Bank of Finland forecast for 2009–2011: Finnish economy to contract strongly, recovery delayed until 2010

World economic growth contracted in unprecedented fashion during the last quarter of 2008. The world economy is now in deep recession, and the Bank of Finland forecast does not envisage it recovering until the first half of 2010. By that time, the massive monetary and fiscal policy support measures undertaken will have begun to take effect and the financial market crisis will gradually begin to ease.

Small open economies like Finland have benefited considerably from growth in international trade and the deepening international division of labour. If international trade were to recede, the international capital markets fragment and protectionism increase, Finland’s productivity growth would slow for a prolonged period.

International measures have stabilised the global banking system, but the capacity of the financial markets has not been fully restored. The need to correct their balance sheets has forced financial institutions to reduce their lending, tighten their terms and conditions of credit, and sell in unfavourable terms some of their investments. In this way, the crisis on the financial markets has already spread extensively into the real economy.

The European Central Bank has taken steps to ensure liquidity in the banking system. Since last October it has lowered its policy rates by a total of 2¾ percentage points. The Eurosystem’s fixed rate for main refinancing operations now stands at 1.5%, while the rate for the deposit facility stands at 0.5%. Since last October the ECB has also carried out the main and longer-term refinancing operations through a fixed-rate tender procedure with full allotment at the interest rate of the main refinancing operations. The ECB has also indicated that it will continue non-standard policy practice for as long as needed, and in any case beyond the end of 2009.

As a result of these measures, there has been a substantial reduction in money market interest rates such as the Eonia and the Euribor. Euribor rates are used extensively in Finland as reference rates.

‘It is worth emphasising that the European Central Bank has not yet used up all its room for manoeuvre in its interest-rate policy. This concerns all key policy rates,’ Bank of Finland Governor Erkki Liikanen pointed out in connection with the publication of the economic outlook issue of the journal Euro&talous.

‘If the recession becomes further prolonged and the downside risks to price stability increase, it will be necessary for the ECB to broaden its arsenal of non-standard measures and extend the duration of the measures. It is important to keep all options open,’ Governor Liikanen continued.

The growth outlook for the Finnish economy has deteriorated sharply in a very short period of time. While the Bank of Finland forecast in September 2008 envisaged cumulative growth in real GDP of a full 5% in the years 2008–2010, the current estimate is a decline by the same amount. More than half of this change in the forecast can be attributed to recent adverse developments. The Bank of Finland estimates that GDP will contract 5% in 2009.

The greatest change is in the outlook for exports. The forecast envisages a substantial drop in the volume of exports. As regards domestic components of demand, the pace of investment growth, in particular, will slow down. Private consumption will also be much more sluggish than before, and there will be a rise in the household saving ratio.

Employment will decline more than previously forecast, with a total of 180,000 jobs being lost over the period 2009–2011. Inflation will slow to close to 1%. The current account surplus will be eroded. General government finances will sink into a sizeable deficit. At the same time, central and local government will move deeper into debt, and the size of the pension funds will decline.

Even if the recession turns out to be short-lived, as envisaged in the forecast, its depth will have a negative long-term impact on the economy. The room for manoeuvre in public finances has been substantially reduced. Finland’s experience demonstrates that it will also take a long time for the labour market to recover.

An expansionary fiscal policy and a related increase in government debt are justifiable under the present circumstances. However, Finland continues to face major public expenditure pressures from population ageing in the years ahead. Measures to stabilise the public finances over the medium and long term will enhance the credibility of expansionary measures and make it easier to fund them.