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IMF: Finnish recovery stalled by Russian invasion of Ukraine

HELSINKI: The Finnish economy recovered swiftly from the pandemic, but Russia’s invasion of Ukraine worsened the outlook, with high inflation and rising interest rates weighing on household purchasing power and investment. Recent estimates indicate that the economy contracted in 2023 (-0.5 percent), and modest growth is anticipated in 2024, with risks to the downside, the International Monetary Fund said in its report.

It recommended that Finland’s fiscal policy should focus on putting debt on a declining path through a gradual but sustained fiscal adjustment. Structural reforms should center on labor markets: reducing skills mismatches, encouraging employment, and boosting productivity.

Despite large buffers, large cross-border exposures, a weakening housing market, and high household debt pose risks to the financial system. This necessitates tightening liquidity regulation and enhancing the macro-prudential toolkit.

Finland’s economic growth has stalled, but employment remains relatively robust. Finland is likely in recession, with high interest rates, weak trading-partner growth, and a downturn in the housing market all weighing on activity. A recovery in household purchasing power, along with easing financial conditions, is expected to support a modest recovery in 2024, with growth projected to be ½ percent, it said.

The labor market remains relatively strong, but unemployment is likely to increase modestly, as the construction sector continues to shed jobs. In the medium term, growth is expected to improve to around 1½ percent due to an anticipated increase in investment and employment resulting from the labor market reforms.

Inflationary pressures are diminishing. Twelve-month headline inflation, which peaked at 9.1 percent in November 2022, has receded to 1.3 percent in December 2023, primarily driven by declining energy prices. Core inflation, although more persistent, has also shown deceleration, particularly in non-energy goods and non-housing services. Supported by modest wage growth, negative base effects, and a growing output gap, headline inflation is anticipated to remain below 2 percent in 2024, gradually recovering over the medium-term.

The fiscal deficit has widened. The deficit is expected to have increased to 2.5 percent of GDP in 2023, primarily due to higher discretionary spending, notably energy-related compensation, defense spending, humanitarian aid, high index-linked increases in social benefits, and support for wellbeing services counties. Gross public debt is expected to have reached 75 percent, further exceeding Nordic peers. Deficits are projected to remain substantial over the medium-term.

Finland’s economic outlook is subject to downside risks. Finland faces several significant external risks, including from greater geo-economic fragmentation and a rebound in international energy prices. But domestic risks are also elevated. The combination of high household debt, falling house prices, higher unemployment, and rising interest rates could tip the economy into a deeper “balance sheet recession”. Large-planned investments from the green transition represent an upside risk over the medium term, according to the Fund.

The government’s ambition to reduce the fiscal deficit is welcome, but stronger policies are needed to achieve this. The government program targets a medium-term fiscal adjustment of about 2 percent of GDP over the next 4 years through spending cuts and fiscal gains from higher employment. This ambition is welcome. However, current policy measures fall well short of achieving this, with the fiscal deficit projected to increase in 2024 and debt to continue to rise. Additional measures are needed to close this gap.

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