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# 52013SC0123

**COMMISSION STAFF WORKING DOCUMENT In-depth review for FINLAND in accordance with Article 5 of Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL AND TO THE EUROGROUP Results of in-depth reviews under Regulation (EU) No 1176/2011 on the prevention and correction of macroeconomic imbalances /\* SWD/2013/0123 final \*/**

  

Contents

EXECUTIVE SUMMARY
AND CONCLUSIONS. 3

1.    Introduction. 5

2.    Macroeconomic situation and potential imbalances. 5

2.1      Macroeconomic scene setter 5

2.2      Sustainability of external positions. 6

2.3      The anatomy of sectorial balance sheets. 7

2.4      Housing market developments. 12

3.    In-depth analysis of selected topics. 15

3.1      Competitiveness and export performance. 15

3.1.1       Export market shares. 15

3.1.2       Decomposition of the export market share loss. 17

3.1.3       Non-cost competitiveness of Finnish exports. 19

3.1.4       The importance of ICT products for the Finnish economy. 22

3.1.5       Cost competitiveness and productivity. 24

3.1.6       Energy intensity of the Finnish economy. 27

3.2      Private sector debt 29

3.2.1       Household debt 29

3.2.2       Corporate debt 31

3.2.3       Health of the financial sector 34

3.3      Growth of financial sector liabilities. 35

3.3.1       Nordea derivatives. 36

3.3.2       MFI deposits. 37

3.3.3       Other liabilities. 38

3.3.4       Assessment 39

4.    Policy challenges. 40

References. 43

EXECUTIVE SUMMARY AND CONCLUSIONS

In May 2012, 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 28 November 2012, 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 In-Depth Review (IDR) takes a broad view of the Finnish economy
in line with the scope of the surveillance under the Macroeconomic Imbalance
Procedure (MIP). The main observations and findings from the analysis are:

·
The loss in competitiveness is one of Finland's main policy challenges. Over a decade, Finland's current account turned from a surplus into a deficit. The country experienced a
loss of 23% in world export market shares over the past five years, and saw its
unit labour cost increase significantly in 2008 and 2009. Unit labour costs
continued to increase  over the last few years  as wage increases continued to outpace
productivity growth.

·
The loss of export market shares is partly
due to the on-going restructuring of the electronics and forestry industries. In electronics, Nokia lost its dominant position and closed down all
assembly factories in Finland, which affects both its own employees and its
subcontractors. The forest industry is relocating its paper and pulp
manufacturing business to Asia and Latin America, where demand is growing and
resources are available. The other main industries (metals, machinery and
minerals) were not able to make up for the loss in exports from the electronics
and forestry industries. These developments demonstrate Finland's vulnerability to structural shocks in the specific product markets in which its exports
are concentrated.

·
High energy dependence will continue to
affect Finland's current account balance through oil and gas price movements. Energy imports, mostly crude oil, accounted for as much as 20% of Finland's total imports 2011, partly on the back of the increased oil price. The overall
high energy intensity stems from the dominance of energy-intensive industries
in Finland. Improved energy efficiency would help to reduce costs and energy
imports.

·
Finland's
declining competitiveness is also related to a relatively low translation of
R&D into marketable products. Despite high
R&D spending and a well-educated workforce, the
forestry and electronics industry still account for a large part of the
business structure and the number of high-growth companies remains low.

·
The loss in cost competitiveness is another factor
at play. The wage increases over the past five
years have been excessive and have tarnished Finland's competitive position,
especially compared to Germany and Sweden, Finland's main benchmarks. The
employers see the need for minimal wage growth for 2013 and 2014 whereas the
employee organizations see solutions in additional public investments into
workforce training and active labour market policy measures. At the same time,
the non-tradable sectors, whose goods and services are partly used as inputs
for the tradable sector, experienced lower productivity growth than the
tradable sectors.

·
Debt levels have increased over the last
decade. The private sector, excluding the financial
sector, has been accumulating debt up to 179% of GDP in 2011 (non-consolidated).
While exceeding the scoreboard threshold of 160% of GDP, it remains lower than
in other Nordic countries. Non-financial corporations account for almost
two-thirds of this private debt, the remainder being held by households. Public
debt remains modest, despite having increased over the last decade, and is
expected to stay below the 60% ceiling, at least until 2014.

·
The level of household debt is a source for
concern, although no sudden deleveraging or instability of the financial sector
is in sight. Household debt grew steadily from 65%
of disposable income to 118%, and is now close to the European Union average. Household
debt (both as a share of disposable income and as a share of GDP) remains,
however, far below the unsustainable levels observed in some other European
countries. Based on the current health of the financial sector and on the still
rather low housing cost overburden rates for households,[1] no
sudden deleveraging is expected in the near future.

·
The year-on-year growth of the
non-consolidated financial liabilities of the financial sector stood at 30.8%
in 2011, far above the threshold of 16.5%. To a
large extent, this high growth resulted from the market movements reflected in
the value of Nordea's derivatives portfolio, the safe-haven effect leading to
inflows of foreign MFI deposits and the double counting of MFI deposits at the
central bank. While these developments do not constitute a direct threat to
financial stability, they warrant close monitoring going forward. Other potential
risks for the Finnish financial sector stem from the high concentration and the
funding structure. Heavy concentration in the banking sector implies contagion
risk from the main systemic bank; the reliance on foreign sources and wholesale
markets implies risks for bank financing.

The IDR also discusses the policy
challenges stemming from these developments and possible policy responses. A
number of elements can be considered:

·
Measures aimed at fuelling innovation, rising
product quality and facilitating existing firms and products to grow and export
would be highly beneficial to the Finnish economy, leveraging
the country's high R&D intensity. This would help diversify the business
structure and soften the impact of the on-going restructuring in the
electronics and forest industries. Wage agreements could explicitly take
productivity growth into account, in order to curb labour cost growth. In
addition, productivity increases could be achieved through the enhancement of competition in product and service markets, and measures to achieve
efficiency gains in public services such as healthcare and education. In order
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 and statutory retirement age could be
envisaged.

·
Measures to curb household debt growth would
soften the risks with regards to the financial position of households. Such
measures could include a cap on loan-to-value ratios for mortgage loans and the
abolition of tax deductibility for mortgage interest payments.

1.
Introduction

On 28 November 2012, 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 and what type of follow-up it
will recommend to the Council.

This is the second IDR for Finland. The previous IDR, published on 30 May 2012, led the Commission to conclude 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 Finnish economy in line with the scope of the
surveillance under the Macroeconomic Imbalance Procedure (MIP).

2.
Macroeconomic situation and potential imbalances

1

2

2.1
Macroeconomic scene setter

Finland's economy
proved highly sensitive to the collapse in global demand in 2009, with GDP
falling by an unprecedented 8.5% in that year. In the following two years GDP rebounded,
growing by 3.3 % in 2010 and 2.8 % in 2011, driven by domestic demand,
but declined again slightly by -0.2% in 2012. Slow growth is expected for 2013
and 2014, with exports only gradually picking up as the world economy recovers.
Sensitivity to the global environment is connected to the export structure; 80 %
of exports consist of capital goods and intermediate goods for which demand is
typically more volatile and influenced by the business cycle.

The Finnish economy faces strong headwinds
from the ageing population. The working-age population has started to shrink.
Productivity and living standards rank high among the developed countries, but erstwhile
strong industries such as electronics and forestry are in difficulty and, in
general, the share of manufacturing in GDP is declining. Although Finnish
labour productivity has traditionally been high in manufacturing, this is less the
case in the services sector.

Public finances have been managed prudently
and the current account was in steady surplus over the last decade. However,
unit labour costs increased strongly and the current account surplus
continuously fell since 2007 and turned into a deficit in 2011, the first time in
nearly two decades. Simultaneously, the private sector became increasingly
indebted. This raises the question as to whether external imbalances are
building up and if the increasing private sector debt burden is sustainable.

2.2
Sustainability of external positions

Finland's
Net International Investment position has undergone substantial changes in
recent years. The country's net international
investment position (NIIP) experienced a huge drop in the late nineties,
recovered in the early 2000s to its previous levels and remained fluctuating
below zero up to 2008, as shown in Graph 1. As of 2009, Finland's NIIP became slightly positive. Net external debt, on the contrary, increased from a
close-to-zero position in 2008 to a more significant negative position in
subsequent years. The main component driving the changes in the NIIP is net
portfolio investments. As described in the previous in-depth review, Nokia's
share price evolution had a large influence on Finland's NIIP through these net
portfolio investments. With about 75% of Nokia shares held by foreigners and
its total market capitalization being sizeable compared to Finland's GDP, valuation effects triggered large swings in Finland's net international investment
position. The recent decline of Nokia's market capitalization dampened its
influence on Finland's NIIP, allowing for other factors to gain importance
again. Especially net direct investments remained positive throughout the
years; Finland thus attracts more inward investment than its residents and
corporations invest abroad through foreign direct investments.

Finland's
trade performance has weakened over the past years. The current account balance declined steadily from an 8% of GDP surplus
in 2002 to a 1% deficit in 2011. The current account is forecast to remain in
deficit in the coming years. Graph 2 depicts how the declining trade balance of goods, itself turning into
deficit as well in 2011, is the main driver of this evolution. The declining
trade balance of goods is caused by a restructuring of the electronics and
forestry industries and by a loss of competitiveness. These developments have
resulted in a 23% loss of world export market share over the past five years. Finland's weak trade performance can be partly explained by wage developments, with nominal
unit labour costs increasing sharply during the crisis years. Although the
current wage agreements set lower wage increases for 2012 and 2013, wage growth
still exceeds productivity growth. Another factor at play is the decline in the
2000s of Finland's electronics exports. A third element is the relocation of
the pulp and paper industry to Asia and Latin America. Given that exports are
forecast to grow slower than imports in 2013 and 2014, causing a deficit in the
trade balance of goods, these developments warrant an in-depth analysis.

The transition towards a current account
deficit weakens Finland's economic position. Current
account deficits and surpluses are not necessarily macroeconomic imbalances, as
they can be seen as a natural consequence of economic interactions between
countries. Nevertheless, countries with a rapidly ageing population may find it
opportune to save today (i.e. run surpluses) to smooth consumption over time
(European Commission, 2012b). At the moment the current account deficit is
still small, as is the level of external debt. While Finland's external
sustainability is still strong, it is weakening. Instead of building up
reserves, Finland is now gradually eating up its reserves from the past, while
in the light of the ageing population, the country would be better off by further
building up reserves for the future.

Graph 1: Composition of Net IIP (% of GDP) || Graph 2: Trade balance and current account balance (% of GDP)

Source: Commission Services || Source: Commission Services

2.3
The anatomy of sectorial balance sheets

Net lending/borrowing of the total
economy deteriorated, moving from a sizeable net lending to a net borrowing
position of 1% of GDP in 2011. This decline, shown
in Graph 3, limits the domestically-available
means which forces the country to borrow externally to cover investments. As the
net lending/borrowing position of an economy reflects the saving and investment
decisions of the domestic institutional sectors, Graph 4 splits these out by sector. Most of
the decline in savings is due to the drop in government saving since 2009,
induced by the crisis through decreases in tax revenues and increases in
expenditure through automatic stabilizers; as well as increases in discretionary
spending to mitigate the effects of the crisis on the Finnish economy.
Households reinforce again their position as net borrower, after slightly
deleveraging in 2009.

Graph 3: Net lending/Borrowing by sector (% of GDP) || Graph 4: Savings and investments by sector (% of GDP)

Source: Commission Services || Source: Commission Services

Fiscal consolidation is on-going and the
government has proclaimed the reduction of the debt ratio by 2015 as one of its
most important goals. The budget balance of the Finnish
general government turned from a surplus of 4.4% of GDP in 2008 into a deficit
of -2.5% of GDP in 2010. Fiscal consolidation led to a narrowing of the public
deficit to -0.6% of GDP in 2011, but the deficit is expected to have widened to
-2.2% in 2012. The central and local government deficit has been offset by the
surplus of social security funds of 2.5- 2.8% in these years. A small general government
deficit target can therefore still imply a substantial deficit at the central
government, which would entail general government debt level increases. In
2013, the central government deficit is likely to widen further, even based on
the optimistic government forecast of still 1% GDP growth in 2012 and 2013 underlying
the budget proposal. In light of fiscal measures decided in 2012 that took
effect in 2013, public net borrowing is expected to be on a declining path in
2013 and 2014. The general government net assets are sizeable (54% of GDP,
shown on Graph 5) because these
include the assets of the social security funds.

The continuous accumulation of debt by households
is worrying. Over the past decade, apart from a
small deleveraging episode in 2009, households had a net borrowing position,
leading to an accumulation of household debt. Although households deleveraged
slightly in 2009, they re-accumulated debt in 2010 and 2011. The household
savings rate jumped during the crisis from 7.8% of gross disposable income in
2008 to 11.7% in 2009, before declining again to about 8% in 2012. Over the
coming years a stabilization of the household savings rate is expected. In the
context of an ageing population, the net borrowing of households over the last
decade and the declining savings rate translate into a declining ability to
cover the future costs of ageing. A deleveraging of households, combined with
fiscal consolidation, would bring Finland back to a net lending position. Despite
the accumulation of debt, net assets of households remain positive (Graph 5).

Both the financial and non-financial corporate
sector consistently saved more than they invested, resulting in a net lending
position. While the financial corporate sector posts
a net lending position of 0.8% of GDP in 2011, the non-financial corporate sector's
share in the net lending/borrowing position of the Finnish economy is more important,
as well as its share in total savings and investments. The net lending position
of non-financial corporations was reduced to almost zero in 2008, after which
it jumped back to sizable levels, partly compensating the net borrowing
position of households and the general government.

Debt levels have increased over the last
decade. The private sector, excluding the financial
sector, has been accumulating debt up to 179% of GDP (non-consolidated) in 2011,
illustrated by Graph 6. While exceeding
the scoreboard threshold of 160% of GDP, it remains lower than in other Nordic
countries. Non-financial corporations account for almost two-thirds of this private
debt, the remainder being held by households. Public debt in % of GDP remains
modest, despite having increased over the last decade, and is expected to stay
below the 60% ceiling, at least until 2014. Risks of derailing public debt
levels are seen as low as the Finnish government prepares for the rising
ageing-related expenditures in the near future by keeping the budget under
tight control.

Graph 5: Net assets by sector || Graph 6: Decomposition of debt (% of GDP)

Source: Commission Services || Source: Commission Services

The financial sector remains strong
relative to many other national financial sectors of the euro area. The banking sector did not need government support during the
crisis and has been seen as stable (the 'safe haven' phenomenon). Exposure to Greece, Portugal, Italy and Spain is limited as are non-performing loans (Table 1). Furthermore, the
banking system has remained overall profitable; the average return on equity is
around 10 %. This has allowed improving solvency with the average capital
adequacy ratio of around 14 %.[2]
The main banks operating in Finland; Nordea Bank, Danske Bank and OP-Pohjola
Group; were not required to take measures in order to comply with the 9%
minimum core Tier 1 capital ratio following the EBA EU Capital Exercise of
December 2011. Still, OP-Pohjola Group[3]
strengthened its Core Tier 1 ratio from 14% at the end of 2011 to 15.1% in June
2012.

Table 1:
Selected macro-financial stability indicators

Nevertheless,
the year-on-year growth of the non-consolidated financial liabilities of the
financial sector amounted to 30.8%, by far the highest growth rate among EU
Member States. The second-largest growth recorded
in the EU was only 11.3%, with all other countries recording changes between
-5% and 9%. The extraordinary growth of the non-consolidated financial
liabilities of the Finnish financial sector therefore warrants a closer examination.
The financial sector's assets and liabilities have continuously grown as from
the late nineties (Graph 7). This is analysed in detail in section 3.3.

Graph 7: assets and liabilities of the financial sector

Source: Commission Services

2.4
Housing market developments

Since the mid-1990s, housing became
significantly more expensive in inflation-adjusted terms. Real house prices increased by 92% in Finland over the years
1993-2007 (from trough in 1993 to peak in 2007), indicating a relative increase
in housing costs vis-à-vis consumption prices. This cumulated increase and the
continuous upward path might signal concerns with regard to the sustainability
of the housing market. In most countries however, this increase exceeded 100%.

The housing market could represent a risk
to the Finnish economy, as certain structural features of the Finnish housing
market tend to amplify price volatility. Cuerpo
Caballero and Mordonu (2011) discuss the effect of various policies on a
possible build-up of housing imbalances. Firstly, policies aimed at encouraging
home ownership, especially for the low-income population, may have a negative
impact on house price stability. Fostering a stable and properly functioning
rental market instead, particularly focusing on lower-income households, might
reduce the occurrence of housing imbalances. Secondly, variable mortgage
interest rates appear to increase the risk of housing market imbalances.
Thirdly, high loan-to-value ratios play a role. Finally tax incentives for
house purchase may come at the cost of lower market stability. The Finnish
government focuses efforts on providing social housing and granting housing
allowances to low-income households, irrespective of renter or home-owner
status (Vartia, 2006). Because of this equal treatment of low-income tenants
and low-income home-owners, the Finnish institutional setting does not seem to
excessively encourage home ownership for low-income households. On the other
hand, other factors prevail in Finland, with virtually all mortgage loans being
on variable interest rates, high loan-to-value ratios for first-time buyers,
tax deductibility of mortgage interest payments, low property taxation and the
absence of taxation applied on capital gains from selling the owner-occupied
property (if the property has been held for more than two years).

Analysis suggests that the Finnish
valuation gap is still somewhat above the long-term average. The European Commission (2012a) discusses a range of valuation
methods. These indicate that house prices for Finland are above, but close to,
the long-term average (Graph 8).

Graph 8: House price valuation gap based on imputed rents, selected euro area economies (%)

Current date is 2011 Q4 and the starting point differs across countries: BE 1976Q4, IE 1987Q1, ES 1981Q1, FR 1973Q3, NL 1974Q2, FI 1980Q3. Sample max. and min. values are depicted by the blue bars. Source: Commission Services, ECFIN calculations

However, a levelling off of the house
price increase is in sight. Although still rising
in 2010, deflated house prices slightly receded in 2011 and remained stable in
the first half of 2012, reflected in Graph 9. This change is accompanied by much
smaller increases in the total amount of loans for house purchases in 2011
compared to previous years. Graph 10 illustrates how building permits and residential investment are
stabilizing. Data on the first three quarters of 2012 indicates that new
construction activity has been decreasing, while we forecast it to remain below
its recent peak trough 2013.

Graph 9: House price index and MFI loans for house purchase || Graph 10: Residential investment and building permits

Source: Commission Services || Source: Commission Services

All in all, the Finnish housing market
seems to respond to structural changes in underlying supply and demand factors. Low mortgage interest rates result in higher total lending amounts
for the same level of monthly repayments. Hence the increase in prices relative
to income is partly driven by the feed-through of higher lending amounts into
prices, as well as by limitations to housing supply. New construction activity
decreased from its recent peaks and is expected to remain below it throughout
2013. The phasing-out of incentives encouraging debt-financed house purchase
should help to reduce upward pressures on housing prices.

3.
In-depth analysis of selected topics

3

3.1
Competitiveness and export performance

At first sight, the Finnish economy
remains one of the most competitive of the EU. The
European Commission's Innovation Union Scoreboard ranks Finland fourth, within the group of four 'innovators' together with Germany, Denmark and Sweden (top position). Finland's national competitiveness[4]
ranks third in the World Competitiveness Index of 2012. As noted in the report
by the World Economic Forum (2012), Finland is considered to be the world
leader in health and education and the country is in the top five regarding
innovation, financial markets and institutional setup. Weaker points listed are
the macroeconomic environment, labour market efficiency and product market
efficiency. Finland occupies the eleventh place in the ease of doing business
index of The World Bank (2012).

3.1.1
Export market shares

Over the period 2007-2011, Finland recorded a loss of 23% in its export market share. Graph 11 shows
how Finland's exports managed to keep up with world export growth in value
terms in 2007 and 2008, resulting in a stable export market share. In 2009 the
crisis caused world exports to decline by 16% compared to 2008. Unfortunately
the downturn hit Finland hard, causing the country's exports to decline by more
than one fourth. This caused Finland to experience a loss of 11.6% in export
market share. In 2010, world exports recovered and Finnish exports as well,
albeit to a lesser extent, again resulting in a large loss in export market
share. The recovery of world exports continued in 2011, but Finnish export
growth continued to trail behind world export growth, resulting again in a loss
of export market share, although much smaller than the previous years. Graph 12 depicts the negative contribution of
goods to Finland's export market share during the crisis years, while services
delivered a positive contribution in 2007-2008 followed by a small negative
contribution in 2009-2010. The increase in services exports might also reflect
increased outsourcing of auxiliary activities. Many activities that were earlier
handled by companies themselves, such as logistics, have been outsourced and
are currently recorded as business services. Given the still smaller share of
services in Finnish exports, Finland could only regain export market share in
the near future by strengthening its goods exports, whereas an increase in
services exports would gain influence over the overall trade balance over the
medium term.

Graph 11: Export market shares (EMS) in goods and services (in value terms) || Graph 12: Contribution to the change in export market shares (in value terms)

Source: Commission services || Source: Commission services

Declining exports are also reflected in
the trade balance, which turned into deficit due to
negative contributions from fuel and consumer goods. Throughout the late nineties and the early 2000s the trade balance
surplus fluctuated between 9 and 10% of GDP, before shrinking towards zero and
turning into a small deficit in 2011. Graph 13 splits out the contribution to the
trade balance by four broad categories of goods. The overall surplus in the
early 2000s can mainly be attributed to intermediate and capital goods. These
two categories lost ground by the end of the same decade, accompanied by
deficits for fuel and consumer goods. Finland is highly dependent on energy
imports (mostly crude oil), accounting for 22% of total imports in 2011. The
increase in oil and gas prices therefore has a large impact on Finland's energy imports, although the net effect on Finland's trade balance is lessened by the increases in prices of refined oil exports. Imports of consumer goods largely exceeded exports in 2009-2010,
reflecting Finnish households' increased appetite for imported consumer goods
while exports of consumer goods in absolute terms increased less than imports.

Graph 13: Trade balance contribution by broad category

Source: Comtrade, ECFIN calculations

Contrary to goods, the trade balance of
services was much smaller and moved in the opposite direction, from a deficit of about 1.5% of GDP in the late nineties to a
small surplus in 2011. If continued, this evolution could support the current
account balance in the future. Services imports and exports are, however,
difficult to measure and tend to be more volatile than imports and exports of
goods, especially with the presence of multinational companies. The
headquarters of these companies charge headquarter services to their
subsidiaries abroad, which are recorded as services exports and imports in the
respective countries. These services include overarching activities such as for
example IT, marketing and accounting services, for which the company itself can
set the level of the internal pricing according to the tax regimes of the
different countries in which it operates.

3.1.2
Decomposition of the export market share loss

To a large extent the export market
share loss reflects competitiveness losses. In Graph
14 the loss in export market share for goods is broken down into four
components. Part of the change in export market share can be attributed to the
geographical destination composition, reflecting growth (decline) if the change
in export demand in Finland's destination countries is more positive (more
negative) than the world average. Secondly, change can partly be due to product
composition, reflecting growth (decline) if the change in export demand in Finland's product markets is more positive (more negative) than the average of all product
markets combined. Both of these merely reflect a presence in expanding or
shrinking geographical and product markets. For Finland these had only a small
influence on the country's export market share. The negative effect from Finland's product composition can be attributed to the fact that global investments have
declined more than consumption, because capital goods represent a relatively
large share of Finnish exports. The largest contribution comes from the
competitiveness change in geographical destinations, meaning that within Finland's export destinations demand for Finnish exports has been losing ground vis-à-vis
total demand for foreign goods. Additionally, Finland also records a decline in
competitiveness in products, representing a demand for Finnish products lagging
behind total demand for the same types of products. To summarise, Finnish
exported goods are losing ground within their respective product markets and
geographical destinations, reflecting losses in competitiveness.

Graph 14: Growth in nominal exports of goods relative to global growth in exports of goods (constant-market share analysis) ||

Source: Commission services ||

The product composition of Finland's exports had only a small influence on the export market share loss. It is worth noting though that the concentration of Finland's exports in terms of products makes the country vulnerable to structural shocks.
Finland's main export products are wood and paper products, chemicals and
oil products, metals, machinery and electrical products. Together these
accounted for 79% of total Finnish exports in 2011 (Graph 15). Over the last few years, the pick-up
of growth in metals, chemicals and machinery has only partly compensated for
the decline in electronics and forestry. Finland exports mainly intermediate
goods (around 50% of exports of goods) and capital goods (around 30% of exports
of goods).

The geographical destination composition
also accounted only for a small part of the export market share loss. The European Union is Finland's main export destination for both
goods and services, accounting for over half of total exports with one third of
Finnish exports sent to euro area countries and about one quarter to the
remaining Member States (Graph 16). Of all euro area countries, Finland has the highest share of
trade with countries outside the euro area. In 2011 about 70% of Finnish
exports went outside the euro area, whereas for the total euro area this is about
50%. Finland's main non-euro area export destinations on the European continent
are Sweden (12% of total exports in 2011) and Russia (9%). Finland's main export destinations, apart from Russia, are not high-growth markets. All in all, only
16% of goods and services were exported to developing economies in 2011. A
later-than-expected recovery in Europe would be a drag on Finnish exports,
especially if Germany and Sweden would maintain low capacity-utilization rates.
On the positive side, Russia represents a promising and growing market for
Finnish exports.

Graph 15: Composition of goods exports from Finland (current prices) || Graph 16: Main export markets for Finland, goods and services combined (2012)

Source: Commission services || Source: Tulli Customs

3.1.3
Non-cost competitiveness of Finnish exports

Finland's
strongest export industries have been losing ground between 2000 and 2010. Wood and wood products, metals, machinery and electrical products,
but also raw hides, skins, leather and furs each have a world market share
above Finland's average of 0.6% in 2009-2010, henceforth representing Finland's
main export industries. These four categories are the only categories for which
the Finnish economy boasts a positive comparative advantage. Compared to
2000-2001 however, Finland heavily lost market share in wood and wood products
as can be observed in Graph 17. Machinery and electrical goods lost a large
part of their market share over the same period, while the metal industry
managed to limit market share losses. Despite the losses in market share, three
of these industries maintain their comparative advantage, illustrated by the
Symmetric Revealed Comparative Advantage Index[5]
shown on Graph 18. The comparative advantage in wood and wood products has
remained stable over the 2000-2010 decade and improved for metals and raw
hides, skins, leather and furs; while it declined for machinery and electrical
products. In services, the market share of the broad category of other services[6]
lies above the market share of total services, while travel and transportation
lag behind (Graph 19). The
'Other services' category is the only services category in Finland enjoying a
comparative advantage vis-à-vis the rest of the world, shown on Graph 20. The
comparative disadvantage in travel services and transportation services
increased even further, the latter partly reflecting the stricter emission
rules for water transportation on the Baltic Sea coming into force in 2015.

Finland
should work on effectively translating its high R&D intensity into the
development of new products. This is reflected in
the Innovation Union Scoreboard, where of all sub dimensions Finland's score is lowest (15th place, barely above EU27 average) on
"innovators", encompassing SMEs introducing product or process
innovations and SMEs introducing marketing or organisational innovations. The
Finnish government is in this matter initiating or strengthening several
measures encouraging entrepreneurship and innovation. Finnvera, a specialized
financing state-owned company, has been given increasing risk financing
abilities targeted at homeland financing purposes. Through this law active up
to end of 2015, Finnvera can cover corporate losses up to 58-60% of
programme-companies. The so-called business-angel law is targeted at investing
in small companies with a turnover below 10 million euros or maximum 50
employees. The law allows an individual investor to deduct 50% of his capital
income after investing in a limited company in 2013-2015. Another measure
allows additional deductions on R&D costs for companies between 2013-2015.
A tax deduction on revenue from licensing intellectual property rights is still
under discussion.

Export market shares could be gained in
certain niche sectors. The market share loss of the
forest industry reflects the on-going move to close down production plants in Finland, moving them to lower-cost countries and closer to growing demand. In the medium
term however, the Finnish forest industry might be able to reorient itself
towards clean-tech, with high value-added products. Other sectors in which Finland could gain export market share are mining products, off-shore related machines and
equipment and ICT products and services.

Graph 17: Sectoral export market shares in goods (in value terms) || Graph 18: Revealed comparative advantage across product categories

Source: Commission services || Source: Commission services

Graph 19: Sectoral export market shares in services (in value terms) || Graph 20: Revealed comparative advantage across services categories

Source: Commission services || Source: Commission services

3.1.4
The importance of ICT products for the Finnish
economy

Nokia provided a large contribution to
Finland's Gross Value Added growth, exports performance and employment in the
early 2000s. The company became leader in its
industry and Finnish subcontractors thrived on its success. In 1995 the ICT
cluster produced 5% of Finland's total gross value added, which increased to
11% in 2000 (Graph 21). Up to half of the growth in gross value added during
1998-2000 can be contributed to the ICT sector (Graph 22). Nokia itself
accounted for 4% of GDP in 2000 and contributed 2% points to growth in GDP
(ETLA, 2012). When competition to Nokia intensified, the company struggled to
maintain its leading position. As a consequence, the importance of the ICT
cluster in (growth of) Finland's gross value added diminished.

Graph 21: Share of ICT[7] in total GVA, current prices || Graph 22: Contribution of ICT to GVA growth

Source: Commission services, ECFIN calculations || Source: Commission services, ECFIN calculations

The share of ICT products[8] in Finnish
exports has declined compared to its heydays in 2000. Expressed as a share of exports of goods, ICT products went from
31% in 2000 to only 13% in 2011. This is not surprising, taking into account
the on-going relocation of Nokia's production outside of Finland. By end-2012 the company closed its last manufacturing line in Finland, effectively bringing the amount of mobile phones exported to zero as of 2013.
Within Finland, Nokia now has the role of an exporter of services, namely
R&D and headquarters services.

The ICT sector is expected to emerge
much smaller from restructuring, based on smaller companies and a strong focus
on R&D. Companies such as Samsung and Lenovo
announced the planned setup of R&D centres in Finland, presumably
leveraging the presence of well-trained and experienced engineers in Finland. International success has been encountered by the emerging smartphone and tablet
game industry. The government-funded Tekes foundation is providing funding and
support for several new start-ups in the ICT sector.

The government is looking into ways to
support the on-going restructuring process. The ICT
2015 working group recently identified 4 critical directions that should be
followed to re-establish Finnish technological lead in ICT. These are: i) fast
development of common architecture for all public services; ii) establishment
of a 10 year programme on ICT related research, development and innovation; iii) establishment
of funding programme to secure the funding for high-growth enterprises; and iv)
establishment of a governmental expert group to ensure long-term development.

3.1.5
Cost competitiveness and productivity

Recent improvements in cost
competitiveness are driven by exchange rate movements. Between 2007 and 2009 the real effective exchange rate (REER)[9] increased sharply, especially
with the unit labour cost as deflator (shown in Graph 23). The subsequent large drop in 2010
was followed by a negative or close-to-zero real effective exchange rate growth
in 2011 and 2012, indicating an improvement of Finland's cost competitiveness.
However, the nominal unit labour cost depicted in Graph 24 increased over the same period and
is forecast to continue rising. The improvement in cost competitiveness was
thus mostly due to exchange rate movements vis-à-vis Finland's main trading
partners, such as Sweden, Denmark and Russia. The large decline in 2010 was
partly induced by the appreciation of the Swedish Krona.

Graph 23: Nominal and real effective exchange rate (HICP- and ULC-based) || Graph 24: Growth in nominal unit labour cost and its components vis-à-vis IC36

Source: Commission services || Source: Commission services

Low productivity growth causes the
nominal unit labour cost to increase. Finland's nominal unit labour cost consistently grows faster than the average for Finland's main trading partners (IC36). Although not shown in Graph 24, nominal unit labour cost growth in
Finland exceeded both the Eurozone's and the EU27 average growth. While in
most years between 1998 and 2007, productivity and wage developments were closely
linked and real compensation per employee and inflation were largely offset by
productivity increases, this does not hold anymore for 2008 and 2009. In 2007
new sectoral wage agreements were negotiated providing for high wage growth, as
a severe impact from the crisis was not expected at the time. In 2008 and 2009
productivity growth turned negative, due to less hours worked and labour
hoarding, resulting in a jump in ULC far above previous Finnish levels and the
euro area average. In 2010, productivity growth outpaced inflation and real
compensation per employee, offsetting only partly the ULC increases of the
years before, again followed by low productivity growth in 2011 and 2012. As a
result, productivity growth dropped below that of Finland's trading partners
during the crisis. Over the period 2000-2007, the Finnish manufacturing
sector enjoyed high productivity growth of 7% on the back of a strong
productivity growth in the ICT sector, compared to 4.2% in Germany and 6.6% in Sweden. Afterwards this reversed to -2.9% over 2007-2011, compared to -1.9% in Germany and 0.9% in Sweden (Ministry of Finance, 2012). Without measures to spur productivity growth
or wage moderation, compensation per employee is forecast to continue outpacing
productivity growth in 2013 and 2014, resulting in further increases in the
nominal unit labour cost.

Unit labour costs are increasing for
market services, but decreasing for manufacturing. These
opposite movements, shown in Graph 25, reflect diverging developments in labour cost competitiveness
across sectors. Labour cost developments outpaced productivity developments in
market services, which are less traded than manufactured products, and thus in
general experience less competition. If productivity in manufacturing increases
while stalling in market services, and the centralized wage agreement framework
ensures an equal wage evolution in all industries, this will lead to higher
unit labour costs in market services. Productivity differences have, however,
lately been shrinking, as a result of the declining share of the electronics
industry.

Wage growth in the non-tradable sector
puts pressure on the tradable sector. As
illustrated by Graph 26, prices
in the non-tradable sector are rising faster than in the tradable sector. The
same is true for the compensation of employees. Hence, the non-tradable sector
now accounts for a larger part of compensation of employees, to be covered
fully by domestic demand. This in turn hurts the tradable sector, as it
increases the cost of intermediate goods purchased domestically, such as
business services and construction. It also increases the cost of ageing, since
ageing-related services, such as healthcare, are included in the non-tradable sector.
The fastest rise in the hourly compensation of employees within the
non-tradable sector has been in construction and private healthcare services
(Ministry of finance, 2012).

Graph 25: Sectoral unit labour costs || Graph 26: Tradable versus non-tradable shares

Source: Commission services Note: Based on data according to the nomenclature of economic activities Nace Rev1. Market services include industries G\_K. || Source: Commission services

The latest wage agreement [10] still resulted
in wage growth above productivity growth. The
recent Tripartite Agreement negotiated end of 2011[11] and valid for two years sets
wage growth at a moderate pace. However, in light of the stagnating labour
market, ULC have increased by 3.6% in 2012 and are forecast to increase by 2.7%
in 2013. On top of inflation, this nominal ULC growth includes a growth of real
compensation per employee that outstrips productivity growth. Nominal unit
labour cost growth is expected to remain above other countries' ULC growth.

Population ageing affects labour supply.
The working age population is expected to decline
as of 2013 due to ageing of the Finnish population. Over the near future
activation policies and immigration can still offset the effects of ageing,
keeping the total labour force stable. However, companies are expected to
experience labour shortages, especially for highly qualified or specific
profiles, which in turn could affect wage developments or productivity levels.
An increase in the effective and the statutory retirement age would result in a
slower decline in the working age population. Currently there is a large spike
in the number of people who draw their pension as soon as they are allowed to.
In addition, there is no evidence of any delay in taking pension since the 2005
reforms took effect. These outcomes are in line with international experience
and consistent with the findings of behavioural economics (Barr, 2013). Linking
the statutory retirement age to life expectancy would therefore be more
effective than the current link between monthly pension benefits and life
expectancy through the life-expectancy coefficient.

The next wage agreement should aim for lower
wage growth, in line with productivity growth. Negotiations
between the employer associations and trade unions will start in 2013. Given
the current state of the economy, the employer associations are hinting towards
a nominal wage freeze as their starting position for the negotiations. This
would help to bring wages back in line with productivity levels. Productivity
developments should be considered explicitly in each wage negotiation round. Sectoral
agreements as opposed to one centralized agreement could help ensure wage
growth does not outpace productivity growth in one of the sectors. The approach
of the 2007 round of sectoral agreements however should be avoided, where the
first concluded sectoral agreement was taken up by the other sectors as a
minimum benchmark, with each sector outbidding the other sectors' wage growth.

3.1.6
Energy intensity of the Finnish economy

Finland's energy intensity is high
compared to its Nordic neighbours and the euro area members, as shown on Graph 27. The industry covers almost half of
the final energy consumption, within the manufacturing sector the forest
industry is by far the largest energy consumer, followed by the metal and the
chemical industry (Graph 28).

A high energy intensity combined with
energy imports affects the industries' cost competitiveness and Finland's trade balance. Through a high energy intensity rising
energy prices translate into increasing production costs for the Finnish
industries. Although the overall high energy intensity stems from the dominance
of energy-intensive industries in Finland, a focus on energy efficiency could
provide these industries with a competitive edge vis-à-vis competing industries
in other countries. Finland cannot fully cover energy consumption by domestic
production; more than half of the consumed energy is imported (Graph 29), mostly from Russia. The high dependency on Russia for energy imports partly originates from the
structure of the existing infrastructure. Finland is an "energy
island" and could benefit from the cooperation with the Baltic States in
linking electricity and gas networks.

Already more than one fourth of the
consumed energy originates from renewables. Most of
the energy from renewables is produced through by-products of the forestry
industry, indicated as wood fuels on Graph 30, complemented by hydro and wind
power. The high share of renewables reduces the impact of energy prices on Finland's trade balance as less fossil fuel needs to be imported.

Graph 27: Energy Intensity (2011) || Graph 28: Energy consumption by sector (2011)

Source: Commission Services || Source: Commission Services

Graph 29: Total energy consumption in Finland (2011) || Graph 30: Total energy consumption by source (2011)

Source: Commission Services || Source: Statistics Finland

3.2
Private sector debt

In nominal terms, both non-financial
corporations and households piled up debt over the past ten years, with
households accumulating at a faster pace.
Non-financial corporations experienced a big increase from 2007 to 2008 which
cannot be explained by an increase in domestic intercompany lending, as
consolidated data show the same jump. The rise in non-consolidated private debt
of non-financial corporations was in line with GDP growth until the jump in
2008, maintaining a level of around 100% of GDP up to 2007 (Graph 31). The level reached in 2011, 116% of
GDP for non-financial corporations, sits above the EU average of around 100% of
GDP, but below the 150% of GDP attained in Sweden. Household debt increased much
faster, nearly doubling over the last decade from 33% of GDP in 2000 to 63% of
GDP in 2011. It has to be noted that in Finland a special kind of structure –
housing corporations – exists, that although statistically classified in the
corporate sector, is more akin to household borrowing. This increases
non-financial corporations' debt, while decreasing total household debt.

Graph 31: Private debt in % GDP

Source: Commission services

3.2.1
Household debt

Finnish household debt has nearly
doubled over the last decade from 65% to 118% of
disposable income. The increase is almost fully due
to an increase in mortgage loans, with consumption loans for other purposes
remaining more or less constant around 5-7% of GDP (Graph 32). Apart from the household debt
level, currently at the euro area average, its distribution among households warrants
to be monitored. The share of households with debt levels exceeding 500% of
their disposable income lies only at 4.5% (Statistics Finland).

Lenient loan conditions and policies facilitating
home ownership encouraged debt accumulation and real house price increases. Over the past years decreasing interest rates and lengthening of the
average maturities enabled larger loan amounts for the same level of monthly
payments. In this context, it is important to note that virtually all mortgage
loans in Finland are tied to variable interest rates. In addition,
loan-to-value ratios of 100% or even above were not uncommon, especially for
first-time buyers. The tax deductibility of mortgage interest rate payments is meant
to encourage home ownership, but may by reducing the cost of financing
contribute to an upward pressure on house prices that reduces the affordability
of houses.[12]
Property taxation on home ownership is low and capital gains from selling the owner-occupied
property are not taxed (if the property has been held for more than two years).

Graph 32: Real house prices and housing and consumption loans of households || Graph 33: Composite indicator on deleveraging pressures for EU27 member states, households (2011)

Source: Commission services || Source: Commission services

Households do not face excessive
deleveraging pressures. Two composite indicators
have been constructed[13]
to assess deleveraging pressures according to, on the one hand, the capacity to
repay and, on the other hand, leverage (debt to assets). These are shown in Graph 33. Finnish households have a higher
capacity to repay than the last third of the distribution (the 66th
percentile line), while in terms of the leverage indicator deleveraging
pressures on Finnish household are a bit more pronounced. Despite weaker
consumer expectations, mortgage debt was still growing in the first three
quarters of 2012. This may have been partly attributable to household wanting
to take advantage of the old rules before more restrictive conditions on mortgage
loans are being phased in in the near future and the increase in the transfer
tax from 1.6% to 2% in March 2013.

Although prevailing debt levels are currently
not considered a major risk to the stability of the Finnish economy, measures
to curb debt growth are most welcome. The net
overall borrowing position of Finnish households and their low savings rate is
a cause for concern. The Finnish Financial Supervisory Authority's recommendation
on maximum loan-to-value ratios of 90% is not always followed up by financial
institutions and might therefore have to become binding. Talks are indeed on-going
to turn the recommendation into a regulation, in which the Finnish Financial
Supervisory Authority would decide on the maximum loan-to-value ratio for
mortgage loans, which at it tightest could be even set at 80%. The tax
deductibility of mortgage interest payments should be phased out. A first step
has been taken, reducing the tax deductibility from 100% to 85% in 2012, 80% in
2013 and 75% in 2014. A ceiling on the maximum deductible amount was already in
place, in order to prevent the government from supporting excessive lending. In
addition, banks are urged to maintain a  cautious approach towards
amortisation-free housing loans, which at the moment account for no more than
1% of all mortgage loans in Finland.

3.2.2
Corporate debt

The high level of corporate debt with
respect to Finland's GDP need not be a problem as it might be due to the high degree
of internationalisation and the lowering interest rates, which could lead to an overestimation of the risks
associated with non-financial corporation debt.

The international character of the
non-financial corporate sector could play an important role. First of all, gross debt levels can be inflated by a large share of
domestic intercompany loans. Netting out of domestic intercompany loans which represent
around one fifth of corporate debt in Finland, results in a still elevated consolidated
debt level of 90% of GDP. Secondly, contrary to domestic intercompany loans, cross-border
intercompany loans are not cancelled out when consolidating the debt of
non-financial corporations. Cross-border intercompany loans and multinational
companies concentrating part of their debt in Finland therefore increase the degree
of indebtedness of Finnish non-financial corporations. As multinationals
service their debt with revenues from global sales, the debt sustainability is
not directly linked to Finland's GDP. In that case, the debt-to-equity and
debt-to-assets ratios of the sector of non-financial corporations provide a
more accurate view; these are given in Graph 34 and Graph 35. Still, even by these measures Finland's corporate sector is characterised by still high debt levels, contrary to, for example, Sweden where despite high debt-to-GDP levels the debt-to-equity and debt-to-assets ratios
are much lower. Ideally, the share of cross-border intercompany lending should
be consolidated before calculating these ratios on a sectorial level by
country; unfortunately this is not possible due to data constraints. Depending
on the share of cross-border intercompany lending, the debt ratio of companies
residing in Finland might be overestimated compared to companies in other
countries. This is especially the case when imperfections in local capital
markets and tax systems favour allocation of lending within a group in such a
way that disproportionally high levels of debt are accounted for in Finland.

Furthermore, the increase in
non-financial corporation debt potentially reflects an increased appetite for
loans linked to the historically-low level of interest rates. The interest rate dropped from an average of 5.7% in 2007 to 4.4%
in 2008, which might partly explain the higher debt-to-GDP levels in the period
2008-2011, compared to the years before. Nevertheless, the biggest drop
actually occurred from 2008 towards 2009, falling from a level of over 4% to
barely 2.5%; this was not accompanied by further increasing debt levels. Presumably,
the further drop in interest rates reflected a 'safe haven' effect, while the
crisis context did not encourage the companies to leverage further.

Graph 34: Debt-to-equity ratio of non-financial corporations (2011) || Graph 35: Debt-to-assets ratio of non-financial corporations (2011)

Source: Commission services || Source: Commission services

Even when taking these factors into
account, Finnish non-financial corporations are highly indebted; but risks are limited.
Given that companies are currently net lenders to
the rest of the economy, access to financing remains good and deleveraging is
not pressing at the moment; corporate indebtedness is not seen as a major issue
in the Finnish economy. The assessment is confirmed by the constructed
composite indicators[14]
along the capacity to repay dimension and the leverage dimension, shown in Graph 36. Finland's non-financial
corporations score below the last third of the distribution on both dimensions.

Graph 36: Composite indicator on deleveraging pressures for EU27 member states, non-financial corporations (2011)

Source: Commission services, ECFIN calculations

3.2.3
Health of the financial sector

Credit supply and demand conditions
remain solid. Graph 37 and Graph 38 compare the credit supply and demand
conditions in Finland with the European Union average.[15] Finland's financial
corporations score above the average on all financial soundness indicators,
such as the increase in non-performing loans and the tier 1 capital ratio. On
the demand side, consumer confidence and SME loan demand are slightly below
average, indicating the impact of the crisis on consumer confidence and the
Finnish economy as a whole. The indicators illustrate how the financial
position of the Finnish banking sector has remained solid throughout the
crisis. Based on these fundamentals, no sudden credit crunch or deleveraging is
expected in the near future.

Graph 37: Stress map of credit supply conditions || Graph 38: Stress map of credit demand conditions

Source: Commission services || Source: Commission services

3.3
Growth of financial sector liabilities

The year-on-year growth of the
non-consolidated financial liabilities of the financial sector stood at 30.8%
in 2011, far above the threshold of 16.5%. In fact,
the non-consolidated financial liabilities of the financial sector have
increased substantially over time and were mostly concentrated in the subsector
S122 – other monetary financial institutions, with a part of that growth
originating from the central bank, as can be observed in Graph 39.

Graph 39: Non-consolidated financial liabilities by subsector || Graph 40: Non-consolidated financial liabilities of S122 (Other monetary financial institutions)

Source: Commission services || Source: Commission services

Regarding the expansion of the
commercial banks' liabilities, it was driven mainly by currency and deposits
(F2) and securities other than shares (F3), as
demonstrated by Graph 40. The
former category includes deposits from all sectors, including other MFIs. The
latter one encompasses debt securities (short- and long-term) as well as
derivatives. Although not visible in the presented charts, more than a quarter
of total bank liabilities is towards counterparties outside the euro area.[16]

The Finnish banking sector is highly concentrated, with Nordea Bank Finland holding two thirds of the total assets. Data of the
Finnish Financial Supervisory Authority allow for splitting out the movements
in Nordea Bank's liabilities (Table 2). Nordea Bank Finland, subsidiary of Swedish Nordea Group, accounts for over half of the growth in total
financial liabilities of the entire financial sector.

Table 2: Non-consolidated financial liabilities by
subsector

Source: Commission Services

3.3.1
Nordea derivatives

The growth of the Nordea derivative portfolio accounts for more than
one third of the growth in total financial liabilities of the Finnish financial
sector. According to a decision at group level, all
Nordea derivatives were to be concentrated in the Finnish subsidiary. The  expansion
of Nordea Finland liabilities by EUR 113 billion in 2011 was largely due to the
increase in value of Nordea's derivatives portfolio by EUR 73 billion.[17] At the end of 2011, the gross
value of Nordea's derivative portfolio stood at EUR 166 billion. The values of
derivatives on the assets and liabilities sides were balanced.

According to corporate information, Nordea hedges its derivative
portfolios by the corresponding contracts and use of collateral. The most common risk-mitigation technique is the use of closeout
netting agreements, which allow to net positive and negative replacement values
of contracts under the agreement in the event of default of the counterparty.
In addition, Nordea mitigates the exposure towards large banks, hedge funds and
institutional counterparties by an increasing use of financial collateral
agreements, where collateral (mainly cash and government bonds) is placed or
received on a daily basis to cover the current exposure. After reductions from
closeout netting agreements (EUR 150 billion) and held collateral (EUR 5
billion), Nordea's net derivative exposure at the end of 2011 amounted to only
EUR 11 billion, compared to a gross exposure of EUR 166 billion.

The steep growth in the derivatives portfolio in 2011 resulted
mainly from the significant fall in interest rates and the appreciation of the
dollar in that year, which pushed up value of the contracts.[18] The bulk of derivatives in Nordea's portfolio reflects client
business while proprietary trade is very limited. The contracts include mainly interest-rate
swaps and options and currency swaps, whose fair value changes according to
market volatility.[19]
High value swings are typical for this portfolio, reflecting volatility of the
underlying markets. After having expanded by as much as 173% in 2008 and
declined by 16% in 2009, the value of Nordea's derivative portfolio increased
by 76% in 2011. In the first two quarters of 2012, it fell slightly again (8%
since end 2011).

It can be concluded that the increase of the value of derivatives
portfolio in the Finnish banking sector did not lead to a proportional increase
in the risk level, but resulted to a large extent
from the underlying market developments (i.e. interest rate falls and US dollar
appreciation), consistently with the nature of derivative contracts. Nevertheless,
the business volumes also increased in 2011 (by 22%) measured as notional
volumes of newly-concluded contracts. Overall, the sizeable derivatives
portfolio concentrated in Nordea Finland features specific risks (counterparty
credit risk and settlement risk, portfolio risk).[20] Therefore, Nordea's relevant
risk mitigation techniques and practices should be carefully monitored by the
competent supervisory authorities.

3.3.2
MFI deposits

Apart from Nordea's derivatives portfolio, the growth of the
financial sector liabilities resulted mainly from the increase in foreign deposits
at Finnish MFIs. This phenomenon concerned all
commercial banks as well as the central bank. In 2011, total currency and
deposits at Finnish MFI, excluding the central bank, increased by EUR 67
billion (Table 3), or one third of the growth in total financial liabilities of
the Finnish financial sector. MFI deposits at the central bank increased by EUR
50 billion.

The foreign deposits flew in through a specific channel. Directly, they came mostly from the banks based in the Nordic non-euro
area countries: Sweden, Norway, Denmark and also the UK. Indirectly, according
to information received during the IDR mission, they originated from banks
established in the crisis-hit euro-area countries. The deposits of banks from
euro area countries, mainly Southern peripherals, increased substantially in
2011 in Northern Europe due to its 'safe haven' reputation. Faced with the
substantial deposit inflows, Swedish, Norwegian or Danish banks transferred
their excess euro-denominated liquidity to their Finnish branches or
subsidiaries in order to subsequently place them with the Bank of Finland; the
only central bank in the region belonging to the Eurosystem.

The above-mentioned developments are
reflected in the aggregated balance sheets of the Finnish banking sector. In 2011, total interbank lending in Finland increased by EUR 57
billion, while interbank borrowing increased by EUR 4 billion.[21] Thus, the net interbank
lending by Finnish commercial banks amounted to EUR 53 billion. Their EUR 50
billion deposits at the central bank made up the bulk of this sum.[22] In the same period, external
liabilities of Finnish commercial banks increased by EUR 58 billion. This
includes intra-group fund transfers from non-euro area banks to their Finnish
branches and subsidiaries. The analysis of the aggregated accounts of the Finnish
banking sector indicates that a large share of these external funds was
transformed into interbank lending, i.e. mainly commercial bank deposits at the
central bank as described above.

Bank deposits at the central bank are double-counted
in total non-consolidated liabilities of the financial sector. For example, a deposit received from Sweden by Nordea Finland and subsequently placed at the Bank of Finland is recorded among the commercial banks'
liabilities and also on the liability side of the central bank balance sheet. The
EUR 50 billion increase in deposits of monetary and financial institutions
(MFIs)at the Bank of Finland in 2011 led to the double counting effect amounting
to 8 percentage points within the total 31 per cent financial sector liabilities
increase. The double counting, however, is also taken into account in setting
the relatively high threshold for the growth of non-consolidated financial
sector liabilities indicator in the MIP Scoreboard.

Table 3: Split of financial liabilities of S122

Source: Commission Services, FinFSA[23]

3.3.3
Other liabilities

Abstracting from the impact of
derivatives and MFI deposits, other liabilities of the financial sector also increased,
although at a more moderate pace. Both non-MFI
deposits and wholesale funding, as well as an increase in the own funds,
contributed to the overall growth. In Finland, loans and deposits account for a
relatively small part (less than a half) of the total banking sector balance
sheet. In 2011, deposits of households and non-financial corporations increased
by 6% (EUR 7 billion). It was below the growth of credit to the private sector,
which amounted to 8 % in 2011 (EUR 14 billion), up from 1 % in 2009
when the economy was deeply in recession. At around 140 %, the
loan-to-deposit ratio in Finland is relatively high and the structural liquidity
position of the banking sector could benefit from further enhancement. However,
banks have currently no difficulties in financing their operations as access to
the wholesale market is open at advantageous conditions, reflecting the Nordic
countries' 'safe haven' status. As a consequence, there are no credit supply
constraints and surveys show that enterprises do not see lack of credit among
their most serious problems.

The wholesale funding market is
supported by the highest credit rating for the Finnish sovereign, which ensures the value of collateral. In 2011, the issuance of
debt securities by Finnish banks increased by 17%, especially in the segment of
maturities above 2 years (by EUR 10.5 billion). The increase of average bond
maturity (currently at 7 years for bonds with maturities above 1 year) enhanced
funding stability. Simultaneously, the role of covered bonds was increasing in
the pool of bonds issued by Finnish banks. By end 2011, covered bonds accounted
for 35% of total bond portfolio.[24]

3.3.4
Assessment

The strong growth of financial sector
liabilities, while not raising undue concern, requires careful monitoring. To a large extent, the high growth of financial sector liabilities
resulted from the market movements reflected in the value of Nordea's
derivatives portfolio, the 'safe haven' effect leading to inflows of foreign
MFI deposits and the double counting of MFI deposits at the central bank. The
change of fair value of interest rate or currency swaps on the Nordea's balance
sheet did not change the risk level of its derivatives portfolio. The inflow of
foreign deposits did not stimulate a lending boom by Finish banks (be it
domestic or foreign), but were rather deposited at the central bank.
Nevertheless, the situation warrants close supervision. As explained above, the
derivatives business features inherent risks. Secondly, the hitherto prudent
treatment of foreign deposits by banks does not guarantee prudence in the
future. Excessive liquidity should not lead to excessive risk taking.

Potential risks for the Finnish
financial sector stem also from its high concentration and its funding
structure. Nordea Bank holds 67% of total banking
assets in Finland. Such a strong position of one banking group is exceptional
in the euro area. The second player in the market, OP-Pohjola Group, holds 15%
of the assets. The insurance market is highly concentrated as well, closely
intertwined with the banking sector and currently suffering from adverse
economic conditions. This heavy concentration in the banking sector implies
contagion risk from the systemic bank. Next, the reliance on foreign funding sources
and wholesale markets imply risks for bank financing. So far Finnish banks are
seen as solid, characterised by high capital adequacy and high profitability ratios
as well as by low non-performing loans and low exposure to troubled economies.
They are mainly increasing their long-term bond issuance, benefitting from the
advantageous market terms. However, a tail event in Finland or an external
shock could abruptly reverse the flow of foreign funds.

4.
Policy challenges

The analysis in sections 2 and 3 indicates
that macroeconomic developments in the areas of competitiveness, the high level
of private debt and the structure of the financial sector are among the main
challenges in Finland.

It should be recalled that these challenges
were identified under the MIP in the first IDR and relevant policy responses to
improve competitiveness were reflected and integrated in the country-specific
recommendations issued for Finland in July 2012. 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 challenges identified
in this IDR.

Concerning the challenge of improving
competitiveness a number of different avenues can be considered:

Measures aimed at increasing Finland's non-price competitiveness would be highly beneficial. Leveraging the country's high R&D intensity, this should be more
effectively translated into the development of new products. Encouraging
companies to introduce product, process, marketing or organisational-related
innovations would be highly beneficial for the Finnish economy in terms of
increasing exports and in terms of the diversification of exports beyond
forestry and electronics. It should be recalled that
country-specific recommendation nr 5 from 2012 called for a continuation of efforts
to diversify the business structure, in particular by hastening the
introduction of planned measures to broaden the innovation base. Measures aimed at fuelling innovation and rising product quality
unfortunately typically take a long time to produce effects, while an
improvement would be most welcome already in the medium term. Measures facilitating
already existing firms and products to grow and export could generate quicker
effects on non-price competitiveness for Finland. One example would be the
facilitation of the access to foreign export markets by small- and medium-sized
enterprises. This is tackled in Finland through Finnvera, the credit guarantee
and lending agency. With regards to the longer term, the Finnish government is providing
additional support for R&D through the Tekes foundation; it provides
support for research activities and it aims to foster a more entrepreneurial
and risk-taking attitude. In addition, the Finnish government set up the ICT
2015 working group, which recently identified 4 critical directions that should
be followed to re-establish Finland's technological lead in ICT. These are: i) the
fast development of a common architecture for all public services; ii) the
establishment of a 10-year programme for ICT-related research, development and
innovation; iii) the establishment of a funding programme to secure
funding for high-growth enterprises; and iv) the establishment of a governmental
expert group to ensure long-term development.

Measures to improve the energy
infrastructure and lower the country's energy intensity would have a positive
impact on Finland's trade balance and cost competitiveness. Given its structure, Finnish industry is relatively energy
intensive. Its growth and productivity potential will therefore also depend on
meeting the climate change challenges and improving energy efficiency. Related
to this, Finland could improve its energy infrastructure. Finland is an "energy island" and could benefit from the cooperation with the Baltic States in linking electricity and gas networks.

Labour cost growth could be moderated
through wage moderation, productivity increases, or both. The current wage formation system implies that those industry
branches, which show below-average productivity growth, have come under
additional pressure due to relatively higher growth in their unit labour costs.
It would therefore be important to increase the responsiveness of the wage
formation system to sectoral productivity developments. In particular,
productivity developments should be considered explicitly in each wage
negotiation round, as included in the country-specific recommendation nr 5 from
2012. Productivity increases should not only be focused on tradable sectors,
but also on non-tradable industries, especially those serving as inputs to the
tradable industries. Increases in productivity would also attenuate the labour
force decline due to ageing. In this respect efficiency gains in public
services such as healthcare and education (through cutting down the length of
studies and speeding up graduation in higher education) would be most welcome. It
should be recalled that the country-specific recommendation nr 2 from 2012
included the need to take further measures to achieve productivity gains and
cost savings in public service provision. The country-specific recommendation
nr 4 from 2012 called for the enhancement of competition in product and service
markets.

Measures are needed to increase labour
supply. It would be important to take measures to
increase labour supply in the longer term, in order to counter the negative
effects on the labour market from population ageing and the related decline in
the working age population. An increase in the effective and the statutory
retirement age would result in a slower decline in the working age population
as well as soften the cost pressure of pensions for the government. The
country-specific recommendation nr 3 from 2012 urged for the activation of
young people, the long-term unemployed and older workers, as well as an
increase of the effective retirement age taking into account improved life
expectancy.

Concerning the challenges linked to
the high level of private debt, a number of measures can be considered as
regards:

Although prevailing private debt levels
are currently not considered a major risk to the stability of the Finnish
economy, measures to curb debt growth are most welcome. The Finnish government is aware of the increase in household debt,
accompanied by lower saving rates, and takes measures to reduce incentives for taking
on and holding debt. A proposal to make the recommendation by the Finnish
Financial Supervisory Authority, on a cap on loan-to-value ratios for mortgage
loans, binding is currently being studied. The tax deductibility of mortgage interest
payments is currently being decreased.

Concerning the challenges linked to
the financial sector, close monitoring is required:

Close monitoring of the Finnish
financial sector is required, as potential risks stem from its high
concentration and its funding structure. Heavy
concentration in the banking sector implies contagion risk from the systemic
bank; the reliance on foreign funding sources and wholesale markets imply risks
for bank financing. The large derivatives portfolio of Nordea Group
concentrated in Finland requires strong supervisory oversight. Finally, the
recent liquidity inflows related to the euro area crisis, so far largely
absorbed by the central bank, should not lead to risky investments. All these
developments require close monitoring by the Finnish FSA, both at the
micro-prudential and the macro-prudential level[25], in cooperation with its
Nordic counterparts.

References

Bank of Finland, 'External balance and
competitiveness of the Finnish Economy', Presentation during our visit, 19
December 2012.

Bank of Finland, 'Growth in financial
sector liabilities', Presentation during our visit, 19 December 2012.

Barr, N. 'Evaluation of the Finnish pension
system part I: The pension system in Finland: Adequacy, sustainability and
system design', for Eläkturvakeskus (Finnish Centre for Pensions),  2013.

Cuerpo Caballero C. and A. Mordonu, 'House
Price imbalances and structural features of the housing markets' in European
Commission (Directorate General for Economic and Financial Affairs), 'Quarterly
report on the euro area', Volume 10 n°3, 2011.

Cuerpo, C., I. Drumond, J. Lendvai, P.
Pontuch, and R. Raciborski, ‘Indebtedness, deleveraging dynamics and
macroeconomic adjustment,’ European Economy Economic Papers, 2013
(forthcoming).

ETLA (The Research Institute of the Finnish
Economy), 'EU Commission visit to Finland – discussion topics', Presentation
during our visit, 20 December 2012.

European Commission (2012a), 'Assessing the
dynamics of house prices in the euro area', in Quarterly Report on the euro
area vol.11 n°4

European Commission (2012b), 'Current
account surpluses in the EU', European Economy 9/2012.

European Commission (2012d), 'Innovation
Union Scoreboard 2011', 2012.

European Commission (2012e), 'Tax reforms
in EU member states', 2012.

Federation of Finnish Financial Services,
'Private indebtedness and state of the banking sector', Presentation during our
visit, 20 December 2012.

Federation of Finnish Financial Services,
'Saving, borrowing and paying in Finland', 2012 (http://www.fkl.fi).

Federation of Finnish Technology Industries,
'Industrial trends and outlook – the technology industry', Presentation during
our visit, 20 December 2012.

Federation of Finnish Technology
Industries, 'Economic situation and outlook 4/2012', 1 November 2012 (http://www.techind.fi).

Finnish Financial Supervisory Authority,
Statistics, 2012 (http://www.fin-fsa.fi).

Kajanoja, L. 'Suomen vaihtotaseen
heikkeneminen', Bank Of Finland Online 12/2012

Ministry of Finance, 'EU Commission visit
to Finland – discussion topics', Presentation during our visit, 19 December
2012.

The World Bank, Doing business, 2012
(http://www.doingbusiness.org).

Tulli Customs, Uljas statistical database,
2012 (http://uljas.tulli.fi/).

Vartia, L., 'Finland's housing market:
Reducing risks and improving policies', OECD Economics Department Working
Papers, No 514, OECD Publishing, 2006.

World Economic Forum, 'The global
competitiveness report 2012-2013', 2012.

[1] The housing cost overburden rate is the percentage of the
population living in households where the total housing costs ('net' of housing
allowances) represent more than 40 % of disposable income ('net' of housing
allowances).

[2] However, the equity ratio has been decreasing in recent years.
Equity ratio relates total capital to total assets. It is a non-risk weighted
capital adequacy measure, which is used as a complementary measure by the Bank
of Finland (Financial Stability Report, May 2012)

[3] The only Finnish banking group which participated in the EBA
exercise, as Nordea Bank is a Swedish institution and Danske Bank a Danish one.

[4] A concept defined by the World Economic Forum as the set of
institutions, policies, and factors that determine the level of productivity of
a country.

[5] RCAci = (Xci/ΣiXci) / (Xbi/ΣiXbi). The numerator
represents the share of a given sector (i) in national exports (Xci are exports
of sector i from country c). The denominator represents the share of a given
sector (i) in the total exports of a benchmark economy (b) (in our case the
rest of the world). RCA can be in the range between 0 and infinity; with levels
below 1 indicating a comparative disadvantage and above 1 an advantage (or
specialisation. The symmetric RCA (SRCA), which is more convenient to
interpret, equals (RCA − 1)/(RCA + 1) and ranges from −1 to +1.
Positive values of SRCA represent a comparative advantage while negative values
reflect a disadvantage.

[6] Other services includes services in the domains of communication,
construction, insurance, finance, and computer and information, as well as
royalties and license fees, other business services, personal, cultural and
recreational services and government services.

[7] The ICT industry comprises C26 (computer, electronic and optical
products), C27 (electrical equipment), J61 (Telecommunications) and J62-J63 (Computer
programming, consultancy, and information service activities)

[8] Referring to goods only, i.e. C26 (computer, electronic and optical
products) and C27 (electrical equipment)

[9] Real effective exchange rates (REER) are aggregate relative price
and cost indicators which may be used to assess a country's price or cost
competitiveness relative to its principal competitors in international markets.
They correspond to the nominal effective exchange rate deflated by selected
relative price or cost deflators, here the harmonized index of consumer prices
(HICP) and the unit labour cost (ULC).

[10] The Finnish labour market is highly organised. The majority of both
employers and employees are members of the organizations that participate in
collective bargaining. These negotiations are facilitated by the government,
who could lend its support to the agreement by agreeing to modify a tax level
or increase certain types of support to enterprises or households. As an
example, corporate income tax was lowered to facilitate the 2011 agreement.
Whereas national legislation forms the basis for regulating the labour market,
specific employment terms are determined according to collective agreements
within each branch. If the parties to a collective agreement cover at least
half of the employees within a specific branch, the collective agreement has
general applicability for all companies within that branch.

[11] The latest agreement was reached in October 2011. The agreement
sets the framework for pay and cost increases in branch-level collective
agreements for a period of 25 months. According to the framework agreement, the
total cost effect of the sectoral agreements shall not exceed 2.4 % for
the first 13 months, followed by 1.9 % for the next 12 months. The numbers
include the rise in payroll costs and the cost effects of changes made in the
terms and conditions of employment. The annual cost effect is calculated to be
about 2 %.

[12] Mortgage interest rate payments are
deductible from capital income. Beyond that, 28% of the deficit due to interest
on owner occupied dwellings up to EUR 1400 can be credited against taxes paid
on earned income. (European Commission, 2012e)

[13] The composite indicators were derived
using clustering techniques in combination with Principal Component analysis
(PCA). Data on the following variables – debt-to-GDP ratio, debt-to-gross
operating surplus (or disposable income for households) ratio,
debt-to-financial assets, and debt-to-deflated financial assets - for the
"accumulation phase" 2000 to 2008 and for 2011 were collected for all
27 Member States. In a first step, clustering techniques were used to reveal
underlying similarities or mathematical distances between the multi-dimensional
data vectors (in order to classify countries into different categories).
Subsequently, PCA analysis was carried out to reduce the dimensionality of the
data and to create composite indicators that account for the highest possible
variation in the underlying variables set using the smallest possible number of
factors.
Non-consolidated figures. Debt includes loans and securities other than shares.
The methodology is described in detail in Cuerpo et.al., 2013.

[14] The composite indicators were derived using clustering techniques
in combination with Principal Component analysis (PCA). Data on the following
variables – debt-to-GDP ratio, debt-to-gross operating surplus (or disposable
income for households) ratio, debt-to-financial assets, and debt-to-deflated
financial assets - for the "accumulation phase" 2000 to 2008 and for
2011 were collected for all 27 Member States. In a first step, clustering
techniques were used to reveal underlying similarities or mathematical
distances between the multi-dimensional data vectors (in order to classify
countries into different categories). Subsequently, PCA analysis was carried
out to reduce the dimensionality of the data and to create composite indicators
that account for the highest possible variation in the underlying variables set
using the smallest possible number of factors.
Non-consolidated figures. Debt includes loans and securities other than shares.
The methodology is described in detail in Cuerpo et.al., 2013.

[15] The charts present stress maps of credit supply and demand
conditions. For each variable the range of the graph is given by the maximum
and minimum observation among all Member States (MS) with available data. A
weighted average of all available EU27 Member States is provided as a visual
reference. Variables are plotted on a regular or inverted scale ensuring that a
larger map corresponds to more adverse conditions. Credit supply-related indicators
include the change in overall non-performing loans relative to 2007, the banks'
Tier 1 capital ratio, banks' return on equity,  banks' exposure to high risk
foreign claims as % of GDP, the sovereign CDS spread, the Bank Lending Survey
(BLS) tightening of credit standards for: (i) loans to enterprises; and
(ii) house purchase loans (trailing 4-quarter average), and the Survey on
the access to finance of SMEs (SAFE) loan request failure rate (percentage of
requests that did not receive all or most of the amount requested). Credit
demand-related data include the EC Consumer Confidence Indicator, the Economic
Sentiment Indicator, the unemployment rate, the house price evolution relative
to 2007Q4, the BLS changes in demand for: (i) enterprises; and (ii) house
purchase loans, and the SAFE variable on External financing needs. Most recent
available data are presented (2012 Q2, Q3 or Q4).

[16] According to ECB data, it amounted to 28% in October 2012.

[17] Fitch data

[18] The average maturity of an interest rate derivative contract is 5
years, so a number of contracts was concluded at the time when interest rates
were higher. The fall in interest rates in 2011 automatically increased the
fair value of these contracts reflected on the balance sheet.

[19] Bank of Finland. 2012 "Financial Statistics Annual Review
2011".

[20] Counterparty credit risk is the risk
that a counterpart in a FX, interest, commodity, equity or credit
derivative contract defaults prior to maturity of the contract. Settlement risk
is the risk of losing the principal on a financial contract, due to a
counterpart’s default during the settlement process. Portfolio
risk is the risk that balancing market risks by cross-hedging the positions
does not bring the expected results.

[21] ECB data

[22] The remaining EUR 3 billion were lent to other euro area MFIs

[23] The amounts assigned to Nordea Bank Finland are based on statistics
from the Finnish financial supervisory authority.

[24] Data by the Federation of Finnish Financial Services.

[25] Macroprudential supervision in Finland will be in the remit of the
Finnish FSA Board, with the Bank of Finland contributing through the provision
of analytical underpinnings and advice, according to a draft law currently in
consultation.

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