O1996 International Monetary Fund
September 1996
IMF Staff Country Report No. 96/95
Finland—Selected Issues and Statistical Appendix
This report on selected issues and statistical appendix on Finland was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with this member country. As such, the views expressed in this document are those of the staff team and do not necessarily reflect the views of the Government of Finland or the Executive Board of the IMF.
Copies of this report are available to the public from International Monetary Fund • Publication Services 700 19th Street, N.W. • Washington, D.C. 20431 Telephone: (202) 623-7430 • Telefax: (202) 623-7201 Telex (RCA): 248331 IMF UR Internet: [email protected] Price: $15.00 a copy
International Monetary Fund Washington, D.C.
©International Monetary Fund. Not for Redistribution This page intentionally left blank
©International Monetary Fund. Not for Redistribution INTERNATIONAL MONETARY FUND
FINLAND
Selected Issues and Statistical Appendix
Prepared by T. Feyzioglu, D. Tambakis (both EU1) and C. Pazarbasioglu (MAE)
Approved by the European I Department
July 10, 1996
Contents Page
I. Inflation and Wage Dynamics in Finland: A Cointegration Approach 1
1. Introduction and summary 1 2 . Data sources and statistical properties 4 a. Data sources and definitions 4 b. Order of integration 4 3. Empirical estimates 6 a. Modeling strategy 6 b. Cointegration and error correction 8 c. Model multipliers 10 4. Outlook for CPI and nominal wage inflation: 1996-2001 14 a. Baseline scenario 14 b. Alternative scenario: further depreciation in 1996 17
References 20
II. The Determinants of the Equilibrium Real Exchange Rate: An Application to Finland 22
1. Introduction and summary 22 2 . Theory 24 a. The model 25 b. Effects of changes in the fundamentals 27 3. Empirics 28 a. Data 28 b. Methodology 32 c. Results 34
References 43
©International Monetary Fund. Not for Redistribution - ii -
III. The Finnish Banking System and the Credit Crunch Hypothesis 46
1. Introduction 46 2. Literature review 47 3. Finland: An overview of financial sector developments (1986-95) 48 4. The model 54 a. The credit supply equation 54 b. The credit demand equation 56 5. Empirical methodology 57 6. Estimation results 59 7. Conclusions 63
Appendix I 64
References 65
Text Tables
1. Results of Integration Tests 5 2. Baseline Scenario: Exogenous Variable Projections, 1996-2001 15 3. Wage Drift Projections, 1996-97 17 4. Univariate Statistical Properties 32 5. Diagnostic Tests 35 6. Cointegration Tests 36 7. Cointegration Vectors 36 8. Exclusion and Exogeneity Tests 37 9. Key Figures for the Deposit Banks, 1992-95 51 10. Bank Structure 55 11. Estimation Results 60
Charts
1. Inflation, 1975-95 2 2. Simulation Results, 1996-2001 12 3. Simulation Results, 1996-2001 13 4. Baseline Forecasts, 1996-2001 16 5. Alternative Forecasts, 1996-2001 18 6. Real Effective Exchange Rates, 1975-1996 23 7. Internal and External Equilibrium 27 8. Determinants of Real Exchange Rates 29 9. Real Effective Exchange Rates, 1975-2000 40 10. Real Effective Exchange Rate Misalignments, 1975-1995 41 11. Gross Investment/GDP 50 12. Interest Rate Linkages in Banks' Markka Lending 53 13. Demand and Supply for Bank Credit 62
©International Monetary Fund. Not for Redistribution - iii -
Statistical Tables 1. National Accounts Summary, 1992-96 67 2. National Income and Household Deposable Income, 1992-96 68 3. Gross Fixed Investment, 1992-96 69 4. Financial Balances, 1992-96 70 5. Gross Domestic Product by Sector of Origin, 1992-96 71 6. Labor Force, Employment, and Participation Rate, 1992-96 72 7. Wages, Costs, and Prices, 1992-96 73 8. Central Government Cash Revenue and Expenditure, 1992-96 74 9. Central Government Revenue and Expenditure, 1992-96 75 10. Municipalities' Revenue and Expenditure, 1992-96 76 11. Social Security Fund's Revenue and Expenditure, 1992-96 77 12. General Government Finances, 1992-96 78 13. Honey Markets Rates and Rates Applied by the Bank of Finland, 1992-96 79 14. Monetary Survey, 1992-96 80 15. Interest Rates, 1992-96 81 16. Balance of Payments, 1992-96 82 17. Indices of Foreign Trade, 1992-96 83 18. Exports by Commodity Group, 1993-97 84 19. Indicators of Competitiveness, 1991-95 85 20. Imports by Commodity Group, 1993-97 86 21. Invisibles, 1992-97 87 22. Gross Official Convertible Reserves, 1991-96 88 23. Direction of Trade, 1991-95 89 24. International Investment Position, 1991-96 90
©International Monetary Fund. Not for Redistribution This page intentionally left blank
©International Monetary Fund. Not for Redistribution I. Inflation and Wage jyvnamics in Finlan A Cointegration Approach I/
1. Introductic
Following the abandonment of the markka's unilateral link to the ECU in September 1992, the Bank of Finland (BoF) committed itself in February 1993 to stabilize underlying inflation at around 2 percent. £/ This commitment was tested in late 1994 and early 1995, when monetary policy was tightened significantly amidst increased inflation expectations. These expectations were due to the strengthening of aggregate demand, and to the acceleration of wages in the context of the more decentralized wage negotiation mode adopted in the fall of 1994. Inflationary pressures in 1995 weakened (annual CPI inflation was 1 percent), owing to the slowdown of growth, the appreciation of the markka, and the decline in food prices related to the accession in the EU (Chart 1). Starting in October 1995, the BoF has eased monetary policy significantly, citing weak inflationary pressures and a positive wage outlook; the latter reflected the moderate two-year wage agreement reached that month. I/ The October 1995 agreement marked a return to a centralized wage bargaining framework. 4/
The wage moderation of the October agreement bodes well for the inflation outlook. However, there is uncertainty regarding the size of the wage drift, as well as the effect on prices of the recent weakening of the markka and the fading away of the effects of EU accession. Against this background, this paper presents econometric projections on consumer price and nominal wage inflation in Finland over 1996-2001. A simple model of
I/ Prepared by Demosthenes N. Tambakis. I/ Underlying inflation is the annual growth rate of the CPI excluding indirect taxes and subsidies and capital costs of owner-occupied housing (Akerholm and Brunila (1994)). I/ The tender rate, which is the BoF's key monetary policy instrument, has been lowered seven times by a total of 250 points over the last nine months. 4/ See Appendix II of "Finland--Recent Economic Developments11 (August 21, 1995) and Tyrvainen (1995c) for a discussion of the wage bargaining process in Finland. The two-year wage agreement reached in October 1995 involves a nominal wage increase of 1.8 percentage points over the 12-month period from November 1, 1995, and an increase of 1.3 percentage points over the 12-month period from November 1, 1996. The agreement includes a clause related to wage differentiation, whereby annual wage increases may be reviewed in August 1996 in light of developments in wage drift. In addition, the following escalator clause is specified: if CPI inflation in the 11-month period from August 1995 to July 1996 exceeds 3.1 percent--an annualized rate of 3.4 percent--nominal earnings in August 1996 will rise by the full amount of the difference of the realized CPI inflation from 2.6 percent. Given recent weak inflationary pressures, it is unlikely that the clause will be triggered.
©International Monetary Fund. Not for Redistribution - 2 - CHART 1 FINLAND INFLATION, 1975-95 I/ (In percent)
Source: Bank of Finland.
I/ Annual growth rates. 2/ CPI excluding indirect taxes, subsidies, and housing-related capital costs. 3/ Excluding nonwage labor costs.
©International Monetary Fund. Not for Redistribution - 3 -
inflation and wage dynamics is constructed based on Johansen's cointegration framework. It is shown that a VAR system consisting of a long-term relationship for CPI inflation and another for real wages and their respective error-correction mechanisms offers a parsimonious description of wage-price interaction.
To preview the results, the main influences on price and wage inflation are as follows. In the long term, CPI inflation is related to nominal wage growth and imported inflation; in the short term, there is also positive feedback from changes in indirect taxes. In the long run, the real wage depends on unemployment, labor productivity, and indirect taxes, while in the short run there is a significant contribution of changes in unemployment and indirect taxes in eliminating deviations from the real wage equilibrium. Changes in unemployment and indirect taxes exert a stronger influence on real wage adjustment than productivity growth. Finally, the impact of cyclical variables on wage and price behavior is found to be insignificant, with the exception of the unemployment rate.
A relevant implication of the model is that an increase in indirect taxes raises real wages net of taxes in the short term, whereas in the long term a negative correlation prevails. This evidence confirms earlier results by Tyrv&inen (1995c) in favor of "real wage resistance"; it suggests that high unemployment in Finland may be at least partly explained by the increase in the tax wedge in recent years.
The VAR system is used to project CPI and nominal wage inflation for 1996-2001. The model implies that*-under reasonable assumptions on the behavior of the unemployment rate, labor productivity, and indirect taxes-- the BoF's 2 percent inflation target can be maintained as long as the markka remains broadly stable on the levels reached in the first quarter of 1996. Specifically, CPI inflation is projected to peak in early 1997 at about 2 percent under the assumption of no further nominal effective depreciation after the first quarter of 1996. Regarding nominal wage inflation, the outlook is for a moderate increase over the period.
The remainder of the paper is divided into three parts. Section 2 discusses the data set used (quarterly data covering the period from 1975 to 1995) and the statistical properties of the relevant time series. Section 3 presents the model and the empirical estimates. The final section provides an outlook for CPI and nominal wage inflation for the period 1996 :Q1- 2001:Q4.
©International Monetary Fund. Not for Redistribution - 4 -
2. Data sources and statistical properties
a. Data sources and definitions
The data set employed consists of seasonally adjusted quarterly time series for the past two decades (1975:Q1-1995:Q4). I/ The key endogenous variables are the consumer price index (P) and the index of nominal wages (W). The latter covers both the public and private sectors and excludes nonwage labor costs, such as social security contributions. £/ The other variables employed in the final form of the VAR system are the unemployment rate (U), £/ labor productivity (LPR) measured as the real GDP-to- employment ratio, an indirect tax index including subsidies and consumption taxes (T), and the import price index (PH). Import prices are measured in Finnish markka and are thus affected by both exchange rate and world price changes. Some of these variables enter the model in terms of differences: for example, DP and DW denote the four-quarter difference of P and W. Fourth quarter differences are used to remove seasonality and reduce the volatility of differenced variables. Simplifying the lag structure in this way keeps the number of estimated parameters manageable, albeit at the cost of reducing the short-term interaction among the variables.
b. Order of integration
Before carrying out the cointegration analysis, the relevant variables need to be tested for the order of integration. Augmented Dickey-Fuller (ADF) unit root tests were performed on the logarithms of the time series to determine their stationarity properties (Table 1). As is often the case with nominal variables, the consumer price index and the nominal wage index are each integrated of order two--so that the time series have to be differenced twice to obtain stationarity--while their four-quarter growth rates are integrated of order one. Real wages are nonstationary and integrated of order one. Labor productivity and the indirect tax index are integrated of order one, while their four-quarter growth rates are stationary. The import price index appears to be integrated of order one at 5 percent probability. However, as the power of the test is low and the critical values of the test statistics are typically sensitive to the unknown true dynamic structure of the data generating process, we will treat import prices as being integrated of order two, in order to allow for cointegration between traded goods prices and the exchange rate and domestic prices. 4/ Finally, the unemployment rate is integrated of order zero at 5 percent but integrated of order one at 1 percent probability. This
I/ These data were provided by the BoF, which uses these time series in its macroeconometric model (see Bank of Finland (1990) for an earlier version of the model). 2/ Nonwage labor costs are included separately; see below. 3/ As measured by Statistics Finland. 4/ The same problem was encountered by Ford and Krueger (1995) in the case of Italy.
©International Monetary Fund. Not for Redistribution - 5 -
Table 1. Finland: Results of Integration Tests
Constant/ ADF Test Critical Order of Variable I/ Trend Lags Statistic Value 2/ Integration
Consumer price index (P) Yes/No 3 -1.363 -2.882 1(2) Nominal wages (V) Yes/No 4 -1.619 -2.883 K2) Consumer price inflation (DP) 2/ No/No 4 -0.886 -1.942 KD Nominal wage inflation (DW) 3_/ Yes/Yes 4 -2.796 -3.442 KD
Real wages Yes/No 4 -1.506 -2.882 KD Labor productivity (LPR) Yes/Yes 4 -2.235 -3.467 KD
Indirect taxes (T) No/Yes 4 -0.878 -3.443 KD Import price index (PM) Yes/No 3 -2.796 -2.898 KD
Unemployment (U) No/Yes 3 -3.893* -3.442 KO)
Source: Staff calculations. I/ All series except the unemployment rate are in logarithms. 2/ MacKinnon (1990) 95 percent critical values for rejection of hypothesis of a unit root. 3/ Four-quarter growth rate.
©International Monetary Fund. Not for Redistribution - 6 -
evidence of nonstationarity likely reflects the structural break accompanying the sharp rise in unemployment following the onset of the recession in 1990; it suggests that cyclical output measures are not particularly reliable indicators of macroeconomic policy changes in Finland (see below).
3. Empirical estimates
a. ^iodeling strategy
When nominal macroeconomic time series are nonstationary I/, standard estimation methods are inappropriate. Engle and Granger's (1987) two-step method suggests that there may be a linear combination of the individual nonstationary series which is stationary; this is referred to as a cointegrating vector and is usually interpreted as a long-term equilibrium relationship between the variables. Deviations from the long-term equilibrium are dealt with in the context of an error-correct ion mechanism (ECM).
This paper adopts the maximum likelihood procedure of Johansen (1988, 1991) and Johansen and Juselius (1990) for constructing a VAR (Vector Autoregression) system permitting the simultaneous consideration of several cointegrating vectors. Johansen9s framework distinguishes between long-term effects and short-term dynamic responses of variables, while allowing all relevant parameters to be estimated simultaneously. Ideally, the data support a unique long-term relationship, deviations from which are gradually eliminated via the error-correction mechanism.
Muhleisen (1995) applied elements of Johansen's and Engle and Granger's methodologies in the context of a wage-price model for Finland; Johansen1 s maximum likelihood test was first carried out to obtain the long term relationships and the Engle-Granger approach was then used to analyze short- run inflation adjustment. Instead, this paper focusses on Johansen's methodology and constructs a VAR system allowing the estimation of long-term and short-term relationships for CPI inflation and real wages. In this way, it is possible to separate equilibrium behavior from short-term dynamic responses and avoid the possible single equation bias that would likely disturb the two-stage results.
The simplest cointegration framework for modeling inflation and wage dynamics would posit a single equilibrium relationship for nominal wage inflation as a function of consumer price inflation and the growth rate of labor productivity. An error-correction mechanism would be jointly estimated to handle the system's dynamic response to deviations from equilibrium.
I/ The variance of a nonstationary series changes over time. In general, a data generating process is strictly stationary if all its moments are constant over time.
©International Monetary Fund. Not for Redistribution - 7 -
In implementing this approach two problems arise. First, although a unique cointegrating vector relating the three variables can be identified, the sign of the cointegrating residual in the error-correct ion mechanism for price inflation fails to have the appropriate (positive) sign. It follows that a deviation from equilibrium is magnified rather than eliminated, leading to inflation dynamics which eventually explode. Second, the estimate of the coefficient of the error-correct ion term in the ECM equation for the growth rate of labor productivity is significant, suggesting that productivity growth is entirely endogenous in this system, and does not depend on either technical progress or innovation. These problems appear both in the basic version of the VAR system, in which only the variables in the cointegrating vector enter into the ECM, as well as in several extended versions in which potential explanatory variables enter exogenously into the ECM. Exogenous variables that were used include woodpulp prices--considered a good leading indicator of GPI inflation in Finland (see MOhleisen (1995))--the nominal exchange rate, employers' social security contributions as an proxy of firms' nonwage labor costs, expected (imported) inflation, proxied by the first difference of the deviation of the import price index from domestic manufacturing prices, the growth of the money supply (both Ml and M2) scaled by real GDP growth, capacity utilization in manufacturing, cyclical and total unemployment, and the output gap. I/ On account of these difficulties, a somewhat more complex procedure was followed. Specifically, a VAR system was estimated consisting of one cointegration vector for the f]T?TWBMIr price index and another for real wages. and their respective error-correction mechanism. In this way, the VAR system has two distinct attractors, 2/ a**d the dynamic responses of the cointegrated variables to deviations from equilibrium turn out to be well defined.
I/ The output gap is computed as the ratio of actual to potential output; the latter was obtained using the Hodrick-Prescott filter. 27 An attractor is the space defined by the cointegrating relationship, to which the system will converge. This attractor may correspond to certain macroeconomic equilibria (see Engle and Granger (1991)).
©International Monetary Fund. Not for Redistribution - 8 -
In this specification, the real wage is negatively related to the unemployment rate and positively related to labor productivity. I/ Short-term real wage adjustment is then described by an error-correction mechanism. £/ As a statistical matter, imposing homogeneity between wages and prices a priori is a desirable restriction given the relatively small size of the data set, as it reduces the dimension of the VAR system. Moreover, Tyrv&inen (1995c) in a different context indicated that imposing this restriction improves the overall fit of a wage equation. As to the cointegration vector for consumer prices, CPI inflation is directly related to the growth rates of nominal wages and the import price index. The long-term relationship may thus be interpreted as a mark-up equation, an approach also adopted by Ford and Krueger (1995) and Muhleisen (1995) for Italy and Finland, respectively. An attempt was also made to estimate a long-term relationship between the CPI and the PPI. However, using Johansen's maximum likelihood test it was concluded that the consumer price and producer price indices are not cointegrated over the last two decades. This is not too surprising: the large size of Finland's export sector suggests that fluctuations in the producer price index may not be a good indicator of CPI changes. b. Cointegration and error correction
The previous discussion is consistent with the statistical properties of the time series. The levels of nominal variables are nonstationary and integrated of order two, with the exception of the indirect tax index, while the levels of real variables are integrated of order one, with the exception of the unemployment rate. Therefore, the variables in the cointegration vector for the consumer price index should enter in first differences, while their dynamic response should be in second differences. Correspondingly, the variables entering the long-term relationship for real wages should be in levels, while the equation for the error-correct ion mechanism should be in growth rates.
I/ It might seem that a measure of cyclical unemployment (such as the output gap) would be more appropriate than actual unemployment in explaining movements in real wages. Indeed, the concept of cyclical unemployment has been shown to yield a long-run Phillips curve for the United States and several European countries (Alogoskoufis et al. (1995)). In Finland, however, the severity of the recession of 1990-93 and the associated sharp rise in unemployment make it difficult to estimate potential output and the output gap (Andersen and Mannisto (1995), Brunila (1996)). Actual unemploy- ment thus seems to be the more appropriate measure. 2/ This approach is also taken in Ford and Krueger (1995) and Pujol and Griffiths (1996).
©International Monetary Fund. Not for Redistribution - 9 -
Johansen's maximum likelihood procedure then yields the following cointegration relationships for CPI inflation and the real wage: I/
AP - 0.60 AW + 0.36 APM -I- CIP
W-P - - 3.05 - 0.02 U + 0.98 LPR - 0.30 T + CIW, where CIP and CIW are the stationary cointegrating residuals. Each cointegration vector is unique at the 5 percent significance level. As to the real wage equation, the estimated coefficients have the appropriate signs: the level of productivity and the unemployment rate are, respectively, positively and negatively correlated with the real wage. The negative coefficient on indirect taxes suggests that in the long run a higher level of indirect taxes yields a loiter real wage. More generally, an increase in the tax wedge is eventually born by labor, as also documented by several cross-country studies. £/
The error-correct ion mechanism in the VAR system involves the joint estimation of the short-term dynamic responses of the variables to deviations from the equilibrium. The KM for the consumer price index is specified in second differences, while that for real wages is in first differences; the latter incorporates a Phillips curve in the form of changes in the unemployment rate. Several cyclical variables potentially influencing the adjustment processes for inflation and real wages--including the unemployment rate, output gap measures, and short-term interest rates-- were included but were not found significant. An exception was the indirect tax index, which enters significantly the ECM for CPI inflation as an exogenous variable.
For each cointegration vector under consideration, the coefficient of the cointegrating residual is significant only in the adjustment equations for CPI inflation and real wages. Deleting the coefficients of insignificant variables in these two VARs yields the following adjustment equations (t-statistics are reported in parentheses):
Inflation adjustmant:
2 2 2 2 A P - 0.40 A P(-1) + 0.07 A T(-1) + 0.03 A PMPI(-1) - 0.23 CIP(-1) (4.05) (2.27) (1.87) (-1.93)
11-84 (75:1,95:4), R2 * 0.32, SEE-0.006, Schwartz Information Criterion—10.05
I/ An intercept is included in the cointegration test for the real wage. The t-statistics are not reported as the distributions of the estimated coefficients are nonstandard. £/ See, for example, Symons and Robertson (1990).
©International Monetary Fund. Not for Redistribution - 10 -
Real waffe adjustment!
A(W-P) - - 0.07 A(W-P)(-1) - 0.01 AU(-l) + 0.12 AT(-l) - 0.05 CIW(-1) (-2.91) (- 2.43) (2.44) (-2.06) H-84 (75:1,95:4), R2 - 0.39, SEE-0.01, Schwartz Information Criterion—8.53
Constant terms were included in the regressions but were not found to be significant. According to the first equation, short-term fluctuations in nominal wage inflation do not have a significant influence on CPI inflation adjustment, whereas the first lag of CPI inflation does. Fluctuations in real wages are also affected by their first lag, albeit with a small negative sign. Changes in unemployment and indirect taxes have opposing influences: an increase in unemployment lowers real wages, whereas higher indirect taxes contribute to higher real wages in the short term.
The positive impact of higher indirect taxes on real wages is evidence of "real wage resistance.* namely a situation where firms' real labor costs rise as a result of exogenous changes in the "tax wedge" which reduce workers' real take-home pay. I/ Tyrv&inen's (1995c) study of wages, taxation, and employment in Finland has shown that the impact on real labor costs is independent of whether tax revenue is collected in the form of income taxes, indirect taxes, or social security contributions. In the context of this model, therefore, higher indirect taxes lead to a temporary increase in real labor costs and yield higher unemployment in the short term. Real wage resistance is also consistent with the fact that the correction of deviations from the long-term equilibrium is faster for CPI inflation than it is for real wages: the coefficient of the cointegrating residual for real wages (0.05) implies that three years are required for 50 percent of any deviation from the equilibrium real wage to be eliminated. 2/
c. Model multipliers
In order to investigate the properties of the estimated model, four simulations of the four-equation VAR system were carried out, each
I/ The tax wedge is defined as the difference between the relevant real wage for the employer (real labor cost) and the relevant real wage for the trade union (real take-home pay). It consists of income taxes, indirect taxes, social security contributions, and the difference between the consumer and producer price indices. 2/ The considerable duration of the short-term effect is also found in the study by Symons and Robertson (1990) for 16 OECD countries. According to their study, a rise of 1 percentage point in the tax wedge on average leads to an immediate rise in real labor costs by one half of a percentage point, and about half of this effect remains after five years.
©International Monetary Fund. Not for Redistribution - 11 -
subjecting the model to a unit shock to an exogenous variable. I/ The following shocks were considered: a 1 percentage point permanent decline in the unemployment rate; a 1 percentage point permanent increase in indirect taxes; a 1 percentage point permanent increase in import prices; and a 1 percentage point increase in productivity growth for 1996 (leading to a permanent rise in the level of productivity).
The results of the unemployment and indirect tax shocks are shown in Chart 2. Lowering unemployment by 1 percentage point leads to about 1 percentage point higher real wage growth in the first 4 quarters compared to the control solution. Subsequently, nominal wage growth converges to CPI inflation, so that real wage growth remains broadly in line with the control solution. Thus real wage growth eventually returns to its control value; the cumulative increase in the real wage level amounts to slightly over 1 percentage point.
A permanent increase in indirect taxes by 1 percentage point initially raises real wage growth above the control values, indicating an overshooting of wages with respect to prices. However, after the first four quarters the error-correction term delivers a sharp decline in excess wage inflation, resulting in marginally lower real wage growth compared to the control solution over the five-year projection period. Eventually, the permanent unit shock to indirect taxes by 1 percentage point leads to a cumulative decrease in the real wage level of less than one half percentage point.
The results of shocks in productivity growth and import prices are shown on Chart 3. As the difference of real wage growth from the control solution fades to zero, a one-time increase in the productivity growth rate leads to a cumulative increase in the real wage level by 0.7 percentage points. However, the speed of adjustment is quite slow: complete convergence occurs beyond the five-year simulation period. In the short term, nominal wage and CF1 inflation increase marginally compared to the control values, reflecting the fact that productivity growth is not significant in the ECM for real wages.
A permanent increase in the import price index by 1 percentage point raises both CPI and wage inflation by under one half percentage point against the control values over the first four quarters. Convergence to the control values roughly occurs by the end of the five-year simulation period. However, this multiplier effect should be interpreted with caution, as it suggests that an import price increase is reflected in a decrease in firms' profits by the same amount. The dynamic response of prices and wages is
I/ The control solution consists of the inflation time paths obtained by keeping the exogenous variables at their end-1995 levels over the forecast period, with the exception of productivity growth, whose growth rate was fixed at its end-1995 value.
©International Monetary Fund. Not for Redistribution - 12 - CHART 2 FINLAND SIMULATION RESULTS, 1996-2001 (Percent difference from control values)
Source: Staff calculations. I/ Annual growth rates.
©International Monetary Fund. Not for Redistribution - 13 - CHART 3 FINLAND SIMULATION RESULTS, 1996-2001 (Percent difference from control values)
Source: Staff calculations.
I/ Annual growth rates.
©International Monetary Fund. Not for Redistribution • 14 -
identical because import prices enter only in the cointegrating vector for CPI inflation, and homogeneity between prices and wages is imposed both in the cointegrating vector and in the error-correct ion mechanism. I/ 4. Outlook for CPI and nominal wage inflation: 1996-2001
In this section, the estimated model is used to project CPI and wage inflation over the period from 1996 :Q1 to 2001 :Q4 under different assumptions on exogenous variables.
a. ne scenario Under the baseline scenario, it is assumed that the unemployment rate will decline by one percentage point per year, from 17 percent at end-1995 to 11 percent in 2001. This path falls short of the authorities' target of 9 percent unemployment by 1999, reflecting the limited progress achieved in 1995-96 in lowering unemployment. The index of indirect taxes is assumed to remain at its end-1995 level. Labor productivity is projected to increase by 1.6 percent in 1996--down from 2.5 percent in 1995 and an average 3.4 percent for 1984-94--reflecting the slowdown in output growth; subsequently it is assumed to increase by 2.7 percent and 3.1 percent per year in 1997 and 1998, respectively, as growth picks up (Table 2).
The import price index (in domestic currency) is affected by developments in the exchange rate and traded goods prices. The baseline scenario assumes that the nominal effective exchange rate of the markka will stabilize at its end-March 1996 level (reflecting a nominal effective depreciation of 4.2 percent in the first quarter), with no subsequent change. Traded goods prices are assumed to change according to the projections of export deflators for goods and services for partner countries (measured in US dollars) based on the May 1996 issue of the World Economic Outlook.
The model's projections for annual consumer price and nominal wage inflation are shown in Chart 4. CPI inflation increases from its end-1995 low to just under 2 percent in 1997 :Q1, reflecting the weakening of the exchange rate in 1996 :Q1 and the decline in the unemployment rate in 1996. Subsequently, inflation drops to 1.5 percent by 1998:Q2 and then rises smoothly to edge above 2 percent by the end of 2001. The trend increase from 1998 onwards is accounted for by the steady decline in unemployment and the roughly constant rate of nominal effective depreciation.
Annual nominal wage inflation drops from its end-1995 high of 6.2 per- cent to 4.8 percent in 1996:Q1 and 2-2.5 percent in 1997. Subsequently, annual wage growth rises steadily to about 3 percent in 2001, yielding slightly under 1 percentage point of real wage growth per annum. The sharp
I/ Import price changes were introduced as an exogenous variable in the ECM but their effect was found to be insignificant.
©International Monetary Fund. Not for Redistribution - 15 -
Table 2. Finland: Baseline Scenario: Exogenous Variable Projections, 1996-2001 I/
(In percent^
Uneaploynent Import Price Change in Year Rate Inflation i/ Productivity
1996 16 4.4 1.6
1997 15 0.6 2.7 1998 14 1.0 3.1
1999 13 1.0 2.5
2000 12 1.1 2.5 2001 11 1.3 2.5
Source: Staff projections.
I/ Indirect taxes are assumed constant at their end-1995 level. 2S Annual growth rates.
©International Monetary Fund. Not for Redistribution CHART 4 FINLAND BASELINE FORECASTS, 1996-2001 (In percent)
Source: Staff calculations.
©International Monetary Fund. Not for Redistribution - 17 - decline in 1996 is explained by the process of equilibrium adjustment of nominal wages (see Chart 1) rather than by the trend projections for the exogenous variables. Specifically, the sharp decline in wage inflation upon the onset of the recession in 1990 and the subsequent increase in late 1994 and 1995--due partly to the recovery and partly to the generous wage agreement in 1994--could be viewed as a deviation from the negative trend observed for most of the 1980s.
Wage drift--wage increases obtained at the industry level over and above the negotiated rate--is obtained as the difference between the wage inflation projections and the annualtzed wage growth specified in the two- year wage agreement of October 1995. In Finland, wage drift has exceeded 2 percent each year from 1970 until 1991, I/ after which it has remained below 2 percent (Tyrv&inen [1995c]). The implications regarding wage drift in 1996 and 1997 are as follows:
Table 3. Wage Drift Projections, 1996-97 (In percent)
1996 1997
Negotiated wage increase 1.7 1.1 Projected wage increase 3.1 2.2 Wage drift 1.4 1.1
Sources: Ministry of Finance; and staff calculations. I/ • Annual growth rate of nominal wages under the two-year wage agreement. i/ Annual growth rate under the baseline projections.
b. Alternative scenario: further depreciation in 1996 This scenario considers the effect on inflation of a further nominal effective depreciation of 5 percent between the second and fourth quarter of 1996. The remaining exogenous variables are unchanged from their baseline projections. The model's inflation projections are shown in Chart 5.
I/ With the exception of 1979, when it was just tinder 2 percent.
©International Monetary Fund. Not for Redistribution CHART 5 FINLAND ALTERNATIVE FORECASTS, 1996-2001 I/ (In percent)
Source: Staff calculations.
I/ A further nominal effective depreciation of 5 percent over the baseline in 1996.
©International Monetary Fund. Not for Redistribution - 19 -
On account of the larger depreciation in 1996, annual CP1 inflation is considerably higher than under the baseline scenario, peaking at 3.2 percent in the second quarter of 1997. From 1998 onward, CPI inflation stabilizes at just under 2 percent and eventually edges above it. Nominal wage inflation declines more slowly than under the baseline scenario, reflecting the higher CPI inflation. However, this result should be treated with caution because--as was discussed in the case of the multiplier for import prices in Section 3--import prices do not directly influence real wages, and therefore prices and wages have to move together in the short term.
©International Monetary Fund. Not for Redistribution - 20 -
References
Akerholm, J., and A. Brunila (1994), Inflation Targeting! The Finnish Experience. Paper presented at the CEPR Workshop "Inflation Targets" in Milan, Italy. Alogoskoufis, 6., et al. (1995), "Unemployment: Choices for Europe," Moni- toring European Integration 5, CEPR.
Andersen, K. And H.-L. M&nnist6 (1995), "Output Gaps and the Government Budget Balance: The Case of Finland," Bank of Finland Discussion Paper 27/95. Banerjee, A., J. Dolado, J. Galbraith, and D. Hendry, "Co-Integration, Error-Correct ion, and the Econometric Analysis of Non- Stationary Data," Advanced Texts in Econometrics. Oxford University Press 1993.
Bank of Finland (1990) , The BOF4 Quarterly Model of the Finnish Economy. Bank of Finland, D:73. Brunila, A. (1996), "Estimates of Cyclically Adjusted Budget Deficits: Are They Reliable?," Bank of Finland Bulletin. 3/96.
Engle, R. and C. Granger (1987), "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica 55, No.2.
, (1991), "Introduction," in Engle, R. and C. Granger (eds.) 1991, Long-Run Economic Relationships. Oxford University Press.
Ford, R. and T. Krueger (1994) , Exchange Rate Movements and Inflation Performance: The Case of Italy. International Monetary Fund, Working Paper 95/41. Johansen, S. (1988), "Statistical Analysis of Cointegration Vectors," Journal of Economics Dvn*"»ics and Control 12, 231-254.
. (1991), "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrtca 59, No.6.
MacKinnon, J. (1990), "Critical Values of Cointegrating Tests," University of California-San Diego Discussion Paper. No 90-4.
Muhleisen, M. (1995) , Monetary Policy and Inflation Indicators for Finland. International Monetary Fund, Working Paper 95/115. Symons, J. and D. Robertson (1990), "Employment Versus Employee Taxation: The Impact On Employment," in 9ECP Elplovment Outlook.
©International Monetary Fund. Not for Redistribution - 21 -
Tyrvainen, T. (1995a) , "Wage Setting, Taxes and Demand for Labour: Multivar- iate Analysis of Cointegrating Relations," Empirical Economics, 20, 271-297.
, (1995b), "Real Wage Resistance and Unemployment: Multivariate Analysis of Cointegrating Relations in 10 OECD Countries," The QECD Jobs Study Working Paper Series 5, OECD.
, (1995c), "Wage Determination, Unions and Employment: Evidence from Finland," Bank of Fifllflpd Studies E:3.
©International Monetary Fund. Not for Redistribution - 22 -
II. The Determinants of die Equilibrium fteal Exchange Rate: An Alication to Finland I
1 . Introduction arift
The real effective exchange rate for Finland has been subject to large swings in recent years (Chart 6). Starting in 1986, for instance, the GPI based rate has first appreciated by some 15 percent, then depreciated more than 30 percent, and since 1993 appreciated by approximately 20 percent. This pattern holds whether the real exchange rate is measured using relative CPIs or relative unit labor costs.
What are the reasons for these swings? And to what extent are they related to a shift of the equilibrium exchange rate rather than to (tempo- rary) shifts away from equilibrium? Of course, it can be argued that at any moment the exchange rate is an outcome of an equilibrium between supply and demand, particularly if the exchange rate is floating, and therefore there can be no misalignment. But this in itself does not guarantee that a particular exchange rate is sustainable in the long run. Therefore it is important to be clear about what we mean by equilibrium: following other studies (e.g. Williamson (1994), Edwards (1994), Montiel (1996)) we define the equilibrium real exchange rate, ERER, as the rate that is sustainable in the long run, i.e., consistent with both internal and external long run macroeconomic balances. The level of such an equilibrium is especially relevant for the possible entry of the markka in the ERM: if the nominal exchange rate is fixed at a level for which the real exchange rate is in disequilibrium, the adjustment will require changes in domestic prices with respect to foreign prices, with potential short-term real effects.
This chapter is an attempt to estimate the factors affecting the equilibrium exchange rate in Finland. The model used is based on the equilibrium exchange rate theory developed in Montiel (1996) . The funda- mentals that determine the equilibrium exchange rate (which in turn is determined by the internal and external balances) are the terms of trade, world real interest rates, the productivity differential, trade policies, and government spending. The theory implies a reduced form that links the equilibrium to the fundamentals. We empirically examine this reduced form, in the spirit of Edwards (1994). In our analysis, given the nonstationary nature of the variables, we use cointegration techniques introduced by Johansen (1988 and 1991). This method has the advantage of defining a relationship between the real exchange rate and its determinants that is valid in the long run, even though there may be large deviations from equilibrium in the short run.
I/ Prepared by Tarhan Feyzioglu.
©International Monetary Fund. Not for Redistribution CHART 6 FINLAND REAL EFFECTIVE EXCHANGE RATES, 1975-1996 (In lop)
Source: PDR, Information Notice System.
©International Monetary Fund. Not for Redistribution - 24 -
We find that during the sample period the equilibrium real exchange rate appreciated (depreciated) in response to positive (negative) shocks in the terms of trade, world real interest rates, and the productivity differ- ential between Finland and its trading partners. The short-run movements were also affected by the price differential between Finland and its trading partners, and by the deviations from the uncovered interest parity. The implied equilibrium exchange rate is quite stable between 1976 and 1985, during which the effects of the terms of trade shocks are mitigated by interest rate and productivity shocks. The equilibrium exchange rate appreciates between 1986 and 1990, primarily due to very favorable terms of trade. With the collapse of trade with the former Soviet Union and the deterioration of the terms of trade in the early 1990's the equilibrium exchange rate depreciates substantially. As the nominal exchange rate is kept unchanged, the markka stays overvalued for more than two years. However, after the markka was floated in September 1992, there seems to have been a long episode of an undervalued markka. The misalignment is estimated to have virtually disappeared in 1995, and projections suggest that the equilibrium real exchange rate is likely to remain close to its present level in the medium term.
The second section briefly describes the theory of the equilibrium exchange rate. The effects of fundamentals on the exchange rate are also discussed. The third section is devoted to the key empirical issues: the properties of the data, the cointegration method, the cointegration results and tests, and the implied long-run equilibrium and short-run dynamics.
2. Theory
There is a wealth of theoretical and empirical work on the determinants of the equilibrium real exchange rate. One important strand of literature is associated with Williamson's seminal work (Williamson 1985) that has its roots in an approach developed by IMF staff (Artus 1977). I/ Williamson defines the fundamental equilibrium exchange rate, FEER, as the rate that "would produce a current account (at internal balance) consistent with the expected saving-investment behavior of both private and public sec- tors". 2/ In order to determine the FEER, it is first necessary to formu- late an econometric model for the trade sector that captures the relation- ships among output, balance of payments, demand and competitiveness. Second, internal balance is defined, usually as the level of economic activity that keeps the inflation rate constant. Third, a normative current account target is chosen by paying particular attention to past imbalances.
I/ The recent advances can be found in Williamson (1994). This approach is used for Finland by Hoj (1995) and Saarenheimo (1995). 2/ If the outcome is unsustainable, the target current account would be that implied by the smallest fiscal adjustment that secures sustainability. If the current account targets of the trading partners are collectively inconsistent, then the largest target surpluses would be reduced until inconsistency is eliminated.
©International Monetary Fund. Not for Redistribution - 25 -
The FEER is then calculated as the exchange rate that maintains equilibrium in both sectors, given the projected output, current account and trade balances, and capital flows. A critical summary of this approach by Black (1994) points out that the policy mix to achieve internal balance, the timing of the implementation of that policy mix, and the target for the current account balance remain serious questions. An alternative approach, followed in this chapter, is to investigate the equilibrium exchange rate by looking at the reduced forms implied by a theoretical model. The theoretical model is based on the long-run equilib- rium real exchange rate model by Montiel (1996)--see also Khan and Montiel (1996). Similar to Williamson's approach, the long-run ERER is defined as the level that is consistent with simultaneous internal and external balance. In addition, a set of exogenous "fundamental** variables are defined. These variables determine the internal and external balances, and thus the long-run equilibrium exchange rate. The reduced form constructed between the exchange rate and the fundamentals lets us investigate the nature of the equilibrium. One major difference with respect to Williamson's approach is that in this approach, there is no need to decide what the appropriate level of current account balance and the external net position should be: they are endogenous to the system.
a. The model
The model is an extension of the two-good null open economy model by Dornbush (1974). The real exchange rate is defined as the relative price of nontraded goods in terms of traded goods, and the nominal exchange rate is assumed to be fixed. I/ The model consists of producers of traded and nontraded goods, representative households that maximize their discounted utility functions, and a consolidated government with a balanced budget. 2J
The producers, households and the government are modeled as follows. The producers are price takers in the world market. Output is produced with a fixed, sector specific input and homogenous, perfectly mobile labor. 2/ Firms in both sectors maximize profits by setting the marginal productivity of labor to the wage rate. The representative household maximizes current and discounted future consumption of traded and nontraded goods, subject to the budget constraint. Each period, the household decides to allocate its
X/ As is seen the results, the fact that markka has been floating in the last three years does not affect the long-run relationship we are seeking. 27 The assumption of balanced budget results in households doing all the borrowing in the economy. The reduced form we examine does not depend on who borrows; this assumption just keeps the model simple. 3/ Of course, this assumption is not strictly true for the Finnish economy, given the large cyclical component of unemployment. However, the long-run results are not affected by this assumption. For a different approach, see Obsfeld and Rogoff (1995).
©International Monetary Fund. Not for Redistribution - 26 -
the budget constraint. Each period, the household decides to allocate its net worth between foreign bonds that pay a nominal interest rate i*, and domestic money that reduces the transaction cost of consumption. The public sector consists of the government and the central bank. The central bank exchanges currency and passes the interest receipts on the foreign bonds it holds to the government. The government keeps a balanced budget, with lump- sum taxes and purchases of traded and nontraded goods. Regarding external borrowing, the arbitrage condition dictates that the country can borrow with a risk premium that is determined by the country's international indebtedness . The model, when solved, implies an external and an internal equilibrium condition. External equilibrium is attained when the level of consumption and the real exchange rate lead to a sustainable current account balance:
where ** is the world inflation rate, a* is the net foreign assets of the country, jj(e) is traded goods output, e is the real exchange rate (relative price of nontraded to traded goods) , I/ i* is the nominal domestic interest rate, r* is the transaction costs associated with consumption, 9 is the (constant) share of traded goods in total private consumption, and gj is government consumption of traded goods. The nominal interest rate is determined by the world nominal interest rate iv and a risk premium that depends on the international asset position of the country. In this equilibrium, the trade surplus is equal to (y^(e) - (r* + $)c • gj). Interest receipts are equal to net foreign assets times the interest rate: i*a*. The two components added up give the current account balance as the right hand side of equation (1). The left hand side shows the portion of net foreign assets that lost its value due to inflation. The equilibrium implies that the sustainable current account amounts to the inflationary erosion of the real value of net foreign assets. Put differently, a sustainable trade deficit must equal the real return on the net foreign assets that depends on the real world interest rate and the risk premium as well as the stock of net foreign assets. Since traded goods output depends inversely on the exchange rate, to sustain the equilibrium, as exchange rate appreciates, consumption of traded goods (as well as total consumption, as 0 is constant) has to fall. This trade off is depicted in Chart 7 as the external balance locus (EB) .
Internal equilibrium is defined by the nontraded goods market:
7N(e) - (1 - 9)c/e + gN (2)
I/ Thus, an increase in e involves a real appreciation.
©International Monetary Fund. Not for Redistribution - 27 - where y# is nontraded goods production, positively related to the exchange rate, and g^ is government consumption of the nontraded good. Given the consumption decisions of the households and the government, this condition defines the equilibrium real exchange consistent with nontraded goods market clearing. An appreciated exchange rate increases the production in the nontraded goods sector. This, in equilibrium, requires an increase in consumption» and this relationship is captured with the internal balance (IB) locus in Chart 7.
CHART 7 Internal and External Equilibrium
Equations (1) and (2) express an equilibrium condition tat must hold in the long run. Chart 7 depicts this equilibrium as the point where the two loci intersect. Of course, the two loci in turn depend on variables that we call fundamentals. A change in the fundamentals changes consumption and the real exchange rate. These fundamentals are discussed in the next section.
b. Effects of changes in the fundasentals In this section, we describe how the fundamentals affect the equilibrium exchange rate, starting with real world interest rates. An increase in the world real interest rate increases the local interest rate, and decreases the demand for money, raising savings and improving the current account balance; to restore external equilibrium a real appreciation is needed. Moreover, if the country is a net creditor in the international markets, interest receipts increase, and the external balance locus also
©International Monetary Fund. Not for Redistribution - 28 -
shifts up involving an increase in consumption and an appreciation of the ERER. On the other hand, if the country is a net debtor in the inter- national markets, as is the case for Finland, the interest payments on existing debt go up. However, as long as the effect of interest payments does not dominate the effect of increased saving, the external balance locus still shifts up even if a country is net debtor. In conclusion, an increase in interest rates leads to an appreciation of the real exchange rate unless the country is net debtor and the saving propensity is not much elastic to interest rates. The terms of trade also affect the equilibrium exchange rate. To see this, the model can be modified by splitting tradables into exportables and importables, with the real exchange rate redefined as the price of nontradables in terms of importables. A positive terms of trade shock (an increase in the price of exports relative to the price of imports) causes the output in the nontradables to decline, creating an excess demand in the nontraded goods sector, and shifting the internal equilibrium locus up. At the same time, the external equilibrium locus shifts up as well, reflecting the necessity to have an appreciated exchange rate in order to maintain the sustainable trade balance. Thus, the new equilibrium requires an appreciation of the real exchange rate. Productivity differentials also influence ERER. An increase in the productivity of the traded goods sector relative to the nontraded goods sector results in an expansion of the traded goods sector at the expense of the nontraded goods sector. Similar to a positive terms of trade shock, such a shift creates an excess demand for nontraded goods, which can be eased by a real appreciation of the exchange rate. This implies an upward shift of the internal equilibrium locus. The positive productivity shock improves the trade balance, which also requires a real appreciation to keep the trade account at a sustainable level. Finally, government decisions on its consumption level and trade policy have effects on the ERER. An increase in government consumption of nontraded goods requires an increase in production in the nontraded goods sector; in turn, this requires an exchange rate appreciation. Conversely, if government consumption of traded goods increase, the trade balance deteriorates, and a depreciation is necessary to achieve external balance. Also, a reduction in an export subsidy has a similar effect on internal balance as a deterioration of terms of trade: IB shifts down as the increase in nontradables creates excess supply. External balance also shifts down, similar to a terms of trade change, but without the income effect. As a result, the exchange rate depreciates.
3. Empirics
a. Data
The quarterly data set spans two decades, starting in the first quarter of 1975 and ending in the second quarter of 1995 (Chart 8). All variables,
©International Monetary Fund. Not for Redistribution - 29 -
CHART 8 FINLAND
DETERMINANTS OF REAL EXCHANGE RATES
Sources: International Financial Statistics, Bank of Finland, Competitiveness Indicator System, and staff calculations.
©International Monetary Fund. Not for Redistribution - 30 -
except the interest rate, are in logarithms. For the real exchange rate, reer, we use the CPI based real effective exchange rate, calculated by the IMF. I/ An increase in the rate means an appreciation. The productivity variable, prod, is the difference in productivity in the manufacturing sector between Finland and its trading partners. £/ For world interest rates, R, we use long-term real interest rate in Germany. The terms of trade, tt, are the price of exports relative to the price of imports.
We also use additional variables that are not directly taken into account in the theory section. The structure of trade, and therefore the exchange rate permanently shifted as trade with the Former Soviet Union collapsed. We capture this effect with a dummy variable, Dum91, equal to unity starting in the first quarter of 1991. There are also large, one-time jumps in the real exchange rate due to devaluations. We single out these points by using a dummy variable, dumdev, that is unity during the devaluation periods.
We have not included government consumption and tariffs, quotas, and export subsidies in our dataset. Government consumption decomposed into tradable and nontradable goods is not available. A summary index of protection is not available in a usable form, either. Moreover, the degree of protection appears to have been relatively constant across our sample.
One last aspect, relating to the short-run real effects of nominal variable, needs to be discussed. In periods of fixed exchange rate, the observed real exchange rate may deviate from its long-run equilibrium not only because of adjustment lags, but also as a result of financial policies. For example, a monetary expansion that results in higher domestic inflation brings about a real appreciation if the nominal exchange rate is fixed. This appreciation moves the observed real exchange rate away from equilibrium. This deviation is not sustainable in the long run. However,
I/ We use this definition (external exchange rate) rather than the internal real exchange rate used in the theoretical part because we lack good measurement of the former. As long as the law of one price holds for the traded goods, it can be shown that the external rate is equal to the internal rate, scaled by the internal rate of the rest of the world (see Hinkle and Nsengiyumva (1996)). We assume that the variation in the aggregate internal exchange rate of Finland's trading partners is not large enough to reverse the relationship between the external exchange rate and the fundamentals. For simplicity we also concentrate on the CPI based real exchange rate rather than the unit labor cost based measure. For a detailed analysis of the difference between these definitions, see Lipschitz and McDonald (1992). 2J The theory section emphasized the productivity difference between the tradable and nontradable sectors, but such data are not readily available. The expected influence on the exchange rate of the productivity measure we use, given our definition of the real exchange rate is the same as in the theoretical model.
©International Monetary Fund. Not for Redistribution - 31 -
in the short run, financial policies may explain even large swings in the observed real exchange rate. These swings can, in principle, be modelled as done in Edwards (1994). In practice, however, modelling these effects through some measure of financial policies is difficult: for example, using some measure of the money supply is not appropriate if there are relevant shifts in money demand. I/ Thus, we tackle with this problem by including in our equations a variable that measures directly the effect of the stance of financial policies: the price differential between Finland and its trading partners, ppoth, which is nonzero before the exchange rate was floated. As an increase in ppoth signals a relaxation of monetary policy, under fixed exchange rate, we expect it to be positively correlated with the real exchange rate. Under the floating exchange rate, a different short term effect should be considered. An increase in domestic interest rates stimulates capital inflow, bringing with it an appreciated nominal exchange rate, and if prices do not adjust immediately, a temporary appreciation of the real exchange rate. To capture such short term effects, we use the deviations from uncovered interest parity uip, calculated by assuming perfect foresight, for the period when the exchange rate was floating.
We paid special attention to the stationarity properties of the variables. Since fundamentals are defined as variables that affect the real exchange rate in the long run, they should have the sane order of integration as the real exchange rate. If the real exchange rate is stationary, in the sense that it reverts to a particular mean, then the fundamental should be stationary too. However, if the exchange rate is nonstationary, then any stationary variable cannot be a fundamental. This is because any variable that drifts stochastically permanently away from its mean cannot be affected in the long run by a variable that reverts to its mean; the effects remain only in the short run. Of course, nonstationary variables should be examined under the framework of cointegration.
The univariate statistical properties of the variables are summarized in Table 4. £/ The real effective exchange rate appears to contain a unit root: neither the Augmented Dickey-Fuller (ADF) test nor the Phillips-Peron (PP) test rejects the null hypothesis of a unit root, and the estimated roots are very close to unity. I/ This result is in line with other findings in the literature. &/
I/ Indeed, money demand in Finland is regarded as quite unstable. £/ In all the tables in this chapter, three stars means that the test statistic is significant at 1 percent probability, two stars at 5 percent probability, and one star at 10 percent probability. 2/ The results do not change when we consider a break in 1991, and repeat the tests by splitting the sample. 4/ For example, see Juselius (1995). For an exception, see Lothian and Taylor (1996), where they find mean reversion in the Dollar/Sterling and Franc/Sterling real exchange rate that spans almost two centuries.
©International Monetary Fund. Not for Redistribution - 32 -
Table 4. Univariate Statistical Properties
Variable trend lags ADF PP
reer No 3 -2.3439 -2.2360 tt No 2 -1.4071 -1.6524 r No 2 -3.2017** -2.6426* prod Yes 2 -3.7057** -3.9291** ppoth No 3 -2.3912 -3.7617*** uip No 0 -2.5852* -2.5381
The unit root test results are mixed and inconclusive for some of the variables. The existence of a unit root cannot be rejected in the case of the terms of trade. By contrast, the hypothesis of a unit root in the german long-term real interest rate can be rejected at 5 percent if ADF test is used, but cannot be rejected if FP test is used. For the productivity differential, the null hypothesis can be rejected at 5 percent, irrespective of the type of the test, in favor of stationarity around a deterministic trend. The existence of a trend could be at least partly explained by the high investment ratio in Finland relative to its trading partners. We should note that if we do not include a deterministic trend in modeling the productivity differential, we do not reject the existence of a unit root. The price differential appears strongly stationary under the PP test, but nonstationary under the ADF test. Uip has the opposite characteristic. Since the tests are not conclusive, we cannot rule out the possibility that the series are nonstationary. After all, the inference is biased toward too frequent rejections only if we mistakenly assume that a series is stationary. The cointegration technique discussed below also can shed some light into this issue: if a variable is stationary, then it should not significantly affect the cointegration relation and could be kept out. If we do not find a variable significant in the cointegrating vector, that becomes another indication that that variable is stationary.
b. Methodology
In this section, we discuss the empirical methodology used in investigating the relationship between the real exchange rate and its fundamentals. As discussed above, there is a strong indication that the CPI based real exchange rate in Finland does not tend to revert to any mean.
©International Monetary Fund. Not for Redistribution • 33 -
Stochastic and deterministic trends are also found in the fundamentals. Such statistical properties of die data require us to use the cointegration technique, which is suitable for handling nonstationary data to search for a relationship between the variables of interest. I/ Another characteristic of cointegration is that the relationship uncovered holds in the long run, which is more appropriate for the fundamentals we are searching for.
We utilize the full information maximum likelihood system approach (Johansen (1988, 1989), and Johansen and Juselius (1990)). We define the long-run relationship between the real effective exchange rate and the fundamentals as follows:
where xt is the vector of the fundamentals, ft is the vector of cointegrating coefficients, and zt is the error term. If the exchange rate and the variables that we consider to be fundamentals form an equilibrium, then they should not deviate from each other too much for too long. This means that the error zt, which can be interpreted as deviations from the equilibrium, should be stationary. The exchange rate that is predicted from this equation (et* -Jtt'/}*, where ft* is the estimated vector of coefficients) is the long-run equilibrium rate that is defined by the fundamentals at each time t.
We also define the short-run dynamics consistent with the long-run equilibrium. This is done by modeling the exchange rate as an error correction mechanism (ECM):
Here, the change in the exchange rate is affected by its past changes, and by changes in fundamentals and other short-run variables, wt. More important, it is affected by past deviations from the equilibrium. If, for instance, the exchange rate at t-1 was overvalued relative to the fundamentals, then zt_j is positive. This period, the exchange rate corrects itself by an amount dictated by the coefficient a. Contemporaneous values of the fundamentals can be introduced on the right hand side if such variables are weakly exogenous, in the sense that in the long run they are
I/ Edwards (1994) uses least squares method in searching for the fundamentals. Elbadawi (1994)and Faruqee (1995) use the cointegration method, but within different theoretical frameworks.
©International Monetary Fund. Not for Redistribution - 34 -
not influenced by the equilibrium. The coefficients of the contemporaneous differenced variables can also be interpreted as short-run elasticities. Lagged differenced values of the exchange rate and the fundamentals are introduced to Whiten the error. The system full information maximum likelihood method is the most efficient among the alternatives, if the assumptions on the data generating processes of the random shocks to the system are valid (see Hamilton 1995). The errors should have normal distribution, should not be serially correlated, and should not have any conditional heteroscedasticity or nonlinearity. The diagnostic tests are performed by estimating an unrestricted VAR with sufficient lags to eliminate any remaining serial correlation, and then checking the properties of the residuals. The Jarque- Bera and the portmanteau tests are used to for normality and serial correlation. For nonlinearities, squared terms of the variables are tested for significance. We test for the existence of a relationship between the set of fundamentals and the real effective exchange rate using the Johansen cointegration test. Once cointegration is established, we test for the significance of each variable in the cointegrating vector. Acceptance of insignificance of a variable may mean that that variable is not a fundamental. We also test for the weak exogeneity of the fundamentals. Economic theory suggests that we should take the exogeneity of the variables as the maintained hypothesis. Thus, testing for exogeneity can be seen as another means of model validation. Next, we model the short-run adjustment by incorporating the cointegrating vector obtained from the Johansen procedure into the ECM. Here, we go from general to specific by starting with the longest lag length for all variables, and eliminating the insignificant ones. c. Results (1) Cointegration diagnostics and results
In the unrestricted VAR, we included three lags of the real exchange rate and its fundamentals (terms of trade, the German long-term real interest rate, and the productivity differential). We also included the shift dummy for the collapse of trade with the Soviet Union, the dummy that indicates the devaluation periods, and a trend term to explain the trend in the productivity differential variable.
We are interested in the outcome of the diagnostic tests on the residuals: if there are no indications against the validity of the assumptions for system estimation, we can use the Johansen procedure. The results of the diagnostic test are presented below in Table 5. None of the test statistics rejects the null hypothesis in question. Three lags seem to be sufficient to eliminate any serial correlation in the residuals. The
©International Monetary Fund. Not for Redistribution - 35 -
assumptions of normality and conditional homo see das ticity are not rejected for any of the residuals. There are no signs of a nonlinear relationship in the system either.
Table 5. Diagnostic Tests
Test Test Test Distribution Statistic
serial correlation X2<9> 16.89 normality X2(2) 4.52 reer equation ARCH F(4,55) 0.53 nonlinearity F(27,35) 1.75
serial correlation X206) 122 . 24 The whole VAR system normality X2(8) 8.72 nonlinearity F(270,270) 0.74
The results of the cointegration tests are in Table 6. The trace statistics, adjusted for the degrees of freedom, point to a single cointegrating vector. I/ The cointegrating vectors associated with each cointegration test are tabulated in Table 7.
I/ We produce the unadjusted figures to get a sense of the lack of power due to a small sample. Unadjusted for the degrees of freedom, both the trace statistic and the eigenvalue statistics indicate the existence of a cointegrating vector, and trace statistics hint for a second cointegrating vector. There may be a second cointegrating vector, especially if we believe that the productivity differential is stationary, since it dominates the second cointegrating vector with its large coefficient.
©International Monetary Fund. Not for Redistribution - 36 -
Table 6. Cointegration Tests
Eigenvalue statistics Trace statistics
Ho: p — number of cointegrating Adjusted Unadjusted Adjusted Unadjusted vectors for d.f. for d.f. for d.f. for d.f.
p — 0 29.19 34.42** 69.91*** 82.43*** p <- 1 21.62 25.49 40.72 48.02** p <- 2 13.59 16.03 19.10 22.52 p <- 3 5.51 6.50 5.51 6.50
Table 7. Cointegrating Vectors
reer tt r prodf dun91 trend
1 1.00 -0.90 0.09 3.75 0.18 -0.03
2 -10.21 1.00 -4.10 26.64 -11.93 -0.01
3 -29.10 21.51 1.00 -6.63 -1.48 0.02
4 -0.07 -0.92 0.03 1.00. -0.08 -0.00
©International Monetary Fund. Not for Redistribution - 37 -
Next, we run a set of exclusion and exogeneity tests on the system, with results given in Table 8. I/ The exclusion restrictions are all rejected, lending support to the hypothesis that the real exchange rate and the vector of fundamentals are of the sane order of integration. More important, these results imply that the terms of trade, real interest rate, and productivity affect the exchange rate in the long run.
Table 8. Exclusion and Exogeneity Tests
Test Variable X2 statistic
tt 2.6642* Exclusion from the fundamentals r 3.6622* prod and trend 11.9928***
tt 0.1481 Weak exogeneity r 0.0255 prod and trend 8 . 6682***
The tests also show that the terms of trade and the real interest rate are exogenous to the system, as expected. However, weak exogeneity in the case of the productivity differential is rejected. 2/ It is conceivable that productivity can deviate from its trend due to some common factors that affect the exchange rate. Nevertheless, this effect can only be in the short run and cannot justify a feedback to productivity in the long run.
I/ All tests have x2 distributions with 1 degree of freedom, except the tests on prod and trend where there are 2 degrees of freedom. 2/ This test is conducted jointly with the trend variable because the trend in the cointegrating equation was included only to model the trend in the productivity variable. If productivity is not included, the trend should not be included in the cointegrating vector either.
©International Monetary Fund. Not for Redistribution - 38 -
Given our priors, we model all the fundamentals as exogenous, and estimate the cointegration relation with this maintained assumption. The resulting vector is as follows:
e - cons + 0.37*tt + 0.031*r + 0.85*prod - 0.14*Dum9I - 0.006*trend (5)
The coefficients are of the expected sign: the real exchange rate appreciates in the long run if the terms of trade improve, or the interest rate goes up, or the productivity differential increases above the trend.
We also model the short -run adjustment through the ECM. We take the implied error correction vector, Z£-l» from the Johansen procedure and use it in the ECM, together with current and past differenced fundamentals and other variables that affect the real exchange rate in the short run. We eliminate all variables that are not significant. The results are as follows : i/
Areert - 0.54 - 0.11*zt_i "*" 0.14*Areert_i + 0.18*Areert_2 + 0.73*Appotht (0.11) (0.02) (0.07) (0.07) (0.31)
All the coefficients are highly significant. The price differential has the expected sign: a higher price level in Finland leads to an appreciated real exchange rate in the short run, during the managed exchange rate period. Similarly, a positive deviation from the uncovered interest parity leads to an appreciated exchange rate during floating exchange rate period. As model validation, we see that both lagged dependent variables are significant, justifying the use of three lags in levels, and the adjustment coefficient is almost identical to the one estimated in the Johansen method.
I/ The figures in parentheses are standard errors. All t-statistics are significant at 5 percent probability.
©International Monetary Fund. Not for Redistribution - 39 -
(2) Implications The fundamentals imply a long-run equilibrium exchange rate at each point in time that is calculated from the cointegrating vector we estimated above (Chart 9). The movements of these estimated equilibrium rates can be explained by combining the individual effects of each of the fundamentals. At the beginning of our sample, in 1975, there was a sharp decline in the equilibrium exchange rate as the terms of trade and the productivity differential fell. Since then, the equilibrium exchange rate seems to have been quite stable until the mid-1980s. During this period, the impact of a decline in the terms of trade was rougly offset by the effects of an increase in the world real interest rate and more rapid productivity growth.
In the past decade, the equilibrium exchange rate seems to have had two major shifts. In 1986, the equilibrium rate appreciated sharply, owing to a strong improvement in the terms of trade. The effect of further improvement in the terms of trade in late 1980's was offset by that of a sharp decline in interest rates. This appreciated level of equilibrium was maintained until the beginning of 1990's when the declines in the world interest rates and relative productivity and a deterioration of the terms of trade caused the equilibrium rate to depreciate dramatically below the early 1980's level. This depreciation was also influenced by the collapse of trade with the Former Soviet Union. More recently, the recovery of the terms of trade and the interest rate, combined with a sharp increase in the relative productivity, has pushed up the equilibrium rate. However, since the structure of trade with the Former Soviet Union countries has changed, the previous equilibrium level has not been attained. We also made projections for the equilibrium exchange rate into the near future. In our projection, we assume that productivity will continue to rise along its trend, world real interest rates will not change, and that the terms of trade will fall by 1.5 percent and 3.9 percent in 1996 and 1997 (see SM/96/159). Incorporating these assumptions into the estimated model leads to projections of the equilibrium real exchange rate that remain roughly unchanged in the next few years. The actual exchange rate has deviated from the estimated long-run equilibrium exchange rate at times with long durations (Chart 10) . As the equilibrium rate appreciated in 1986, the actual exchange rate remained undervalued for approximately three years, until 1989. When the equilibrium rate depreciated at the end of 1990, the actual exchange rate remained overvalued for two years before the markka was floated and the actual rate
©International Monetary Fund. Not for Redistribution CHART 9 FINLAND REAL EFFECTIVE EXCHANGE RATES, 1975-2000 (In logs)
Sources: PDR, Information Notice System, and staff calculations.
©International Monetary Fund. Not for Redistribution CHART 10 FINLAND REAL EFFECTIVE EXCHANGE RATE MISALIGNMENTS, 1975-1995 (In logs)
Source: Staff calculations.
©International Monetary Fund. Not for Redistribution - 42 -
surpassed the equilibrium rate. I/ Since then, the markka stayed undervalued until 1995, when the markka seems to have converged back to a level that is broadly in line with the fundamentals. The ECM can shed some light to the nature of these large deviations. The adjustment coefficient that captures how much a deviation from equilibrium influences the exchange rate is small: it takes approximately one and a half years for half of the adjustment to take place. Also, none of the contemporenous differenced fundamentals are significant, implying that the short-run influence of the fundamentals is minimal.
The variables that primarily explain the short-run deviations are the price differential between Finland and its trading partners, and deviations from uncovered interest parity. An increase in domestic prices relative to the prices of Finland's trading partners is not immediately reflected in the nominal exchange rate during the managed exchange rate era, and this leads to periods of overvaluation. Similarly, there are important deviations from uncovered interest parity. As expected, an increase in the domestic interest rate (without a corresponding increase in the world interest rate) lowers consumption and leads to capital inflows, appreciating the real exchange rate during the floating exchange rate period.
I/ The sharp decline in the estimated long run exchange rate is partially due to the dummy variable set to switch in 1991, to capture the collapse of trade with the Soviet Union. Even though the largest one-time decline is in 1991, signs of weakening trade were present before. Since we do not use a smooth dummy, we may be overestimating the equilibrium exchange rate just before 1991.
©International Monetary Fund. Not for Redistribution . 43 -
References
Bayoumi, Tamim, Peter Clark, Steve Symansky, and Mark Taylor, "The Robustness of Equilibrium Exchange Rate Calculations to Alternative Assumtions and Methodologies* in Estimating Equilibrium Exchange Rates. ed by John Williamson.
Black, Stanley, 1994, "On the Concept and Usefulnessof the Equilibrium Rate of Exchange," in tt^i^lny Emtllibri^i Exchange Rates, ed by John Williamson.
De Gregorio, Jose, Alberto Giovannini, and Thomas Krueger, 1993, "The Behavior of Nontradable Goods Prices in Europe: Evidence and Interpretation," International Monetary Fund Working Paper Series, No. 45.
De Gregorio, Jose, and Holger Wolf, 1994, "Terms of Trade, Productivity, and the Real Exchange Rate," NBER working paper series, No. 4807.
Dornbush, Rudiger, 1974, "Real and Monetary Aspects of the Effects of Exchange Rate Changes , " in HfttJM*! Monetary Policies and the International Financial System, ed by R. Z. Aliber, University of Chicago Press.
Edwards, Sebastian, 1994, "Real and Monetary Determinants for Real Exchange Rate Behavior: Theory and Evidence from Developing Countries," in Estimating Equilibyj,\m Exchange Rates, ed by John Williamson.
Elbadawi, Ibrahim, 1994, "Estimating Long -Run Equilibrium Real Exchange Rates " in Estimating Equilibrium Exchange Rates ed by John Williamson.
Faruqee, Hamid, 1995, "Long-Run Determinants of the Real Exchange Rate: A Stock-Flow Perspective," IMF Staff Papers.
Froot, Kenneth and Kenneth Rogoff, 1995, Perspectives on PPP and Long-Run Real Exchange Rates , Handbook of International Economics , Vol 3 .
Greenwood, Jeremy, 1988, "Non-Traded Goods, the Trade Balance, and the Balance of Payments , " Canadian Journal of Economics .
Hamilton, James, 1994, Time Series Analysis. Princeton University Press
Hinkle, Lawrence and Fabien Nsengiyumva, 1996, "The Relationship Between the External and Internal Real Exchange Rates: Competitiveness, Productivity, and the Terms of Trade," mimeo, The World Bank
Ho j , Liselotte, 1995, "Fundamental Equilibrium Exchange Rate - A Case Study of the Finnish Markka," Bank of Finland Discussion Papers, No. 2/95.
©International Monetary Fund. Not for Redistribution - 44 -
Johansen, Soren, 1988, "Statistical Analysis of Cointegration Vectors It Journal of Economic pYnapiCiff and Control. No. 12, PP» 231*254. 1991, "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica. Vol. 52, pp. 389-402. and Katarina Juselius, 1990, "Maximum Likelihood Estimation and Inference on Cointegration - with Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics. Vol. 52, pp. 169-210. Juselius, Katarina, 1995, "Do Purchasing Power Parity and Uncovered Interest Rate parity Hold in the Long Run? An example of Likelihood Inference in a Multivariate Time Series Model," Journal of Econometrics. Vol. 69, No. 1, pp. 211-240. Khan, Mohsin and Peter Montiel, 1996, "Real Exchange Rate Dynamics in Small, Primary Commodity Exporting Country", in Functioning of the International Monetary System, ed. by J. A. Frenkel and Morris Goldstein, International Monetary Fund. Lipschitz, Leslie and Donough McDonald, 1992, "Real Exchange Rates and Competitiveness," Empirica. Vol. 19, No. 1, pp. 37-69.
Lothian, James, and Mark Taylor, 1996, "Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries," Journal of Political Economy. Vol. 104, No. 3, pp. 488-509.
Mark, Nelson, 1995, "Exchange Rates and Fundamentals: Evidence on Long- Horizon Predictability," AHKrrJJCan Economic Review. MacDonald, Ronald, 1995, "Long-Run Exchange Rate Modeling: A Survey of the Recent Evidence," International Monetary Fund Working Paper No. WP/95/14. , and Mark Taylor, 1993, "The Monetary Approach to the Exchange Rate," IMF Staff Papers.
Meese, Richard and Kenneth Rogoff, 1983, "Empirical Exchange Rate Models of the 1970's: Do They Fit Out of Sample?," Journal of International Economics.
Montiel, Peter, 1996, "The Theory of the Long-Run Equilibrium Real Exchange Rate," mimeo, Oberlin College. Obstfeld, Maurice, 1995, "International Currency Experience: New Lessons and Lessons Relearned," Brookings Papers on Economic Activity.
©International Monetary Fund. Not for Redistribution . 45 -
, and Kenneth Rogoff, 1995a, "Exchange Rate Dynamics Redux," Journal off PoXl.ti.cal Economy« , and Kenneth Rogoff, 1995b, "The Intertemporal Approach to the Current Accountv " in Handbook of Internatio_Qal Econoinics, Vol. 3. Saarenheimo, Tuomas, 1995, "The Equilibrium Exchange Rate for the Finnish Markka," Bank of Finland Discussion Papers, No. 29/95. Taylor, Mark, 1995a, "The Economics of Exchange Rates," Journal of Economic Literature.
, 1995b, "Exchange-Rate Behavior under Alternative Exchange-Rate Arrangements " in Understanding Interdependence. Williamson, John, 1985, "The Exchange Rate System," Policy Analyses in International Economics 5. Washington: Institute of International Economics. Williamson, John, 1994, BfftJBitiiflff Equilibrium Exchange Rates. Institute for International Economics.
©International Monetary Fund. Not for Redistribution - 46 -
III. The Finnish Banking System and the Credit Crunch Hypothesis i/
1. Introduction
The purpose of this paper is to provide a survey of the conditions of the banking system in Finland and to evaluate whether there has been a credit crunch in the aftermath of the banking crisis of 1992-93. As background, the Finnish banking industry underwent considerable changes in the second half of the 1980s. The period was marked by increased competition in financial services, economic deregulation, the removal of cross-border restrictions on capital flows, and financial innovation. After a sharp credit boom, it also proved to be a period leading to financial fragility, as lower asset quality and declining profitability deteriorated banks' balance sheets to the point where the Government in the early 1990s had to support some of the largest banks to preserve financial stability. As a result of problem assets, bank profitability deteriorated sharply, and income from financial operations declined due to the loss of interest payments on nonperforming assets and growing loan losses. Subsequent to the banking crisis, the loans to the private sector by the banking sector declined significantly, leading to concerns that the weak conditions of the banks brought about a credit crunch.
A credit crunch is generally defined as a decline in the supply of credit resulting from a reduced willingness to lend by banks that is not reflected in higher lending rates. Most factors that limit credit supply by banks also affect alternative sources of financing. However, there are certain factors which are unique to banks, such as increased regulatory oversight and banks1 own reaction to deterioration of bank asset values and profitability. In this framework, credit crunch results from rational profit maximizing behavior of lenders under asymmetric information. More specifically, banks may not be willing to increase the interest rate enough to eliminate excess demand if the adverse selection and incentive effects of such an increase lead to decreasing expected profits.
Understanding whether weak business credit growth is related to a credit crunch or to weak demand for credit is important from a policy perspective. If the supply of credit or the willingness to lend play an important role, then structural measures (e.g., regulatory changes and intervention to strengthen the banking system) may be needed to remove the obstacles to growth. With this in mind, a disequilibrium model of credit supply and demand is estimated in an attempt to identify the factors determining business credit. The results of the empirical analysis suggest that even though there may be some evidence of a credit crunch immediately after the banking crisis, since 1993 the reduction in bank lending has been mainly in reaction to a decline in credit demand, rather than to a credit crunch.
I/ Prepared by Ceyla Pazarbasioglu.
©International Monetary Fund. Not for Redistribution - 47 -
The rest of the paper is organized as follows. Section 2 provides a review of the relevant empirical literature. Section 3 reviews the financial market developments in Finland during 1980-95. Sections 4 and 5 outline the model and the estimation methodology, respectively. Section 6 presents the empirical results. Concluding remarks are provided in Section 7. Appendix 1 provides data sources. 2. Literature review
The flow of credit results from factors which affect both the supply and demand for credit. Thus, the observed decline in the volume of credit may be the result of a decline in willingness to lend or a weak demand for loans. I/ In the relevant empirical work on this topic, disequilibrium econometric models have been used to establish the empirical significance of a credit crunch. The results of Laffont and Garcia (1977) for Canada, Sealy (1979) for the United States, Ito and Ueda (1981) for Japan and Kugler (1987) for West Germany and Switzerland indicate large disequilibrium situations in the market for bank loans. In contrast, the empirical results do not show any evidence of disequilibrium for the United States in Ito and Ueda (1981), for the United States and United Kingdom in Kugler (1987) and for Australia in Blundell-Wignall and Gizycki (1994). Using data for different states of the U.S. Bernanke and Lown (1991) conclude that bank capital limited banks9 credit supply (supporting the "credit crunch11 hypothesis").
Following the approach of Bernanke and Lown (1991), Solttila and Vihri&l& (1992) find a very small, but statistically significant, negative relationship between the growth of lending by individual Finnish savings banks in 1991 and their projected capital adequacy indicator. However, as reported by Vihri&lft (1996a) the analysis suffers from a very inadequate treatment of demand factors, and there is no attempt to account for differences in borrower quality. In a recent study, Saarenheimo (1995) analyzes the linkages between the recent collapse in investment and the decline in bank credit in Finland. The main question he addresses is whether the decline in bank credit and investment merely reflects the fall in the demand for credit or whether the slump in investment is due to the tightening of bank credit and firms' inability to raise external funds. He finds SIMM evidence that the latter may be the case in Finland. His first argument is that the margin between the loan rate linked to the interbank rate and the three-month interbank rate shows an upward shift around 1990. He notes that the fact that there has not been any reduction in interest margins seems to imply that the weak demand for loans alone does not explain the sluggishness in the credit market. Saarenheimo1s second argument is that the commercial paper issued by firms continued to grow for several years after the decline in bank
I/ See Bhattacharya and Thakor (1993) and Vihri&l& (1996a) for a survey of the theoretical literature on credit rationing.
©International Monetary Fund. Not for Redistribution - 48 •
loans. This implies that firms nay have substituted this alternative source of funds in response to a decline in access to bank credit. Furthermore, debt financing became less advantageous as tax deducibility was reduced. He also reports that according to surveys and various informal sources, small and medium-sized firms have faced problems in obtaining bank loans because of insufficient collateral.
Vihrialfi (1996a) reports that in public discussion credit crunch due to capital shortages of batiks, risk aversion by bank managers, and regulatory tightening have been blamed for the sharp recession and the slow recovery experienced in Finland. Based on aggregate data, he concludes that the tightening of capital regulations, the substantial depletion of bank capital, and changed risk attitudes and disturbances caused by restructuring are possible explanations of the negative supply shocks. In particular, the results appear to confirm the existence of a credit crunch due to bank capital problems in 1991*92.
In another study, Vihrial& (1996c) analyzes bank lending in the early 1990s for 393 savings and cooperative batiks and concludes that the findings do not support the hypothesis of a general credit crunch caused by inadequacy of capital. However, some banks, especially cooperative banks, with potentially weak capital base appear to have accelerated their credit expansion ("gamble for resurrection"). Vihriall also notes that the weak borrower quality contributed to the contraction of bank lending in 1991*92.
3. Finland: An overview of financial sector developments (1986*95)
The Finnish banking sector underwent considerable changes following the financial liberalization which took place from the mid-1980s. In August 1986, the Bank of Finland totally abolished the regulation of banks1 average lending rates, and companies were allowed to raise foreign credit either through a bank or directly from foreign sources, with no quantitative restrictions. I/ Similar to the experience of other Nordic countries, such as Norway and Sweden, Finland experienced a pronounced and long-lived boom-and-bust cycle. The significant improvement of terms of trade due to the oil price decline and the surge in world market prices for paper and pulp products in the late 1980s, as well as the easier access to credit led to a sharp increase in domestic demand. The domestic boom, also characterized by higher investment activity, was reinforced by the rapid expansion of credit that fueled speculation in shares and real estate, which in turn raised wealth levels and thus made additional borrowing possible.
I/ See Brunila and Takala (1993), Drees and Pazarbasioglu (1995), and Nyberg and Vihriala (1993, 1994) for further information on the financial liberalization measures taken in Finland and the evolution of the banking crisis.
©International Monetary Fund. Not for Redistribution . 49 -
Prior to the deregulation of financial Markets from 1986, the sheltered banking environment, which was characterized by limited price competition, fostered a business mentality and strategies aimed at long-term relation- ships with clients. It also allowed decentralized credit decision making (often at the branch level) and lax credit risk management, and encouraged cross-subsidization between various banking services. Since deposit rates were regulated, banks competed for market share by building extensive branch networks. Profitability was largely assured by the interest rate regulations and lack of competition, and most measures of bank profitability remained quite stable. More generally, banking regulation appears to have supported cost structures in banking that would not have been viable in a deregulated environment.
Banks1 loan losses during the post-deregulation era were very small. At the same time, banks1 capital levels were also low. Thus, they had little cushion against loan losses, making them vulnerable to adverse economic shocks. Taken together, the reduced regulatory costs that were associated with deregulation and the low equity ratios provided a strong incentive for banks to accommodate the surge in credit demand and to bear more risk.
By the late 1980s, the increased borrowing had pushed private indebtedness to unsustainable heights. Tax reforms, in combination with a tightening of monetary policy and lower inflation, raised real after-tax lending rates noticeably and contributed to a sharp drop in property and share prices. In response, households began to consolidate their financial positions by cutting back on consumption, and firms decreased investment considerably (Chart 11). As a result, Finland entered a deep recession that in turn accelerated the asset price deflation. Compounding the initial domestic demand shock was a collapse of trade with CMEA countries in 1990- 91, and a drop in paper and pulp prices in the world market. In addition, the decline in investment by most European countries adversely affected exports by the Finnish metal industry. Furthermore, interest rates increased in most European countries, including, Finland, in the aftermath of the German unification process.
With the collapse of asset prices and the onset of a severe recession, bank loan losses began to mount rapidly in the early 1990s. Given the thin capitalization of banks, the high loan losses impaired greatly the financial position of the banking system. The loan losses of the Finnish banks--net write-offs on loans and guarantees--peaked at 4.8 percent of total lending in 1992, compared to 0.5 percent in 1989. Total nonperforming loans declined from about 12.5 percent in 1993 to about 6 percent in 1995. While losses on real estate loans represented a significant share of the overall problem, losses on foreign-currency denominated loans were also large.
Developments in the Finnish banking industry in the aftermath of the banking crisis of the early 1990s have been mixed (Table 9). There have been several steps forward. The credit and guarantee losses of the Finnish banking system declined from about 4 percent of total lending in 1994 to
©International Monetary Fund. Not for Redistribution CHART 11 FINLAND GROSS INVESTMENT/GDP (In percent)
Source: Data provided by the Central Bank of Finland. ©International Monetary Fund. Not for Redistribution - 51 -
Table 9. Finland: Key Figures for the Deposit Banks, 1992-95 (In billions of Finnish markkas)
Groups Consolidated 1992 I/ 1993 I/ 1994 I/ 1995 I/
All deposit banks Income from financial operations 10.7 13.0 13.7 12.4 Other income 9.5 9.7 8.6 8.2 Total income 20.2 22.7 22.3 20.6 Expenses 14.9 15.3 16.4 15.5 Depreciation 1.9 1.9 1.5 1.7 Profit before credit and and guarantee losses 3.4 5.5 4.4 3.4 Credit and guarantee losses 14.0 14.7 11.2 6.2 Profit before extraordinary items, appropriations and taxes -10.6 -9.2 -6.8 -2.8
Total assets 688.9 726.8 667.8 616.6 Nonperforming assets, net 35.9 25.4 19.6
Capital adequacy (BIS), commercial banks (in percent) 10.7 10.7 11.7 11.5 Risk-weighted claims and commitments 404.7 391.1 328.6 286.1
Risk-weighted claims and commitments 488.5 419.5 371.0
Source: Data provided by the Central Bank of Finland.
I/ Excluding Siltapankki, Savings Bank of Finland (SBF) and Arsenal.
©International Monetary Fund. Not for Redistribution 07/10/96 9:42«m - R:\DOC\C2\FIN\CNS\RED-CP.TB1 - 52 -
about 2 percent in 1995. The stickiness of lending rates vis -4- vis the money market rates has declined significantly since 1992. I/ The proportion of loans tied to the base rate--which is determined by the Parliamentary Supervisory Board--has dropped from more than 90 percent in early 1988 to 23 percent in 1995, reflecting the sharp increase in loans tied to banks' prime rates and HELIBOR (Chart 12). Capital adequacy also improved. To cover their losses and safeguard their capital adequacy, the banks have strengthened their equity through share issues and using instruments under tier-two capital which helped raise the capital adequacy ratio well above the required 8 percent. 2J During 1994-95, the banks-- excluding the asset management companies--did not need additional government support in order to maintain capital adequacy and no support is expected in the foreseeable future. I/
Despite these positive developments and prospects, Finnish banks still face significant challenges. The aggregate banking sector posted negative results for 1995. Operating profits before credit and guarantee losses fell consecutively in the last two years, by about 15 percent and 20 percent in 1994 and 1995, respectively. The ratio of net interest income to assets is the lowest among Nordic countries (less than 2 percent compared to 3 percent and above for the other countries) while the ratio of expenses to total assets is the highest.
I/ In late 1995, the bank rates, in particular lending rates followed closely the market rates, and there has been a significant decline in the average rate on new lending since then. 2J However, although the capital adequacy ratios seem high (about 11.5 percent according to BIS standards), a large component of tier-one capital is composed of government capital certificates. The banks will need to pay off these securities in the next two years in order to avoid a sharp increase in the servicing cost of this subordinated loan from the Government. I/ There are about Fmk 40 billion of assets currently in the books of the asset management companies which are owned by the Government. The state had to provide Fmk 8 billion capital support to one of the asset management companies, Arsenal, in 1995 and will provide another Fmk 4 billion in 1996, because assets were written off at above market prices at the time of the takeover from the banks. This support had been anticipated and was financed with short-term money market instruments in 1994. The Finnish authorities do not expect any further need for government support to the asset management companies after 1996. For further information, see Nyberg and Vihriala (1993, 1994).
©International Monetary Fund. Not for Redistribution CHART 12 FINLAND INTEREST RATE LINKAGES IN BANKS' MARKKA LENDING (In percent)
Source: Data provided by the Bank of Finland. ©International Monetary Fund. Not for Redistribution - 54 -
The high operating cost of banks reflect their excessive branch network and oversized staff inherited from the past. Some improvement is expected in the near future. Reflecting the restructuring measures taken by banks after the banking crisis, the number of bank staff and bank branches have been reduced considerably, but these developments have not yet been reflected in the trend of expenses. This mainly reflects the one-off costs of closing branches, severance payments, and other restructuring related items; it is expected that the savings from restructuring will become apparent in 1997-98. However, there is still a need to streamline operations, cut costs, and reduce bank staff. The restructuring process of the Finnish banking system is still continuing and the banks are planning to take additional measures by end-1997.
Restructuring efforts in the aftermath of the banking crisis have led to significant changes in the structure of the Finnish banking sector (Table 10). At end-1995, the three largest banks accounted for about 80 percent of total assets of the deposit banks. The assets of the largest bank, Merita Bank*-which was formed by a merger of the two major commercial banks in mid-1995--accounted for about 50 percent of total assets.
The low level of net interest income, also a major problem, is related mostly to the weakness of lending activity. This is because the most profitable component of banks' portfolios (bank loans) has been shrinking as a ratio to bank deposits. This brings us to the issue of why bank lending has been so slow in recent years.
4. The model
In order to evaluate whether there was a credit crunch in the aftermath of the banking crisis in Finland, this paper estimates a disequilibrium model of a system of equations for the supply of and demand for business credit. Following the work by Laffont and Garcia (1977) and Blundell- Wignall and Gizycki (1994), the supply and demand for business credit is modelled as follows (see Appendix 1 for a discussion of the data).
a. The credit supply equation
The supply of business loans (Ls) is determined by a portfolio management approach. In this framework, given expectations on yields of different assets, the bank takes into account the available resources in deciding on the amount of business credit to supply. In the specification of the loan supply function used in this paper, the available resources are represented by total deposits (D). In addition, the stock market's assessment of the relative expected profitability of banks is included in order to determine the ease with which banks can raise new capital to fund loans in the following period. The banking sector share price relative to the market average (sp^/sp) is used as a proxy for the stock market's assessment. Both D and (spb/sp) increase the resources available to the bank and are expected to have a positive effect on the supply of loans.
©International Monetary Fund. Not for Redistribution - 55 -
Table 10. Finland: Bank Structure
Bank Structure 1986 1990 1994
Total number of banks 629 509 358 I/ Domestic 619 498 348 State -owned 1 1 2 Private 618 497 346 Foreign owned banks or branches 3 4 4 Other banks (mortgage banks) 7 7 6 Total number of employees, all banks 48,245 50,019 35,590 Employees in 5 largest banks 20,001 28,556 21,201 Branches, all banks 3,543 3,344 2,153
(In millions of Finnish markkaa) Total assets, all banks 382,003 729.627 668,397 Total loans, all banks 170,564 388,184 301,693 Total deposits by the public, all banks 145,347 258,789 282,424 Interbank liabilities, all banks (except Bank of Finland) 19,865 24,072 Total liabilities (excluding own capital) , all banks 358,925 683,394 646.646
(Percent of total)
Assets held by 5 largest banks 66 57 73 Public deposits held by 5 largest banks 44 48 63 Loans to public held by 5 largest banks 53 59 65
Source: Data provided by the Central Bank of Finland. I/ The reason for the sharp decline in the number of banks is that most of the savings banks merged to form the Savings Bank of Finland.
©International Monetary Fund. Not for Redistribution - 56 -
The rate on short-term bank loans (i^) is used to denote the profitability of banks' lending activities. This variable is expected to have a positive effect on the supply of business credit. I/
The market capitalization of corporate equity (Ecorp) is used to represent the net worth of the corporate sector and the collateral available to banks, and is expected to have a positive sign.
To account for a cyclical risk premium, the difference between the lending rate and the money market rate is used (i^ - i^,,) . The higher the loan rate relative to the money market rate, the higher are the cyclical agency costs and thus the higher is the risk premium. As in Bemanke and Gertler (1989) , it is assumed that agency costs decline in booms and rise in recessions. These include costs associated with adverse selection and moral hazard which arise due to asymmetric information between borrowers and lenders .
Two alternative proxies are used to represent the state of the overall economic environment. First, the expected inflation rate (ire) is predicted to have a negative effect on the credit supply of banks . The second variable is the expected industrial production (ye) , formulated with a distributed lag, which is expected to have a positive sign.
As in Blundell-Wignall and Gizycki (1994) , the variance of bank share prices (a) relative to the market average is included as a variable reflecting risks specific to the banking sector. A higher a, i.e. higher banking risks are expected to lead to a decline in the supply of business credit by banks.
Thus, the following specification for the credit supply equation was used for estimation purposes:
b. The credit demand equation
As discussed in Laffont and Garcia (1977), it is important not to impose rationing on demand by including explanatory variables which would reflect an eventual rationing such as the volume of actual investment. To
I/ This variable can also be seen as the yield differential of loans with respect to liquidity (the yield of the latter being zerio or constant).
©International Monetary Fund. Not for Redistribution - 57 - avoid this problem, the volume of expected fixed investment is used as an explanatory variable. I/ This variable, (Ie), is expected to have a positive effect on the demand for business credit.
The demand for business credit is expected to depend negatively on the lending rate (i^), as bank customers would delay investment plans during periods in which the lending rates for a given rate of expected inflation are higher. As higher level of inflation would erode the value of nominal debt, the demand for credit depends positively on the expected rate of inflation (we). Similar to the effect on credit supply, expected growth proxied by the distributed lag on the index of industrial production, ye, is expected to have a positive effect on demand for credit. Therefore, the following specification for the credit demand equation was used for estimation purposes:
5. ETRVirJ-ca>l methodology Simplifying equations (1) and (2), the model considered in this paper consists of the following equations:
where Ls denotes quantity of business credit supplied, Ld quantity of business credit demanded, X^t and X2t denote variables that influence supply and demand respectively, and u^t and U2t are the residuals. Allowing for the possibility that the price of credit is not perfectly flexible and rationing occurs, the disequilibrium hypothesis is formulated as follows:
i/ However, it could be argued that bank customers take into account that there may be rationing when making future investment plans. Another potential problem in using data on investment is that loan demand is a stock variable whereas investment is a flow variable.
©International Monetary Fund. Not for Redistribution - 58 -
where 1^. is the actual quantity of business credit observed during period t. As shown by Maddala and Nelson (1974), in the absence of any information concerning the price adjustment process and assuming that the errors are normally distributed random variables, the model itself allows the determination of the probabilities with which each observation belongs to the demand or supply equation. Maddala and Nelson discuss the appropriate maximum likelihood method for this class of models which resembles the method suggested by Tobin (1958) for the estimation of models with limited dependent variables. The log likelihood function (ML) is defined as follows:
where
Using the Newton-Raphson iterative procedure, the log likelihood function shown in equation (6) is used to obtain the maximum likelihood estimates based on monthly data from 1981 to 1995.
©International Monetary Fund. Not for Redistribution - 59 -
6. EfftifflP^^on ^results The estimation results are shown in Table 11. As the Finnish banking sector was fully liberalized in August 1986, equations (1) and (2) are estimated for the periods prior to and after the liberalization. I/
In the loan supply equation, the lending rate has the expected positive sign for both periods; the effect of this variable is stronger in the post- deregulation period. Deposits have the expected positive signs for the post-deregulation period, while they are insignificant for the pre- deregulation period. This may imply that the deposits became more binding in the aftermath of the deregulation due to the expansionary credit policy of the banks. The relative share price index, proxying for the ease with which banks can raise new capital, has the expected positive sign in both periods; as would be expected the effect, of this variable is stronger in the period after the deregulation.
The market capitalization of corporate equity, proxy for the collateral available to banks, enters the equations with the expected positive sign with a higher coefficient in the post-deregulation period. The equations were also estimated for the sub-period 1991-95. The results are comparable to the post-deregulation results; most variables have similar coefficients except the coefficient of the market capitalization variable which becomes stronger suggesting that banks paid more attention to borrower quality in the aftermath of the banking crisis. £/
The effects on loan supply of the proxies for the state of the economy, expected inflation and output, are only significant for the post- deregulation period. The risks specific to the banking sector, represented by the variance of bank share prices relative to the market average, does not appear to have an important explanatory power. The difference between the lending rate and the money market rate, a proxy used to represent cyclical agency costs, has the expected negative sign for the post- deregulation period.
Important determinants of the loan demand equation are lending rate and expected investment and both have the expected signs. Output does not appear to have a significant explanatory power in the loan demand equation for either of the subperiods. Inflation has a negative effect on loan demand in the post-deregulation period.
Based on the estimates obtained for the demand and supply of business credit in the post-deregulation period, the percentage by which demand
I/ Chow tests were performed to test for the stability of regression coefficients over the sample* period. A structural break was identified between 1986-87, the period of financial deregulation. 2J The author would like to thank Vesa Vihriala for useful discussions on this issue.
©International Monetary Fund. Not for Redistribution - 60 -
Table 11. Finland: Estimation Results I/
Pre-Deregulation Period Post-Deregulation Period
(1) (2) LS LD Ls LD Constant -17.21* -11.94* -50.88* -8.32 (-2.56) (-6.48) (-15.89) (-0.75) Lending Rate 2.76* -3.49* 7.36* -4.68* (4.69) (-2.29) (2.47) (-3.14) Deposit 0.02 4.20* (1-46) (17.34) Market Capitalization 0.04* 0.07* (3.27) (4.97) Inflation 0.21 -4.72 -6.89** -5.80* (0.50) (-0.40) (-1.61) (-2.18) Relative Share Price Index 4.77* 9.02* (5.71) (1.98) Variance of Share Price Index 0.05 0.04 (0.88) (0.16) Interest Differential 2.92* -2.68* (15.83) (-2.09) Output 0.71 0.56 2.96* 11.33 (0.33) (1.05) (2.92) (0.97) Expected Investment 0.01* 0.02* (2.88) (1.70) Number of Observations 81 111 Log Likelihood Function -158.04 -408.16 al 1.63* 12.07* (12.57) (11.74) °2 2.42* 8.77 (2.29) 1.43
II The asterisks, * and **, denote significance at 95% and 90% confidence intervals, respectively.
©International Monetary Fund. Not for Redistribution - 61 - exceeds supply is calculated and presented in Chart 13. The excess demand for business credit prevails even after the deregulation of financial markets (1986-88) which reflects the fact that the banks remained constrained with respect to their lending rates. As discussed in the background section, Finnish bank loans traditionally carried variable interest rates and all loan rates were tied to the base rate, which was set administratively by the Bank of Finland and tended to be relatively unresponsive to changes in market conditions. Also, the indebtedness of the corporate sector grew rapidly as corporations had been highly dependent on borrowing from financial institutions and, as in other countries with universal banking systems, relied heavily on debt financing. A major investment boom took place in Finland following the deregulation process, with the majority of investment activity occurring in residential and nonresidential construction, real estate and services. Reflecting institutional changes as well as increased access to credit by borrowers, the period 1989-91 which is also a period of strong credit expansion, is characterized by alternating periods of excess supply and excess demand. In particular, in January 1990, the Bank of Finland allowed banks to set their own prime interest rates on borrowing and lending. Furthermore, banks were allowed to emit their own certificates of deposit. The development of money markets--besides changing the conduct of monetary policy--provided banks with new funding opportunities, permitting more aggressive lending largely financed by bought funds instead of standard retail deposits. Similarly, the lifting of foreign exchange restrictions allowed banks to acquire funds abroad and to lend them as foreign-currency denominated loans to domestic customers. It is interesting to note that in the crisis period (mid-1991 to 1993) the market for business credit was characterized by a significant degree of credit rationing. This is consistent with the findings of Vihri&la (1996a, 1996c). In contrast, the period between 1993 and mid-1994 is characterized by weak demand for credit, perhaps reflecting the balance sheet consolidation efforts of borrowers and the tightened collateral requirements. The turnaround in domestic demand, which was particularly brisk in the first few months of 1994, as reflected in the sharp increase in the sales of consumer durable goods, seems to have led to a short-lived excess demand for capital during late 1994. During this period, increases in corporate sector's profitability, reduced indebtedness of the sector and lower interest rates contributed to a 22 percent rise in machinery and equipment investment. Since then there is no further evidence of credit rationing.
The model predicts more or less an equilibrium situation in the credit market for the second half of 1995 and a slight increase of credit demand over supply. This finding is consistent with recent survey results in which only 10 percent of firms in the manufacturing sector and 8 percent of firms in the services sec tor--including small and medium sized firms--reported financing difficulties.
©International Monetary Fund. Not for Redistribution - 62 -
Chart 13* Finland: Demand and Supply for Bank Credit
©International Monetary Fund. Not for Redistribution - 63 -
7. Cone lus i ons
In this paper, the empirical significance of a credit crunch in Finland following the banking crisis was analyzed using monthly data on financial sector indicators. The results of the disequilibrium analysis for business credit suggest that the marked reduction in bank lending during the 1990s has been mainly in reaction to a cyclical decline in credit demand, reflecting partly the high level of indebtedness of the borrowers. It also appears that banks have become less willing to supply credit during periods associated with a deterioration in asset quality, erosion of rents accruing to banks due to declining regulatory protection from competition, as well as a need to increase capital adequacy levels. The episodes of a reduction of supply relative to demand, such as in 1994, has been accompanied by a rise in the spread between the bank lending rate and the marginal cost of bank funding. Survey results provide some evidence that banks increased collateral requirements during 1994, tightening nonprice credit terms. However, more recent surveys suggest that this process has stopped and that the percentage of firms which face difficulty in accessing credit has declined to less than 10 percent. In sum, the current situation in the Finnish credit market does not seem to suggest the presence of a credit crunch.
©International Monetary Fund. Not for Redistribution CHAPTER III - 64 - APPENDIX I
Description of Data
This appendix provides the description of the data used in the empirical analyses. Credit to business sector by banks: Monthly data on domestic currency and foreign currency lending to the business sector. Source: Bank of Finland.
Lending rate: Monthly data on the weighted average of the lending rate linked to different rates. Source: Bank of Finland. Deposits: Monthly data on total deposits. Source: Bank of Finland. Corporate net worth: Market capitalization of listed equities. Annual data was extrapolated using seasonal adjustment variables. Source: Bank of Finland.
Inflation: Monthly data on the log of the Finnish consumer price index. Source: IFS (line 64), International Monetary Fund. Relative share price index: Monthly data for the ratio of share price index for the banking sector relative to the stock market average. Source: Bank of Finland. Interest differential: Monthly data for the difference between the lending rate and the 3-month HELIBOR rate. Source: Bank of Finland.
Expected investment: Quarterly data on survey results on expected investment by businesses. The data was extrapolated using seasonal adjustment variables. Source: Bank of Finland.
©International Monetary Fund. Not for Redistribution - 65 -
References
Bhattacharya, S. and A. Thakor, "Contemporaty Banking Theory," Journal of Financial Intermediation. Vol.3, pp. 2-50, (U.S.A.: March 1993).
Bernanke Ben, and Mark Gertler, "Agency Costs, net Worth, and Business Fluctuations," American Economuc Review. Vol. 79, No. 1, pp. 14-31, (U.S.A.: December 1989). Bernanke Ben, and Cara Lown, "The Credit Crunch," Brooking Papers on Economic Activity. Vol.1, pp. 205-247, (U.S.A.: June 1991). Blundell-Wignall and Gizycki, "Credut Supply and Demand and the Australian Economy " Reserve Bank of A\|gtralia Research Disc^gg^on Paper, No. 9208 (Australia: 1992). Brunila, Anne, and Kari Takala, "Private Indebtedness and the Banking Crisis in Finland," Bank of Finland Workinf Paper 9/93 (Finland: May 1993).
Drees, Burkhard, and Gey la Pazarbasioglu, "The Nordic Banking Crises: Pitfalls in Financial Liberalization?," International Monetary Fund, Working Paper Series. WP/95/61, (IMF: June 1995). Jonung, Lars, Hans Tson Soderstrom and Joakim Stymne, "Depression In the North: Boom and Bust in Sweden and Finland, 1985-93," Stockholm School of Economics Working Paper (Sweden: 1994).
Ito Takatoshi and K. Ueda, "Tests of the Equilibrium Hypothesis in Disequilibrium Econometrics: An International Comparison of Credit Rationing," international Economic Review. Vol.22, pp. 691-708, (U.S.A.: March 1981) Koskenkyla, Heikki, "The Nordic Banking Crisis.» Bank of Finland Bulletin. Vol. 68, No. 8 (Finland: Bank of Finland, 1994), pp.15-22. Koskenkyla, Heikki, and Jukka Vesala, "Finnish Deposit Banks 1980-1993 Years of Rapid Growth and Crisis," Bank of Finland Working Paper 16/94 (Finland: Bank of Finland, 1994).
Kugler, Peter, "Credit Rationing and the Adjustment of the Loan Rate," Journal of Macroeconomics. Vol. 9, No. 4, pp. 505-525, (U.S.A.: Fall 1987). Laffont, Jean-Jacques, and Rene Garcia, "Disequilibrium Econometrics for Business Loans," Econometrica. Vol. 45, No. 5, pp. 1187-1204, (U.S.A.: July 1977). Lehmussaari, Olli-Pekka, "Deregulation and Consumption Saving Dynamics in the Nordic Countries," Staff Papers. International Monetary Fund, Vol. 37 (March 1990), pp. 71-93.
©International Monetary Fund. Not for Redistribution - 66 -
Maddala, G. S. and F. D. Nelson, "Maximum Likelihood Methods for Models of Markets in Disequilibrium," Econometrica. Vol.42, No. 6, pp.1013-30 (U.S.A.: December 1974).
Nyberg, Peter, and Vesa Vihri&l&, "Finnish Banking Problems: Handling and Prospects," Bank of Finland Bulletin. Vol. 67, No.4 (1993), pp. 3-7.
, "The Finnish Banking Crisis and its Handling," Bank of Finland Working Paper 7/94 (Bank of Finland, April 1994).
Saarenheimo, Tuomas, "Credit Crunch Caused Investment Slump? An Empirical Analysis Using Finnish Data," Bank of Finland Working Paper 6/95 (Bank of Finland, February 1995).
Sealy, G.W., Jr. "Credit Rationing in the Commercial Loan Market: Estimates of a Structural Model Under Conditions of Disequlibrium," Journal of Finance, Vol. 34, pp. 689-702 (U.S.A.: June 1979).
Solttila, Heikki, and Vesa Vihri&l&, "Finnish Banks1 Problem Assets: Results of Unfortunate Asset Structure or Too Rapid Growth?," Bank of Finland Working Paper 23/94 (Finland, December 1994) .
Vesala, Jukka, Testing for Competition in Banking: Behavioral Evidence from Finland. Bank of Finland Studies E:l, (Finland, March 1995).
Vihriala, Vesa, "Theoretical Aspects to the Finnish Credit Cycle," Bank of Finland Working Paper 8/96 (Bank of Finland, April 1996).
, "Credit Growth and Moral Hazard: An Empirical Study of the Causes of Credit Expansion by the Finnish Local Banks in 1986-1990," Bank of Finland Working Paper 10/96 (Bank of Finland, April 1996).
, "Credit Crunch and Collateral Squeeze? An Empirical Study of the Credit Supply of the Finnish Local Banks in 1990-1992," Bank of Finland Working Paper 11/96 (Bank of Finland, April 1996).
©International Monetary Fund. Not for Redistribution - 67 - STATISTICAL APPENDIX
Tabla 1. Finland: national Accounts Summary, 1992-96
In Billions of Finnish Harkkaa iit Currant Pricas Armual parntare Chanes at Constant 1990 Prices 1995 1992 1993 1994 1995 1996 I/
Consumption 417.2 -4.1 -3.6 1.5 3.3 2.8 Privata 299.0 -4.9 -2.9 1.8 4.2 3.5 Public 118.2 -2.2 -5.3 0.9 1.1 1.3 Gross fixed investment 84.6 -16.9 -19.2 -0.3 8.1 12.7 Private 70.6 -19.6 -19.5 -0.3 11.2 14.6 Public 14.0 -2.0 -17.8 -5.4 2.8
Final domestic demand 501.8 -7.0 -6.8 1.2 4.1 4.6
Stockholding J/ £/ 1.3 1.5 1.2 2.3 -0.2 -0.3
Total domestic damand 503.1 -5.6 -5.5 3.6 3.7 4.2
Exports of goods and sarvicas 203.2 10.0 16.7 13.3 7.9 3.3 Imports of goods and sarvicas 160.3 1.1 0.8 12.6 7.1 7.4
For sign balanca £/ 2.1 4.2 1.0 0.8 -0.9
Gross domestic product 550.1 -3.6 -1.2 4.4 4.2 3.0 Memorandum itams: Salaetad pries deflators Exports of goods and sarvicas 6.7 6.5 1.1 5.2 1.7 Imports of goods and sarvicas 7.2 8.7 -0.2 -0.3 3.0 GDP 0.7 2.4 1.1 3.7 1.3
Sources: Statistics Finland, ftaviaad National Accountff; Ministry of Financa . Raviaad Hatiovial Budftat May 1996; data provided by the Finnish authorities.
i/ Official projections. £/ Including the statistical discrepancy. 3/ Changes in percent of GDP in the preceding year.
©International Monetary Fund. Not for Redistribution - 68 - STATISTICAL APPENDIX
Tabla 2. Finland: Rational Income and Houaahold Dispoaabla Income, 1992-96
In Billions of Finnish Markkaa Percentage Change from Preceding at Currant Prices Yaaj? Excent a* Noted 1995 1992 1993 1994 1995 1996 i/
Wages md salaries 218.1 -5.7 -6.5 0.6 6.9 6.0 Employers' contribution* to social insurance 63.6 -5.3 -2.8 4.1 10.3 3.0 Net property and entrepreneurial income 98.9 0.2 33.1 43.1 24.4 -4.0
National income at factor cost 380.5 -4.9 -0.6 8.8 11.6 3.0
Indirect business taxes laaa subsidies 59.5 -5.1 1.0 5.7 2.0 13.0 National income at market pricaa 440.1 -4.9 -0.3 8.3 10.1 5.0
Household disposable income 310.1 1.1 -1.3 -0.7 8.6 3.5
Household consumption -5.1 -2.9 2.0 4.3 3.5 Manorndum itans: CM*4mv vm¥4t* 9/ M K 10.i A 4A 8 .« x 4 .44 7 .2 6 .5 Real household disposable income £/ -2.9 -5.3 -2.1 7.4 3.5 Households' indebtedness ratio £/ 75.5 72.2 70.4 61.4 60.5
Sources: Statistics Finland. Revised National Accounts :Ministry of Finance, Revised National Budxet May 1996: data provided by the Finnish authorities.
y Official projections. 2/ Household saving as a percentage of disposable income. S/ Deflated by the private consumption deflator. 4/ Households' outstanding debt at and of period as percent of disposable income.
©International Monetary Fund. Not for Redistribution - 69 - STATISTICAL APPENDIX
Table 3. Finland: Gross Fixed Investment, 1992-96
At Current Prices Percent In Constant Prices ; of Total Annual Percentage Changes 1995 1992 1993 1994 1995 1996 I/
Total gross fixed investment 100.0 -K.? -19.2 dLl &J> 12-2 Of which: Private 83.6 -19.6 -19.5 -0.3 11.2 14.6 By type of asset Buildings 43.5 -19.2 -20.7 -4.1 1.2 9.0 Other construction 13.4 -8.3 -10.9 -0.2 -1.0 2.5 Machinery and equipment 43.1 -16.0 -20.0 6.2 26.0 24.5 Memorandum item: Gross fixed investment as percentage of GDP 18.4 14.8 14.6 15.4 16.8
Sources: Ministry of Finance, National Budget February 1996. and data provided by the Finnish authorities.
I/ Official projections.
©International Monetary Fund. Not for Redistribution - 70 - STATISTICAL APPENDIX
Table 4. Finland: Financial Balances, 1992-96
(In percent of GDP)
1992 1993 1994 1995 1996 I/
Gross national saving 12.1 13.0 16.7 20.0 20.4 Households 10.0 8.5 5.9 7.7 7.0 Enterprise 4.2 8.6 12.8 13.8 12.6 Financial institutions 0.1 6.8 0.7 0.8 1.0 Nonprofit institutions 0.1 0.2 0.4 0.4 0.4 Public sector I/ -2.3 -5.2 -3.1 -2.7 -0.6
Gross capital formation 16.7 14.3 15.4 15.6 17.2 Statistical discrepancy -0.5 0.3 -0.7 -1.6 -1.5 Current account balance -4.6 -1.3 1.3 4.3 3.2
Sources: Ministry of Finance, Revised National Budget Mav 1996: and data provided by the Finnish authorities.
I/ Official projections. £/ Includes semi-public pension funds.
©International Monetary Fund. Not for Redistribution - 71 - STATISTICAL APPENDIX
Table 5. Finland: Gross Domestic Product by Sector of Origin, 1992-96
Shara in GDP in Parcant Annual Percentage Changes in Volume 1995 I/ 1992 1993 1994 1995 1996 g/
Enterprise sactor 79.9 -3.4 0.7 6.0 4.4 2.5 Agriculture, fishing and hunting 3.0 -11.2 4.8 -0.2 -6.4 1.0 Forastry 3.5 13.1 4.0 15.3 3.4 -6.0 Mining and quarrying 0.4 -2.2 -2.6 12.0 -0.1 3.0 Manufacturing 28.1 2.0 5.4 11.8 9.1 3.5 Elactricity, gas, and water 2.4 -0.5 4.2 5.7 -2.7 3.0 Building construction 4.7 -17.2 -17.1 -2.7 3.6 6.0 Othar construction 1.7 -7.4 -6.3 -1.9 -2.3 2.0 COBBMTCa J/ 10.4 -11.8 -5.5 4.0 4.0 4.5 Transport and communication 8.9 -0.5 3.2 4.6 3.8 2.5 Finance, raal astata 4/ 17.5 -4.6 4.2 0.9 1.5 2.5 Othar sarvicas 2.5 -1.9 -2.4 0.2 0.2 2.0 Laas: imputed bank sarvioa changas -3.1 -17.3 8.7 -7.0 -2.8 6.5
Government sarvicas 18.0 -2.2 -4.5 0.2 1.7 1.5 Othar i/ 2.1 0.4 -0.9 1.5 1.0 (TOP at factor cost 100.0 -3.1 -0.4 4.7 3.9 2.4 GDP at aarkat pricas -3.6 -1.2 4.4 4.2 3.1
Soureas: Ministry of Financa, Ravi sad National Budset May 1996. and data provided by tha Finnish authoritias.
I/ Preliminary estimate* as of February 1996. y Official projections. £/ Including hotels and restaurants. y Including insurance and business sarvicas. £/ Including nonprofit institutions and domestic sarvicas of housaholds.
©International Monetary Fund. Not for Redistribution - 72 - STATISTICAL APPENDIX
Tabla 6. Finland: Labor Forca, Employment, and Participation Rate, 1992-96
In Thousands 1995 1992 1993 1994 1995 1996 i/
(Pejpcenta&e chanRe from nrevious irear) Labor forca survey data Population of working ag« £/ 3,839 0.6 0.5 0.6 0.4 0.3 Labor forca 2,497 -1.2 -0.7 -0.2 0.7 0.5 Employment 2,060 -7.1 -6.1 -0.8 2.2 1.5 Agriculture and forestry 158 -5.6 -7.0 -4.0 -5.4 -6.3 Mining, manufacturing, and utilities 454 -9.8 -6.4 0.5 6.6 1.3 Construction 120 -16.8 -16.1 -8.8 5.3 3.3 Services 1,328 -5.2 -5.0 -0.2 1.4 2.5
(In percent of the labor fprce) Participation rate 65.0 66.1 65.3 64.9 65.0 65.1 Unemployment 17.2 13.1 17.9 18.4 17.2 16.0 Youth unemployment £/ 29.9 25.2 33.5 33.6 29.9 27.0
Source: Ministry of Finance, Reavised Rational Budrcet May 1996* and data provided by the Finnish authorities.
I/ Official projections. y Ages 15 to 74 years. 3/ Ages 15 to 24 years.
©International Monetary Fund. Not for Redistribution - 73 - STATISTICAL APPENDIX
Table 7. Finland: Wages, Costs, and Prices, 1992*96
(Annual Dercentaffe chATlffAS^
1992 1993 1994 1995 1996 I/
Hourly wages and salary earnings 1.9 0.8 2.0 4.7 4.0 Negotiated wages increase 0.9 -- 0.7 3.7 3.0 Wage drift 1.0 0.8 1.3 1.0 1.0 Real hourly wage and salary earnings £/ -0.7 -1.4 0.9 3.7 3.0 Average hourly compensation i/ 1.8 1.2 1.4 4.6 3.8 Unit labor costs 4/ Whole economy -2.6 -5.3 -3.2 3.6 3.0 Manufacturing -8.0 -6.3 -3.2 6,1 Producer prices of manufactured products 2.2 3.9 1.5 3.4 • • •
Consumer prices (1990 - 100) 2.6 2.2 1.1 1.0 1.0 (December on December) (2.3) (1.6) (1.6) (0.3) (2.0) Basic price index for domestic supply 1.1 3.3 1.4 0.7 • • •
GDP deflator, at market prices 0.7 2.4 1.1 3.7 1.3
Sources: Bank of Finland Bulletin; Ministry of Finance. Revised National Budget Mav 1996: and data provided by the Finnish authorities. I/ Official projections. £/ Adjusted for the consumer price index. I/ Total wage and salary earnings and employers' social insurance contributions from the national accounts, divided by hours worked. Thus, beside earnings and insurance contributions, compensation includes fringe benefits, overtime pay, and the effects of shifts in the structure of employment. 4/ Index of compensation divided by a volume index of production.
©International Monetary Fund. Not for Redistribution - 74 - STATISTICAL APPENDIX
Table 8. Finland: Central Government Cash Revenue and Expendituref 1992-96
1992 1993 1994 1995 1996 1/
(In billioiis of Finnish narkk Excluding nonbudgetary funds £/
Total revenue 127.9 127.6 128.2 143.1 156.4 Taxas and revenue similar to taxes 105.1 100.2 104.3 108.5 122.9 Income and waalth taxas 32.0 29.1 32.2 37.9 43.3 Salas tax 40.0 37.3 37.7 36.9 43.6 Dutias on foreign trada 1.7 1.5 1.5 0.3 0.1 Excisa dutias 18.5 20.4 21.0 21.8 23.0 Othar 12.9 11.6 11.9 11.8 12.9 Othar ravanua 22.8 27.4 23.9 34.6 33.5
Total expenditure 174.8 181.6 183.1 195.0 197.7 Consumption 53.8 50.8 52.2 54.3 56.1 Transfers 107.7 110.4 107.3 113.5 110.2 Raal invastmant 5.0 4.3 3.7 3.2 3.2 Othar axpanditura 8.2 16.1 20.0 24.0 28.2 Ravanua balanca -46.9 -54.0 -54.9 -51.9 -41.3
Loans rapaid to tha stata 1.2 2.8 1.5 0.8 0.7 Financial invastaant 10.0 7.2 10.1 9.9 5.9
Financial balanca -55.7 -58.4 -63.5 -61.0 -46.6 Including nonbudgetary funds £/
Total ravanua 126.6 129.2 128.6 144.6 158.0 Total axpanditura 168.0 177.9 182.9 194.6 197.6
Ravanua balanca -41.4 -48.6 -54.3 -50.1 -39.6 Financial balanca -71.8 -61.0 -64.9 -58.9 -46.2
(In oar cant of GDP) Excluding nonbudgatary funds £/ Ravanua balanca -9.9 -11.2 -10.8 -9.4 -7.2 Financial balanca -11.7 -12.2 -12.5 -11.1 -8.1 Including nonbudgatary funds £/ Ravanua balanca -8.7 -10.1 -10.7 -9.1 -6.9 Financial balanca -15.1 -12.7 -12.7 -10.7 -8.1 Memorandum itans: Central government debt 34.7 53.0 60.4 65.1 71.2 Defense expenditures (in billions of markkaa) 9.3 9.0 8.5 8.1 ...
Sources: Ministry of Finance. National Budget Februaryr 1996: data mrovided by tha Finnish authorities; Bank of Finland Bulletin.
I/ Official estimates. 2/ Funds closa to tha central government sector but normally not consolidated with tha central government budgat.
©International Monetary Fund. Not for Redistribution - 75 ~ STATISTICAL APPENDIX
Table 9. Finland: Cantral Government Revenue and Expenditure. 1992-96
1992 1993 1994 1995 1996 y
(In millions of Finnish markkaa)
Revenue 125.771 118.930 124.765 137.345 150.365 Property and entrepreneurial income 6.783 9,157 6.980 9.244 8.575 Direct taxes 36,201 27,822 33.577 38.295 44.700 Indirect taxes 74,403 73,927 76.865 77.906 84.960 Contributions to social security schemes 6,657 6,715 6.328 5,877 5.880 Currant transfars from other government sectors 1,029 840 811 578 580 Other revenues £/ 698 469 204 5.445 5.670
Current expenditure 153.340 166.716 174. S46 181.263 185.280 Consumption 38,399 36.039 37.556 37.746 38.665 Subsidies 16,218 15.454 15.082 14.827 15.550 Social security benefits 16,341 11.331 11.681 12.168 12.700 Social assistance and othar currant transfers 14,886 15,843 11.699 14.113 17.350 Currant transfars to othar government sectors 58,794 70,014 76.264 75.701 70.465 Other expenditure £/ 8,702 18,035 22.564 26.708 30.550
Saving -27,569 -47,786 -50.081 -43.918 -34,915
Gross capital formation £/ 8,308 7,274 7.923 8,131 7,760 Consumption of fixed capital and net capital transfars -489 763 17 -2,105 300
Financial balance (net lending) -36,366 -54,218 -57,987 -54,154 -42.375
(In percent of GDP)
Revenue 26.4 24.7 24.5 24.9 26.2 Current expenditure 32.2 34.6 34.4 32.9 32.3
Saving -5.8 -9.9 -9.8 -8.0 -6.1
Gross capital formation £/ 1.7 1.5 1.4 1.5 1.4 Consumption of fixed capital and net capital transfars -0.1 0.2 0.1 0.1
Financial balance (net landing) -7.6 -11.2 -11.4 -9.8 -7.4
Sources: Ministry of Finance. Economic Survey 1996: and data provided by the Finnish authorities. i/ On a national accounts basis. 2/ Official estimates. £/ Imputed social insurance contributions, current transfars from othsr domestic sectors and transfars from abroad from 1995 onward. 4/ Mainly interest expenditure. £/ Including purchases of land and changes in inventories.
©International Monetary Fund. Not for Redistribution - 76 - STATISTICAL APPENDIX
Table 10. Finland: Municipalities' Revenue and Expenditure, 1992-96
1992 1993 1994 1995 1996 g/
(In millions of Finnish markkaa)
Revenue 91.345 94,014 98,497 99,298 99.310 Property and entrepreneurial revenue 3.800 4,288 3,880 4,122 4,255 Direct taxes 46,069 47,078 54,238 55,498 62,160 Indirect taxas and fees 127 130 120 128 125 Transfers from central government 40,206 41,258 38,985 38.172 31,300 Other revenue £/ 1,143 1,260 1,274 1,378 1,470
Current expenditure 93,843 91,882 91,518 94,829 93,035 Consumption 77,223 73.153 73.319 77,220 80,410 Subsidies 810 922 774 744 730 Social assistance and other income transfers 7.251 4,458 4.615 4,791 5,150 Transfers to other government sectors 4.234 8,633 8,676 8,255 3,510 Other expenditure 4/ 4.325 4,716 4,134 3.819 3,235
Saving -2,498 2,132 6,979 4.469 6,275
Gross capital formation £/ 8,113 6,094 6,675 7.010 7,515 Consumption of fixed capital and net capital transfers 6,766 5,875 6,302 6.388 6,880
Financial balance (net lending) -3,845 1,895 6,606 3.847 5,640 0ta percent of GDP) Revenue 19.2 19.5 19.4 18.0 17.3 Current expenditure 19.7 19.0 18.0 17.2 16.2
Saving -0.5 0.4 1.4 0.8 1.1
Gross capital formation £/ 1.7 1.3 1.3 1.3 1.3 Consumption of fixed capital and net capital transfers 1.4 1.2 1.2 1.2 1.2
Financial balance (net lending) -0.8 0.4 1.3 0.7 1.0
Sources: Ministry of Finance, Economic Survey 1996: and data provided by the Finnish authorities. I/ On a national accounts basis. 2/ Official estimates. £/ Imputed social insurance contributions and casualty insurance benefits. 4/ Casualty insurance premiums, pension expenditure and interest. £/ Includes purchases of land and changes in inventories.
©International Monetary Fund. Not for Redistribution - 77 - STATISTICAL APPENDIX
Table 11. Finland: Social Security Funds' Ravanua and Expenditure. 1992-96
1992 1993 1994 1995 1996 y
(In millionis of Finnish markka*)
Revenue 102.698 122.107 136,134 138,653 135,565 Property and entrepreneurial revenue 14.714 14.265 14,316 12.934 13,470 Social insurance contributions, compulsory 59.231 63.385 68.903 72,780 72,435 By employers 42.407 43.773 45.500 51,833 52,270 By insured parsons 16.824 19.612 23,403 20,947 20,165 Transfers from central government 24.154 40.522 49,250 49,062 45,765 Other revenue £/ 4.599 3.935 3,665 3,877 3,895
Current expenditure 90.115 108.293 116,708 118,839 118,055 Consumption 2.831 2.998 3,174 3,210 3.280 Social security benefits 75.315 81,284 81,710 82,814 84.225 Social assistance and other income transfers 8.580 19.024 27,372 28,755 26,650 Transfers to othar government sectors 2.361 3.973 4,106 3,856 3,670 Other expenditure £/ 1.028 1.104 346 204 230
Saving 12.583 13.814 19.426 19,814 17,510
Gross capital formation £/ 492 424 431 430 440 Consumption of fixed capital and net capital transfers 228 227 249 247 260
Financial balance (net lending) 12.319 13.617 19.244 19,631 17,330 (In nercant o:
Revenue 21.5 25.3 26.7 25.1 23.6 Current expenditure 18.9 22.4 22.9 21.5 20.6
Saving 2.6 2.9 3.8 3.6 3.1
Financial balance (net landing) 2.6 2.8 3.8 3.6 3.0
Source: Ministry of Finance Ecomic Survey 1 and data Provided995; by the Finnish authorities.
i/ On a national accounts basis. y Official estimates. £/ Casualty insurance premiums, imputed social insurance contributions and othar current transfers from the private sector. 4/ Interest and other comparable expenditure and insurance claims, i/ Includes purchases of land and change in inventories.
©International Monetary Fund. Not for Redistribution - 78 - STATISTICAL APPENDIX
Table 12. Finland: General Govaznmant Financas, 1992-96
In Millions of Finnish m§ f^v^^i In Percent of GDP 1995 1992 1993 1994 1995 1996 y
Revenue 287,484 53.4 52.3 53.1 5.7 53.6 Property and entrepreneurial income 26.458 5.3 5.8 5.0 4.8 4.6 Interest income 22.157 4.6 4.9 4.1 4.0 3.8 Direct taxes 93.793 17.3 15.5 17.3 17.0 18.6 Indirect taxes and £••• 78.034 15.6 15.4 15.1 14.2 14.7 Social security contributions 81.893 14.6 15.1 15.4 14.3 13.7 By employers 58.137 10.9 10.6 10.3 10.2 9.9 By insured persons 23.756 3.7 4.5 5.1 4.0 3.8 Other income 7.306 0.6 0.6 0.4 1.9 1.9
Current expenditure 307.119 57.0 58.9 57.8 55.7 55.6 Consumption 118.176 24.8 23.3 22.4 21.4 21.3 Subsidies 15,571 3.6 3.4 3.1 2.8 2.8 Social security benefits 95.583 19.4 19.3 16.5 17.3 17.0 Social assistance grants 34.148 4.3 5.9 6.6 6.2 5.7 Other current transfers 13,511 2.1 2.3 2.0 2.5 2.9 Interest 29.767 2.6 4.6 5.1 5.4 5.7 Other expenditure 363 0.2 0.2 0.1 0.1 0.1
Saving -19.635 -3.7 -6.6 -4.7 -3.6 -1.9
Gross capital formation £/ 15.571 3.5 2.8 3.0 2.8 2.7 Consumption of fixed capital and net capital transfers 4,530 1.4 1.4 1.3 0.8 1.3
Financial balance (net lending) -30,676 -5.9 -8.0 -6.3 -5.6 -3.4 MenoranduB items: Gross public debt £/ 41.5 57.3 59.8 60.3 62.8 Gross tax ratio 46.8 45.4 47.3 45.5 47.2 Net tax ratio 18.5 15.5 18.0 18.3 20.7
Sources: Ministry of Finance, National Budcat Februarv 1996 ; and data provided by the Finnish authorities. Jt/ On a national accounts basis. £/ Official estimates. £/ Includes purchases of land and changes in inventories. 4/ EMU definition.
©International Monetary Fund. Not for Redistribution - 79 - STATISTICAL APPENDIX
Table 13. Finland: Mon*y Market Rates and Rates Appliad by the Bank of Finland, 1992-96
(In parcant i ayagaaa of daily ohsarvations Last iponth of ouartar)
Intarbanlt Bsnli of Finland Ral Ovarnishl Melsnki Inarnk Offared Pate Liquidity Call Monay Rata 1 Month 3 Months 6 Months 12 Months Credit Rat* Daposit Rata Basa Rata
1992 1st qtr. 14.27 12.95 12.38 12.08 11.99 15.00 4.00 8.50 2nd qtr. 13.58 13.58 13.70 13.83 13.76 15.00 4.00 9.50 3rd qtr. 16.65 17.79 16.41 15.29 14.71 19.15 i/ 13.43 I/ 9.50 4th qtr. 10.20 10.55 10.68 10.70 10.70 11.69 7.69 9.50
1993 1st qtr. 9.13 8.99 8.90 8.69 8.62 9.96 5.96 7.50 2nd qtr. 7.77 7.70 7.62 7.57 7.55 8.72 4.72 7.00 3rd qtr. 6.35 6.81 6.68 6.49 6.29 7.76 3.76 6.00 4th qtr. 6.22 6.16 5.90 5.68 5.52 8.21 4.21 5.50
1994 1st qtr. 4.39 4.82 4.80 .88 5.12 6.76 2.76 5.25 2nd qtr. 3.93 5.20 5.61 .24 6.86 7.18 3.18 5.25 3rd qtr. 4.07 5.07 5.57 .36 7.25 7.13 3.13 5.25 4th qtr. 4.57 5.41 5.70 .18 7.02 7.38 3.38 5.25
1995 1st qtr. 4.66 5.78 6.06 .48 7.07 7.75 3.75 5.25 2nd qtr. 5.77 5.93 6.02 .21 6.57 7.93 3.93 5.25 3rd qtr. 6.20 5.97 5.95 5.97 6.04 8.00 4.00 5.25 4th qtr. 4.60 4.56 4.54 4.57 4.66 6.56 2.56 4.86
1996 1st qtr. 3.83 3.95 4.01 4.12 4.36 5.94 1.94 4.50
Sources: Bank of Finland, Bulletin: and data provided by the Finnish authorities. I/ Prior to July 1992, both the call swney deposit rate and the liquidity credit rate (then named the call noney credit rate) were set by the Bank of Finland, whereas since July 1992 both rates are tied to the tender rate.
©International Monetary Fund. Not for Redistribution - 80 - STATISTICAL APPENDIX
Table 14. Finland: Monetary Survey, 1992-96
lat 2nd 3rd 4th lat Otr. Otr. Otr. Otr. Qtr. 1992 1993 1994 1995 1996
(In,billions of Finnish nuarkkaa* and of period) Domestic cradit 440.0 405.6 371.8 382.8 386.1 386.1 373.2 Private 439.9 403.7 365.7 372.5 371.6 367.6 353.3 ... Government 0.1 1.8 6.1 10.3 14.5 18.5 19.8
Net foreign assets -68.1 -26.0 12.8 23.4 16.2 25.9 25.5 Of which: Bank of Finland 26.5 32.1 51.6 52.3 49.8 46.6 46.8 42.1
Other items, net -97.9 -100.0 -98.0 -114.0 -105.7 -119.3 -94.9
Broad money (M3) 310.7 322.4 328.5 332.2 340.1 338.0 329.8 326.4 Money (Ml) 134.8 141.8 154.4 159.9 164.9 161.7 175.9 178.9 Transaction deposits 123.3 128.7 140.9 147.8 152.9 149.9 163.0 Other 11.4 13.1 13.5 12.1 12.0 11.8 13.0 Quasi -money 175.9 180.7 174.1 172.3 175.2 176.3 153.9 149^5
(Percentage chance fr Domestic cradit -5.2 -7.8 -8.3 -4.0 -1.5 3.6 0.4 Private -6.6 -8.2 -9.4 -6.2 -4.6 -1.9 3.4 Broad money (M3) -0.1 3.8 1.9 -0.3 0.53 1.3 0.4 -1.2 Money (Ml) 3.2 5.1 8.9 7.4 7.5 6.9 14.0 11.8 Quasi -money -2.4 2.7 -3.7 -6.6 -5.2 -3.3 -11.7 -13.2 Sources: IMP, International Financial Statiaticat Bank of Finland Bulletin: and data provided by the Finnish authorities. ©International Monetary Fund. Not for Redistribution Table 15. Finland: Interest Rates, 1992-96 (Average of daily observations in last month of Quarter: In percent per ain^ifft. except as noted) Deposit Banks Lendinc Rates Deposit Rates Bank of Finland Average Liquidity Average Rate Pate on Masorandue ites Credit Ra^f I/ Average Rate, Average Rate, Average Rate on Other all markka Bond Inflation Rate 3/ Base Rate (Period Average) Mew Lending All Lending on Deposits Funding Funding Yield J/ 1990 - 100 1991 1st qtr. 8..50 15.00 14.91 12.31 7.29 15.07 .62 12.5 4.9 2nd qtr. 8..50 15.00 13.54 11.91 7.05 12.35 .61 11.1 4.5 3rd qtr. 8..50 15.00 13.96 11.96 6.95 12.95 .87 11.3 3.4 4th qtr. 8..50 15.00 12.51 12.15 7.08 12.63 .71 12.4 4.1 1992 1st qtr. 8..50 15.00 13.81 11.97 7.23 12.32 .77 11.3 3.0 2nd qtr. 9 .50 15.00 14.39 12.61 7.42 12.94 .15 12.2 3.1 3rd qtr. 9..50 19.15 15.00 13.01 7.80 14.39 10.03 13.3 3.2 4th qtr. 9..50 11.69 11.98 12.34 7.06 11.78 8.62 10.9 2.3 1993 1st qrt. 7.50 9.96 11.29 11.07 5.87 10.04 7.30 9.4 2.7 2nd qrt. 7.00 8.72 9.44 10.35 4.75 9.08 6.18 8.4 2.0 3rd qrt. 6.00 7.76 8.68 .38 3.96 7.88 5.31 7.3 1.7 4th qrt. 5.50 8.21 7.62 .85 3.33 6.94 4.55 6.2 1.6 1994 1st qrt. 5.25 6.76 6.78 .17 2.88 5.77 3.85 6.7 0.4 2nd qrt. 5.25 7.18 7.44 .09 2.89 5.77 3.92 9.0 1.3 3rd qrt. 5.25 7.13 7.86 .19 3.04 5.99 4.11 9.9 1.9 4th qrt. 5.25 7.38 6.71 .0$ 3.11 6.17 4.10 9.5 1.6 1995 1st qrt. 5.25 7.75 7.80 .16 3.22 6.41 4.22 9.2 1.6 2nd qtr. 5.25 7.93 7.60 .14 3.21 6.53 4.13 7.7 1.0 3rd qtr. 5.25 8.00 7.86 .11 3.20 6.35 4.14 7.2 0.4 4th qtr. 4.86 6.56 6.21 7.46 2.69 5.28 3.38 6.7 0.3 1996 1st qtr. 4.50 5.94 6.08 6.99 2.44 4.98 3.15 6.8 0.6 Sources: Bank of Finland, Bulletin: and data provided by the Finnish authorities. I/ Average of daily rates. Call money credit rate until July 2, 1992. £/ Effective yield on fixed-rate taxable government bonds (4-5 years), secondary market. 3/ As measured by the year-on-year percentage change in the consumer price index in the last month of quarter. ©International Monetary Fund. Not for Redistribution - 82 - STATISTICAL APPENDIX Table 16. Finland: Balance of Payments, 1992-96 (In billions of Finnish markkaa) JBL. 1991 1992 1993 1994 1995 1996 I/ Merchandise trade balance 4J 12*6 2U> 33.3 4L1 1(L± Exports, f.o.b. g/ 9ltl 105.8 132.6 152.0 172.3 42.9 Imports, c.i.f. £/ 86.3 93.2 101.6 118.7 125.9 32.0 Monf actor services balance -7.9 -6.2 -5.0 •0.9 -0.4 -0.4 Transportation 3.5 4.3 5.5 1.4 4^8 6.0 Travel -6.0 -4.9 -2.2 -1.4 -2.9 -0.9 Other -5.4 -5.6 -7.6 -5.0 -3.5 -0.9 Goods and services balance dLl i*± 26J* 12*1 i£*i 12*1 Investment income, net -18.7 -24.0 -28.4 -22.2 -19.0 -3.8 Transfers and other income, net -4.9 -4.4 -3.9 -3.7 -3.3 -2.8 Current account balance -26.7 -22.0 -6.4 6.6 23.7 l*i (In percent of GDP) -5.4 -4.6 -1.3 1.3 4.3 2.7 Capital and financial account balance 11*1 11*1 1*1 22.9 -17.6 -12.Q Direct investment net -0.5 5.2 -3.2 -14.2 -2.6 -4.0 Inward -1.0 1.8 4.9 8.2 4.0 1.5 Outward 0.5 3.4 -8.1 -22.4 -6.6 -5.5 Portfolio investment net 33.2 34.8 35.1 38.6 -3.2 0.2 Loans 5.2 -3.4 6.2 8.1 -4.3 1.2 Trade credits -3.3 2.6 1.5 -4.2 -2.6 Other (Capital Account) -17.5 -23.—4 -39.2 -11.1 -3.3 -6.8 Errors end omissions 2.2 -0.3 6.1 -4.0 -7.5 0.8 Overall balance ^7,4 22*3 1*1 22*1 il*i ZL2 Changes in reserves, net (increase -) 7.4 9.2 -1.2 -25.5 1*1 1,1 Sources: Bank of Finland, Bulletin various issues; and data provided by the Finnish authorities. I/ Official projections. £/ Including adjustment items. ©International Monetary Fund. Not for Redistribution - 83 - STATISTICAL APPENDIX Table 17. Finland: Indices of Foreign Trade, 1992-96 (Percentage change from previous year) 1st Otr. 1992 1993 1994 1995 I/ 1996 I/ Volumes Exports, f.o.b. 8.8 18.9 12.8 5.4 -- Imports , c . i . f . -2.0 -3.4 19.9 8.7 -- Unit values Exports, f.o.b. 6.3 5.1 1.7 7.0 6.7 Imports , c . i . f . 10.5 12.4 -2.8 -0.1 0.1 Terms of trade -3.7 -6.6 4.6 7.1 6.7 Sources: Bank of Finland. I/ According to export and import price indices by the Statistics Finland. ©International Monetary Fund. Not for Redistribution Table 18. Finland: Exports by Commodity Group, 1993-97 Share Volume Price (In Percent) (Change in Percent) (Change in Percent) 1995 I/ 1993 1994 1995 JL/ 1996 2/ 1997 2/ 1993 1994 1995 I/ 1996 2/ 1997 2/ Agriculture and forestry 1.2 47 7 -25 -10 0 8 58 -4 15 2 i Food, drink, and tobacco 2.2 36 17 -11 -10 -2 12 -1 4 4 3 Textiles, clothing and leather 2.0 5 12 -2 -2 -2 4 1 3 3 3 Hood industry 7.6 39 22 -4 -2 8 6 -2 -3 4 Paper, printing and publishing 27.9 10 11 -1 -2 9 5 -1 19 -1 -2 Chemicals 9.1 6 18 -3 -1 2 10 -6 4 5 3 Basic metals 8.0 8 9 -1 -2 5 6 -1 10 0 1 Metal products and machinery 39.1 30 12 21 11 5 3 4 1 2 2 Other products 3.0 Total exports of goods 100.0 18.8 13.2 5.8 3.5 5.7 5.1 1.5 6.7 1.5 1.5 Memorandum item: Exports of goods and services 16.7 13.3 7.9 3.3 5.4 6.5 1.1 1.7 1.7 1.7 Sources: Ministry of Finance; data provided by the Finnish authorities. i/ Provisional 2/ Forecast ©International Monetary Fund. Not for Redistribution - 85 - STATISTICAL APPENDIX Table 19. Finland: Indicators of Competitiveness, 1991-95 1991 1992 1993 1994 1995 (Annual Percentage changes) in real terms) Merchandise exports to market economies -1.3 9.0 18.8 13.2 6.0 Non-oil imports of partner countries I/ -1.0 2.5 3.7 11.0 8.6 Export market share £/ -0.3 6.3 14.6 2.0 -2.2 Merchandise imports •16.7 -2.0 -3.4 20.3 10.2 Domestic demand -8.3 -5.6 -5.5 3.6 4.5 (Annmtl percentage changes) Markka currency index £/ 4.2 14.8 13.8 -7.0 -9.4 Nominal effective exchange rate -4.0 -12.9 -12.1 7.5 10.3 Real effective exchange rate <±J -8.3 -18.3 -16.0 3.3 9.2 Unit labor costs in manufacturing 5.9 -7.9 -6.3 -4.9 3.8 Merchandise export unit values £/ 0.3 6.2 5.1 1.7 6.9 Labor productivity in manufacturing -0.9 12.9 12.1 9.0 3.2 Sources: Data provided by the Finnish authorities; IMF, Competitiveness Indicator system; and staff estimates. I/ Weighted by Finland's exports to individual countries according to IMF, Research Department. 27 Volume of exports to market economies relative to non-oil imports of partner countries. i/ The Bank of Finland's currency basket (weights based on total trade); a decline indicates an appreciation. 4/ Relative unit labor costs (normalized) in manufacturing based on weights for 16 industrial countries as calculated by IMF Research Department. 5y Export price index for 1995. ©International Monetary Fund. Not for Redistribution Table 20. Finland: Imports by Commodity Group, 1993-97 Share Volume Price (In Percent) (Change in Percent) (Change in Percent) 1995 1993 199* 1995 I/ 1996 2/ 1997 g/ 1993 1994 1995 JL/ 1996 2/ 1997 J/ Raw materials and other production necessities 59.5 -3 22 2 7 6 13 -2 1 3 3 Crude oil 4.0 -7 20 -16 2 0 12 -12 -7 7 3 Other 55.5 -2 22 4 7 6 14 -2 3 3 3 Fuels and lubricants 3.4 16 19 -10 2 2 9 -8 -4 5 3 Investment goods 15.3 -1 16 17 17 14 17 -4 -4 2 2 Consumer goods 19.9 -6 22 3 7 6 8 -4 -1 2 3 Other 1.8 ...... Total imports of goods 100.0 -3.4 20.3 4.9 8.4 7.0 12.4 -2.8 -0.1 3.0 2.9 Memorandum item: Imports of goods and services 0.8 12.6 7.1 7.4 6.5 -0.2 -0.3 0.2 3.0 3.0 Sources: Ministry of Finance; data provided by the Finnish authorities. I/ Provisional £/ Forecast ©International Monetary Fund. Not for Redistribution - 87 - STATISTICAL APPENDIX Table 21. Finland: Invisibles, 1992-97 (In billions of Finnish markkaa^ 1992 1993 1994 1995 1996 I/ 1997 I/ Transport, net 4-1 4^1 5^2 £J> i^ i*S Receipts 8.6 10.4 11.4 12.0 12.8 13.4 Payments 4.4 5.6 5.9 6.1 6.0 6.9 Travel, net ^2. il*2 2Ut i5^& Receipts 6.1 7.1 7.3 ^27.5 ^7.28 8.3 Payments 11.0 9.2 8.7 10.5 12.0 13.3 Other services, net zLA. =U>. ilJl ilil ^L2 =1*1 Receipts 7.7 9.4 11.8 15.4 16.6 17.9 Payments 13.4 17.0 16.8 18.9 19.3 20.6 Total nonf actor, net ^L& ^L2. zJLl JLZ J-2 Receipts ^22.25 26.9 30.5 34.9 37.2 39.6 Payments 28.7 31.9 31.4 35.4 37.9 40.8 Transfers and other income, net ^Ji ii*£ zU. ilil ^i ^3_ Receipts 5.9 6.5 4.9 9.2 Payment 10.3 10.4 8.6 12.5 Investment income, net -24.0 -28.4 -22.2 -19.0 -17.5 -16. A Receipts 6.4 6.1 9.6 13.1 Payments 30.4 34.6 31.8 32.1 Total invisibles, net -34.$ -37.3 -26.8 -22.8 -23.5 -21-3 Receipts 34.8 39.5 45.0 57.2 Sources: Bank of Finland, Bulletin; and data provided by the Finnish authorities. I/ Official projections. ©International Monetary Fund. Not for Redistribution - 88 - STATISTICAL APPENDIX Table 22. Finland: Gross Official Convertible Reserves, 1991-96 1st Otr. 1991 1992 1993 1994 1995 1996 (In millions of U.S. dollars ! end of peripd) Gold (at SDR 35 per ounce) 100.2 96.3 96.2 102.3 83.2 81.8 SDRs 225.6 107.8 115.1 325.1 359.2 250.8 Reserve position in the Fund 275.1 331.3 302.7 286.3 385.8 388.1 Foreign exchange 7.108.0 4.774.3 4.993.0 10.050.6 9.293.4 7.626.2 Total 7,708.9 5,309.7 5,507.0 10,764.3 10,121.6 8,346.9 (In billions of Finnish markkaa) 33.6 29.5 33.5 52.7 48.9 38.7 (In weeks of imports .c.i.f.^ I/ Gross reserves 19.9 16.2 16.9 22.7 20.6 Sources: IMF, International Financial Statistics :and Bank of Finland, Bulletin. I/ Including adjustment items. ©International Monetary Fund. Not for Redistribution - 89 - STATISTICAL APPENDIX Table* 23. Finland: Direction of Tradat 1991-95 (In parcant of total) Exoort• 1-aorts 1991 1992 1993 1994 1995 I/ 1991 1992 1993 1994 1995 I/