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.