- We have revised downward our assessment of Finland’s economic growth prospects, as we believe that continuing subdued external demand adds to structural economic and demographic challenges.
- The weaker economic backdrop will further complicate efforts to consolidate public finances and reduce public debt, in our view.
- We are therefore lowering our long-term sovereign credit ratings on the Republic of Finland to ‘AA+’ from ‘AAA’.
- The outlook on the long-term ratings is stable.
On Oct. 10, 2014, Standard & Poor’s Ratings Services lowered its long-term foreign and local currency sovereign credit ratings on the Republic of Finland to ‘AA+’ from ‘AAA’. At the same time, we affirmed the ‘A-1+’ short-term sovereign credit ratings. The outlook on the long-term ratings is stable.
The downgrade reflects our view of the risk that the Finnish economy could experience protracted stagnation because of its aging population and shrinking workforce, weakening external demand, loss of global market share in the key information technology sector, structural retrenchment of the important forestry sector, and relatively rigid labor market.
Over the past decade, Finland’s economy has lagged most peers, with GDP per capita shrinking by an estimated 0.26% (based on an average of actual and projected per capita GDP growth for 2008-2017). This is well below the level we consider to be the norm for economies at a similar level of economic development. We expect 2014 to be the third consecutive year of negative real GDP growth. The estimated 2014 real output remains 6% below the 2008 level. Moreover, Finnish exports have underperformed world trade since 2008, which we interpret as a sign of lower competitiveness, rendering an export-driven recovery unlikely. Despite weak economic performance, and low underlying inflation, between end-2007 and 2013, Finnish labor costs increased by over one-fifth compared with about one-eighth for the eurozone as a whole (based on Eurostat data).
Downside risks to the weak economic growth outlook exist if global demand softens further. We also consider that Finland remains vulnerable to Russia’s economic weakness and, more significantly, to any slowdown of economic activity in the eurozone. Exports to Russia account for one-tenth of total Finnish exports or about 4% of GDP. We estimate that a slowdown in exports to Russia could impede Finnish growth, causing a one-off reduction in GDP growth of 0.8%.
At the same time, we expect that the measures introduced by the government will moderately increase labor market participation, which in turn should support moderate growth in domestic demand from 2015. Even so, we consider that per capita GDP growth is unlikely to systematically exceed 1% over the medium term. This is partly a reflection of an adverse demographic profile. Finland’s labor force has been shrinking since 2011 and its effective retirement age (at 61.8 years according to OECD data) is one of the lowest in Europe.
In our opinion, it remains uncertain whether other sectors can consistently compensate for the output loss in Finland’s wood and paper industry and its electronics industry. In this respect, the collective wage agreement to cap salary increases, which was agreed in the third quarter of 2013, may help Finland recover the cost competitiveness it lost as labor costs rose over the past seven years.
Protracted low growth also makes it more difficult to implement new policies, in our view. The government is likely to find it harder to maintain broad support for reforms aimed at addressing structural imbalances and attaining its fiscal targets over the medium term.
Finland’s innovative and wealthy economy continues to support our sovereign ratings. We estimate Finland’s per capita income at around $49,800 in 2014. Furthermore, net general government debt is low at an estimated 22% of GDP in 2014, supported by large amounts of liquid assets. The ratings also reflect Finland’s high degree of institutional and governance effectiveness. We also consider that the political commitment and societal consensus in favor of prudent policies is stronger than in most other advanced economies.
These strengths are somewhat constrained by Finland’s external performance, which has recently been weaker than expected. In our view, depressed global demand and decreased competitiveness have caused Finland’s current account
position to shift into deficit since 2011. We forecast that the current account will have a deficit of 1.6% of GDP in 2014, before it returns to balance by 2016. We acknowledge that the outlook for the current account remains uncertain, not least in light of the volatility of the income account over the past few years.
Despite this, Finland remained a net external creditor as of end-2013, when we estimate that it had a net external position of about 9% of GDP. We expect it to preserve its position throughout the two-year forecast horizon. Although Finland’s net international investment data indicates rising external debt, at over 200% of current account receipts (CARs) this year, in our view, most of this debt is not related to the domestic economy. The two large Scandinavian parent bank groups finance most of their eurozone operations, including their derivatives books, through their Finnish subsidiaries.
While we consider that membership of the eurozone provides Finland with a strong monetary anchor, giving the economy access to funding at low nominal interest rates, we also believe that membership in a fixed exchange rate area increases the onus on member governments to both ensure fluid labor, product, and services markets, and to build up fiscal buffers against future shocks. This is more the case now than before given that the European Central Bank is undershooting its medium-term price stability target of close to, but below, 2% for the euro area as a whole. Harmonized Indices of Consumer Prices (HICP) inflation in Finland in August was 1.2% year-on-year, while the core consumer price index (CPI) was 0.8% year-on-year.
We anticipate that Finland’s economy will be one of the hardest hit by rising age-related spending over the medium-to-long term (see “Global Aging 2013: Rising To The Challenge,” published on March 20, 2013). In addition, persistent fiscal deficits in the municipal sector continue to weigh on the general government balance. We forecast a further widening of the general government deficit to 2.7% of GDP in 2014 as a result of the continuing recession, exacerbated by the slow implementation of reforms to counter negative fiscal pressures. Accordingly, we expect Finland’s gross general government debt to exceed 60% of GDP in 2015 (and 64% by 2017), from a low level of 33% in 2008.
The government has worked consistently to implement the reforms it originally set out in its 2013 strategic plan, but has made slow progress, in our view. The spending limit package it announced in March 2014 builds on the consolidation measures it announced in the third quarter of 2013. On March 26, 2014, the government announced a frontloaded package of structural consolidation totaling €6.8 billion (over 3% of 2014 GDP) over 2015-2018, of which we estimate that €2.3 billion (1% of 2014 GDP) will have an immediate
effect on finances over the current parliamentary term. The government has complemented its consolidation measures with measures to support growth. These measures include selling €1.9 billion in assets (less than 1% of 2014 GDP), of which the government will use €1.3 billion (or over 68% of the total) to reduce its borrowing requirement. The rest will be invested in growth-enhancing projects.
The draft budget for 2015 supports previous fiscal consolidation efforts and also introduces tax changes to promote social justice, increase excise duties, lower transfers to municipalities, and reduce child benefits.
Certain key reforms, such as the pension and the social and health care services reforms, are expected to be implemented by 2017. We anticipate that these will improve the long-term sustainability of public finances. Given that parliamentary elections are scheduled for early April 2015, we see the success of the structural package as hinging on the next government continuing to pursue reform. We expect that further structural reform initiatives will remain on hold during the run-up to the elections. More fundamentally, we believe that Finnish policymakers will remain strongly committed to pursuing fiscal and structural reforms, and that policymaking will remain prudent, transparent, and consensus-based.
Despite the deterioration in public finances, Finland’s government balance sheet is strong, in our view, primarily because of its holdings of publicly mandated defined-benefit pension assets for public-sector workers, and we have factored this strength into our analysis. We anticipate that general government debt, net of pension and liquid assets, will reach 25% of GDP in 2017, up from 2% in 2007. Our measure of general government debt excludes the guarantees related to the European Financial Stability Facility (see “S&P
Clarifies Its Approach To Accounting For EFSF Liabilities When Rating The Sovereign Guarantors,” published on Nov. 2, 2011, on RatingsDirect).
The banking system appears well-capitalized and is dominated by pan-Nordic banks (see “Banking Industry Country Risk Assessment: Finland,” published Jan. 3, 2014). In our assessment, the system poses only limited contingent liability to the Finnish government.
The stable outlook reflects our view that the sovereign benefits from generally strong policy settings, a wealthy and relatively resilient economy, and a net external creditor position. We consider that fiscal consolidation and structural reforms have sufficient momentum to contain further deterioration in public finances, enabling general government debt levels to stabilize in the medium term.
We could lower the rating if political support for the current reform agenda waned, increasing the likelihood that public debt levels could increase by significantly more than we expect. We could also lower the rating if monetary policy actions at the eurozone level fail to prevent the risk of outright deflationary pressures eroding Finland’s fiscal and growth performance. We could raise the rating if we see more dynamic and sustainable growth rates supported by effective mitigation of Finland’s structural economic challenges, coupled with an improved external position.
The stable outlook indicates that we currently do not expect either of these scenarios to occur during the next two years and that the rating is likely to remain unchanged during this period.