DBRS Confirms Republic of Finland at AA (high), Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Republic of Finland’s Long-Term Foreign and Local Currency – Issuer Ratings at AA (high) and its Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (high). The trend on all ratings is Stable.

KEY RATING CONSIDERATIONS

The Stable trends reflect DBRS’s view that risks to the ratings are balanced. Finland’s economic recovery has gathered considerable pace with GDP projected to grow close to 3% both in 2017 and 2018, benefitting from a strong comeback in exports and investments. Amid this cyclical recovery, steady growth in employment, investment, and productivity is encouraging. This favourable economic environment, coupled with consolidation measures, is driving the reduction in the general government’s fiscal deficit and debt ratios. On the other hand, an ageing population will hold back potential growth and burden public finances in coming years.

Finland’s AA (high) ratings are underpinned by the government’s solid balance sheet, political commitment to sound economic policies, and a wealthy and diversified economy. However, Finland faces some structural challenges, including an ageing population, low potential growth, and its vulnerability to shocks as a small and open economy.

RATING DRIVERS

One or any combination of the following factors would likely lead to upward pressure on the ratings: (1) a continuation of the improvement in fiscal performance, (2) progress in curbing healthcare and long-term care spending growth pressures, potentially through the health, social services and regional government reform, and (3) further evidence of higher potential growth.

Although unlikely in DBRS’s view, the following factors could exert downward pressure on Finland’s ratings: (1) a substantial worsening in the medium term economic position, or (2) a deviation from prudent fiscal policies that results in a significant deterioration in public debt metrics.

RATING RATIONALE

Strong Cyclical Recovery but Lifting Potential Growth Remains a Key Medium-Term Challenge

After a prolonged period of weak economic performance, Finnish real gross domestic product (GDP) grew on average 2.6% per annum in 2016 and 2017 and is due to exceed its pre-crisis peak in 2018. Benefiting from external tailwinds and competitiveness gains, exports and private investment cumulatively grew 17% and 12%, respectively, in 2016-2017. Both construction and machinery and equipment recovered strongly. In this context, employment increased 1.5% in 2016-2017 but the unemployment rate remained relatively high in 2017 at 8.6%. According to the Bank of Finland, GDP growth will average 2.3% a year in 2018-2020 underpinned by strong external demand, improved cost-competitiveness, employment growth and still favourable financing conditions. The main risk to the outlook stems from an escalation of protectionist trade measures that could impact Finnish exports mainly through weaker global trade. Higher oil prices could also weigh on growth. On the other hand, Finland’s positive momentum and productivity growth could further boost investment.

Despite the strong cyclical recovery, long term growth is constrained by labour market rigidities and an ageing population. The European Commission estimates the average potential growth rate for 2016-2070 is 1.3%. Against this backdrop, increasing the employment rate and productivity to boost potential growth will remain key challenges. Compared with 2008, the industrial base has narrowed with a significant drop in employment in the industrial sector. The decline in information technology manufacturing in Finland has been largely offset by sectors with lower productivity such as services and construction. Conversely, the pickup in investment, employment and productivity in recent quarters is encouraging; if these trends prove to be durable, this could help lift potential growth.

Fiscal Performance Improves Significantly But Age-Related Expenditures Will Weigh on Public Finances

In recent years, fiscal performance has improved significantly because of the government’s consolidation measures and strong cyclical recovery. The general government fiscal deficit improved from 3.2% of GDP in 2014 to 0.6% of GDP in 2017. The fiscal deficit is expected to be balanced by 2020. The government has advanced its plan to generate fiscal savings worth EUR 4 billion in 2016-2020, principally through indexation freezing of wages and social benefits and cuts of expenditures. In line with this, the expenditure-to-GDP ratio is projected to drop to 51.7% in 2020 from 57.1% in 2015.

Notwithstanding the cyclical boost to public finances, unfavourable population dynamics will continue to increase age-related expenditures, especially healthcare and long-term care. The pension system reform that entered into force at the start of 2017 ensures that pension contributions will completely finance new accruing pension liabilities. On the other hand, the government needs to implement additional measures to curb increasing healthcare and long-term care spending, which it is trying to do with the passage of the health, social services and regional government reform (SOTE). The reform will shift the responsibilities in organising the healthcare and social services from the municipalities to 18 newly created counties potentially curbing the growth rates in these items from 2.4% to 0.9% between 2021 and 2029. While considerable progress has been made on the health, social services and regional government reform, implementation risks and uncertainties relative to fiscal savings potential remain.

Declining Public Debt Ratio Helped by Lower Deficits and Cyclical Recovery

The public debt dynamics have also showed a significant improvement in recent years. The government debt ratio, which was originally expected to continue increasing, declined to 61.3% in 2017 from 63.5% in 2015. The government projects the debt ratio to drop below the 60% mark in 2019 mostly driven by nominal GDP growth and improving fiscal balances. Interest rate expenditures remained low at 1% of GDP in 2017 and are expected to remain slightly below this figure in coming years despite an expected increase in interest rates for new issuances. Finland’s central government debt has an average maturity of 6.4 years and minimal exchange rate risks (after swaps), enhancing the government’s resiliency to interest and currency shocks.

The general government net financial assets ratio stood at 58.7% of GDP in Q1 2018. However, around two-thirds of the assets are ring-fenced for pension payment and not appropriable for budgetary purposes. According to Statistics Finland, existing pension liabilities as of December 2016 – calculated as the present value of all future pension payments related to work performed up until 2015 – amounted to 301% of GDP. Alongside the debt and pension liabilities, the stock of guarantees from the central and local governments remains high and adds up to around 30% of GDP. Central government contingent liabilities (22.9% of GDP) consist mostly of guarantees to Finland’s export credit agency (Finnvera). Under an adverse scenario, these guarantees could pose an additional burden on the government finances.

Financial System is Sound and Risks to Financial Stability are Contained

The financial stability risks associated with household debt remain contained. The household debt to disposable income ratio at 128.2% in 2017, mostly consisting of mortgage loans, remains higher than most euro area countries although below its Nordic peers. A substantial portion of the mortgages have variable rates, rendering these households more vulnerable to increases in interest rates or unemployment. However, there are no signs of an overvaluation of house prices or excessive debt-driven increases at the national level. Finnish credit institutions have solid capital buffers, with a common equity tier 1 (CET1) ratio of 20.5% as of March 2018 and remain more profitable and efficient than European Union credit institutions on average. Asset quality is strong, with non-performing loans and impairments staying low during the prolonged period of weak economic performance.

Some structural vulnerabilities remain in the banking system such as its aggregate size relative to the economy, concentration, interconnectedness, and low liquidity buffers coupled with its reliance on wholesale funding. Nordea’s plan to relocate the group’s parent company to Finland from Sweden by the end of September 2018 would substantially enlarge the Finnish banking system, amplify some of these vulnerabilities, and broaden the government implicit liabilities. However, the pan-European regulatory, supervisory and resolution framework in place mitigates these risks. Furthermore, the tighter macro-prudential toolkit available to the authorities help to mitigate risks.

Current Account Rebalances as the Competitiveness Gap Closes

After six years of current account deficits, Finland’s external accounts returned to surplus in 2017 (0.7% of GDP) driven by an increase in exports. Export volumes grew 7.8% in 2017, more than doubling the rate of imports (3.7%). Finnish exports benefitted from the pickup in manufacturing activity and investment in Europe, given their tilt towards capital and intermediate goods. Also, Finland has made progress in restoring cost-competitiveness underpinned by wage moderation and productivity gains associated with the Competitiveness Pact. In 2016-2017, unit labour costs per hours worked dropped by 4% in Finland compared with the 1.3% increase in the euro area. In this context, Finland has halted the decline in its export market shares. Finland’s net international investment position stood at -2% of GDP in Q1 2018. Although Finland’s gross external debt-to-GDP is high (186.9% in Q1 2018), a sizable portion corresponds to long-term debt and intercompany lending, which tends to be more stable than other sources of financing.

Strong Institutional Framework and Policy Stability Mitigate Potential Political Uncertainty

The Finnish political and institutional framework is strong. A tradition of coalition governments with strong majorities led to stable and consensual policy making. The coalition formed by the Centre Party (KESK), the National Coalition Party (KOK) and Blue Reform Party (SIN) has a slim majority in Parliament (104 of 200 seats). Political uncertainty could increase ahead of the next general elections to take place by May 2019. Blue Reform Party’s weak performance in opinion polls, differences between the ruling parties over details of the SOTE reform (i.e., freedom of choice), and the risks this reform is further delayed could precipitate the collapse of the current government. However, DBRS does not foresee significant changes in policy direction or commitment to ensuring the sustainability of public finances.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the AAA – AA (high) range. The main points discussed during the Rating Committee include the fiscal and debt metrics, economic performance, structural reforms, cost-competitiveness developments, the banking system, and political developments.

KEY INDICATORS

Fiscal Balance (% GDP): -0.6 (2017); -0.7 (2018F); -0.3 (2019F)
Gross Debt (% GDP): 61.3 (2017); 60.0 (2018F); 59.4 (2019F)
Nominal GDP (EUR billions): 223.8 (2017); 234.0 (2018F); 242.0 (2019F)
GDP per Capita (EUR): 40,568 (2017); 42,309 (2018F); 43,592 (2019F)
Real GDP growth (%): 2.8 (2017); 2.9 (2018F); 1.8 (2019F)
Consumer Price Inflation (%): 0.8 (2017); 1.2 (2018F); 1.4 (2019F)
Domestic Credit (% GDP): 214.2(2017); 212.2 (Mar-2018)
Current Account (% GDP): 0.7 (2017); 0.6 (2018F); 0.8 (2019F)
International Investment Position (% GDP): 5.7 (2017); -2.1 (Mar-2018)
Gross External Debt (% GDP): 184.7(2017); 199.4 (Mar-2018)
Governance Indicator (percentile rank): 96.6 (2016)
Human Development Index: 0.9 (2015)

Notes:

All figures are in euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include the Ministry of Finance, Central Government Debt Management Office, Statistics Finland, Bank of Finland, Finnish Financial Supervisory Authority, European Commission, European Central Bank, Statistical Office of the European Communities, Organisation for Economic Co-operation and Development, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Javier Rouillet, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer - Global FIG and Sovereign Ratings
Initial Rating Date: 14 August 2012
Last Rating Date: 2 February 2018

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