Economic Survey. 29c/2012. Autumn Economic outlook and economic policy

Transcription

1 Economic Survey Autumn c/2012 Economic outlook and economic policy

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3 Economic Survey Autumn 2012 Ministry of Finance publications 29c/2012 Economic outlook and economic policy

4 Print product MINISTRY OF FINANCE PO Box 28 (Snellmaninkatu 1 A) FI GOVERNMENT FINLAND Tel Internet: Layout: Anitta Türkkan Juvenes Print Tampereen Yliopistopaino Oy, 2012

5 Description page Publisher and date Ministry of Finance, September 2012 Author(s) Economics Department Title of publication Economic Survey, Autumn 2012 Parts of publication/ other versions released The publication s language versions: Finnish: Taloudellinen katsaus, kevät 2012 (29a/2012) Swedish: Ekonomisk översikt, hösten 2012 (29b/2012) Publication series and number Ministry of Finance publications 29c/2012 Distribution and sale The publication can be accessed in pdf-format at There are also instructions for ordering a printed version of the publication. Printed by Juvenes Print, Tampereen Yliopistopaino Oy 2012 ISBN (print.) ISSN (print.) ISBN (PDF) ISSN (PDF) No. of pages 108 Language English Abstract The Ministry of Finance s forecast assumes that there will be no drastic changes in the current structure of the euro area. However, as recent events have shown, the situation has become more serious over time and the possibility of an escalating crisis within the currency zone cannot be ruled out. Indeed the forecast also includes the assumption that the problems in the euro area will persist throughout the outlook period. At the same time economic growth in Finland is probably on a prolonged sluggish path as the working-age population has begun to shrink and the investment rate seems to have dropped permanently, too. Uncertainty about where the economy is heading has remained high since the latter half of This is channelled into the Finnish economy via various routes. The growth of uncertainty is particularly reflected in private investment. Sluggish demand especially in the euro area will lead to a slight downturn in exports. The GDP growth projection for the current year is 1%, and this growth will depend entirely on domestic demand. The situation in the labour market is surprisingly strong in view of the broader economic environment: the unemployment rate is edging down and the predicted annual average is 7.6%. The GDP growth projection for 2013 is unchanged at 1%, but this growth will have a more diversified structure. Private consumption will remain the most important driver of growth, but it is predicted that exports will return to a slow growth track. Historically modest output levels will not be enough to maintain employment growth, and unemployment will start rising. In 2014 economic activity is expected to grow by 2%. The Government s budget proposal for 2013 shows a deficit of EUR 7.0 billion. Even fiscal adjustment will reduce the central government deficit in 2013 and throughout the outlook period, the Government Programme target will be exceeded. However it is expected that the growth of the central government debt-to-gdp ratio will level out. Population ageing and the related increase in demand for social and health care services and the cutbacks in central government transfers to local government are weighing down on local government finances, and the local government budgetary position looks set to remain firmly in deficit as well. The increase in earnings-related pension contributions and the prefunding of revenue from these contributions will maintain the surplus in social security funds The predicted rate of economic growth and the adjustment measures adopted by the Government will not be enough to close the sustainability gap in public finances. The general government surplus should stand at around 4% of GDP in 2016 for government to be in the position to fulfil its obligations in the long term. It is not appropriate to try to close the sustainability gap solely by immediate measures designed to increase taxes and cut expenditures. In order to improve the prospects for economic growth and secure the funding of the welfare state, immediate fiscal adjustment must be backed up reforms to economic structures.

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7 Preface The autumn 2012 Economic Survey is an offprint of the annex to the Government s 2012 budget proposal. Compiled by the Ministry of Finance Economics Department, the survey offer projections of the economic outlook in In addition to short-term prospects, the Economic Survey includes medium-term projections extending to The forecasts in the Survey are based on provisional national accounts data for 2011 published in July 2012 by Statistics Finland and on other public statistical sources available before 9 August The Economic Survey has been published since Helsinki September 2012 Ministry of Finance Economics Department Jukka Pekkarinen

8 The source for all data on materialised developments is Statistics Finland unless otherwise indicated. Symbols and conventions used - nil 0 less than half the final digit shown.. not available. not pertinent * provisional ** forecast CPB CPB Netherlands Bureau for Economic Policy Analysis HWWI Hamburgisches WeltWirtschafts Institut IMF International Monetary Fund MoF Ministry of Finance Each of the figures presented in the tables has been rounded separately, and therefore the items may not always add to the totals.

9 Contens Summary Economic outlook Global economy Foreign trade Domestic demand Private consumption Public consumption Private investment Public investment Domestic production Total output Secondary production Services Labour force Incomes, costs and prices Economic policy and public finance General government finances Estimates of fiscal policy impact General government debt Central government Central government expenditure Central government revenue On-budget accounts and national accounts Local government Social security funds Earnings-related pension funds Other social security funds Long-term sustainability of public finances...86

10 Appendix 1 Recent policy measures March-September Appendix 2 Supplementary statistics...95 Box: Productivity growth leads to increased welfare...54 The Government s adjustment measures and adjustment at general government level...63 State Budget and central government spending limits...70

11 11 Summary Economic outlook The Finnish economy posted growth of 2.7% last year, mainly on the strength of private domestic demand. Private consumption was up 2.5% and private investment 7.7% from the year before. Imports grew more than exports, and the trade balance consequently turned strongly negative. The unemployment rate fell to 7.8% and central government finances remained firmly in deficit. The Ministry of Finance outlook for the current year and the next two years assumes that there will be no dramatic changes in the structure of the euro area. However, as recent events have shown, the situation has become more serious over time and the possibility of an escalating crisis within the currency zone cannot be discounted. Even though this outlook is not based on such a scenario, it is also unlikely that the crisis will ease any time soon. Indeed the forecast includes the assumption that the problems in the euro area will persist throughout the outlook period. The continued uncertainty will dampen economic growth, and at the same time the subdued economic environment will exacerbate the lack of confidence. Uncertainty about where the economy is heading has been high since the latter half of This is channelled into the Finnish economy via various routes. The growth of uncertainty is particularly reflected in private investment, which is predicted to fall by more than one per cent from the year before. Sluggish demand especially in the euro area will lead to a slight downturn in both exports and imports. The growth projection for the current year is 1%, and this growth will depend entirely on domestic demand. The situation in the labour market will remain surprisingly strong given the broader economic environment. In 2012 it is forecast that the unemployment rate will continue to edge down, with the average annual figure expected to come in at 7.6%. Consumer prices will increase at a rate of around 2.5%, but with earnings rising about one per cent faster, real earnings will again show improvement. Central government debt will continue to increase, and the debt-to- GDP ratio is expected to climb to 45.2%. The growth projection for 2013 is unchanged at 1%, but this growth will have a more diversified structure. Private consumption will remain the most important driver of growth, but it is predicted that exports will rebound and show growth of 2.5%. Imports, too, will accelerate in the wake of exports, but not as strongly. Private investment will continue to fall slightly. In contrast to the current year industry output will start rising, reflecting the improved export outlook. The persistence of sluggish growth will also begin to be felt in the labour market. Historically modest output levels will not be enough to maintain employment

12 12 growth, and unemployment will start rising. Next year s unemployment rate is expected to come in at 8.1%. Real earnings will rise very slowly, and the central government financial balance will remain negative at 2.8% of GDP, driving up central government debt to 47.1% of GDP. In 2014 economic activity will recover and all demand items are expected to drive economic growth. The growth projection for 2014 is 2%. It is noteworthy that economic growth in Finland is probably on a permanent decline slope as the working-age population has begun to shrink and the investment rate seems to have dropped permanently, too. The current outlook is based on certain background assumptions concerning the development of financial and currency markets, for instance. The euro to dollar exchange rate is pegged at 1.22 through to the end of the outlook period. Crude oil prices are expected to rise moderately, with the barrel price in 2014 projected to stand at USD 120. This moderate movement in prices is explained in part by the easing of political uncertainty in oil production areas. Both in the euro area and in the United States, monetary policy will remain exceptionally easy through the outlook period, and this in turn will be reflected in market interest rates. In Finland both short and long-term interest rates have been falling sharply over the past few months, reflecting the relative strength of the Finnish economy in the common currency area. However if Finnish economic policy lacks credibility in the next few years, interest rates might start fluctuating significantly. The forecast assumes that the 3-month Euribor rate will be no more than just over 1% in 2014, and even the rate on 10-year bonds will rise to no more than 2.2%. Both interests and financial markets have become sharply polarized in the euro area. In the crisis countries, interest rates are several percentage points higher than in the countries with the best credit ratings. In Spain, Ireland, Italy and Portugal, interest rates on 2-year bonds are some 3 6% and interests on 10-year bonds some 4 9% higher than in Germany and Finland. Furthermore the growth of uncertainty has restricted the availability of crossborder financing in the euro area. As a member of the euro area, Finland is faced with major challenges in the near future. The situation in the euro area is problematic and there is no quick fix in sight. Economic growth will remain sluggish in large parts of Europe, and there is even a real risk of recession in the next few years. Finnish export industries, therefore, cannot expect to gain any significant traction from Europe. In other advanced economies and particularly in the US, it is expected that economic growth will be at historically low levels. In Asia, trade among emerging economies is constantly increasing and therefore with intensifying competition it will be ever harder to break into new markets there. Finland s market share in China, for instance, has recently been falling. The nature of the major challenges facing the Finnish economy is such that there is very little the Government can do by way of effective intervention. Because of the openness of our economy, shocks emanating from the financial markets and the international economy will be felt very quickly. Even though Finland is currently one of the strongest economies in the euro area, its openness and the cyclical sensitivity of its exports mean it is also one of the most vulnerable. Changes in Finland s total output are quite sharp in comparison to other advanced industrial countries, and in most cases the reasons can be traced to factors related to foreign trade.

13 13 There is also a real risk of a greater than predicted increase in unemployment. For some time now economic growth has largely depended on domestic demand. On the obverse of this consumption-driven economic growth is that household debt is climbing to a new record high. Confidence in the future is a key determinant of household consumption propensity. When unemployment starts to rise strongly, households tend to become more cautious, which may lead to a negative cycle. In a deteriorating employment situation people are out of work for longer periods at a time, and over time part of unemployment becomes structural. Indeed much of today s unemployment is of a structural nature. The state of public finances depends largely on the development of economic activity in general. It is clear from events in the euro area that in order to retain the confidence of international investors in the country s future growth potential, special focus must be given to the general government budgetary position. Finland has relatively limited capital assets and is therefore dependent on external funding. In the current debt situation it is paramount to maintain the confidence of the markets. What Finland needs to do, then, is to pursue a stable and consistent economic policy that is aimed at closing the sustainability gap in public finances and at channelling resources as efficiently as possible into productive uses. The risks to the global economy continue to remain tilted to the downside. These risks are predominantly related to growing public sector indebtedness, the fragility of banking systems and financial imbalances, but also to sluggish private demand and continued high unemployment rates. Crises in oil producing countries may also drive up energy prices. Risk premiums in the banking system are high throughout the euro area, and it is unclear at what level they will settle over the outlook period. High levels of risk premiums have the effect of deterring global trade and investment in particular. Especially in the euro area, the way that the banking and stability problems are addressed will be reflected in activities in the real economy. High interest rates adversely affect the position of banks in crisis countries and lead to a vicious circle: higher costs of finance and difficulties gaining access to the interbank markets leads to a lowered rate of lending. This further dampens economic activity and undermines the balance of general government finances in these countries, which in turn erodes confidence in the stability of the banking system. Gross domestic product change in volume, % ** 14** Sources: Statistics Finland, MoF

14 14 World economic growth driven by emerging economies World economic growth slowed in late 2011 and the period of slow growth is set to continue at least through the first half of World purchasing power parity adjusted GDP will increase by just over 3% this year, but recover to around 4% in The slowdown of growth is attributed to the withdrawal of government support and stimulus measures, the need to consolidate public finances, and the fragility of private demand. In many industrial countries the need for financial consolidation concerns not just public finances, but also private households and financial institutions, and therefore demand will contract and growth will slow in 2012 and The main focus of growth will remain in emerging economies, but even in this group many countries will see slowing growth. US recovery following the financial crisis has been slower than ever since the 1930s depression, and over the forecast horizon growth will remain below 3%. Growth has stalled in the euro area and the EU, and 2012 will see a mild recession. Growth is hampered by the tighter supply of credit as a result of the banking and debt crisis and continued high levels of uncertainty, the substantial needs for public finances consolidation, sluggish export demand from industrial countries and weak employment trends. Growth in China is hampered by sluggish demand from industrial countries. Nonetheless the Chinese economy will continue to grow at around 8% throughout the outlook period, provided that the country s stimulus policy is successful. The Russian economy has posted strong growth of almost 5% on the back of continued high oil prices. However even strong oil prices will not be enough to sustain this rate of growth because of a shortage of capacity and low investment levels. Finland s export outlook subdued As the debt crisis continues to linger across Europe and feed uncertainty over the future, demand for Finnish exports will weaken in 2012, particularly in the euro area. Outside of Europe, too, export demand will be weaker than previously anticipated. Exports will fall back slightly during the current year and only begin to recover in 2013 with the easing of uncertainty, which will boost global trade and push the euro area back onto a growth track. Exports will increase by 2.5% in During 2014 export demand will rise further as investment gathers pace around the world, and export growth will accelerate to almost 5%. However the rate of growth in Finnish exports will fall short of the global trade growth rate throughout the outlook period. The restructuring of Finnish exports will continue over the outlook period. In the short term the outlook for goods exports is strongest in the chemical industry, whereas the forest and electronics industries will continue the global reorganization of their production to reflect regional changes in demand patterns and costs. Service trade is continuing to gain increasing importance to Finnish exports: in recent years services have accounted for almost 30% of overall exports. In the case of imports, too, services now account for almost 30% of total annual imports. With both exports and investment falling in 2012, imports are set to decline as well. In 2013, driven by higher exports, imports will rebound to growth of 2.2%. In 2014 imports growth will accelerate to over 4% as not only export growth but also domestic investment gathers steam.

15 15 The trade balance moved into deficit last year, and it is projected that the deficit will widen further in The deficit in the balance of goods and services will increase to some EUR 3 billion this year, because exports will decrease slightly more than imports and furthermore the terms of trade will deteriorate. Import prices will rise more quickly than export prices, primarily because of rising oil prices. Over the following years the balance of goods and services will begin to improve with the rebound of exports, and in 2014 the balance will be some EUR 2.3 billion in deficit. The current account deficit will increase from EUR 2.2 billion last year to around EUR 3 billion this year. Economic woes filtering into the domestic market It is projected that over the outlook period, economic growth will be slowest in With manufacturing and construction both declining, value added growth will slow to less than one per cent. Service production is set to grow, mainly by virtue of the growth of consumer services. In 2013 it is predicted that total output will increase by around 1% and in 2014 by 2%. In the early part of the outlook period growth will depend largely on domestic consumption. Growth is supported by a negative real interest rate and easy access to finance. On the flip side of consumption-driven economic growth is that by the end of the outlook period, household debt will have reached a new record high; already Finnish households carry more debt than German households, for instance. It is expected that export industries will only get back onto a slow growth track during the course of next year as external demand gradually picks up and as a more favourable exchange rate bolsters the price competitiveness of some export companies. Industry fell into a technical recession last year, even though the level of value added was around one per cent higher than the year before. In other words all of the growth seen was attributable to a carry-over effect. The performance of industry continued to decline early in the year. In all main sectors of the economy except for the forest industry, output was at a lower level than at year-end The electronics industry s performance was particularly poor: in early 2012 output was down by almost one-fifth from the figures one year ago. In addition the restructuring that is ongoing in the forest industry and the electronics industry is depressing demand both for goods produced in Finland and for production capacity in Finland. The cyclical outlook is bleak. The value of new orders taken by industry has dropped 10% in the first half of the year, order books are lower than normal and only secure production for less than three months. Given the poor start to the year, declining demand and the continuing restructuring in the forest industry and electronics industry, industrial output will fall by 2½% this year. International demand is expected to pick up next year, and new industry orders will return to growth. The outlook in the construction industry has deteriorated sharply. The number of planning permissions issued in the first part of the year has decreased by one-fifth from last year. Annual output figures will show a decline of 1½%. The increase in renovation will dampen the effects of the downturn in new building construction on output and employment in the construction industry. It does not look like the turnaround will happen very quickly. It

16 16 is expected that demand will recover quite slowly in both consumer and commercial construction, and therefore figures for planning permissions will not just suddenly shoot up. Furthermore the uncertainty surrounding the investment environment will probably lead to decisions to postpone investments. Construction output will probably continue to fall in 2013, although only marginally, by less than ½%. Demand will strengthen in 2014, and construction output will recover to its average growth rate of 3½%. The outlook has deteriorated in the service sector, too. Service industries produce a wide range of intermediate products for businesses, and their deteriorating prospects are reflected in the demand for services with very little delay. With demand for services continuing to weaken, service growth will slow to 1½% this year. In contrast to secondary production, it is thought that service production will avoid recession. Service production growth will continue at a rate of around 1½% next year. The prospects for growth are best for business services. The recovery of consumer services will lead to a more broadly-based growth of service production, which will edge up to almost 2% in At that point service production will be 3% higher than in the previous peak year of Investment not to increase until 2014 In 2012 it is estimated that private investment will contract by around one per cent as a result of reduced investment in building construction. According to the current outlook private investment will continue to fall slightly in Despite the lightness of the current monetary policy stance and the abundance of money available, investment plans may be thwarted by difficulties with access to funding. Companies in the civil engineering sector, for instance, have indicated a rise in such problems. However investment plans vary widely across industry branches. Among the major manufacturing branches, the chemical industry, the machinery industry, the metal products industry and the food industry are planning relatively major investments, whereas the forest industry and the technology industry as a whole will be cutting back on investment. The energy sector, too, is planning to continue with its intensive investment programme. In 2013 the rate of investment in machinery, equipment and transport equipment will accelerate as the international economy rebounds. Cyclical conditions in construction have deteriorated steadily since autumn As expected the number of new housing starts and the volume of building construction have started to fall. The outlook assumes that the number of new housing starts in 2012 will reach 27,500, falling slightly next year. However the risks of a downturn have increased because households confidence not only in the national economy but also in their own finances has been waning. In 2013 rail projects and development of the natural gas network will push up civil engineering investment. Civil engineering maintenance is expected to continue to contract over the next few years. In 2014 investment will be boosted by accelerating world trade and global economic growth. The projections are relatively cautious, however, and are close to the average growth rate for the 2000s. Over the outlook period the investment to GDP ratio will remain slightly below last year s figure of 19.6%.

17 17 Economic growth to depend on private consumption In 2012 economic growth will depend almost entirely on private consumption. The development of household disposable real income will continue to remain relatively modest. However in the early part of the year private consumption growth was exceptionally strong. Part of the reason for this was the entry into force of new car tax rules in April, which meant that car sales were much brisker than usual during the first quarter of the year. Indeed, private consumption growth will be much weaker in the latter part of the year than in early 2012, and it is projected to slow to 1.7% this year. This growth is based on the assumption of a continued decline in the household savings rate. The slowdown of new car sales will reduce consumer durables demand by around one per cent. The strongest growth will be recorded for the demand for services, which account for around onehalf of total consumption. In the current environment, household expectations have assumed greater importance than usual with respect to private consumption growth and economic activity. Consumer Barometer data suggest that confidence in the national economy declined at an exceptional rate during the early summer. Consumer expectations of personal finances also deteriorated appreciably. Furthermore, the survey results indicate that consumers are again increasingly concerned about the threat of unemployment. In 2013 private consumption will increase by no more 1.1%, in 2014 the gradual recovery of the economy will push the growth rate to 1.6%. Household debt has grown without interruption since the late 1990s. Even the financial crisis did not reverse this trend, although it did to some extent slow the rate of debt accumulation. The household debt to disposable income ratio at year-end 2011 was 115.6%, which is the average European level. The rapid growth of household debt has been based above all on the growing demand for housing loans, which currently account for 75% of total household debt. Over the past 10 years housing loans have increased on average by over 11% a year, much faster than the level of consumer credit. Employment has developed favourably in view of the economic situation Employment has held up surprisingly well in view of the subdued economic situation, and there is no strong evidence in the statistics published to date that the number of persons employed would already have started to decline. So far the reduced demand for labour input has mainly been reflected in the number of hours worked, which started falling in the second quarter of Indeed it is estimated that overall, the number of hours worked will decrease by half a percentage point this year. Because of the strong trends in early 2012, the number of employed persons (aged 15 74) will by contrast remain at a slightly higher level than last year, even though the employment situation will deteriorate towards the end of the year. In 2013 the number of employed persons will start slowly to grow, but even so remain 0.4% lower than this year. Once output growth gets underway, it is projected that businesses will increase their labour input, initially by increasing the hours of their existing workforces. Indeed in 2013 the number of hours worked will increase by half a percentage point over the current year. In 2014 the number of hours worked will be up by 0.3%. In 2014 the number of employed persons will rise by no more than 0.2%. This is because it is

18 18 thought that the recent structural changes will exacerbate the mismatch problem between labour demand and supply. Data from the Labour Force Survey indicate that unemployment has continued to fall slightly, and the unemployment rate is expected to fall to 7.6% on the back of strong figures in early However it is predicted that unemployment will rise throughout the rest of the year, and by year-end stand at close to 8%. In 2013 the unemployment rate will climb to 8.1%, edging back to 7.9% in Structural problems in the labour market will also slow the decline in the unemployment rate once growth resumes. Inflation rate to remain relatively high The rate of inflation in 2012 is predicted to come in at 2.6%, slowing to an estimated 2.4% next year. The increase in the VAT rate in January 2013 will accelerate average annual inflation by an estimated 0.6 percentage points. The difficult international economic environment has also been reflected in the Finnish economy via prices. Economic uncertainty in the euro area, the modest economic outlook and ECB measures have contributed to lower market interest rates, and consequently interest rates on housing and consumer loans have come down. Although interests account for no more than some 2% of the CPI commodity basket, the relative impact of interest rate changes is considerable when interest rates are low. Despite the presence of numerous factors that are curbing inflation, there are also upward pressures on consumer prices. This is because world market prices of food raw materials, for instance, have been rising sharply in contrast to earlier expectations. It takes some time for rising raw material prices to feed through to consumer prices because there are often several producer tiers in the foodstuffs chain, and each of these tiers involves other costs as well. Furthermore consumer prices are also affected by margins in trade as well as taxes, for instance. In 2013 inflation will be primarily driven by marked increases in food prices. Upward pressures will come from a combination of international factors and domestic developments, including inadequate production levels to meet domestic and foreign demand and an increased VAT rate. The higher VAT rate has a greater than average effect on food prices because the one percentage point increase to the reduced 13% VAT rate is in relative terms greater than the increase to the general VAT rate. In 2013 the EU harmonized consumer price index will continue to rise more sharply in Finland than in the euro area on average, among other reasons because of the VAT rate hike. It is exceptionally difficult at the current time to predict the movement of food prices; indeed this is the single biggest risk to the outlook. Real earnings set to rise moderately The framework agreement negotiated last November by the social partners in the labour market sets the path for nominal earnings for the next few years ahead. The wage increases provided for in the agreement will push up the index of wage and salary earnings by around 3% this year, while last year the contribution of contractual wage increases was around 2%. When the impact of factors other than the negotiated wage increases are

19 19 taken into account, nominal wage and salary earnings will rise by 3.5% this year. In 2013 it is predicted that the rise in wage and salary earnings index will slow since the second increase under the framework agreement is smaller than the first one, and the effect of other factors driving up earnings is expected to remain similar to the current year. Real earnings will rise by 0.9% this year and by 0.2% next year. The growth of unit labour costs will accelerate to 3% this year as wages and remunerations increase more or less in line with the nominal earnings path agreed under the framework agreement, but production growth is sluggish. However with the slowdown of wage bill growth and with economic growth rebounding, the rise in labour costs per unit of output will slow to just over one per cent in the next few years ahead. Key forecast figures 2011 EUR bn ** 2013** 2014** change in volume, % GDP at market prices Imports Total supply Exports Consumption private public Investment private public Total demand domestic demand ** 2013** 2014** Services, change in volume, % Industry, change in volume, % Labour productivity, change, % Employed labour force, change, % Employment rate, % Unemployment rate, % Consumer price index, change, % Index of wage and salary earnings, change, % Current account, EUR bn Current account, % of GDP Short-term interest rates (3-month Euribor), % Long-term interest rates (10-year govt. bonds), % General government expenditure, % of GDP Tax ratio, % of GDP General government net lending, % of GDP Central government net lending, % of GDP General government gross debt, % of GDP Central government debt, % of GDP

20 20 Medium-term outlook It is projected that over the medium term, growth in the Finnish economy will be slower than the average over the past decade. The outlook for the economy is dampened by structural factors. Industrial output as a proportion of GDP already started to decline in the previous decade as increasing international competition and strong growth in emerging economies persuaded industries to relocate their production closer to the end markets. Industrial output declined particularly sharply during the recession in 2009, and has since then not recovered to its previous growth track. Another significant structural factor is population ageing. With the baby boom generations moving into retirement, the growth of the labour supply will slow and towards the end of the current decade begin to shrink. At the same time demand for health care and social care services in particular is set to rise, generating increased demand for labour in public services. The estimates presented here of medium-term economic growth are based on the projected development of productive resources in the economy, i.e. labour, capital and overall productivity, which constitute the foundation for potential output growth. Over the next few years ahead potential output growth will be much slower than over the past decades on average. It is estimated that medium-term economic growth will be faster than potential output growth. Even so the level of potential output will not be reached until Up until the early 1990s capital input growth, i.e. material investment was a significant potential output growth factor. After the recession in the early 1990s, the growth contribution of fixed capital formation has been significantly smaller. Productivity, immaterial investment and innovations, on the other hand, have assumed increasing importance as growth drivers. As population ageing is set to limit the future growth of labour input, potential output growth will be almost entirely dependent on increased total factor productivity. Much of the rapid growth seen in productivity particularly in the early 2000s came from the information and communications industry. Since then the high-productivity ICT sector has accounted for a smaller proportion of GDP, which has slowed overall productivity growth. The shifting emphasis of production towards services is also undermining prospects for productivity growth. In services such as health care and social care provision, labour productivity has traditionally grown more slowly than in industrial manufacturing. It is also more difficult to drive up productivity in labour-intensive services than in industry. Labour market participation has in recent years been increasing in older age groups, and it is expected that this trend will continue in the medium term too. Nonetheless the supply of labour will not increase over the outlook period, and in fact will start slightly to fall in It is projected that the unemployment rate will edge back to 7.5%. Over the next few years ahead a major source of friction in the labour market will derive from the restructuring of the economy, which will see jobs being created in other sectors than those that are facing the biggest redundancies. Therefore, from the point of view of labour supply and continued strong employment trends, it is important to encourage greater geographical and cross-sectoral labour mobility. If a significant proportion of those people who are

21 21 Key forecast figures for the medium term 2010* 2011* 2012** 2013** 2014** 2015** 2016** GDP at market prices, change in volume, % Consumer price index, change, % Unemployment, % Employment rate, % General government net lending, % of GDP Central government Local government Social security funds General government gross debt, % of GDP Central government debt, % of GDP made redundant drop out of the labour market for good, the growth prospects of emerging new branches and new companies starting up in those branches will be hampered by a shortage of labour. Adjustment measures coupled with the moderate economic rebound will strengthen the general government budgetary position over the next few years. The general government budgetary position will move towards balance in the medium term, but nonetheless remain clearly weaker than in the pre-precession years. The Government s adjustment measures will narrow the sustainability gap caused by population ageing, but will not be enough to close that gap. Therefore it will be necessary in the future to persist with structural reforms and other measures designed to strengthen general government. Central government finances deteriorated sharply during the deep recession, and the gradual recovery of economic growth has not been enough to restore balance. Fiscal adjust- Central government debt EUR bn % **14**16** EUR bn, (left scale) % of GDP, (right scale) Sources: State Treasury, MoF

22 22 ment will considerably strengthen central government s budgetary position in the next few years. However central government s post-recession deficit is so big that the Government Programme target of a less than 1% deficit-to-gdp ratio will not be reached. It is estimated that the central government budgetary position will show a deficit of 1.4% in However the growth of the central government debt-to-gdp ratio will level out in the medium term. It is projected that local government finances will remain in deficit in the medium term. Earnings-related pension funds will be the only general government sector continuing to show a surplus. However the financial position of earnings-related pension funds will weaken during the outlook period as a result of rising pension expenditure. Other social security funds, i.e. the Social Insurance Institution (SII) and the Unemployment Insurance Fund, will remain close to balance. Central government financial balance EUR bn % * 12** 14** 16** EUR bn (left scale) % of GDP (right scale) Sources: Statistics Finland, MoF Contributions to Potential Growth per cent ** Total productivity Labour Capital Potential Growth Source: MoF

23 23 Fiscal policy According to the Ministry of Finance s forecast the Finnish economy is suffering from a period of protracted slow growth and from the adverse effects of changes in its production structure, at the same time as population ageing is increasingly weighing down on prospects for economic growth and driving up public expenditure. The main challenges facing fiscal and economic policy are to strengthen the conditions for economic growth and to secure funding for the welfare state. In May this year, the European Commission and the EU Economic Policy Committee published their updated long-term projections for age-related public expenditure in EU Member States. According to these latest figures, age-related expenditure in Finland is expected to increase by 6.9 percentage points in relation to GDP over the next 50 years much faster than in EU countries on average. During the current decade, Finland s rate of age-related expenditure growth will be faster than in any other Member State. At the same time, annual growth of output potential through the economy s productive resources looks set to slow significantly. The Government has decided to tackle these challenges by aiming to restore balance in central government finances and to achieve a substantial reduction in the central government debt-to-gdp ratio by the end of the parliamentary term. In order to reach these targets the Government has committed itself to revenue and expenditure adjustment measures and to restructure the economy so as to facilitate stronger than predicted economic growth. Furthermore the Government has undertaken to implement additional measures if indications are that the central government debt-to-gdp ratio will not start to decrease and if the central government deficit shows signs of settling at over 1% of GDP: In order to achieve these targets, the Government has in various contexts decided on immediate measures designed to reduce central government expenditure and to increase revenue. These measures will be fully rolled out by 2015 and will improve the central government s budgetary position by a net total of around EUR 5.1 billion from With earnings-related pension contribution rates also being increased, the decisions taken will strengthen the budgetary position of general government (central government, local governments and social security funds) by around EUR 5.9 billion. According to the Ministry of Finance s forecast the Government s immediate adjustment measures, together with the predicted rate of economic growth, will improve the central government budgetary position enough to halt the growth of the central government debtto-gdp ratio during the electoral term. Nonetheless the central government deficit will still be higher than the target in The predicted rate of economic growth and the adjustment measures will also not be enough to close the sustainability gap in public finances. That is, the general government surplus should stand at around 4% of GDP for government to be in the position to fulfil its obligations in the long term. 1 The scale of the adjustment has been assessed taking into account the net effect of measures included in the Government Programme, the spending limits decision of October 2011, the framework agreement concluded between the labour market confederations in autumn 2011 and the spending limits decision of April 2012 on on-budget revenue and expenditure in The assessments assume that the Government Programme target of increasing tax revenue by EUR 300 million through efforts to combat the shadow economy will be reached by 2015.

24 24 It is not appropriate to try to close the sustainability gap solely by immediate measures designed to increase taxes and cut expenditures. These immediate adjustment measures must be complemented by reforms to economic structures. Efforts to improve the prospects for economic growth must include reforms that will boost employment and improve productivity especially in public services. A key cornerstone of the Government Programme is the commitment to strengthen sustainable economic growth, employment and competitiveness. Furthermore, in connection with its spending limits decision for , the Government decided on a set of measures aimed at improving the conditions for economic growth. At the same time, the labour market organizations presented their proposals to lengthen working careers. The measures are mainly focused on unemployment security, the early retirement system, education and tax-related growth incentives for small and medium-sized enterprises and R&D activities. These measures are a step in the right direction. At the same time as earlier decisions are being put in place, it is imperative that efforts are continued to reform the economy for increased efficiency and competitiveness and for stronger employment. In the labour market, the main effort is focused on young people and older people, but also on certain core groups of working-age people where employment rates are lower than in other Nordic countries. Reforms that offer incentives to increase human capital, promote innovation, attract investment to Finland and foster competition in the marketplace, would provide important support for productivity growth. Furthermore the ongoing restructuring of municipalities and services is an indispensable part of efforts to increase productivity in public service provision. The purpose of the Government s immediate adjustment measures and the economic restructuring now underway is to maintain confidence in the ability of Finnish government to keep its public finances on a sustainable basis. The confidence factor has become increasingly important during the current crisis in the euro area. A credible and appropriate fiscal and economic policy serves to enhance confidence and by the same token to improve the economy and standards of living in the long-term.

25 25 1 Economic outlook 1.1 Global economy Downside risks predominant World economic growth slowed in late 2011 and the period of slow growth is set to continue throughout World purchasing power parity adjusted GDP will increase by just over 3% this year, but recover to around 4% in The slowdown of growth is attributed to the withdrawal of government support and stimulus measures, the fragility of private demand, the need to consolidate public finances and confusion about the outlook in the euro area. In many industrial countries the need for financial consolidation concerns not just public finances, but also private households and financial institutions, and therefore demand will contract and growth will slow in 2012 and The main focus of growth will remain in developing economies, but even in this group many countries will see slowing growth. The rate of recovery in the US economy is slower than ever since the 1930s depression. Over the forecast horizon growth will remain below 3%. US growth is constrained above all by reduced financial wealth in the household sector and by the slow recovery of employment. Furthermore, the sense of uncertainty is compounded and economic activity is dampened by what is being called the looming fiscal cliff : several temporary tax cuts, extended unemployment benefits and certain fiscal adjustment measures will expire at the end of 2012 unless Congress decides to extend them. According to Congressional Budget Office World trade 2000= ** 14** World trade (seasonally adjusted) Finnish exports (not seasonally adjusted) Sources: CPB Netherlands Bureau for Economic Policy Analysis, Statistics Finland, MoF

26 26 estimates these temporary measures amount to around 4% of GDP, and their expiry may reduce growth by as much as two percentage points in There is deep political uncertainty over whether or not stimulus will be continued. Economic activity is also deterred by uncertainty over how the political system plans to implement stimulus measures in the short term and on the other hand tackle the longer-term challenge of public sector consolidation. Gross domestic product change in volume, % ** 13** 14** China (not seasonally adjusted) United States (seasonally adjusted) Euro area (seasonally adjusted) Sources: Statistical authorities, MoF Growth has stalled in the euro area and the EU, and 2012 will see a mild recession. Growth is hampered by the tighter supply of credit as a result of the banking and debt crisis and continued high levels of uncertainty, the substantial needs for public finances consolidation, sluggish export demand from industrial countries and the growth and persistence of unemployment. Sweden and Germany, for instance, both among the strongest European economies, will post growth rates of no more than around 1 2% this year and next. Countries struggling with the economic and financial crisis will see negative economic growth in 2012 and return progressively to slow growth towards the end of The Russian economy has posted strong growth of almost 5% on the back of continued high oil prices. However even strong oil prices will not be enough to sustain this rate of growth because of a shortage of capacity and low investment levels. In the longer term Russian growth will be hampered by the country s inflexible economic system and markets, as well as by the absence of structural reforms designed to support growth. On the other hand the country s newly acquired membership of the WTO might in the medium term stimulate economic activity, investment and international trade. Growth in China is hampered by sluggish demand from industrial countries. Nonetheless the Chinese economy will continue to grow at around 8% throughout the outlook period, provided that the country s stimulus policy is successful.