III. ECONOMIC TRENDS AND OUTLOOK Summary After three years of recession, the Finnish economy is starting to grow. Gross domestic product (GDP) will probably increase by about two percent in 1994 and by about five percent in 1995. Economic growth is being led by exports, which have increased to record levels. Domestic demand continues to be weak, with consumers hard hit by flat incomes and rising taxes. Unemployment remains very high, about 20 percent in mid-1994, and is projected to decrease only slowly throughout the remainder of the decade. Inflation remains very low, in the two percent range. Finnish competitiveness has greatly increased in the last several years, due both to a major depreciation of the Finnish currency and to corporate cost cutting and increased productivity. It is now running some 40 percent above its long-term average. This has helped price-sensitive exports such as forestry products and ships to increase market share. Finland has also increased exports of high-tech products such as advanced communication hardware and networks and computers. Imports have lagged because of the depressed local market but are beginning to pick up. Government economic policy has been constrained by rapidly mounting debt, much of it foreign. The government has resisted calls for a stimulative economic policy, although small tax cuts may be implemented. In spite of increased recession-induced social outlays and rising interest expenditures, the government has attempted to keep spending constant in real terms. Spending has continued to rise, however, but because of cutbacks, substantially less than earlier projections. Finland completed negotiations on an accession treaty with the European Union in March 1994. Finland will hold a national advisory referendum on EU membership in October 1994, after which the Finnish parliament will vote on the accession treaty. If the treaty is approved, Finland could join the EU as early as January 1995. The European Economic Area agreement was implemented at the beginning of 1994, bringing into effect in Finland a wide body of EU legislation and policy. Economic Growth Finland's GDP dropped by a cumulative 15 percent from 1991-93. The economic decline took place across the Finnish economy, but was most severe in services. The construction industry was particularly hard hit, and continues to contract. The outlook for other services such as banking and retail services is somewhat brighter. Industrial production on the other hand is booming, with manufacturing output increasing at an annual rate of over eight percent in early to mid-1994. All of the main manufacturing sectors, including paper and pulp and other forestry-based industries, electronics, machinery, shipbuilding and other metal-based industries and the chemical industry are growing strongly. Finland's economic situation has become increasing bifurcated between fast-expanding export-oriented industries and much slower growing industries primarily dependent on the domestic market. The latter tend to be less competitive and many are undergoing significant restructuring. The retail field in particular has seen a great deal of downsizing and several large bankruptcies. The food processing industry, which is a large employer and parts of which are quite inefficient, faces additional challenges stemming from EU membership. Economic forecasters are predicting overall growth of about two percent in 1994. Industrial production should increase by some seven percent, following a five percent gain in 1993. Growth in all main industrial sectors is likely and due to strong export demand should be particularly high in electronics and paper, about nine and eight percent, respectively. Output of private services is projected to increase by about two percent, with the greatest growth in transport and communications. Retail sales will likely continue to decline due to soft domestic demand. The rate of decline in the construction industry is slowing, but will likely still be some five percent in 1994. Finland is a net agriculture sector (agriculture/fish/forestry) exporter with purchases of $1.9 billion in 1993 versus exports of $9.0 billion. Finland's leading import category is forest products, totaling $663 million in 1993. Forestry products also dominate the agriculture export sector accounting for $8.1 billion of the export total. Agricultural product exports (excluding forestry) totaled $865 million in 1993. The largest agricultural import by value is coffee, valued at $130 million in 1993. Fruits, vegetables, soybeans, and tobacco are other big import items. Finland's agricultural imports from the United States in 1993 totaled $98 million. Soybeans, raw tobacco, fruits and wheat were the leading import categories. About 9 percent of the agricultural exports (excluding forestry) - mainly oats, cheese, beef and pork - went to the United States. About 6 percent of Finland's forest product exports went to the United States. Investment Investment in 1993 continued to decline sharply, decreasing by about 20 percent from the previous year and totaling less than half its 1989 peak. Business surveys, however, indicate that this trend has now been reversed as capacity utilization rates increase and export orders mount. Lower interest rates and decreasing corporate indebtedness are also sparking the investment turnaround. According to economic forecasters, an increase in investment volume of around three percent is likely in 1994, followed by a double digit increase in 1995. The liberalization of foreign investment legislation at the beginning of 1993 and the simultaneous introduction of a standard 25 percent tax rate on all forms of capital income helped spark a boom in the Finnish stock market. The stake of foreign ownership in many of the larger Finnish companies has grown substantially through foreign purchases of Finnish stocks. Institutional investors from the United States have been particularly active. The government is also slowly implementing plans to reduce the government share in state-controlled companies through the stock market, both through new stock issues and by selling a portion of existing government holdings to private investors. Some of these offerings will be targeted specifically at U.S. investors. Inflation The Finnish inflation rate is nearing historic lows. The consumer price index increased by only 2.2 percent in 1993 and prices may go up by only one percent in 1994. Factors in favor of price stability include still-declining domestic demand and lower real labor costs. The longer term outlook is somewhat less favorable. Among the reasons for a possible acceleration in the inflation rate are expected pay increases in labor contract settlements to be negotiated in fall 1994, higher housing prices, the switch on June 1, 1994 to a value added tax from a turnover tax and residual effects from currency depreciations. Price competition, which has been strong in the face of low domestic demand, may ease as well. Forecasters are predicting an inflation rate of two-three percent in 1995. The Bank of Finland has set as a target a long-term inflation rate of no more than two percent exclusive of housing prices and changes in taxation. Consumption Declining real wages and high unemployment have continued to act as a drag on private consumption. Household real income declined by about 2.5 percent in 1993; increased transfer payments caused the total from dropping considerably more. Consumption in all purchasing categories fell in 1993 and will likely continue to fall in 1994. Total consumption is expected to drop by about 2.5 percent. Durable goods purchases may be an exception; auto sales were starting to rise in early 1994. The decline in demand for services may level off as well. The outlook is brighter across the board in 1995, as the economic recovery takes hold and real income begins an expected rise. The savings rate, which has been at high levels, is expected to drop as well in the face of increased consumer confidence and lower interest rates. Demand should be particularly strong for durable goods, as consumers resume discretionary spending which had been postponed because of the recession. Foreign Trade The export boom which began in 1992 shows no signs of abating. Exports grew 17 percent by volume and 25 percent by value in 1993. Import volume was stagnant, while value increased by eight percent. The balance of trade surplus increased by about 150 percent in 1993, to FIM 31 billion ($5.4 billion), or 6.6 percent of GDP. In line with stagnant domestic demand and booming exports, foreign trade has become an even more important part of the Finnish economy; exports of goods and services are running at about 35 percent of GDP, some 10 percentage points higher than the historic trend. The growth in exports has been broad-based, with volume increases of over 30 percent in metal and engineering products, food and beverages and agricultural and wood products. Paper exports were up by almost 10 percent, and chemical exports increased by 6.5 percent. The growth in electronics exports, at 35 percent in volume, was particularly strong. Communications products and computers led this sector. Geographically, Western Europe remains the dominant market for Finnish exports. The EU and EFTA took 64 percent of Finnish exports in 1993, down from 73 percent a year earlier. The fastest growing markets for Finnish products are East Asia, Russia and Eastern Europe and North America. Germany, Sweden, Britain and the U.S. are Finland's biggest export markets. According to Finnish customs figures, U.S.-Finnish trade increased substantially in 1993, with U.S. exports to Finland increasing 29 percent by value and Finnish exports to the U.S. increasing in value by 65 percent; the U.S. is Finland's single largest market outside Europe and accounted for 7.8 percent of Finnish exports in 1993. Finnish figures show the U.S. trade deficit with Finland in 1993 at FIM 3.0 billion, or $525 million. Reflecting weak domestic demand and a depreciated Finnmark, total Finnish imports decreased 3.5 percent by volume but increased 12.5 percent by value in 1993. The decline was sharpest in consumer goods and less pronounced in raw materials and investment goods. Imports of fuel grew. The volume of imports is expected to grow in 1994 along with the economic expansion and an appreciating Finnmark. The principal sources of Finnish imports are the EU and EFTA, accounting for 65 percent in 1993, down from 73 percent the previous year. The U.S. supplied 7.3 percent of Finnish imports in 1993. European Integration Finnish economic policy is increasingly centered around European integration. The European Economic Area agreement went into effect at the beginning of 1994, bringing into force a wide variety of EU legislation. The principal exception is agriculture, which is not covered by the EEA. In preparation for EEA implementation, Finland liberalized investment legislation at the beginning of 1993, removing several barriers to foreign investment in Finnish companies. The foreign ownership stake of Finnish corporations, particularly through stock transactions, has expanded considerably. Finland has also strengthened its competition legislation in accordance with EU requirements. Finland opened EU membership negotiations in February 1993; the negotiations were completed in March 1994 when a draft accession treaty was agreed upon. The main point of discussion in the talks was agriculture. Finland will be required to introduce lower EU price support levels upon assuming EU membership, but the accession treaty allows for higher support levels both for transitional assistance and for long-term aid to account for poor growing conditions in Finland. Finland will hold a non-binding advisory referendum on EU membership on October 16, 1994 and the Finnish parliament will vote on the accession treaty in November or December 1994. A two-thirds majority is required. The target date for EU membership is January 1, 1995. Many Finnish government officials and business leaders hope that EU membership will spur additional investment in Finland and increase business confidence. They see investors being attracted both by Finland's increased ties to the EU market and by its proximity to and transportation links with the Russian market. Budget Declining revenues and increasing recession-related expenditures have led to an explosion of public borrowing and a rapidly increasing level of public debt. The central government deficit increased from 7.5 to 11.1 percent of GDP in 1993, and the central government debt level from 35 to 55 percent of GDP. For the entire public sector, the deficit stood at 8.0 percent and the debt at 63 percent of GDP at the end of 1993. The end of the recession is expected to slow down the growth in debt accumulation, while the size of the deficit will likely be about the same in 1994 as in 1993. Total debt levels are continuing to climb, however, and the public sector debt/GDP ratio may rise to 80 percent or more by the end of 1995. The government has attempted to keep real spending at 1991 levels exclusive of bank subsidies and extra agricultural spending in connection with EU membership. Increasing interest expenditures and recession-related transfer payments have meant fewer resources for discretionary spending. The government has attempted to keep within budgetary guidelines by cutting back in particular on government personnel and salary expenditures. Concern about rising debt levels and associated higher interest rates has limited the government's ability to increase counter-cyclical spending. While the government has not been completely successful in efforts to control spending, without substantial cutbacks in planned spending the debt and deficit problems would be considerably greater than they already are. Government Economic Policy Government economic policy has centered around increasing the competitiveness and flexibility of the Finnish economy rather than on fiscal stimulation to combat the recession. European integration has been a focal point as well. The government did introduce several small tax cuts although corresponding increases have in effect cancelled them out. The government has tried to reduce the tax burden on business, particularly for non-wage social expenditures, shifting the burden onto individuals. Another point of emphasis has been to use changes in taxation to encourage the growth of small and medium-sized enterprises. In an effort to attract more foreign investment, the government introduced a proposal in early 1994 to tax foreign managers temporarily transferred to Finland at a lower rate; the government withdrew the proposal following parliamentary opposition. While maintaining a commitment to privatization, the Finnish government has been slow to implement privatization plans. The main strategy is to reduce gradually the government stake in state-controlled companies through stock transactions rather than to sell off companies to individual investors. The principal recent change in the taxation system has been replacement of the turnover tax with a value added tax in June 1994. The general rate is 22 percent, with lower rates of selected goods and services. The VAT has increased taxation of services, particularly those offered directly to the public, although the blow is being cushioned with phase-in periods. The introduction of a uniform 25 percent rate on capital taxation at the beginning of 1993 combined with liberalization of foreign investment legislation has led to a substantial growth in equity financing by Finnish companies, with much of the capital of foreign, including U.S., origin. The government and Bank of Finland have shown no inclination to re-introduce a fixed exchange rate for the Finnmark. The currency has been floating since September 1992. The float and an earlier devaluation of the Finnmark in November 1991 resulted in a trade-weighted depreciation of the Finnmark of some 40 percent. In the early months of 1994, the Finnmark gained in value and is predicted to continue to strengthen as the economy picks up and exports surge. The Bank of Finland has not normally attempted to influence the direction of currency movements. Interest rates have fallen greatly although real rates remain high: short-term rates declined from an average of 13.2 percent in 1992 to 7.7 percent in 1993; in mid-1994 they were in the 5-6 percent range. Longer-term rates were higher, however, in the 8- 9 percent range, as doubts remained about the government's ability to enforce fiscal discipline and rein in borrowing. The most intractable economic problem for the government remains unemployment. Despite record levels of industrial output and exports, unemployment stood at nearly 20 percent in mid-1994 and is likely to be in the middle to high teens for several years. Increased productivity, continued weakness in service industries and government cutbacks are the principal causes. The government has focused its efforts regarding the unemployment problem on increased flexibility and deregulation rather than on job- creation programs. In fall 1993, the system of country-wide bargaining on wages and benefits largely broke down in the face of widely varying performances among differing industrial sectors and the disinclination of the government to become involved in the talks. Agreements instead were made on an industry by industry basis. Principal Growth Sectors Manufacturing: All of Finland's export-oriented manufacturing industries are currently doing well and show excellent prospects for further growth. Of particular note are electronics, especially telecommunications, paper and pulp, industrial machinery, shipbuilding and chemicals. Exporters are benefitting from a depreciated currency, cost-cutting and increased labor productivity. Domestically-oriented manufacturing, including textiles and food processing, is still weak. Food processing in particular will have some problems adjusting to lower price levels and increased competition in the EU, although the industry does contain an export-oriented component which is expect to profit from EU membership. Services: Finnish services which have an export component, particularly transportation services, are showing strong growth. Tourism is also growing well as a depreciated Finnmark and stable prices attract more foreign tourists and cause Finnish tourists to stay at home. Domestically-oriented service industries are faring less well. The demand for financial services is increasing, although the position of the industry is still weak and profitability only likely to return in 1995 or later. Further consolidation and downsizing is likely. Construction continues to experience a severe downturn and still suffers from overcapacity; additional mergers and bankruptcies are possible and a recovery is not likely until 1995. Retail sales continue weak due to still-declining purchasing power. Agriculture/food: The U.S. slightly increased its market position for consumer oriented food and drink products in Finland in 1993 despite the sharp decline in the value of the Finnmark against the U.S. dollar. With some decline in the value of the U.S. dollar in 1994 and 1995 relative to strengthening economies in Finland, the United States should gain some price advantage over its main competitors. However, membership in the European Economic Area (EEA) in 1994 and the European Union (EU) in 1995 will fully open the Finnish market to other members of the EU. This will, of course, confer a direct competitive advantage to those countries since border duties will not have to be paid for this "internal" market trade. On the other hand, Finland can serve as an entry point for food and drink products bound for other EU countries. In addition, Finland will remain very active in trade with the Estonia and European Russia, particularly in the St. Petersburg region. Finland is a significant market for dried fruit, almonds, orange juice and apples. However, domestic production of some items and competition from other countries can cause major swings in year to year imports of many of the commodities. The United States dominates the Finnish import market for tobacco, soybeans, wheat, rice, prunes, raisins, almonds and cotton. It is also a significant supplier to the small seafood import market. High fiber-cereals are in demand together with pasta products, pasta sauces, fruit juices of all kinds, avocados, celery, apples and pears. Major local and third country competitors by specific sectors AGRICULTURE - Intra-Nordic trade for high value products is dominated by a handful of companies with major trade linkages among the four Nordic countries which include Denmark, Finland, Norway and Sweden. Self-sufficiency goals and income maintenance among farmers have contributed to over-production in the past and this will continue to be the case in the EU. Agriculture Products - France and the Netherlands among EU countries are major apple suppliers. France also dominates the markets for wine in both Finland and Sweden. Italy provides stiff competition for carrots, grapes, plums and kiwis. Spain, a very efficient and quality conscious producer of fruits and vegetables, is a major supplier to the Finnish market of tomatoes, celery, oranges, tangerines, lemons, strawberries, plums and wines. The Netherlands is also a major supplier of quality produce. Israel is a major competitor with avocados and grapefruit. Morocco supplies half of the tangerine market. Chile is a major supplier of grapes and apples. Argentina is a major supplier of apples and pears. Australia, Chile, Austria and Germany also are major wine competitors. Hungary and Denmark are the major competitors for beef livers. Italy, Israel, Spain, Australia and New Zealand are especially active with market promotion budgets. With the approach of EU membership, Germany has also become more active. FISHERY - Norway, Denmark, Iceland and Canada are among the major competitors for the Finnish market. FORESTRY - Major competitors for the Finnish market include Russia, Germany, Poland and Estonia. Government Role in the Economy The Finnish government has traditionally played a large role in the economy. To redress a perceived lack of domestic investment capital, the government formed state-owned companies in various industrial sectors, including energy, mining, paper, and steel; currently four of the 10 largest companies in Finland are state- controlled. Most state-controlled companies should be gradually privatized in the course of the decade. The Finnish public sector is large, reflecting a wide of array of services, including largely free medical care and education. The bulk of services are provided at the level of local rather than national government. The government provides a wide array of subsidies, including very high agricultural subsidies and an increasing level of industrial subsidies. The government has made some effort to rationalize and eventually reduce industrial subsidies. Linkages between government and industry are strong, with frequent flow of personnel back and forth. Political influence on the boards of state-controlled companies is also strong and rules regarding conflict of interest for government employees are laxer than in the United States. The government has made efforts to reduce its role in the economy, especially by declining to become involved in annual labor-management negotiations and by its rejection of large new countercyclical spending programs. In other respects, however, its role has increased, especially its program to keep the financial system afloat through an array of subsidies to the banking sector, particularly the ailing savings banks. Balance of Payments Situation An increase in the balance of trade surplus to record levels has led to a sharp decline in the current account deficit. In 1993, the balance of payments deficit was 1.2 percent of GDP, down from 4.6 percent the previous year. The current account is widely expected to move into surplus in 1994, to approximately two percent of GDP. In addition to the trade surplus, lower interest payments on foreign debt due to an appreciating Finnmark have also been a factor in the turnaround on the current account deficit, as has a decline in the balance of services deficit. The services account has been strengthened by a decline in the balance of tourism deficit, itself a product of the recession and the past depreciation of the Finnmark, and by the growth in transport service exports, particularly to the former Soviet Union. Finland's net foreign debt will likely begin to decline due to the surplus in the current account and the strengthening of the Finnmark. About 59 percent of GDP at the beginning of 1993, it may fall to some 50 percent of GDP by year's end. The private sector continues to repay foreign debt on a net basis while the public sector remains a heavy borrower of foreign capital. The inflow of capital from portfolio investment has increased dramatically, with net sales of Finnish stocks abroad increasingly 30-fold in 1993. There continues to be a heavy net outflow of direct investment from Finland, although tax changes, the promotion of Finland as a gateway for Russian trade and investment and Finnish membership in the EU may help to attract additional foreign investors. Trade and Investment Barriers The Finnish system of agricultural protection now largely mirrors that of the EU: high producer prices, variable levies on imports and export subsidies to dispose of surplus production. Third countries generally only have open market access for those products which are not produced locally or are in short supply. Finnish membership in the EU will mean adoption of the Common Agricultural Policy and market access for third countries will still be poor. Outside of agriculture, Finland has largely dismantled its remaining trade and investment barriers. As part of the EEA agreement, Finland is implementing the EU Broadcast Directive, which contains guidelines on EU content. Finland also maintains some restrictions on investment in those parts of its insurance industry which handle social insurance and retirement funds. Labor Force The Finnish labor force is highly skilled and well-educated. About two-thirds of the work force is employed in the service sector, over 30 percent in the public sector alone. About one- fifth of the work force works in manufacturing and some nine percent in agriculture and forestry. The percentage of women in the work force in high, about 48 percent. Fringe benefits, including maternity and child care benefits, are generous. The average retirement age is low, in the late 50's, and a steadily aging population has made long-term maintenance of current retirement benefits problematic. About 80 percent of the work force is unionized. Most unionized workers belong to one of three major labor federations. High unemployment has caused some workers to drop out of the labor force or to continue education and training instead. A key issue which has emerged regarding the labor force concerns introducing greater flexibility regarding wages and hours. Finnish employers also hope to increase competitiveness by decreasing non-wage labor costs, currently among the highest in the industrialized world. Infrastructure Situation/Projects Underway Finland has a well-developed infrastructure with few gaps. Because of its highly efficient port system and rail and road network, Finland is increasingly being used as a transshipment point for Russian trade. Finland's rail gauge is the same wide width as Russia's. Finland's ports are highly secure and automated and loading and unloading operations are consequently quick and generally trouble-free. Finland has a wide network of freight forwarders and trucking companies. Finland's domestic distribution system for goods and services is efficient, comparable to that in the United States. Among infrastructure projects contemplated are possible additional road and rail border crossing points with Russia, particularly connecting Lapland with the Kola Peninsula. Also under discussion is possible widening of roads in southern Finland to accommodate increasing transit traffic loads. A high- speed rail network is shortly to begin construction and the first phase should be ready later in the decade. Several Finnish ports are undertaking modernization and expansion plans.