected countries (index) 26
3.23.   High tech
exports by industry  26
3.24.   Non-ICT
exports in values, selected countries (index) 27
3.25.   Services
exports in values, selected countries (index) 27
3.26.   Turnover in
manufaturing for outward foreign affiliates, selected countries 28
3.27.   Turnover in
paper and electronics (in domestic and outward foreign affiliates) 28
3.28.   NEER in
selected countries (index) 31
3.29.   Real
effective exchange rate in Finland (index) 32
3.30.   ULC and
export price based REER, selected countries (index) 32
3.31.   Change in
REER: tasks vs goods (cumulative % change 2000-2011) 33
3.32.   Unit labour
costs, selected countries (index) 34
3.33.   Average ULC,
real wages and productivity, selected countries 34
3.34.   ULC by sector
(index) 34
3.35.   Price index
of Gross value added in tradables, selected countries 35
3.36.   Price levels
of final consumption of households (2012, EU27=100), selected countries 35
3.37.   Share of
low-wage earners, selected countries 38
3.38.   Gross value added
in manufacturing (index) 38
3.39.   Gross value
added in electronics (index) 38
3.40.   Labour costs
to value added ratio, selected countries (index) 39
3.41.   Labour cost
index in manufacturing, selected countries 40
3.42.   Manufacturing
cost structure, % of ouput value (basis prices, 2010) 40
3.43.   Intermediate
consumption deflators in manufacturing, selected countries (index) 43
3.44.   Output
deflators in manufacturing, selected countries (index) 43
3.45.   Profit
margins, non-financial corporations (% of value added) 43
3.46.   Gross
oprating surplus, selected countries 44
3.47.   Gross
operating surplus in main sectors 44
3.48.   Return on
assets (medians solid line, quartiles dotted) 45
3.49.   Return on
assets by sector (medians) 45
3.50.   Trade balance
decomposition  45
3.51.   Global
Competitiveness Index  45
3.52.   Allocated
efficiency (AE) by sectors 46
3.53.   Concentration
and diversification (2011) 46
3.54.   Export
distribution by firm size class (2011), selected countries 47
3.55.   Net
investment rate by sector 48
3.56.   Net
investment rate (medians solid line, quartiles dotted) 48
3.57.   Outward FDI
by sector, stocks 49
3.58.   Inward FDI by
sector, stocks 49
3.59.   Growth in
triadic patents over 1999-2010, selected countries 50
LIST OF Boxes
3.1.     POTENTIAL
GROWTH AND TOTAL FACTOR PRODUCTIVITY IN FINLAND   18
3.2.     FINLAND IN
THE GLOBAL VALUE CHAINS (GVC) 30
3.3.     DETERMINANTS
OF EXPORTS IN FINLAND   33
3.4.     ULC
DECOMPOSITION INTO COST AND PRICE COMPONENTS  37
3.5.     THE NEW
LABOUR MARKET AGREEMENT IN FINLAND   39
3.6.     ENERGY
COSTS IN FINLAND   42
3.7.     GOVERNMENT
SUPPORT FOR BUSINESS DEVELOPMENT AND R&D IN FINLAND   50
LIST OF Maps
No table of contents
entries found.
In April 2013, the Commission concluded
that Finland was experiencing macroeconomic imbalances, in particular as
regards developments related to competitiveness. In the Alert Mechanism Report
(AMR) published on 13 November 2013, the Commission found it useful, also
taking into account the identification of an imbalance in April, to examine
further the persistence of imbalances or their unwinding. To this end this
In-Depth Review (IDR) provides an economic analysis of Finland's economy in
line with the scope of the surveillance under the Macroeconomic Imbalance
Procedure (MIP). The main observations and findings from this analysis are:
·       Finland's medium-term outlook remains subdued. The continuous deterioration of exports weighs on the recovery while
a weak investment activity, a declining working age population and a
significant drop in productivity limit potential growth. These developments
also weigh on public debt dynamics, despite fiscal adjustment measures taken.
On the positive side, financial markets confidence in the economy remains
unshaken and funding costs low. 
·       As the process of industrial restructuring has not yet made up for
the substantial downsizing of the electronics and forestry industries, the
erosion of Finland's external position appears structural. High import growth prior to the crisis and subdued exports
afterwards explain the erosion in Finland's external balance. While Finland
still ranks in the top league of international competitiveness rankings,
exports are still around one fifth lower than in 2008, despite the recovery in
world trade, and the country continues to lose export market shares at a fast
pace. These developments demonstrate Finland's difficulty so far to respond to
the structural shocks in its tradable sectors.
·       Finland's integration into global value chains has also played a
role in the declining performance of exports, while the economy would be well
placed to reap the benefits of integration. To gain
access to worldwide markets and achieve efficiency gains, Finnish
multinationals have favoured outward FDI over exports, partly replacing
domestic investment by investment abroad. This implies high adjustment costs,
but the benefits of integration into global value chains are seen in the
dynamics of the domestic value-added content of exports. A skilled workforce,
significant research and development expenditure and effective active labour
market policies can help minimise the costs of adjustment and reap the benefits
of this inevitable process. 
·       The capacity of the economy to reorient itself is constrained by
increasing costs, which have depressed profitability and investment. In recent years, Finnish exporters have been able to sustain price
competitiveness mainly by compressing profit margins. While competition on
global markets determines prices, domestic costs have increased due to dynamic
wage growth and a high energy-intensity. The worsening profitability failed to
rebound after the crisis, limiting the capacity and incentives to translate the
high innovation potential into new marketable products.
·       The deterioration in competitiveness is mainly due to non-cost
factors. Geographic and product mix factors cannot
fully explain the swift loss in export market shares. A limited number of large
exporting firms selling a narrow product range as well as the lower propensity
of Finnish small companies to export weigh on trade performance. The decline of
the Finnish ICT sector raises concerns about the future path of R&D
investment and total factor productivity. The limited allocative efficiency in
non-tradable sectors and less efficient R&D spending are also among the
underlying drivers. Cost factors play a role as well, given Finland's
specialisation shift from high-tech to more price-sensitive intermediate
products.
·       The dynamics of household debt remains a source for concern,
although deleveraging needs seem not pressing.
Household indebtedness expanded steadily over the past decade; however it
remains far below unsustainable levels observed in other European countries. Housing
cost overburden rates for households are still rather low, but developments in
the mortgage market deserve close attention.
The IDR also discusses the policy
challenges stemming from these developments and what could be possible avenues
for the way forward. A number of elements can be considered:
·       The labour market adjustment capacity to absorb shocks could be
enhanced. Further efforts are envisaged to achieve
productivity gains in public service provision to facilitate reallocation of
workers to more productive sectors. To counter the decline in the working age
population due to ageing, the activation of young people, the long-term
unemployed and older workers, as well as an increase of the effective
retirement age and encouraging part-time employment, are needed. Following the
wage agreement reached by social partners providing significant wage moderation
for at least 2014-15, social partners could pursue efforts to take sectoral and
local productivity growth into account in wage agreements and effectively curb
labour cost growth.
·       Deregulation and a more level playing field would help prevent a
further worsening in competitiveness. Measures
aimed at enhancing competition and deregulation, especially in less
internationally exposed service sectors, could put a lid on price increases
including for intermediate inputs, improve productivity and soften the impact
of the on-going restructuring in traditional industries. 
·       A further focus on energy efficiency would have a positive impact on
Finland's cost competitiveness and trade balance.
Measures aimed at enhancing energy efficiency improve the competitive position
of the industrial sector by lowering the cost of inputs.
·       The export potential could be boosted by providing tailored support
for the internationalisation of smaller firms and leveraging the country's high
R&D intensity. Efforts need to be reinforced in
particular on further supporting the clusters between multinationals and
domestic innovative companies. Given the large number of government agencies and
available schemes involved in funding business development, a review of their
effectiveness would be useful. Finland's high R&D intensity could be more
effectively translated into the development of new products and creating
high-productive jobs, while government funding for R&D could be targeted on
enhancing R&D spillovers.
On 13 November 2013, the European
Commission presented its second Alert Mechanism Report (AMR), prepared in
accordance with Article 3 of Regulation (EU) No. 1176/2011 on the prevention
and correction of macroeconomic imbalances. The AMR serves as an initial
screening device helping to identify Member States that warrant further in
depth analysis to determine whether imbalances exist or risk emerging.
According to Article 5 of Regulation No. 1176/2011, these country-specific
“in-depth reviews” (IDR) should examine the nature, origin and severity of
macroeconomic developments in the Member State concerned, which constitute, or
could lead to, imbalances. On the basis of this analysis, the Commission will
establish whether it considers that an imbalance exists in the sense of the
legislation and what type of follow-up it will recommend to the Council.
This is the third IDR for Finland. The
previous IDR was published on April 10, 2013 on the basis of which the
Commission concluded that Finland was experiencing macroeconomic imbalances, in
particular as regards developments related to competitiveness. Overall, in the
AMR the Commission found it useful, also taking into account the identification
of an imbalance in May, to examine further the persistence of imbalances or
their unwinding. To this end this IDR takes a broad view of the Finland's
economy in line with the scope of the surveillance under the Macroeconomic
Imbalance Procedure (MIP).
Against this background, first section 2
provides an overview over macroeconomic developments while section 3 looks more
in detail into the main imbalances and risks. Section 4 discusses policy
considerations.
A hesitant recovery
The Finnish economy is still struggling
to overcome the crisis, as the recent recovery has proven fairly muted. Following an initial recovery in 2010–11, the economy faced a
recession before returning to tepid growth in the second quarter of 2013.
Stagnant private consumption, subdued confidence and declining investment as
well as lower-than-expected export growth hampered a more vigorous recovery
through end-2013. Output remains below pre-crisis levels, with an estimated
output gap of -2.4% of GDP in 2013.
The continuous deterioration of exports
weighs on the recovery. The
sharp contraction of its traditional industries (i.e. electronics and paper
industries) contributes to Finland’s weak export performance. In addition, the
composition of Finnish exports, dominated by investment and intermediate goods,
exposes exports to the most cyclical components of global demand. A review of
price-cost competitiveness shows that increasing labour costs and declining
export prices also help explaining these developments. Exports are still around
one fifth lower than their pre-crisis level and they
remained weak throughout 2013 with high frequency indicators suggesting that
this overall muted performance is not set to reverse. 
Private consumption, the main driver of
growth since 2010, has lost steam due to faltering income growth. In contrast to the previous years, no positive growth contribution
is expected from consumption in 2013. In the beginning of 2013, the VAT rate
was increased by 1 pp. and income taxation was also increased. Declining
employment, lower wage growth prospects and rising taxes are weighing on
consumer confidence. The impact on consumption was offset only in part by a
decline in the household saving rate. Consumers have become cautious, delaying
the purchase of durable goods. This is most apparent in car sales, which were
exceptionally low in 2013. While household credit continued to expand, pushing
household debt to 106% of disposable income, it did little to support aggregate
demand. Going forward, private consumption is expected to resume growth but at
a slower pace than prior to the crisis.
As elsewhere in Europe, investment also
stalled because of low business confidence related to the weak outlook. Gross fixed capital formation declined in 2012 and is estimated to
have weakened further in 2013. The decline cuts across all sectors
–construction as well as machinery and equipment while investments excluding
construction are low compared to peer countries. This casts a shadow also on
future potential growth.
After considerable stickiness, inflation
has declined throughout 2013, in response to the slack in the economy and
declining energy prices. Wage inertia as well as
increasing energy prices combined with high energy intensity of the economy
kept inflation at higher levels in Finland than in other euro-area countries.
Despite the 2013 hike in consumption taxes and further tax increases in 2014,
HICP inflation receded to 2.2% in 2013 and is set to further drop over 2014-15.
In 2013 this development was largely due to declining energy prices, while over
2014-15 a persistently negative output gap and lower wage increases are
expected to further dampen inflation.
After a steady deterioration, the current
account is stabilising. A review of the current
account components in section 3 indicates that several structural factors
appear to have played a significant role in the continued weakening of
Finland's external position between 2002 and 2011. The current account balance
is estimated to have further stabilized in 2013 (-0.2% of GDP), as a slowdown
in import volume growth is expected to have more than offset a softening in
export dynamics. As consumption and investment are expected to remain weak, the
trade account is forecast to be close to balance in 2015.
Output and labour market trends weigh on
fiscal developments, despite the significant adjustment measures. Low growth in 2013 is reflected through the operation of automatic
stabilizers in an estimated weakening of the general government balance by 0.6
pp., to -2.4% of GDP. The budget deficit is set to widen marginally in 2014,
largely due to a shortfall in revenues amid weak growth outlook. Based on these
developments, the general government debt is expected to reach 60.4% of GDP in
2014 and the muted growth outlook could make it more difficult to reverse debt
dynamics in the medium run.
Labour market rather resilient since the
onset of the crisis
The Finnish labour market has performed
relatively well during the crisis amid the ongoing restructuring of the economy (Graph 2.1). The (seasonally adjusted) unemployment
rate stood at 8.1% in June 2013, below the EU average of 11%, but somewhat
above Sweden and Denmark. Over the period 2008-12, the unemployment rate
increased in Finland by only 1.3 pps., i.e. among the smallest increases in the
EU, while the employment rate was the 7th highest in the EU (2012).
Similarly, the shares of young and long-term unemployed in total unemployment
have increased moderately relatively to pre-crisis levels. ([1]) Looking at the relationship between unemployment and vacancies,
Finland appears to be moving along the same Beveridge curve([2]) as before the crisis, suggesting stable underlying labour market
matching dynamics. On employment protection legislation, the indicator
regarding the strictness of rules regulating hiring and firing in Finland
appears to be in line with peer countries in the region.([3])
However, a more in-depth look at the
Finnish labour market reveals some weaknesses.
Dispersion of regional unemployment rates in Finland increased markedly during
the crisis and reached the highest level among the peer countries (Graph 2.2). Similarly, the unemployment among
low-skilled workers increased, bringing the difference between unemployment of
low and high-skilled among the highest in the region, whereas part-time
employment stayed at significantly lower levels (Graphs 2.3-2.4). These developments suggest that the
adjustment capacity of the Finnish labour market in response to the on-going
restructuring in traditional industries may be rather limited.
Population is ageing faster than in
other EU Member States, impacting labour supply.
Currently, labour market shortages are mainly found in public sector
occupations such as health care professionals, social workers, special teachers
etc. Entrepreneurs face shortages as well, but there are no shortages reported
for occupations in the industrial sector.([4]) However, companies are expected to experience labour shortages in
the near future, as the working age population is forecast to start declining
as of 2013 due to population ageing. In turn, this could affect wage
developments and productivity levels.
Growth prospects remain muted
Growth is not expected to resume before
2015. The economy is estimated to have contracted
by 1.5% in 2013 followed by a weak recovery of 0.2% in 2014, before rebounding
to 1.3% in 2015. This assumes that net exports will profit from a gradual
recovery of the global economy and investment will pick up as the uncertainty
further recedes, while exports are set to continue to be influenced by the
restructuring of export-oriented industries. Both persistent unemployment and
lower increases in wages will weigh on private consumption. On the positive
side, credit conditions remain supportive and demand is not restricted by
deleveraging, making it more apt to respond favourably to an improvement in
confidence. 
The main risks lie in a
weaker-than-expected external environment as well as domestic policy
uncertainty and the ongoing industrial restructuring. Risks to the outlook are balanced and are mainly connected with the
external environment and the future fiscal policy choices. Industrial
restructuring could also be in a more advanced phase than currently considered
and can result in faster than anticipated growth, also thanks to the social
partners' agreement on moderate wage growth. Conversely, export share losses
could be stronger than expected as Finland's traditional industries face
structural challenges and competitive pressures.
Deleveraging in the private sector seems
not pressing
After a slight decline in 2011, private
sector indebtedness has reached a new peak of 158% of GDP in 2012, but risks
appear limited. Non-financial corporations account
for almost two-thirds of private debt, the remainder being held by households.
Given that companies are currently net lenders to the rest of the economy,
access to financing remains good and on an aggregate level deleveraging seems
not pressing at the moment. As highlighted in the previous IDR, the increase in
non-financial corporation debt potentially reflects an increased appetite for
loans linked to the historically-low level of interest rates as well as
cross-border intercompany loans and multinational companies concentrating part
of their debt in Finland. Financial markets´ confidence in the Finnish economy
remains unshaken so far and funding costs have remained low for borrowers.
While household indebtedness remains
below the unsustainable levels observed in some other EU countries at the onset
of the crisis, it has grown steadily since 2001.
Household debt grew steadily from 62% of disposable income in 2001 to 106% in
2012, just below the EU average. Given the factors limiting housing supply like
sluggish construction activity and a relative shortage of land, rising housing
demand could exert overheating pressures on prices in the medium term and lead
to further increases in household indebtedness. Furthermore, aggregate data on
prices might hide regional differences, as prices increased most in the
Helsinki area. However, also given a relatively low housing cost overburden
rates for households, no sudden deleveraging is expected in the near future,
but developments in the mortgage market deserve close attention, the more in
light of a potential increase in mortgage rates. Measures to curb household debt
growth would soften the risks related to the financial position of households.
Despite ranking in the top league of
international competitiveness rankings, Finland has been losing export market
shares at record speed since 2008. Even though
external sustainability is not a concern, the current account balance has
turned from a large surplus into a limited deficit within only a few years. The
section 3.2 takes a close look at export developments and explores the factors
driving them. The loss of export market shares comes alongside a decline in
potential output, in particular total factor productivity, suggesting that the
two developments have common roots, related to the fact that industrial
restructuring in Finland has not yet been able to make up for the large
downsizing of the electronics and forestry industries. An analysis of the role
of price/cost factors in the loss of competitiveness in section 3.3 reveals
that Finnish exporters, facing increasing costs, have been able to sustain
price competitiveness mainly by compressing profit margins, thus limiting their
capacity to invest. At the same time, Finland's integration into global value
chains – which is a positive feature - also plays a role in the declining
performance of exports. Non-cost factors, discussed in section 3.4, take a
front seat in explaining the deterioration in competitiveness: a limited number
of large exporting firms selling a narrow product range and a lower propensity
of small companies to export. In addition, the declining efficiency of research
and development spending and slow investment, including low inward FDI, result
in difficulties to translate the high innovation potential into new marketable
products. 
The weakening of exports and a
significant drop in potential growth indicate that both developments might be
closely linked. The lower potential growth in
Finland is based on subdued developments in all contributing factors. Declining
working age population due to population aging impacts labour input whereas low
investment weighs on capital accumulation. Especially the decline of the ICT
sector had a substantial impact on total factor productivity (see Box 1).
3.1.      Current
account balance
3.1.1.   Main
developments and savings-investment balances
It is the steep downward trend of the
current account balance rather than its level that raises concerns. As highlighted in the previous IDRs, Finland's current account
balance steadily eroded within a decade from a significant surplus of over 8%
of GDP in 2002 into a deficit of -1.5% in 2011. This was due to a weakening in
the trade balance of goods, which also moved into deficit as of 2011 (Graph 3.1). Since then, the current account
deficit trended sideways and is expected to reach -0.2% of GDP in 2013. High
import growth prior to 2008 and subdued exports since the onset of the crisis
explain the stronger decline in merchandise trade in Finland than in similar
advanced countries (Graph 3.2). The deterioration in the current
account balance was also driven by worsening terms of trade as the increasing
price of imported oil and raw materials, on which the economy is structurally
dependent, affected the goods balance (Graph 3.3 and 3.4).
Finland has continued to lose export
market share not only globally but also relative to peers. Trailing behind world trade growth is not exceptional among
advanced countries following the increasing role of emerging economies and the
changing structure of world trade.([5]) However, Finland has been losing export market shares (EMS) at the
fastest pace in the EU during the recent global downturn and, despite the
recovery in world trade, exports relative to GDP are 8 pps. lower than in 2008.
This trend remains mostly unchanged from last year's IDR and contrasts with
developments in peer economies. Finland, Sweden and Denmark witnessed similar
market share changes until 2008 (Graph 3.5), but the decline in Finland's EMS
intensified afterwards. The large drop of EMS over 2009-10 have slightly
weakened over 2011-12, but a reversal is still not estimated for 2013. Graph 3.6 depicts the strong negative contribution
of goods to Finland's EMS particularly during the crisis, whereas services
brought a brief positive contribution in 2007-08 followed by a small negative
contribution over 2009-12.
The trade balance of goods seems to be
driven by several structural factors. Prior to the
crisis, growing domestic demand translated into increasing imports.([6]) Fast growth of imports in value terms can be explained not only by
a more dynamic household consumption, but also by the energy import dependency
on the back of rapidly rising energy prices and high energy intensity of the
economy. The already large trade deficit in energy products expanded
considerably from 1.9% in 2000 to 3.5% of GDP in 2012 (see Graph 3.7). While in other peer countries the
increasing energy bill was offset by a higher trade surplus in other categories
of goods, the Finnish trade balance in non-energy products gradually weakened
(from 13.8% to 6.1% of GDP over 2000-12).
In contrast, balances for the trade of
services, income and current transfers showed no major changes over the past
decade. Current transfers typically display a
stable negative balance (around -0.9% of GDP), reflecting i.a. Finland's
position as a net contributor to the EU budget (about ½% of GDP) and foreign
aid to third countries. Unlike in other countries where the services trade
surplus increased, mirroring a shift towards services-oriented economies, the
Finnish services balance has remained slightly negative over the past decade.
Since a positive net international investment position is a relatively recent
development, net income flows increased somewhat over 2009-12 mainly reflecting
low net returns. Finland relied to varying degrees on foreign direct
investment, portfolio debt or equity, as well as unsecuritised inter-bank
loans, as vehicles to invest its savings abroad (Graph 3.8). As in other Nordic countries, past
surpluses, which are supported by significant surpluses of social security
funds, were mainly invested through portfolio instruments.
The erosion of Finland’s external
balance appears mainly structural. After the strong
decline over 2002-10, the current account has been stable since 2011. For 2014
and 2015, a small surplus of around 0.5% of GDP is expected according to the
Commission forecast. Recent estimates on the cyclically-adjusted current account
balance appear to confirm that most of the deterioration in the external
balance is permanent, i.e. it would prevail if both the domestic and trading
partner economies were at potential output (see Graph 3.9).
The deterioration in the current account
was mainly driven by a continuous fall in the national saving rate, while investment has remained broadly stable. From a
saving-investment perspective, both corporate and public sectors were behind
the accumulation of ample net savings until 2008. Since the crisis, most of the
decline in savings (7.8 pps of GDP over 2008-12) stems from the cyclical drop
in government saving, amid lower tax revenues and increased public spending
linked to stimulus measures. Net borrowing by the government therefore reached
2.7% of GDP in 2009-10 and decreased only slightly afterwards (Graph 3.10). Households reinforced their net borrower
position in particular by continuing housing investment. In turn, the financial
sector consistently saved more than it invested, reflected in a net lending
position throughout the past decade. Finally, non-financial corporates (NFC)
have recorded sizeable saving surpluses, but the previous ample savings lost
significant ground since the onset of the crisis (Graph 3.11) as Finnish NFCs experienced an
exceptional swift decline in profitability, as discussed in section 3.4.
In particular corporate investment net
of construction is lower in Finland than in other peer countries. A trend decline in the investment ratio seems to be a common
feature across developed economies, linked to economic woes, production
outsourcing and capital-saving biases in new technologies. The investment level
in Finland (19.8% of GDP in 2012) is similar to the EU average, but a comparison
with investment patterns in peer countries reveals that Finnish investment was
driven by the construction sector. Once investment in construction is netted
out, the investment rate is significantly lower than in neighbouring countries
as well as than in the euro area and in the EU, particularly since 2008 (see
Graphs 3.12-3.13). In particular, prior to the crisis,
NFCs' investment has also been less dynamic than what could have been expected
given their high profitability.
No substantial changes in the sectoral
net positions are expected in the medium term. Given
the muted recovery outlook, the operation of automatic stabilisers will uphold
the negative saving position of the public sector. A low interest rate
environment will continue to support growth in housing investment resulting in
an increasing indebtedness of the household sector over the medium term and a
declining ability to cover the future costs of ageing. With a low investment
ratio, limiting growth prospects going forward, the corporate sector is
envisaged to remain in a net lending position. This will offset by the combined
net borrowing positions of the public sector and households. Persistent
surpluses in the corporate sector would continue to underpin a broad
stabilisation of the current account deficit. Conversely, a further improvement
in the economic outlook could entail a recovery in investment and an ensuing
worsening of the current account balance if not accompanied by a corresponding
increase in the saving rate.
3.1.2.   Net
international investment position and cross-border financial linkages
External sustainability seems not to be
a reason for concern. As highlighted in the
previous IDR, the net international investment position (NIIP) improved
steadily from -27.9% of GDP in 2007 and peaked at a surplus of 21.4% of GDP by
the end of 2010. More recently, the country's net position broadly trailed the
current account balance and slightly declined to 18.4% of GDP in 2012 (Graph 3.14). Looking at its composition, the NIIP
is supported by net outward FDI, portfolio investment and reserve assets (21.5%
of GDP, 1.9% of GDP and 4.4% respectively in 2012), which more than offset the
net negative position of other investments (-13.8% of GDP). In a regional
perspective, Finland's NIIP is higher than the level in Sweden (-10.2% of GDP
in 2012) but lower than in the Netherlands (46.8%), Germany (41.5%) or Denmark
(37.8%).
Valuation effects have shaped Finland's
NIIP over the past decade. The NIIP conceals large
gross stocks of foreign assets and liabilities, which render the net position
susceptible to large valuation changes. The large swings in NIIP since the euro
adoption were mainly driven by negative valuation effects related to the rising
market value of Finnish equities held by foreign investors as well as the
appreciation of the euro over 2003-08 and their reversal since the crisis
(Graph 3.15).  
The NFCs and households hold increasing
stocks of net foreign assets albeit from low levels. During the crisis, the non-banking private sector increased its net
holdings of external assets, typically including outward FDI and inter-company
lending (for a discussion of FDI see section 3.4). In a regional comparison,
the net holdings of the Finnish non-banking private sector (17.4% of GDP in
2011) are in line with those in Sweden (14%), but markedly lower than in
Germany (41%), Denmark (80%) or the Netherlands (112%).
In contrast, the government's net
foreign assets are on a decline. Graph 3.16 shows that the public sector in Finland
has remained a net external creditor, given the large, albeit declining, stock
of foreign assets managed by the social security funds. Given the large size of
the expected ageing-related costs, these reserves are expected to only
partially meet the corresponding financing needs over the long term.
While the net positions of the financial
institutions deteriorated significantly, they were matched by the increasing
net creditor position of the Finnish central bank.([7]) The sharp widening of the balance of portfolio debt securities and
other investments since 2007([8]) is reflected
by the increase in net external liabilities of the banking sector (in the form
of currency and deposits). As described in the previous IDR, deposits of banks
mainly from Southern euro-area countries, increased substantially over 2011 in
Northern Europe mostly reflecting safe-haven effects.
A high degree of integration in the
global financial markets implies challenges for financial sector supervision. Both the stocks of domestic portfolio debt and equity owned by
foreign investors and the gross holdings of foreign portfolio assets by
residents (122.7% of GDP and 124.6% respectively in 2012) are high in Finland.
This can be explained by the intense investment activity of residents as well
as the relative attractiveness for foreign investors of Finnish corporate and
government bonds, as safe investment instruments. Similarly, the high 'other
investment' stocks, in particular inter-bank loans, reflect the importance of
financial corporations in intermediating saving and investing. Given the large
and concentrated banks operating in the Nordic countries, indebted households
and elevated housing prices, shocks can be transmitted rapidly across the
region.([9]) More
generally, these uncertainties could weigh on the financial system and the
whole economy.
3.2.      Trade
performance and Finland's integration into the global value chain
Losses in competitiveness vis-à-vis
Finland’s trading partners, a narrow product range of exports and downsizing of
production in traditional sectors have been key drivers of the country’s poor
export performance. This section analyses the
geographical and product composition of exports and the impact of outsourcing
and downsizing in traditional industries as well as Finland's position in the
global value chain. 
The Finnish exports have been supported
by a favourable geographical orientation. Before
the crisis the destination market composition of Finnish exports was rather
supportive to exports. In turn, in 2009 the halving of Finnish exports to
Russia, one of the main trading partners, offset the previous positive
destination market effect. Overall, exports have been directed relatively
strongly towards the growing emerging markets and neighbouring economies, where
import demand expanded faster than import demand globally (Graph 3.17). In fact, compared with its regional
competitors, Finland's presence is the highest in the BRICs (Graph 3.18). Correspondingly, the country is the
least dependent on euro-area for goods exports (about 30% of total exports),
while roughly 40% of exports are directed towards other dynamic European
destinations (out of which about a half to the Nordic countries).
However, Finland is rapidly losing
market shares in the dynamic emerging markets.
Finland's relatively large presence in emerging markets could be explained by
the product composition of its exports, which is concentrated in investment and
intermediate products. A constant share of exports to BRICs implies that
Finland is also losing EMS fast in these dynamic markets while the export
shares of peer countries to BRICs are steadily increasing. Increasing
outsourcing of production in traditional sectors reflected in expanding outward
FDI in the same sectors might lie behind these developments.
The Finnish goods exports are
concentrated in cyclical products, but the cyclical impact on market share
losses has been limited. The product composition of
Finnish exports, with its bias towards high-tech goods, helped the country meet
the brisk foreign demand prior to the crisis.([10]) Finland's main export goods are concentrated in machinery and electrical
products, wood and paper products, metals and chemicals, with about 30% being
classified as capital goods (Graph 3.19). At a global level, demand for such
goods was robust during economic upswings and correspondingly weak through
downturns, as these products are largely capital goods (and also high income
elasticity products). In contrast, the demand for low tech products remained
slower than world trade growth throughout the last decade (see the low-tech
imports of BRICs in Graph 3.20). However, while the structure of goods
exports contributed to Finland's declining EMS during the recent downturn, the
declining EMS cannot be explained by this factor alone. When compared with its
main competitors, Finnish high- and medium-tech goods lost significantly more
ground after 2008 (Graph 3.21). The relative performance of Finnish
low-tech exports also appears less favourable (Graph 3.22).
The collapse exports of the ICT sector
largely explains the decline in high-tech ([11]) exports, but only partially the weakening performance of total
exports (Graph 3.23). As highlighted in the previous IDR,
the importance of the ICT cluster, dominated by Nokia, in Finland's value added
steadily diminished during the past decade amid intensified global competition.
Similarly, the share of exports of ICT products in total goods exports collapsed
from 25% to 7% over 2000-11. However, even if the ICT-related exports are
netted out from total goods exports in the sample countries, Finland's export
performance remains the lowest in the region (Graph 3.24).
Finnish service exports appear to have
held up well through the downturn but the outlook is uncertain. Services exports play an increasing role in Finland, with their
value more than doubling in the last decade and reaching 11.4% of GDP in 2012([12]). Their destination is also fairly diverse as almost a third goes
to Europe and a quarter to Asia. However services exports have grown more slowly
in recent years than in competing economies (see Graph 3.25), reflecting the sluggish performance
in exports 'of other services' which comprises high value added services such
as IT, consulting, planning, marketing and expert services.([13]) The concentration in terms of both industry and the type of
service is high with IT accounting for one third of 'other services' and more
generally the electronics industry for almost two thirds, making the country's
exports vulnerable to shocks in these sectors. In addition, a major part of
this trade is intra-group business services often linked to the exports of
goods and pricing of services may thus not reflect the actual costs incurred.
 Arguably, a more entrenched and
widespread global recovery will not reverse the current trends in Finland's
export performance. At first sight, Finland's
export specialisation in cyclically sensitive goods such as capital goods could
help the country once again to boost its trade over the next global cycle.
However, the competition from China and other emerging economies has already
shifted from low-tech products to the higher value added production segments.([14]) Graph 3.20 indicates that high-tech imports in the
BRICs have been trending down since 2006-07 while BRIC's share of high-tech
exports peaked in 2009 and is already above the level in most euro-area
countries.([15]) These
developments might suggest that some of the fast growing economies have already
reached the peak of their demand for high-value added goods that still cannot
be produced domestically. Furthermore, a low diversification of exports and
high concentration of Finnish exporters imply that the country is less well
positioned to benefit from the global trade integration.
Growing competitive pressures from
low-cost countries might have speeded the restructuring in some traditional
sectors amid the recent global crisis. The impact
of competition from low-cost countries on Finland has been so far contained to
some industries (electronics and paper) while others (chemicals and metals)
appear to have been more sheltered from competition from low-cost economies and
benefited from trade integration. 
The strategies of Finnish multinationals
have also played a role in the EMS decline. To gain
access to worldwide markets, Finnish industries seem to have favoured FDI over
exports, the value of production generated by Finland's foreign affiliates
exceeding the domestic turnover in paper and electronics sectors (see Graphs 3.26-3.27, see also section 3.4 on FDI
developments).([16]) However it
is not clear to what extent these decisions were motivated by cost factors.
Finland's specialisation shift from
high-tech to more price-sensitive intermediate products brings further
vulnerabilities. Finland is becoming increasingly
specialised in medium-tech products as these goods increased their share in
Finnish exports from 35% to 50% over 2000-11. This mirrors a decline in the
prominence of high-tech goods with their share shrinking from above 20% to less
than 10% over the same period. Finland's technological configuration has thus
diverged from that of the euro area, the shift reflecting the internationalisation
of production and the integration of the Finnish economy into global production
chains. Conversely, this trade specialisation entails risks as medium-tech
goods tend to be more price elastic than high-tech capital products, exposing
the economy to increasing competition from low labour costs emerging economies.
Finnish exports showed a relatively good
performance in terms of value-added. Trade in value
added aims to capture the domestic content-value that countries are adding to
the value of goods and services exported.([17]) Finland benefitted from being increasingly integrated into global
value chains (GVC) as proved by the dynamics in its domestic value-added
content of exports (see Box 2). Available data on Finland also show that not
only electronics and paper industries but also other traditional sectors such
as chemicals and metals are already well integrated into global value chains.
However, the integration in GVCs comes along with increased output volatility
and high adjustment costs, as industries optimize costs by relocating across
countries.([18]) 
3.3.      Price
and cost competitiveness
The analysis in the previous section has
emphasized that increasing specialisation in cost-sensitive intermediate
products makes price-cost competitiveness a prominent issue for Finland's
export performance. In the following, cost competitiveness indicators are
analysed against the developments in peer countries, assessing their contribution
in explaining the Finnish export performance. Thereafter, labour costs are
examined in greater detail in section 3.3.2, looking into sectoral unit-labour
cost (ULC) developments, productivity and prices as well as their interplay.
Section 3.3.3 highlights the importance of other cost pressures on
competitiveness in manufacturing, beyond wages (e.g. energy costs, input prices
from non-tradable sectors) as well as the impact on profitability.
3.3.1.   Nominal
and real effective exchange rate
Finland's nominal effective exchange
rate cannot explain the country's subdued export performance. Developments in Finland's nominal effective exchange rate (NEER)
are largely similar to other euro-area Member States like Germany and
Netherlands, whereas Finland experienced the largest drop in export market
share (Graphs 3.28). As highlighted in the previous IDR,
exchange rate movements vis-à-vis Finland's main trading partners, particularly
Sweden and Russia, have briefly amplified the appreciation in the NEER in 2009,
however the overall impact was modest and has reversed in the meantime.
Finland's conventional real effective
exchange rate (REER) indicators present a mixed picture. Finland's REER, based both on HICP and ULC, largely trailed the
developments in the Euro/USD exchange rate. As a small open economy, the
HICP-based REER may not be a good competitiveness measure for Finland as prices
are significantly influenced by external price developments. The cumulated
appreciation in total economy ULC-based REER implies a deterioration in
Finland's cost competitiveness of about 15 pps. over 2000-09, followed by a
modest adjustment of about 5 pps.([19]) ULC dynamics amplified developments in the REER particularly in
2008-09 when the sectoral wage agreements provided high wage growth and output
fell at a faster rate than employment. These increases in ULC-based REER were
only partially compensated in 2010, while thereafter the REER stabilised. The
ULC-based measure for Finland also indicates the largest loss in cost
competitiveness among peer countries. Germany experienced a similar
appreciation of its NEER, but the impact on REER was offset by considerable
wage restraint and decreasing relative ULC. 
The appreciation of the REER based on a
broader set of deflators appears significantly more limited. ([20]) In
particular since 2007, price deflated REER indicators point to no further
deterioration (Graph 3.29). ([21]) Graph 3.30 shows that Finland experienced the
largest discrepancy between the ULC- and export prices deflated REER,
suggesting that Finnish exporters have increasingly compensated the gap in cost
competitiveness by adjusting prices and cutting their profit margins. As
described in section 3.3.3, retaining price competitiveness in the short run by
depressing profit margins undermines the capacity of companies to invest and
thus reduces overall competitiveness in the longer run and contributes to
further outsourcing of production. 
Alternative REER based indicators do not
point to a gap in competitiveness. With an
increasing role of global supply chains and production sharing, changes in
relative prices of goods have become less sensitive to changes in relative
factor prices. Thus conventional REERs might be less suitable in assessing
price competitiveness when imports are increasingly used in exports. Both
tasks-based REER ([22]) and Goods
REER ([23]) show that
the competitiveness challenge in Finland appears less dire than suggested by
cost-based indicators (Graph 3.31). A more general finding would also be
that both appreciations and depreciations in REERs tend to be moderated when
accounting for outsourcing. Finland's tasks-based REER even indicate a slight
improvement in competitiveness, as its participation in GVCs has helped
offsetting the impact of rising domestic costs and its competitiveness has not
been eroded by the increasing cost of imported production factors from emerging
economies (with higher inflation).
REER-based indicators seem not to be the
main drivers of changes in Finnish exports. Box 3
indicates that foreign demand dynamics are the main driver of the variance in
exports whereas Finland's REER explains about 15% of the long term changes. ([24]) Although it appears that ULC-based REER has no major direct impact
on export dynamics, wage increases affected profitability, with a corresponding
impact on investments.
3.3.2.   Labour
costs
Losses in cost competitiveness are
largely attributed to rising prices and productivity-adjusted wages in the
non-tradable sector. The analysis in this section
also finds that economy-wide unit labour cost developments mask large
divergences between ULC in tradable and non-tradable sectors. ULC dynamics in
Finland appear to be higher than in the peer economies, but the difference is
not so evident in manufacturing, while it is more prominent in non-tradable
sectors, leading also to higher aggregate price levels. Due to price effects
from the electronics industry it also appears that manufacturing ULC indicate a
more benign picture than the one displayed by labour costs to output value. In
response to these developments, the agreement reached by social partners to
contain wage growth is a positive sign, while to correct the accumulated
competitiveness gap entirely will take time. 
Finland's losses in EMS have overlapped
with an increase in unit labour costs since 2009.
Until 2008, economy-wide ULC growth in Finland was slower than in peer
economies and the euro area as a whole, if Germany is regarded as an outlier
with its prolonged wage moderation (Graph 3.32). Real compensation per employee
expanded by 2.1% on average per year over 1999-2007 with only Sweden recording
similar growth rates, but productivity also increased at a faster pace in
Finland (Graph 3.33). Despite the relatively subdued ULC in
the pre-crisis period, Finland's trade performance lagged behind in the region,
emphasizing the puzzling role of labour costs in measuring competitiveness. As
of 2008 however, ULC in Finland have expanded at a faster pace following the
stronger growth of wages as well as negative productivity developments and the
drop in EMS accelerated.
Sectoral ULC developments show steadily
increasing labour costs in non-tradables and subdued in tradables. Large divergences between ULC in the tradable and non-tradable
sectors, caution against using aggregate ULC as an indicator of export
competitiveness (Graph 3.34). Labour compensation expanded on
average at the same rate in tradable and non-tradable sectors in Finland until
2008, whereas productivity growth in manufacturing significantly outpaced
productivity growth in sectors more sheltered from international competition
like services and construction. Since 2008 labour compensation slowed down in
most of the sectors, however it was still growing faster in non-tradable
sectors. Although ULC dynamics in Finland appear to be higher than in the peer
economies, the difference is not so evident in manufacturing, whereas it is
more pronounced in non-tradable sectors.
ULC increases are closely linked with
rising prices in the Finnish non-tradable sector.
An alternative decomposition of ULC shows that losses in cost competitiveness
are largely credited to growing prices in the non-tradable sector, which may
affect the tradable sector only indirectly via escalating input prices and
mounting pressures for wage iincreases amid tighter labour markets (see Box 4).
More generally, the relative price of tradable to non-tradable declined
substantially over time in Finland, reaching the lowest ratio among its peers
(Graph 3.35). Prior to the crisis, the negative
contribution of the share of wages to ULC in Finnish manufacturing (-0.8% per
year) was offset by more negative price developments (-2.4% per year),
indicating that companies have more than passed through their cost gains to
prices, squeezing profit margins. These developments highlight that Finland has
experienced limited price competitiveness losses in the tradable sector, as
exporters are generally price takers of exogenous international prices and they
remained relatively insulated from the domestic demand-driven escalating
prices.
Weak competitive pressures in
non-tradable sectors lead to high prices, aggravating the erosion of external
competitiveness. The price level in Finland is
among the highest in the euro area (see Graph 3.36). The level mirrors the high prices of
the non-tradable sector (labour intensive) relative to those in the tradable sector
(capital intensive), which tend to be similar across countries with the free
trade of goods. While excluding volatile energy and seasonal food prices,
Finland also performs worse than its neighbours and the euro-area average in
terms of core inflation. This reflects relatively weak competitive pressures.
Increasing competition could lower both production costs and mark-ups of
Finnish companies, resulting in a lower price level.
Low wage dispersion may contribute to
high price levels in Finland. More equal wage
distribution (i.e. smaller wage dispersion) typically reflects less
differentiation across various skill levels of workers and seems to be
associated with higher prices. Both Finland and Sweden have very low
proportions of low-paid workers (Graph 3.37) which together with relatively high
unemployment among low-skilled imply high prices for unskilled services. Lower
wage dispersion could also lead to a negative effect on the productivity of
highly skilled workers and combined with better work conditions in the public
sector may discourage skilled workers from taking jobs in the private sector
(Mahy et al., 2011).
ULC developments in manufacturing are
distorted by price effects from the electronics industry. Competitiveness measures based on ULC in manufacturing are rather
difficult to interpret in the presence of significant differences in industrial
structures across countries or divergences in sectoral prices. Nominal value
added in manufacturing sector gradually declined relative to output volume,
mainly due to remarkably weak price developments in the Finnish industry. Graph
3.38 shows that prices in manufacturing
dropped by 20% in Finland since 2000, whereas they marginally increased in the
euro area. Therefore the value added in manufacturing remains below the 1999
level, a situation unique to Finland among the peer countries. Given the weight
of the electronics in the Finnish industry, price developments in this segment
had a particularly strong impact on the overall manufacturing sector (see Graph
3.39). As a result, ULC in manufacturing
displayed a declining path in Finland until 2008 in line with the apparently
stronger output and productivity growth amid falling prices.
Manufacturing ULC indicate a more benign
picture than the one displayed by the labour compensation to output value
ratio.([25]) When measured against the output value to account for the cost
structure and profitability conditions in which manufacturing companies operate,
labour costs remained flat in Finland in the pre-crisis period, with only
Sweden recording higher rates (Graph 3.40). After 2008, the labour cost indicator
expanded strongly (by more than 25% over 2008-12), reaching the highest level
in the region.  In addition, these trends appear to be confirmed by the
developments in the labour cost index in manufacturing ([26]), depicting Finland above the euro-area average by more than 25
pps. over 2000-13Q3 (Graph 3.41).
The new labour market agreement in
Finland could become an important step in restoring cost competitiveness. The recent Tripartite Agreement, which became effective in October
2013 and will be valid for two years, sets wage growth at a moderate pace (see
Box 5). The growth of compensation of employees is forecast to slow down from
the current 2.4% level to about 1.6% for the years 2014-15. According to the
autumn forecast, the agreement lowers the growth of unit labour costs to 0.4%
in 2015, from a 3.7% growth in 2012 while assuming a productivity increase of
1.3%. However, the current wage formation implies that industries which show
below-average productivity growth may have come under pressure due to
relatively higher labour cost growth. Wage agreements do not explicitly take
sectoral productivity growth into account to effectively curb labour costs
growth. In addition, the current 25 months duration of wage agreements might be
rather long in view of adjustment needs to unexpected changes in cyclical and
competitiveness conditions and a review of the effectiveness of bargaining
system is needed. In this respect, after the wage increases over 2008-09
decided just before the financial crisis it might take years for Finland to
regain cost competitiveness relative to trade partners.
3.3.3.   Other
cost components and profit margins
In recent years, Finnish exporters have
been able to sustain price competitiveness mainly by compressing profit
margins. As highlighted above, wages represent a
growing share in manufacturing output, nevertheless, cost competitiveness is
also undermined by other factors described in this section. High energy
intensity and energy imports expose Finland to price shocks, affecting
industries' competitiveness. Exporting industries are also facing increasing
cost pressures from prices of intermediary inputs whereas unfavourable
end-price developments compound the cost effects. The worsening profitability
in manufacturing failed to rebound after the crisis, limiting its capacity to
invest and create jobs. Restoring profitability in the tradable sectors could
help firms to increase investment and improve their non-price competitiveness.
Amid rising labour costs, exporting
industries are also facing increasing cost pressures from intermediary inputs. Based on the input-output tables for Finland, the share of
intermediate goods and services in manufacturing output is significant at about
75%. High intermediate consumption and low value added may indicate that
manufacturing labour costs are relatively less relevant to the price formation
of final goods in the sector. Over a third of intermediate inputs in
manufacturing come from domestic industries and about 40% from imports (see
Graph 3.42 and Box 2). As noted earlier,
deteriorating terms of trade have thus affected the cost competitiveness of Finnish
exporters with energy costs playing an important role in this development (see
Box 6). 
Unfavourable end-price developments for
exporting industries compound the cost effects. The
price of intermediate consumption in Finnish manufacturing increased by 21%
over 2000-11 broadly in line with developments in the region, nevertheless
output price rose by only 7% over the same period, significantly lower than in
the peer countries (see Graphs 3.43-3.44). This is also reflected by REER
developments based on export prices showing that Finnish firms have compensated
the most among their peers in the region the deterioration of cost
competitiveness by adjusting prices and reducing profit margins. As discussed
above, the electronics industry played also some role in these developments
with its output price halving over the last decade. 
The gross operating surplus of Finnish
businesses has been on a downward trend since 2008.
Profit margins across the Finnish economy, as measured by entrepreneurial
income and gross operating surplus as a share of gross value added, have
markedly declined since 2008 after staying flat over the pre-crisis period
(Graph 3.45). ([27]) Profitability suffered particularly in 2008 and 2009 amid the
global downturn, however, the margin recovered considerably less in Finland
than in the peer countries over the following years. Whereas differences in
profitability among sectors could be largely explained by sector-specific
capital intensities and technological progress, changes in profitability over
time point to the relative strength of businesses operating in various sectors.
The deteriorating profitability reflects divergent trends across sectors in
recent years. Graph 3.46 indicates that the overall decline in
operating surplus is driven by erosion in manufacturing profitability while construction
and market services show signs of recovery.
Declining profitability in the manufacturing
sector weighs on the overall competitiveness of the economy. Operating surplus in the manufacturing industry has significantly
dropped since 2008 as companies were unable to pass through production cost
increases to prices (see Graph 3.47). This suggests that Finnish industries
have been able to support price competitiveness mainly by compressing profit
margins, which in turn has limited their financial capacity and incentives to
invest. The open output gap would be expected to put downward pressure on real
wages and restore profitability over time, but the adjustment might be slowed
by a low inflation outlook. More generally, although Finland may offset losses
in cost competitiveness with gains in non-cost competitiveness, losses in cost
competitiveness and the ensuing low profitability undermine the capacity of
companies to invest in non-price competitiveness factors (such as innovation),
closely linking the two types of competitiveness.
Also firm-level based data on
profitability might hint at product market imperfections in Finland. Prior to the crisis years profitability as measured by return on
assets of firms in the non-tradable sector was above that of firms in tradables
sectors in Finland (also in France, Spain, Greece or Portugal), but not in
Germany. Finnish NFCs’ profitability in both tradable and non-tradable sectors
fell over 2008-09 in line with developments in other euro area countries and failed
to rebound afterwards (see Graphs 3.48-3.49). In contrast, profitability in Germany
experienced only a temporary set-back during 2008-09 while already exceeding
pre-crisis levels in 2011. Even more important, the compression of
profitability was in general stronger in the non-tradable sector, while
tradables tended to hold up relatively better to the adverse economic shock. An
inversion of relative profitability in favour of tradables occurred in most of
the surveyed euro area countries, whereas the gap only marginally closed in
Finland pointing to possible product market rigidities that hamper the
readjustment process. 
3.4.      Non-price
competitiveness
Although cost competitiveness is a
contributing factor, the deterioration in trade performance seems mainly due to
losses in non-cost competitiveness. As concluded in
the previous section, Finnish export prices remained competitive despite cost
competitiveness losses when compared to developments in peer countries,
suggesting that a poor export performance might rather be explained by quality
related factors. Available estimates based on disaggregated product data,
disentangle the separate effects of the price and non-price components on
Finland's trade balance (see Graph 3.50). According to this framework, it
appears that the deterioration in the trade balance over the last decade is
mainly driven by non-price factors whereas changes in net price and net energy
components played a smaller role.
In global rankings Finland is seen among
the top league of the most competitive economies and Finland has one of the
highest R&D expenditures. Finland's
competitiveness ranks third in the Global Competitiveness Index of 2013-14 and
compares also well with other innovation driven economies on the ease of doing
business indicators. The country is considered to be the world leader in
institutional setup, health, education and innovation, while retaining top
positions regarding financial markets development and business sophistication
(see Graph 3.51). In turn, somewhat weaker points are
the macroeconomic environment, labour market and product market efficiency. In
addition, total R&D spending as a share in GDP in Finland is the highest in
the EU.
The interplay of various factors can
help explaining the apparent paradox of a competitive and innovative economy
losing export market shares at record speed. Recent
sluggish productivity increases in Finland illustrate the importance of
focusing on non-price competitiveness (see Box 1). Stagnating total factor
productivity growth appears to be related not only to lack of competition but
also to the failure of many Finnish firms to grow and become international players.
The limited allocative efficiency in non-tradable sectors, less efficient
R&D spending and capacity of firms, in particular SMEs, to develop
exporting activities, quality of the products as well as lack of investment in
manufacturing are among the underlying drivers examined in this section. 
Weak competition in non-tradable sectors
is hampering allocative efficiency within sectors.
Estimates on allocative efficiency indicate that resources are allocated in a
less efficient way in most of Finnish services and some factors (such as
excessive regulation or rent-seeking) prevent competition to work properly (see
Graph 3.52). The OECD's 2013 Product Market
Regulation scoring also points to relatively high regulation when compared to
other euro area countries in transport sectors, energy, retail trade and postal
services. While some progress has been made in recent years in enhancing
competition in Finnish network industries, improvements have been slower than
in other euro area countries, largely reflecting a high share of public
ownership in transport and utilities sectors.
A limited number of large exporting
firms selling a narrow product range contributed to the poor export performance
in Finland. Whereas firm size is a significant
determinant of ability to engage in export activities as larger firms are
typically more capable of doing the initial investment for penetrating foreign
markets, a concentration of exports in a limited number of large trading firms
could become equally problematic. The impact of electronics industry (Nokia) on
declining exports is one recent example. In 2012, the top 1% Finnish exporting
firms accounted for 76% of gross exports. Structural indices of Finnish
merchandise exports confirm a relatively higher concentration and lower
diversification of exports (see Graph 3.53), suggesting that the country's trade
performance is more prone to shocks in specific sectors/products.
Similarly, a lower propensity of Finnish
small companies to export also weighs on trade performance. Although the average Finnish firm across sectors is similar to its
peers in the region both in terms of employment and productivity levels, small
firms contribute less to total exports than in other countries (about 2%, see
Graph 3.54). Whereas the lower propensity of
Finnish small companies to export could be related to a relatively more dynamic
domestic demand, microeconomic factors (e.g. cultural aspects, export promotion
policies) might also play a role in their lower export performance. A review of
size-dependent policies with lock-in effect in the areas of taxation and public
funding for business development and R&D could reveal their role in
discouraging the small firms to grow and contribute to exports (see Box 7).
Efforts of the Finnish companies to
enhance their products quality proved insufficient, particularly in
high-technology industries. As quality encompasses
physical characteristics as well as intangible characteristics of products
(e.g. brand name and reputation, labelling, consumer tastes etc.), evidence on
quality of exported goods is mostly indirect. While increasing export market
shares combined with higher prices is typically a good indicator of
improvements in quality as in this combination higher prices capture consumer
preferences for product quality, the developments in Finland's trade
performance and export prices suggest lower improvements in quality relatively
to peers. Furthermore, the losses in market shares have been concentrated in high-quality
product segments corresponding to higher unit values, where firms could benefit
from substantial price premiums. 
Increasing competition and improving
quality of products from developing countries weigh on competitiveness in
Finland. Disaggregated trade data shows that
increased competition from developing economies puts pressure on developed
economies to constantly improve the quality of their exported goods. More
generally, most of the advanced countries suffered losses in non-price competitiveness,
while developing economies experienced gains. For example, Benkovskis and Wörz
(2012) find substantial quality improvements in exports of EU 10, with an
asymmetric impact on EU advanced economies. While estimates on Finland are not
available, in a sectoral perspective, EU 10 countries showed strong quality
gains over the past decade in traditional sectors for Finnish exports like
machinery and mechanical goods, followed by improvements in transport
equipment, base metals and chemical products. These findings suggest that
faster quality improvements in developing countries might put a permanent lid
on the trade performance in traditional industrial products in advanced
economies, including Finland.
Non-price competitiveness seems to be
hampered by a weakened capacity to invest and innovate, particularly in the
non-tradable sectors. As highlighted in the
previous section, the deterioration in profit margins may have impeding
companies' ability to invest and innovate. A breakdown of net investment on
sectors shows that construction as well as professional and technical
activities, public administration (included in 'other services' in Graph 3.55) registered the highest investment
rates amongst sectors. Even in these areas, positive growth rates of investment
were recorded only prior to the crisis followed by negative rates afterwards.
In turn, investment dynamics in the Finnish manufacturing and complementary
services (i.e. trade and transport) trailed behind the developments in non-tradables,
partly reflecting relatively lower returns in tradables versus non-tradables.
Although the investment gap to tradable sector contracted somewhat, relatively
unfavourable investment rates in manufacturing suggest that a significant
reallocation towards tradable sector was not yet in sight as of 2011 (Graph 3.56).
While domestic investment is sluggish,
Finnish companies are increasingly investing abroad for efficiency and market
seeking purposes. At the end of 2012, the net FDI
position in Finland was about 22% of GDP. While this is still lower than e.g.
in Netherlands (48% of GDP) and Denmark (32% of GDP), the stock of direct
investment abroad rose from 44% of GDP in 2006 to 60% of GDP in 2012. Outward
FDI is concentrated in traditional industries (Graph 3.57). Notably, Finnish companies continued
to invest abroad throughout the crisis, with even larger shares being directed
in the traditional sectors- ICT, metal and machinery production industries.
Outward FDI in the pulp and paper industry peaked in 2005-06 and slightly
declined afterwards, although it remained significant. Overall, the investments
abroad are dominated by the traditional manufacturing sectors in which the
Finnish economy is specialized and has a positive comparative advantage. While
it is rather difficult to disentangle to what extent FDI flows went into
horizontal (market seeking) or vertical (efficiency seeking) investment
components, the significant investment volume and the observed decline in the
traditional industries' exports point to a non-negligible vertical investment
share. Similarly, the expanding outward FDI in services might reflect increased
investment abroad linked to outsourcing of auxiliary activities (business
services) as many activities that were earlier handled by domestic companies
themselves, such as logistics, have been outsourced. 
In turn, recently Finland has not been
able to attract significant foreign FDI. The stock
of FDI in Finland increased marginally from low levels (from 35% to 38% of GDP
over 2007-12) while in Sweden it expanded by about 9 pps. to 68% of GDP in
2012. However, the stock of FDI in Germany and Netherlands remained broadly
constant while it decreased in Denmark over the same period. More importantly,
inward FDI in the Finnish manufacturing remains very low (about 10% of GDP)
whereas financial intermediation dominates the services component (Graph 3.58).
Although Finland's R&D spending is
the highest in the EU, it is also less efficient in terms of transferring
research results into practice. Finland's high
level of spending in R&D has been driven to a large extent by the private
sector, whereas government related spending is more modest. While the overall
level of R&D expenditures in the private sector is higher in Finland than
in other developed countries (2.4% of GDP against 1.9% in Germany in 2012),
R&D outlays are very much concentrated in the ICT sector. In terms of
innovation output, the decrease in Finnish triadic patents over the last decade
points to less impressive results (see Graph 3.59). This is also reflected in the 2013
Innovation Union Scoreboard, where Finland's score is low on SMEs introducing
product or process innovations and marketing or organisational innovations.
Notwithstanding the measures already adopted or proposed by the government in
the area of R&D, and whose positive effects depend on their swift
implementation, the significant decline of the Finnish ICT sector brings
concerns about the future path of R&D investment and total factor
productivity.
The analysis in sections 2 and 3 indicates
that factors underlying macroeconomic potential growth and particularly in the
areas of export performance and competitiveness are among the main challenges
in Finland.
It should be recalled that these challenges
were already identified under the MIP in the first and second IDR and relevant
policy responses were reflected and integrated in the country-specific
recommendations issued for Finland in July 2013. The assessment of progress in
the implementation of those recommendations will take place in the context of
the assessment of the Finnish national reform programme and stability programme
under the European Semester. Against this background, this section discusses
different avenues that could be envisaged to address the challenge of improving
growth, export performance and competitiveness.
Concerning the challenge of improving
competitiveness a number of different avenues can be considered:
Cost competitiveness and labour costs: The analysis in this IDR has highlighted that the recent
stabilisation of the external balance does not take away the concerns on
subdued export performance. Increasing specialisation in cost-sensitive
intermediate products makes labour costs a prominent issue for Finland's
competitiveness. Higher dynamics of productivity-adjusted wages compared to
peers since the onset of the crisis is a significant element with regard to
deteriorating competitiveness in Finland. In particular, increasing labour
costs and their pass through to prices in segments producing intermediate
inputs for manufacturing have contributed to weakening the competitiveness of
export industries. In addition, the current wage negotiation mechanism implies
that those sectors with below-average productivity growth or exposed to less
favourable export prices have come under additional pressure due to their
relatively higher labour cost growth. 
Since the publication of the 2013 IDR, the
agreement reached by social partners to contain wage growth is a positive sign.
Wages and unit labour costs are forecast to grow at a more moderate pace, while
to correct the accumulated competitiveness gap to the main trading partners
will take time. This adjustment will only materialise gradually and will
require relatively low wage growth and higher productivity as trading partners
have been undertaking relevant labour market reforms while reducing their wage
dynamics. 
Given the expected slow recovery in the
current juncture, it is important that policies also focus on developing the
adjustment capacity of the labour market to absorb (external) shocks. An
important factor is ensuring that wage setting mechanism are responsive to
sectoral productivity developments and allow differentiation among sectors
based on relative strength. In particular, productivity developments could be
considered explicitly in each wage negotiation round. Further efforts are still
needed to better develop part-time employment and achieve productivity gains in
public service provision to facilitate reallocation of workers to more
productive sectors, thus ensuring an optimal labour allocation between dynamic
and less dynamic sectors.
Cost competiveness more broadly and
profitability: The analysis above has also
underlined the importance of other cost pressures for competitiveness, beyond
wages. 
First, high energy intensity and energy
imports expose Finland to price shocks, affecting industries' competitiveness.
Given that the overall high energy intensity stems from the dominance of
energy-intensive industries, an improvement in the energy efficiency enhances
the competitive position of the industrial sector by lowering the cost of
inputs.
Second, low productivity and weak
competitive pressures in services as well as compressed wage distribution lead
to high prices, eroding both domestic welfare and external competitiveness.
Higher prices of consumer goods and services than in the neighbouring countries
point to a lack of competition in the retail sector and networking industries
(energy, transport and postal services). Providing robust competition and
deregulation would lower costs for companies, resulting in a lower price level
and a lower cost level for intermediate inputs.
The above aspects amplified the financial
difficulties of Finnish companies during the global downturn and profit margins
failed to rebound afterwards. A worsening of profitability in manufacturing
limits its capacity and incentives to invest and create jobs. Restoring profitability
in the exporting sector thus becomes a pre-condition for firms to increase
investment in non-price competitiveness factors (such as innovation and
products quality). 
Non-price competitiveness: Recent sluggish productivity increases in Finland illustrate the
importance of focusing on non-price competitiveness. Stagnating total factor
productivity growth appears to be related not only to lack of competition but
also to the failure of many Finnish firms to grow and become international
players. A limited number of large exporting firms selling a narrow product
range as well as the lower propensity of Finnish small companies to export
weigh on trade performance. As costs and conditions for exporting to emerging
markets are typically challenging, the export potential would be boosted by
providing further tailored support for the internationalisation of smaller
firms. Given the numerous government agencies and available schemes involved in
financing of business development, a review of their effectiveness in view of
further streamlining would also be useful. In addition, a review of
size-dependent policies with lock-in effect in the areas of taxation and public
funding for business development and R&D could also be explored with a view
to provide incentives for firms to expand and align capital taxation across
organisational forms.
Efforts need to be reinforced in particular
on further support for clusters between multinationals and domestic innovative
companies, as well as the further development of entrepreneurial education
towards more risk-taking attitude. Efforts to diversify the business structure,
in particular by accelerating the introduction of planned measures to broaden
the innovation base remain important. Finland's high R&D intensity could be
more effectively translated into the development of new products and creating
high-productive jobs. The government funding for R&D could be targeted in a
larger extent on enhancing the R&D spillovers. 
It should be recalled that the
country-specific recommendations from 2013 included the need to take further
measures to attain cost savings in public service provision. Efficiency gains
in public services such as healthcare and education (through reducing the
length of studies and speeding up graduation in higher education) would be most
welcome. In addition, public sector accounts for over a third of total
employment in Finland, there might be scope for further adjusting employment in
this sector in line with productivity growth and reallocating workers to more productive
sectors. Productivity growth would also attenuate the labour force decline due
to ageing and the impact on labour supply. An increase in the effective and the
statutory retirement age would result in a slower decline in the working age
population as well as help curbing the cost pressure with pensions. In this
context the activation of young people, long-tern unemployed and older workers
as well as an increase of the effective retirement age taking into account
improved life expectancy are also important aspects.
Concerning the challenges linked to
the high level of private debt, a number of measures can be considered:
Addressing the risks from high private
debt levels: Although the current high private debt
levels are not considered a major risk, the economy would benefit from measures
to curb debt growth as the increase in household debt is followed by lower
saving rates and a deterioration in the financial position of households. The
tax deductibility of mortgage interest payments is gradually being phased out
with a view to reduce incentives for taking on and holding debt. The
recommendation by the Finnish Financial Supervisory Authority on a binding cap
on loan-to-value ratios for mortgage loans is not yet implemented.
Altomonte, C., di Mauro, F. and C. Osbat
(2012), 'Going beyond labour costs: How and why 'structural' and micro-based
factors can help explaining export performance?' CompNet Policy Brief No
1/2013.
Bems, R. and R. C. Johnson (2012),
'Value-Added Exchange Rates', NBER Working Papers 18498.
Benkovskis K. and J. Wörz (2012),
'Non-price competitiveness of exports from emerging countries', Bank of
Finland, BOFIT Discussion Papers 19/2012.
Benkovskis K. and J. Wörz (2013), 'What
drives the market share changes? Price versus non-price factors', Bank of
Finland, BOFIT Discussion Papers 18/2013.
Bayoumi, T., Turunen, J. and R. T. Harmsen
(2011), 'Euro Area Export Performance and Competitiveness', IMF Working Papers
11/140.
Bayoumi, T., Saito, M. and J. Turunen (2013),
'Measuring Competitiveness: Trade in Goods or Tasks?', IMF Working Papers
13/100.
Darvas, Z. (2012), 'Compositional effects
on productivity, labour cost and export adjustments', Bruegel Policy
Contribution 2012/11.
ECB (2012), 'Competitiveness and external
imbalances within the euro area', A team of the Working Group on Econometric
Modelling of the European System of Central Banks, ECB Occasional Paper Series
No 139 / December 2012.
European Commission (2013), 'Innovation
Union Scoreboard 2013', 2013. 
European Commission (2013), 'Product Market
Review 2013: Financing the real economy', European Economy 8/2013.
European Commission (2012), 'Current
Account Surpluses in the EU', European Economy 9/2012.
Gaulier, G. and V. Vicard (2012), 'The
signatures of euro area imbalances', Mimeo.
Kajanoja, L. (2012), 'Finland’s
competitiveness and its measurement', Bank of Finland Bulletin 5/2012.
Kivisto, J. (2013), 'Sector-specific labour
cost developments from the perspective of the industrial sector's cost structure',
Bank of Finland Bulletin 3/2013.
Kumar U. and J. Felipe (2011), 'Unit labor
costs in the Eurozone: the competitiveness debate again', Levy Institute
Working Paper, No. 651.
Mahy, B., F. Rycx, and M. Volral (2011),
'Does wage dispersion make all firms productive?', Scottish Journal of
Political Economy, Scottish Economic Society, vol. 58(4).
OECD (2013), OECD Employment Outlook 2013,
OECD Publishing.
OECD (2012), 'Restarting the growth
engine', in OECD Economic Surveys: Finland 2012, OECD Publishing.
OECD (2013), 'Finland: Fit for the Future',
OECD February 2013.
Osbat, C., Özyurt, S. and T. Karlsson
(2012), 'Trade balance contributions of price and non-price factors: a
cross-country analysis', CompNet Workshop, Frankfurt, 10-11 December 2012.
Salto, M. and A. Turrini (2010), 'Comparing
alternative methodologies for real exchange rate assessment', European Economy.
Economic Papers. 427. September 2010.
Rodríguez, A., Pérez-Quirós, G. and R.
Segura-Cayuela (2012), 'Competitiveness indicators: The importance of an
efficient allocation of resources', Banco de España Economic Bulletin. Jan
2012.
Timmer, M., Los, B., Stehrer, R. and G. De
Vries (2013), 'Fragmentation, Incomes and Jobs. An analysis of European
competitiveness. Paper presented at the CompNet conference in Washington, April
2013.
The World Bank, Doing business, 2013
(http://www.doingbusiness.org). 
World Economic Forum (2013), 'The global
competitiveness report 2013-2014'.
([1])  According to the Ministry of Employment
and the Economy, the growing level of unemployment in Finland is mainly due to
a lengthening of unemployment spells rather than higher inflows. However, Finland,
along with Sweden and Denmark are also the countries with the lowest average
duration of unemployment in the EU, supported by relatively high and increasing
amounts spent for active labour market policies.
([2])  The Beveridge curve is the graphical
representation of the relationship between unemployment and the job vacancy
rate (the number of unfilled jobs expressed as a proportion of the labour
force). It has vacancies on the vertical axis and unemployment on the
horizontal, and slopes downwards, as a higher rate of unemployment normally
occurs with a lower rate of vacancies (For a detailed description of the analysis
and its methodology, see the report ‘Labour Market Developments in Europe
2013’.)
([3])  Although regulation on collective
dismissals is loose and there are no severance payments in Finland, the
protection against individual dismissal of permanent workers exceeds the OECD
average (the indicator is close to France and Sweden but significantly above
Denmark). Further taking into account fixed term contracts (with a high
incidence in Finland) and temporary agency work, regulation is at OECD average.
(OECD, 2013)
([4])  Ministry of Employment and the Economy
in Finland based on Occupation Barometer III/2013 which monitors the labour
market balance for over 200 occupations.
([5])  Declining export market share appears
to have been common to most advanced economies.
([6])  Annual growth in Finland's domestic
demand was the highest in the region until 2008 and remained relatively strong
afterwards (see Graph 3.2).
([7])  This development is due to the rapid
growth of intra-Eurosystem claims – TARGET2 (Trans-European Automated Real-time
Gross settlement Express Transfer system).
([8])  Correspondingly, the net external debt
surged by 38.5 pps. to 36.4% of GDP in 2012.
([9])  As described in the previous IDR, the
Nordic banks present in Finland are heavily reliant on wholesale funding, with
bonds becoming an increasingly important source of financing.
([10]) See the high-tech imports of BRICs until
2006-07 in Graph 3.24.
([11]) High technology products include
Aerospace, Computers-office machines, Electronics-telecommunications, Pharmacy,
Scientific instruments, Electrical machinery, Chemistry, Non-electrical
machinery, Armament. 
([12]) However, the services' trade balance
was -0.8% of GDP in 2012.
([13]) The turnover in IT services and
consulting engineering increased throughout 2013 according to the technology
industries confederation's recent report
(http://www.teknologiateollisuus.fi/file/17116/TT_SitOut_1_2014.pdf.html).
([14]) The impact of increased competition
from fast growing emerging economies in Asia on the northern Europe countries
is asymmetric with Germany benefiting from the new outsourcing opportunities
brought by the integration of the low-cost emerging economies in the EU.
(Current account surpluses in the EU, European Commission, 9/2012)
([15]) BRIC's average share of high-tech goods
masks diverse country performances. For example, China's high-tech export
reached 34% of total goods exports in 2006 while Russia's high-tech export
share is only 1%.
([16]) Graph 3.29 shows that the turnover of Finnish
affiliates abroad in manufacturing is significantly higher than in peer
countries. Their turnover peaked in 2009 and declined afterwards, suggesting
that not only Finnish exporters but also their affiliates abroad were less
successful in recent years. In addition, the number of their employees abroad
dropped by about 10% to 337 thousands over 2007-11. 
([17]) The value-added in trade statistics
also reflects to what extent a country can compete with others in terms of
activities related to global manufacturing, rather than competing in
manufacturing goods as measured by exports. A favourable gross exports-based
indicator does not necessarily indicate a competitive edge in the production of
a specific product and might mask the fact that a country is merely specialised
in the final assembly of that good by importing intermediate inputs while
creating less value added.
([18]) Changes in the set of activities
carried out in global manufacturing production have not been factor-neutral as
the share of capital income increases faster than labour income, both in mature
and emerging economies, according to Timmer et al. (2013).
([19]) Darvas (2012) estimates that the
constant-weight REER-ULC in Finland depreciated by an additional 2.5% than the
conventional ULC-based REER (cumulative % change over 2008-11). This is mainly
due to the impact of compositional changes on average productivity, labour
compensation and REER-ULC, as sectoral shifts, such as shrinkage of low labour
productivity and the low-wage construction sector, can lead to apparent
increases in average labour productivity and wages, especially when capital
intensity differs across sectors.
([20]) This is also confirmed when examining a
range of REER-indicators (based on wholesale prices, CPI, ULC, and export unit
values) separately on intra- and extra-euro area trade for Finland. (Bayoumi et
al., 2011)
([21]) HICP- and ULC-based REERs face a number
of limitations in gauging competitiveness, as they depict the relative prices
of domestically sold consumer goods including taxes and import prices or, in
the case of the latter, reflect only a subset of costs- labour, omitting other
input costs and profit margins. A common issue shared by consumer price
indices, GDP deflators and producer price indices is that they comprise both
non-traded and traded goods, whose prices may diverge over time due to
different sectoral productivity growth paths. 
([22]) Tasks-based REER (Bems &Johnson, 2012)
captures the overall cost competitiveness of the full range of a country's
production factors. Under this framework, countries compete in the supply of
value-added (tasks) rather than products. The method uses bilateral trade in
value added to construct weights and GDP deflators to measure changes in
relative prices, as they summarize both capital and labour factor costs.
([23]) Goods REER (Bayoumi et al., 2013)
reflects the interplay of outsourcing in offsetting the effects of domestic
price inflation by including the changes in the cost of intermediate inputs. The
method uses GDP deflators to measure changes in relative prices and bilateral
gross trade and the foreign versus domestic composition of value added embedded
in tradables to construct weights.
([24]) Rodriguez et al. (2012) estimated
export equations on ten advanced economies using REERs based on ULCs,
manufacturing wages and GDP deflators. The findings suggest that although there
is a long-term relationship between relative-price-based competitiveness
indicators and exports, the REERs in most cases explain well below 10% of the
variance in individual exports, while world trade is the variable that best
explains export developments (about 80%, with the remainder being explained by
the past behaviour of exports).
([25]) As ULC indicator is based on output
volumes, it does not reflect the declining value of output due to decreasing
export prices in manufacturing.
([26]) Labour cost index measures the change
in average labour costs per hour worked (Eurostat).
([27]) Restructuring in the traditional
tradable sectors, lower export prices and higher labour costs are among the
underlying factors behind these developments.