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1 BANK OF FINLAND BULLETIN Vol. 7 No. Monetary policy and economic outlook The electronic equipment industry and Finland s transformation into a high-tech economy Structural inflation differences in an enlarged euro area Retail payments in Finland: changes in the 99s
2 Contents BANK OF FINLAND BULLETIN Monetary policy and economic outlook The electronic equipment industry and Finland s transformation into a high-tech economy by Pentti Forsman Structural inflation differences in an enlarged euro area by Nils Björkstén 7 Retail payments in Finland: changes in the 99s by Jussi Snellman Items: 8 The Board of the Bank of Finland Supplementary budget Commemorative coin for the church Commemorative coin for Helsinki The Eurosystem s monetary policy instruments Recent Bank of Finland research publications Finland in brief 8 Visiting Scholars Programme Balance sheet of the Bank of Finland Vol. 7 No. / Bank of Finland Bulletin is a quarterly publication. Publisher Suomen Pankki Bank of Finland Editorial Board Antti Juusela, Chairman Heikki Koskenkylä Pentti Pikkarainen Antti Suvanto Juha Tarkka Editor-in-Chief Matti Vanhala Edited by the Bank of Finland s Publication and Language Services Mailing address: P.O.Box 6, FIN- HELSINKI Phone: National (9) 8 International Internet: Telex: SPFBFI Fax: Cable: SUOMENPANKKI Charts Bank of Finland Organization C Printed by Sävypaino, Espoo The contents of the Bulletin may be freely quoted, but due acknowledgement is requested. ISSN (print) ISSN 6-87 (online) The Bank of Finland Bulletin is posted on our website ( BANK OF FINLAND
3 Monetary policy and economic outlook BULLETIN The world economy has continued to grow at a robust pace. In the United States, real GDP grew more strongly than expected in the first part of the year. In the euro area, the rate of economic growth has picked up noticeably. Furthermore, several of the Asian economies have continued their rapid recovery from the economic crisis of a few years ago. The strong growth of the world economy, coupled with the rise in the oil price, has, however, increased upward pressure on prices in many countries. In the euro area, the depreciation of the euro has, in addition, pushed up import prices. As a result, there has been a general tightening of monetary policy. The European Central Bank also has raised its official interest rates on a number of occasions this year in response to mounting inflationary pressures and the risk they pose to price stability. The Finnish economy also continued to grow strongly in the first part of the year and the prospects for a continuation of robust growth are good. For several years now the Finnish economy has been growing at a distinctly faster pace than the euro area economies on average. As a result of the rise in import prices, especially the oil price, but also because of domestic factors, Finland s rate of inflation has accelerated markedly and is higher than the euro area average. The monetary policy stance in the euro area is still too lax with regard to Finland s cyclical position. Given the fiscal stance implied by the Government s budget proposal for, the overall macroeconomic policy stance in Finland is becoming markedly loose with respect to the cyclical outlook. Implementation of tax cuts without any reduction in spending to offset their effects on demand could exacerbate the prevailing boom conditions. The tax cuts contained in the budget proposal will provide incentives to increase labour supply in the economy, and they can therefore be considered a step in the right direction from the standpoint of structural and employment policy. Achievement of significant employment effects will require a further easing in the taxation of labour income in the years ahead. The tax cuts need to be accompanied by other measures designed to improve the functioning of the labour market. World economic outlook remains positive The growth prospects for the world economy remain favourable, despite the tightening of monetary policy and the high oil price. According to the IMF s spring forecast, the world economy will grow at an annual rate of about % in both and. In the light of recent developments, even faster growth is possible. The main risks to world economic growth are related to the low rate of household saving and large current account deficit in the United States and the deterioration in public finances and growing unemployment in Japan. In the early part of the year technology stock prices generally declined somewhat from their previously high levels. This partial downward adjustment has reduced the probability of a sharp fall in stock market values. Stock markets have nevertheless remained very nervous. The US economy has been expanding at a rapid pace for more than eight years now (Chart ). According to preliminary data, GDP grew at an annual rate of over % in the first six months of the year and at the same time productivity growth remained strong. The fact that inflation has remained low despite robust economic growth is largely due to the rise in productivity. In the late spring and early summer, however, the first signs began to appear that economic activity was slowing. Contributing to this development has been the tightening of monetary policy that has occurred thus far.
4 - Chart. Real GDP growth Percentage change on the same quarter a year earlier Euro area. Finland. United States Sources: Eurostat and Statistics Finland. A recovery in the Japanese economy has been expected for a long time. Recently, signs of recovery have been stronger, but much uncertainty still remains. The Tankan survey of business conditions for June showed a market increase in confidence and investment intentions among large firms compared with March whereas small firms continued to be more pessimistic. World oil prices have been rising for about eighteen months in dollar terms. During this time the oil price has climbed from around USD per barrel to about USD per barrel (Chart ). Quotations for crude oil futures indicate that markets do not expect oil prices to fall significantly in the near term, even though OPEC has recently announced production increases. So far, the production increases have been small in relation to the strength of demand in industrial countries and the need to replenish stocks of oil products. As a counterweight to higher oil prices, world market prices of non-energy commodities have fallen slightly on average this year. Inflation has picked up in the euro area and Finland Chart. Crude oil price and industrial producer prices in the euro area USD/barrel -month percentage change Crude oil (left-hand scale). Industrial producer prices in the euro area (right-hand scale) Sources: Reuters and Eurostat. The rate of increase in consumer prices in the euro area accelerated in June July of this year to almost ½%, as measured by the Harmonized Index of Consumer Prices (HICP; Chart ). Earlier in the year the annual rate of inflation was % and a year ago around %. The pick up in the rate of inflation is mainly due to the rise in world oil prices, since prices of energy products in the euro area in the first half of were about % higher than a year ago. The direct impact of the rise in energy prices on consumer price inflation in July was. percentage points. But when energy and unprocessed food prices are excluded, inflation remained virtually unchanged in the first half of the year at somewhat more than %. The rate of increase in the non-energy industrial goods component of the euro area HICP has remained low in the current year, despite the fact that import prices have risen rapidly as a result of the depreciation of the euro. Industrial producer prices have also risen significantly. The subdued rise in prices of nonenergy industrial goods is probably partly due to increased competition and moderate wage developments in many euro area countries. BANK OF FINLAND
5 The direct effect of the rise in energy prices on consumer inflation is likely to diminish over the coming months since the oil price had already reached a high level in the same period a year ago. By contrast, the rate of increase in other components of the HICP could pick up, if the high oil price and weakness of the euro start to pass through into the prices of these goods and services. Moreover, the further improvement in growth prospects for the fast growing euro area economies and rise in capacity utilization levels in these countries could generate inflationary pressures in the near future. Consumer price inflation in Finland has also picked up in the course of this year (Chart ). The annual rate of change in HICP inflation increased to.9% in July from.% in January. Measured by the national consumer price index, inflation rose to.7% in July. Although the pick-up in inflation was mainly due to higher energy prices, the rate of increase in services prices has also risen. An additional factor behind the increase in CPI inflation was a rise in lending rates. By contrast, the rate of increase in nonenergy industrial goods has remained fairly muted. Prices of these goods rose by.% in the year to July. Consumer price inflation in Finland is expected to remain relatively high in the second half of this year, mainly because of the high oil price and weakness of the euro. This means that inflation in could turn out to be slightly higher than forecast by the Bank of Finland in June. Although the direct effect of the oil price on the inflation rate is likely to gradually diminish, the indirect effects of the rise in the oil price and the depreciation of the euro have increased upward pressure on prices in, for example, the transport sector. There is a danger that, in conditions of strong domestic demand, these price rises could trigger second-round effects and that the rate of increase in prices of other goods and services could also accelerate. Monetary policy has been tightened in the euro area in a forward-looking fashion The Governing Council of the ECB has raised the Eurosystem s official interest rates by a total of. percentage points in the current year (Chart ). The Governing Council s aim with regard to interest rates Chart. Harmonized Index of Consumer Prices -month percentage change Euro area, total index. Euro area, services. Finland, total index. Finland, services Source: Eurostat. Chart. Official interest rates % USA: fed funds target rate. Sweden: repo rate. Eurosystem: main refinancing rate/minimum bid rate (German repo rate before 999). Japan: discount rate Source: Reuters. BULLETIN
6 Chart. Interest rates in the euro area % month Euribor. -month Euribor. Average -year government bond yield Source: Reuters. For further details, see The switch to variable rate tenders in the main refinancing operations ECB Monthly Bulletin, July. has been to operate in a forward-looking fashion in order to ensure that economic growth can continue without running up against rising inflation. The most recent rate increase was in early June, when the Governing Council raised the ECB s official interest rates by basis points. The Governing Council also decided to switch to variable rate tenders in the conduct of the main refinancing operations, starting from the end of June. Variable rate tenders are conducted by applying the multiple rate auction procedure, in which for each accepted bid the counterparty receives financing at the bid rate. The switch was made in response to the overbidding that had occurred in the context of fixed rate tenders. A minimum bid rate was set for the main refinancing operations, which is currently.%. The minimum bid rate signals the monetary policy stance in the same way as the rate applied to fixed rate tenders previously used to do. The announcement of the tender results include, in addition to the total amount allotted, the marginal rate (ie the lowest bid rate at which funds are allotted) and the weighted average rate on accepted bids. The announcement also includes bids accepted at the marginal rate as a percentage of the total amount of bids submitted at this rate. The Governing Council s decisions to raise interest rates were based on developments in both pillars of the monetary policy strategy. As for the first pillar, monetary and credit aggregates grew strongly throughout 999 and have continued to do so in the current year, indicating that liquidity is ample. Although the annual rate of increase in the broad monetary aggregate M has slowed slightly since May, it still exceeds the reference value. The three-month moving average of annual M growth was 6.% in the period from April to June, compared with 6.% in the previous three-month period. The growth of loans to the private sector has likewise slowed a little, but it is still high. In June the annual rate of growth of loans to the private sector was 9.%, a decline of one percentage point from the previous month. As regards the second pillar, it was noted above that there has been upward pressure on consumer prices as a result of rising import prices, which, in turn, reflect the effects of the depreciation of the euro and the higher oil price. The rate of growth of the Finnish contribution to euro area M has fluctuated substantially in the course of this year, mirroring variations in the amount of money market paper outstanding. This development, in turn, is partly due to factors connected with the government s cash management. The three-month moving average of the rate of growth of the Finnish contribution to M was 7.% in the period from April to June. The rate of growth of loans to the private sector in Finland has slowed in recent months and fallen below the corresponding rate for the euro area. The rate of growth in the period from May to June was about 7%, compared with about % in the early months of the year. Contributing to this development have been the rise in interest rates and the quieter conditions in the housing market. The stock of bank loans to non-financial corporations has actually de- BANK OF FINLAND
7 creased as compared with the previous year, but this has been offset by increased borrowing abroad and from other financial institutions and insurance companies. The euro has remained weak Short-term money market interest rates in the euro area have risen by roughly the same amount as official interest rates this year (Chart ). Because of strong interest rate expectations, most of the rise in market rates occurred before the hikes in official rates. Bank lending rates have moved hand in hand with market rates. At the present time market expectations are that the Governing Council of the ECB will continue to tighten monetary policy during the autumn. Official interest rates in the United States have also been raised on several occasions in the current year, most recently in May. US consumer prices have risen as a result of the increase in energy prices and the rate of growth of labour costs has also picked up. Rapid productivity growth has, however, partly offset the effect of wage increases. Recently, signs of a slowdown in US economic activity have strengthened and this has reduced market expectations of interest rate increases. In August the Bank of Japan ended the zero interest rate policy that it had maintained for one and a half years and raised the target for the overnight call rate to.%. The official discount rate was kept unchanged at.% (Chart ). The decision to raise the call rate was based on the perception that deflationary pressures had receded along with the gradual recovery of the economy. Like international interest rates, long-term government bond yields in the euro area declined slightly in the early part of the year (Chart ). Among the factors behind this development were the generally volatile conditions in stock markets and the prospect of changes in the supply of bonds. In the period from April to August the average yield on ten-year bonds in the euro area remained fairly stable at slightly under.%. The differential between US ten-year bond yields and comparable German bond yields has narrowed this year to about basis points. In foreign exchange markets, the effective exchange rate of the euro weakened by more than % BULLETIN Chart 6. Euro's effective exchange rate and US dollar euro exchange rate Index A. Before 999 a trade-weighted index of the currencies of the euro area countries. An upward movement in the index represents an appreciation of the euro. B. To December 998, the rate for the ecu. Source: European Central Bank. Euro/USD Index, 999 Q = (left-hand scale) (A). Units of USD per euro (right-hand scale) (B) in the first four months of the year (Chart 6). The euro s depreciation was due to a number of factors, including conflicting data on the recovery of the euro area economy and the markets disappointment at the slow pace of structural reform. The euro strengthened temporarily in May and early June against the major currencies, including the dollar, in response to positive developments in economic growth indicators for the euro area and increased signs that US economic activity was slowing down. Later in the summer the euro fell back against the dollar with the release of better-than-expected growth figures for the US economy. By the end of August the euro had depreciated by more than % in effective terms since the beginning of the year while against the dollar it had depreciated by over %. The strength and flexibility of the US economy and good earnings prospects of new-technology companies have for a long time now been factors that have attracted investors to dollar-denominated investments
8 Chart 7. Housing prices and growth of housing loans in Finland Index 98 = FIM billion Real prices of old dwellings, whole country (left-hand scale). Nominal prices of old dwellings; whole country (left-hand scale). Price of old two-roomed flats in the Greater Helsinki area (left-hand scale). Stock of bank housing loans (right-hand scale) Sources: Bank of Finland, Huoneistokeskus and Statistics Finland. Chart 8. Unemployment and vacancies in Finland % Unemployment rate, Statistics Finland measure, seasonally adjusted* (right-hand scale). Unemployment rate, Ministry of Labour measure** (right-hand scale). Number of vacancies as a percentage of the labour force, seasonally adjusted* (left-hand scale) * Seasonally adjusted by the Bank of Finland. ** Unemployed jobseekers, persons participating in labour market policy programmes and persons receiving unemployment pensions as a percentage of the labour force. Sources: Statistics Finland and Ministry of Labour. % Strong economic growth in the euro area Rapid world economic growth, the weakness of the euro and relatively easy monetary conditions have helped to boost economic activity in the euro area. In the first quarter of real GDP in the euro area grew by about.% compared with the same quarter a year earlier. Industrial production has been growing at robust pace, with year-on-year production growth of more than 6% in the three-month period from March to May. It is noteworthy that industrial production growth has picked up appreciably in the core euro area countries, particularly Germany. Industrial confidence indicators have reached or even surpassed the levels of their previous cyclical peaks, which points to a continuation of strong growth of industrial production in the months ahead. Private consumption in the euro area was firm in the first quarter of. The consumer confidence indicator for the euro area remains at a high level and close to its all-time high, implying that private consumption is likely to continue growing at a fairly rapid pace. There was also a marked increase in private investment in the first quarter. Export demand was boosted by the rapid growth of the world economy and the weakness of the euro. The contribution of net exports to GDP growth was not particularly large, however, as imports also grew strongly. The rate of unemployment in the euro area has been declining for nearly three years now. In May the unemployment rate stood at 9.%, which was lower than in Finland. The largest declines in the unemployment rate this year have occurred in Spain and France. Given the prospect of continuing robust economic growth, the chances of a further reduction in unemployment are good, but could be slowed by structural factors. Favourable economic conditions in Finland The Finnish economy grew at an annual rate of about % in the first half of, which has been the average rate of output growth in Finland since the mid- 99s. Like the euro area in general, industrial production growth has been exceptionally robust, spurred in particular by strong export demand. Industrial pro- 6 BANK OF FINLAND
9 duction grew by 8.% in the first six months of the year, compared with the same period a year ago. The increase in investment activity in the euro area has boosted the exports of the Finnish metal and engineering industries, in particular. Contributing to the good export performance has been the weaker euro, as almost two-thirds of exports go to countries outside the euro area. Moreover, the main sectors have benefited from favourable developments in world market prices this year. Industrial confidence indicators have strengthened further in recent months and cyclical conditions in industry are good on the whole. As a consequence of the rapid growth of industrial output, capacity utilization rates have risen to high levels, and this is beginning to be an obstacle to continued growth in some sectors. On the other hand, capacity shortages may prompt firms to bring forward planned investment. The survey of investment intentions conducted by the Confederation of Finnish Industry and Employers in the spring points to a marked increase in industrial investment in Finland this year as compared with 999. Consumer demand has been robust in the current year. Private consumption expenditure in the first quarter was up by.% from the same quarter a year earlier. Strong growth of retail sales volumes in April and May points to continued robust consumer demand in the second quarter. The business survey conducted by the Finnish Confederation of Commerce and Trade in June showed that retailers were optimistic about the prospects for sales in the second half of this year. On the basis of the performance of the Finnish economy in the first part of the year, the Bank of Finland s forecast of real GDP growth of about % for still seems to be realistic. However, growth this year has been based more on total domestic demand, notably private consumption, than forecast by the Bank in June. Housing market activity has remained strong in the current year, although signs of calmer conditions have been discernible since the late spring. Estate agents report that the number of transactions so far this year is down slightly on last year s figures and that properties are taking longer to sell. Prices of old two-roomed flats in the Greater Helsinki area have actually fallen a little (Chart 7). Furthermore, recent evidence from the consumer confidence survey indicates that consumers house-buying intentions BULLETIN weakened in the spring. Apart from the perception that dwelling prices are high, the reduced buying interest may reflect the fact that interest rates on new housing loans rose by percentage point in the first six months of the year. Indeed, the rate of growth in the stock of housing loans has slowed this year. Continuing robust economic growth could, however, mean that housing demand will remain strong, particularly in growth centres, regardless of higher interest rates and the high level of prices. Since housing supply responds slowly to changes in demand, rising housing prices in growth centres could become a constraint to growth. Despite rapid economic growth, employment and unemployment have improved fairly slowly in the current year (Chart 8). According to the labour force survey conducted by Statistics Finland, the seasonally adjusted unemployment rate stood at 9.% in July, which represents a fall of about half a percentage point from one year earlier. The seasonally adjusted employment rate was slightly higher than in July 999. Although the number of jobs in industry has risen significantly over the past year, a shortage of skilled labour could impede employment growth in industry in the future. Employment has also increased in the finance and business services sectors. By contrast, there has been only a modest increase in jobs in the trade sector. One feature of recent employment developments has been a reduction in the number of jobs based on fixed-term contracts, particularly among newly employed young people. This reflects both the improved economic situation and a reduction in funds made available for employment subsidies in the public sector. Increased challenges for economic policy The Government s budget proposal for provides for cuts in receipts from state income taxes and social security contributions totalling FIM 6. billion a year, equivalent to.8% of GDP in comparison with current tax and contribution rates. Income tax revenue is estimated to fall by FIM.7 billion, of which FIM. billion represents an inflation adjustment to tax tables. No changes are proposed in indirect taxation. In the programme drawn up by the Government after the parliamentary elections in spring 999, 7
10 Box. The Bank of Finland s Monetary Conditions Indices Monetary Conditions Indices (MCIs) can be used to try to assess developments in the stance of monetary policy. As monetary policy affects economic activity and prices mainly through interest rates and the exchange rate, MCIs are normally calculated as the weighted average of a (short-term) interest rate and an exchange rate. The weights reflect the relative impact of the interest rate and the exchange rate on aggregate demand or prices. For large, relatively closed economies the ratio of the weight of the interest rate to the weight of the exchange rate can be as high as while for very open economies ratios typically range from to. If, for example, the ratio is, then the effect of a one percentage point decrease in the interest rate is equivalent to the effect of a % depreciation in the exchange rate. The Bank of Finland compiles MCIs for Finland and the euro area in both nominal and real terms. The interest rate used in the nominal MCIs is three-month Euribor (prior to 999 three-month Helibor for Finland and a corresponding weighted money market rate of the euro area countries for the euro area). The exchange rate used for Finland is the narrow plus euro area measure of the national competitiveness indicator and for the euro area the effective exchange rate of the euro compiled by the European Central Bank. Each MCI is calculated using alternative ratios of the weight of the interest rate to the weight of the exchange rate: ½ or ½ in the MCI for Finland and or in the MCI for the euro area. These values can be considered as some kind of extreme values. The deflators used in the real MCIs are harmonized indices of consumer prices. For details of the competitiveness indicators calculated by the Bank of Finland, see the article The new competitiveness indicators compiled by the Bank of Finland, by Lauri Kajanoja in Bank of Finland Bulletin, /. Chart 9. Nominal Monetary Conditions Indices 999 Q = 6 Chart. Real Monetary Conditions Indices 999 Q = Finland, ratio.. Finland, ratio.. Euro area, ratio. Euro area, ratio Source: Bank of Finland Finland, ratio.. Finland, ratio.. Euro area, ratio. Euro area, ratio Source: Bank of Finland. 8 BANK OF FINLAND
11 Measured in terms of the nominal MCIs, monetary conditions eased in the euro area countries on average in the second half of the 99s (Chart 9). In the period the easing was mainly due to a marked fall in money market rates in euro area countries, but starting from the beginning of 999 the depreciation of the euro was also a contributory factor. From mid-999 onwards the picture of movements in monetary conditions differs slightly according to which MCI and thus which ratio is used. Both MCIs nevertheless indicate that monetary conditions were still easier than prior to the onset of Stage Three of EMU. In the case of Finland, the nominal MCIs show that in recent years monetary conditions have developed in parallel with the euro area on average. Again, it seems to make little difference which ratio is applied. Only in the past few months have movements in the two indices diverged to some extent: the index which gives more weight to movements in the exchange rate indicates that monetary conditions in Finland are still easier than they were in 998 while the index which gives more weight to changes in the interest rate indicates that there is scarcely any difference anymore. According to the real MCIs, the easing in monetary conditions in the euro area prior to transition to Stage Three was less pronounced than indicated by the nominal MCIs, reflecting a slowdown in inflation (Chart ). The real MCIs show that monetary conditions in both the euro area and Finland have eased further since the middle of 999, despite the rise in interest rates. the Government undertook to reduce taxes on labour income and social contributions by a total of FIM billion during its four-year term. If Parliament approves the budget in its present form, cuts totalling about FIM 8 billion will have been implemented by the end of. From the standpoint of reducing structural unemployment, the Government s proposed tax cuts are a step in the right direction because the heavy tax burden on labour income is a major factor holding back the growth of the economy and employment. Several international organizations, in addition to most Finnish economic research institutes, have repeatedly drawn attention to the need to increase incentives to work and job creation by lowering taxes. In its review of the Finnish economy published in the summer, the IMF proposed an overall reduction of FIM billion in income taxes and social security contributions over the period. It was further proposed that the tax cuts be complemented by moderate wage settlements and structural measures to increase labour supply. Calculations show that it would be possible to cut taxes and social security contributions on such a scale without jeopardizing the structural surplus in central government finances and the BULLETIN target set for bringing down the debt-to-gdp ratio. Without complementary measures, tax cuts would increase the risk of economic overheating. Central government expenditure in the budget proposal totals FIM 96.6 billion. In its programme the Government set the target of keeping spending unchanged in real terms at the budgeted level for 999. Last March the Government fixed the medium-term ceilings for the various spending categories. Taking into account these ceilings and the latest inflation forecast, projected central government expenditure in the budget proposal exceeds the overall spending ceiling by about FIM billion. As the economy has grown faster than expected, the original spending ceilings have become less stringent and the fiscal stance has also eased in this respect in relation to the target laid down in the Government s programme. Since taxes are to be lowered without any offsetting reduction in spending in a situation where the outlook is for continued strong growth, this means that the fiscal stance will ease still further and that the risk of economic overheating will increase. Besides more stringent fiscal policy and moderate wage agreements, ensuring conditions conducive to balanced economic growth calls for structural reforms 9
12 aimed at improving the functioning of the labour market and increasing the productive potential of the economy. Spending discipline is of vital importance since improvement in employment will require new tax cuts in the future. Moreover, developments in other OECD countries are creating pressures for further reductions in the taxation of labour income, in particular. With the general improvement in public finances, easing the tax burden has become a key priority in economic policy in nearly all euro area countries and the United States. In Germany, for example, the Bundesrat, the German upper house, recently approved a major taxcutting package that will reduce the tax burden of mainly individuals and small and medium-sized enterprises by an amount corresponding to.9% of GDP in the period. A weak euro and interest rates that are calibrated to economic developments in the euro area as a whole have resulted in monetary conditions that for a considerable time now have been lax with regard to the needs of the Finnish economy. When, in addition to this, the fiscal stance in Finland is set to ease in, wage settlements assume even more importance than before. Given the present cyclical outlook, it is not evident that wage settlements alone can bring about or restore conditions necessary for more balanced economic growth. Regardless of what form settlements take, there should be recognition of the fact that employment developments have not been satisfactory in all areas of the economy. There should be sufficient flexibility in agreements to allow relative wages to better respond to the labour situation in each sector. This would lead to higher employment and help to keep inflation in check. Higher-than-expected inflation as a result of the rise in the oil price and a smaller-than-expected rise in real wages during the current agreement period must not lead to compensatory wage increases when the new settlements are negotiated. The high oil price is putting a burden on the profitability of many firms and any compensatory wage increases would only strain it further. A rise in labour costs would lead to faster inflation and in the worst case precipitate a wage-price spiral that would be difficult to control, resulting in weaker-than-expected employment performance. The proposed tax cuts alone will bring about a fairly substantial increase in take-home pay, and this should be borne in mind when negotiating new settlements. There should also be recognition in the labour market of the need for structural labour market reforms aimed at bringing about a significant reduction in unemployment, which remains stubbornly high. Reforms aimed at enhancing the flexibility of the labour market and productive potential of the economy are also essential for maintenance of price stability, especially in the long term. 8 August Key words: inflation, monetary policy, economic situation BANK OF FINLAND
13 The electronic equipment industry and Finland s transformation into a high-tech economy by Pentti Forsman, Economist Economics Department Bank of Finland The last few years have seen the emergence in Finland of a very strong information and communications technology (ICT) cluster, built largely around the telecommunications giant Nokia. The ICT cluster currently embraces some, firms. Although the cluster is dominated by the electronic equipment industry, it also includes a number of key service providers, such as telecom operators. The electronic equipment industry, in particular, has brought about major structural changes in several sectors of the economy, one result of which has been diversification of exports. The rise in the economic significance of the cluster is the outcome of heavy investment in research and development. Expenditure on R&D in Finland as a percentage of GDP now ranks with that in the leading industrial countries (Chart ). The firms making up the cluster are classified as part of the new economy, and they have helped to generate a substantial increase in wealth through higher stock market values. This wealth, in turn, provides a pool of capital that can be used to finance other rising technology firms. The structural change that has occurred in the Finnish economy is most clearly evident on the Helsinki Stock Exchange, where market capitalization as a percentage of GDP is now one of the highest in the world (Chart ). The sharp rise in equity prices and partly related increase in housing prices has aroused suspicions that the technology boom poses a risk to the Finnish economy. It nonetheless appears that the danger of economic overheating has receded along with a rise in interest rates. Often, rapid growth gives rises to expectations that the good times can continue indefinitely, and in these circumstances the potential risks are easily forgotten. Ali-Yrkkö et al. (). Malkamäki and Virén (). Ericsson is almost as important for the Swedish economy as Nokia is for the Finnish economy. The growth of the Finnish electronic equipment industry has led to a marked increase in tax revenues and provided room for manoeuvre in the public sector. Expansion of the public sector during boom times may, however, have to be followed by renewed fiscal tightening during the next economic downturn. Factors behind the success of the electronic equipment industry The ground for the emergence of Finnish and Swedish companies in the 99s as world leaders in the manufacture of mobile telephones and supply of mobile telephone networks was laid in earlier times. Chart. R&D expenditure as a percentage of GDP (Gross domestic expenditure on research and development) % Finland European Total Sweden Germany United Japan Union OECD States Sources: OECD and Malkamäki and Virén (). BULLETIN
14 Market capitalization of listed shares as a percentage of GDP, June * % Switzerland Chart. * GDP figures are forecasts. ** NYSE and Nasdaq. Sources: FIBV, Eurostat and Bank of Finland. Index 99 = 6 8 Chart. Employment Finland USA** Netherlands Sweden United Kingdom Luxembourg Greece France Japan Spain Germany Belgium Ireland Italy Portugal Denmark Norway Austria Whole economy. Manufacturing (excl. electrical and optical equipment). Electrical and optical equipment Sources: Statistics Finland and OECD. The Nordic countries first discussed a common mobile telephone standard in the 96s, and these discussions subsequently led to the introduction of the first-generation analogue mobile telephone system NMT (Nordic Mobile Telephony). Technological development was also fostered by the fact that telephone markets in the Nordic countries were competitive to some degree. Although the provision of telephone services was in the hands of monopolies, the market for equipment was open to competition. This made for increased efficiency and responsiveness to the changing needs of consumers. Sales of mobile phones in the Nordic area were already quite considerable in the late 98s, and large domestic markets made it possible to invest heavily in product development. In the 98s Nokia was, for a time, the world s largest manufacturer of mobile phones. GSM (Groupe Speciale Mobile, also known as Global System for Mobile Communications), the second-generation technical standard for digital mobile telephone networks, was introduced in Europe at the end of the 98s. At this time Finland and Sweden were already well advanced in both the manufacture of digital mobile phones and supply of digital networks. They were therefore in a strong position when the growth of the mobile telephone sector took off in Europe. The world s first GSM call was made in Finland in 99 and since then the sector has expanded at phenomenal pace. A key factor contributing to the success of the Finnish ICT cluster is the strategic decision taken by Nokia, the dominant player in the sector, to focus on mobile telephone communications. The popularity of Nokia among foreign investors and the resultant rise in the company s stock market value have also supported Nokia s other lines of business. The severe economic recession experienced by Finland in the early 99s and the difficulties encountered by traditional industries may also have been conducive to the establishment of the new sector; both highly educated engineers and the labour needed for assembly were readily available at the time. Growth and profitability of the electronic equipment industry Initially, the recovery of the Finnish economy from the recession of the early 99s was very difficult. BANK OF FINLAND
15 Although a sharp fall in the markka boosted exports, growth of output was achieved mainly by raising productivity. In fact, the electronic equipment industry was the only sector where there was a significant increase in the number of employees in the period up to 998 (Chart ). In spite of this, productivity growth in the sector was huge, as production grew five-fold after 99 while the number of employees increased by only one and a half times (Chart ). With the emergence of labour shortages in the home market, the number of new jobs in the sector is currently growing at faster rate abroad than in Finland. A feature of the electronic equipment industry that sets it apart from other sectors is its excellent profitability, which also explains the high stock market values of firms in the sector. In 999 operating surplus accounted for between and 6% of value added in the electronic equipment industry (Chart ). Profitability in the sector was already very high in the 98s in comparison with other manufacturing sectors, despite relatively low levels of capital. 6 Admittedly, the profitability of other manufacturing sectors did rise in the period but only to the average level for the 98s. The exceptionally high profitability of the electronic equipment industry and the high stock market values of firms in the sector have had no impact on general wage inflation, which right up until very recently has remained moderate. The ease with which firms in the sector can shift production abroad if costs become too high may have increased wage moderation. A relatively small number of workers are actually employed in the manufacture of mobile phones and telephone exchanges in Finland and a considerable proportion of executive and other professional Of Nokia s total labour force of 6,, about, work in Finland. According to Ali-Yrkkö et al. (), a further, people work for Nokia in Finland in some subcontracting firms. A firm s value added is obtained by subtracting the value of raw materials and services purchased by the firm from the value of its sales. It consists of wages paid and profits earned by the firm. Broadly speaking, the value added of the whole economy is the sum of all firms value added. 6 The exceptional profitability performance of the sector is most clearly evident in Nokia s results for the first six months of, which show that annualized profit per employee (including those employed outside Finland) was high as EUR 96, compared with EUR 7, in 999. Volume of industrial production Volume 99 = 6 8 Chart Finland, total index (left-hand scale). EU-, total index (left-hand scale). Finland, manufacture of electrical and optical equipment (right-hand scale) Sources: Statistics Finland and OECD. Chart. Operating surplus as a percentage of value added Market production. Manufacturing (excl. electrical and optical equipment). Electrical and optical equipment Sources: Statistics Finland and Bank of Finland. BULLETIN
16 % 6 Chart 6. Nokia's share of GDP and exports GDP (left-hand scale). Exports (right-hand scale) Source: Ali-Yrkkö et al. (). staff participate in share option schemes of various kinds. Evidently, the shift in income distribution in the economy in favour of capital income has become a lasting phenomenon. The importance of Nokia and other ICT firms for the Finnish economy The rise of the ICT cluster has made a major contribution to the growth of the Finnish economy during the past decade. In 999 Nokia alone accounted for a full. percentage points of Finnish GDP growth of % (Ali-Yrkkö et al., ), just under % of GDP (Chart 6) and % of total exports. The electronic equipment sector as a whole accounted for nearly % of total Finnish exports, which is almost as large as the share of the forest industries. High-tech products make up an increasingly large part of Finnish exports. In 997 the ratio of hightech exports to high-tech imports in Finland was one of the highest in the EU area. 7 This trend has become even more pronounced with the recent rapid growth of exports by the electronic equipment industry. Similarly, there has been heavy investment in R&D. Malkamäki and Virén () estimate that in 998 R&D expenditure in Finland as a percentage of GDP rose to close to the level prevailing in the United States, Sweden and Germany. In particular, Nokia s share of total R&D expenditure has increased substantially. 8 It is quite clear that Finland owes its new found position at the forefront of technological development in the industrialized world to the rise of the electronic equipment industry. This, in turn, has boosted the demand for highly skilled workers and Finland can, with justification, now be said to be a knowledgebased economy. In principle, a highly educated labour force should make the economy less prone to cyclical fluctuations by making it easier for labour to adapt to changes in demand. In addition to human capital accumulation, the rapid development of the ICT cluster has created new stock market wealth in Finland. True, a substantial portion of this wealth is owned by foreigners. While the bulk of this newly generated wealth has gone to investors, key employees in ICT firms have also received a share. Finns own about % of Nokia (equivalent to almost EUR billion). If Nokia s share price fluctuates widely, foreign investors bear most of the risk. Foreign ownership carries other advantages apart from risk diversification. In international markets the entire electronic equipment industry is evaluated on the basis of the same criteria and the same information. Investors force firms to compete with each other not only for market share but also in terms of the effectiveness of R&D efforts in generating efficiency gains. Foreign ownership has therefore made firms more competitive and given them greater visibility in global markets. 7 Ali-Yrkkö et al. (). 8 Ali-Yrkkö et al. (). BANK OF FINLAND
17 Opportunities and challenges Wireless telecommunications is currently one of the fastest growing markets and seems set to expand further in the near future. The number of mobile phone subscribers worldwide is probably well over million and the one billion mark is expected to be passed in the next few years. This year alone sales of mobile phones are projected to exceed million units. In a number of large European markets such as France and Germany penetration rates for mobile phones are still low in comparison with the Nordic countries. Adding to the demand for mobile phones is the fact that in many developing countries, like China, mobile telephones are often a cheaper solution than a fixed telephone network. But perhaps the most important consideration from the point of view of profitability is the extension in the use of mobile phones beyond voice transmission to data and image transmission. Similarly, the practice whereby a subscriber has number of mobile phones for different purposes is becoming increasingly widespread in industrial countries. Over the last few years the financial position of the public sector in Finland has improved at a rapid pace, partly because of the growth of the ICT cluster. If, as the market expects, the earnings performance of ICT firms improves further in the years ahead, corporate and personal income tax revenues will continue to soar as a result of option-related share sales and capital gains. 9 This could make it difficult to curb the growth of public expenditure, which is a key requirement for the growth of the economy in the longer term. Market difficulties would probably not have an immediate impact on employment in the electronic equipment industry, however, because of the cushioning effect provided by good profitability. On the other hand, a weakening in the profit outlook would push down share prices, which could lead to lower consumption and tax receipts. 9 For example, Nokia paid corporate tax totalling EUR. billion on its pre-tax profit of EUR.8 billion in 999, with EUR.7 billion of this sum being paid in Finland. This year Nokia s pre-tax profit is expected to total more than EUR billion, so that corporate tax payable in Finland will be more than EUR billion, when calculated using the same relative share as in 999. BULLETIN There has been some concern in Finland that ICT firms or their head offices might relocate abroad. In Sweden it has been suggested that research activities and other highly skilled work might shift abroad along with the head office. Braunerhjelm and Lindqvist (999) nevertheless argue that there is little evidence to support this view and that relocation abroad is not even necessary given the excellence of today s communications. In their calculations Braunerhjelm and Lindqvist show that the relocation of the head office abroad or the sale of the firm to a foreign company as a subsidiary would not have a serious impact on either employment or government tax revenues in the home country. Corporate tax is paid on basis of the location of the place of business, not of the head office. In that case the firm concerned would pay corporate tax on the basis of profits earned in Finland, provided it did not want to, or could not, transfer profits abroad. Braunerhjelm and Linqvist do, however, draw attention to a number of other significant drawbacks associated with the relocation of the head office abroad, such as the drying up of demand by the head office for locally provided services requiring a very high level of skill. Also, the interest of foreign investors and other key stakeholders in the sector and in Finland in general could diminish. Summary Profitability in new industries is typically good in the beginning but falls with time as competitors develop substitute products. The product cycle may also come to an end because of lack of interest by consumers. The product cycle of the electronic equipment industry may eventually enter the stage of decline but it could take years or even decades before this happens. Product development in this sector is very rapid and good profitability can be maintained by constantly developing new products. Globalization offers further opportunities for Finland s electronic equipment industry. China s possible membership of the World Trade Organization is a good example of the potential in this regard. The success of the electronic equipment industry has affected the fortunes of other firms and sectors in the economy. The rapid expansion of the industry and the recruitment of resources that has accompanied it have, at least to some extent, displaced other
18 activities. On the other hand, the rise of the electronic equipment industry has helped to diversify Finland s industrial base by adding a third pillar alongside the traditional forest and engineering industries. At the macroeconomic level, the sector is likely to continue to be a major factor contributing to Finland s rapid economic growth and dampening the amplitude of cyclical fluctuations. References: Ali-Yrkkö, J, Paija, L, Reilly, C, and Ylä-Anttila, P (), Nokia a big company in a small country, B 6, ETLA, nd edition. Braunerhjelm, P and Lindqvist, T (999), Utvandrarna effekter och drivkrafter bakom huvudkontorslyften, Ekonomisk Debatt 8/999 (in Swedish). 8 August Key words: electronic equipment industry, information and ommunication technology cluster (ICT cluster), Nokia Malkamäki, M and Virén, M (), Technological innovation and economic performance in the Nordic countries, The Council on Foreign Relations project on Technological Innovation and Economic Performance. Country studies: The Nordic Countries (unpublished). 6 BANK OF FINLAND
19 Structural inflation differences in an enlarged euro area by Nils Björkstén, Senior Economist Economics Department Bank of Finland In the soon-to-be countries of the euro area, there are considerable differences in living standards. Measured in euro, the per capita GDP of Portugal and Greece are each less than half that of Germany or Austria. A further countries are in line for accession, several with per capita GDP levels that are less than half those of Portugal or Greece. In the coming years and decades, a catching-up process should lessen these differences. This is a welcome and healthy development, which will ultimately make for a stronger, richer, more vibrant and more stable EMU. Nonetheless, the catching-up process may also imply structural inflation differences for some time to come. The process should therefore be monitored closely by policymakers. Differences today The scope for catching up in living standards is illustrated in the accompanying chart. This chart includes all countries currently in the EU, as well as those that are formal candidates for accession. Per capita GDP is shown on the vertical axis, with the EU average normalized to. The horizontal axis shows cumulative population, and the countries are ordered from richest to poorest. As presented, the scope for catching up is large, and is set to increase further with EMU enlargement. For the current euro area plus Greece, the scope for catching up is also illustrated in the accompanying table, which shows relative per capita incomes in euro and relative price levels. This article is based on the author s paper Real convergence in the enlarged euro area: a coming challenge for monetary policy, Economics Department Working Papers, /, Bank of Finland. Catching up via faster growth and inflation Catching up occurs via two mechanisms: faster real growth and faster inflation. These two variables move together in a process first described by Balassa and Samuelson in 96. The intuition is that incomes are lower in poorer countries because manufacturing productivity is lower. Since prices of manufactured goods are set on world markets, lower productivity translates into lower wages. As productivity increases, the economy will grow in real terms and wages will increase. In contrast with the manufacturing sector, productivity in the non-traded (service) sector is similar in both rich and poor countries. Nevertheless, service sector prices are much lower in poorer countries, because prices are set in local markets instead of on world markets. As poor countries catch up with Table. Relative rankings of income and price levels in the euro area and Greece GDP per capita Price level Luxembourg 8 8 Austria 8.9 Germany 6. 8 Finland.7 9 Belgium. 98 France 9. 8 Netherlands Ireland Italy Spain Greece n.a. 8 Portugal 6 Data from 999, not PPP-corrected; Euro=. Data source: Eurostat. Data from 997; EU=. Data source: European Commission. BULLETIN 7
20 Chart. Relative per capita GDP distribution of European countries Per capita GDP 8 Luxembourg 6 Denmark 8 6 Sweden Austria Germany Netherlands France Belgium Finland United Kingdom Ireland Italy Spain Cyprus Greece Portugal Slovenia Malta EU average = Average of all countries Czech Poland Slovakia Hungary Estonia Turkey Lithuania Romania Latvia Bulgaria 6 Cumulative population, millions rich countries in manufacturing productivity and wages, however, changes in the local markets will result in wages rising in the service sector as well. Prices will also rise because these wage increases are not matched by increases in service sector productivity. Hence, catching up occurs via both real growth and measured inflation, and as poorer EU countries catch up with richer ones, they can be expected to experience higher inflation. In theory, adroit monetary policy in the catchingup countries should allow them to maintain external balance, stable traded-goods prices and stable exchange rates despite higher consumer price inflation and higher across-the-board wage increases. This would imply that monetary policy accommodates the increase in non-traded goods prices, but no more. Real interest rates would be lower than in more advanced countries, and current accounts would show deficits without, however, putting pressure on the exchange rate. A lower rate of growth of money supply would require that the nominal exchange rate appreciates and domestic currency prices of traded goods decline. In practice, however, catching-up processes have often followed a particular macroeconomic path of development. First, rapid growth is accompanied by higher inflation, which causes the currency to appreciate in real terms. This real appreciation causes an external imbalance, as exports become less competitive and imports rise, especially consumer imports. External balance is then restored by adjusting the exchange rate downwards. Lately, this process has become less stable because of the emergence of large cross-border capital flows. Such flows may magnify and accelerate the real appreciation, an external imbalance and a subsequent exchange rate adjustment. Consequently, with greater capital mobility, the dangers associated with fixed exchange rate regimes are now more pronounced than in the past, with currency adjustments sometimes having very disruptive consequences. Now consider how catching-up might take place under EMU, with a common currency, a common 8 BANK OF FINLAND