Scope Ratings GmbH has today affirmed the Republic of Finland’s long-term issuer ratings at AA+ and short-term issuer ratings at S-1+, in both local and foreign currency. The sovereign’s senior unsecured debt is also affirmed at AA+ in both local and foreign currency. All Outlooks are Stable.

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Rating drivers

Finland’s AA+ ratings are supported by the country’s sound public finances, underpinned by a gradually decreasing public debt ratio, low annual government financing needs and high government debt affordability. The ratings are also supported by the nation’s wealthy economy, highly educated labour force and enhancements in macro-prudential supervision. The government’s net public asset (rather than net public debt) position is a credit strength, as are improvements to the economy’s external competitiveness in recent years. These strengths are, however, counter-balanced by structural challenges, including an ageing population, which, coupled with labour market rigidities, weighs on growth potential and the medium-term sustainability of the social welfare system. Current account deficits and high external debt are rating constraints, as are financial stability risks, including those arising from the size of the Finnish banking sector relative to the domestic economy.

Finland’s government debt ratio has been on a downward trajectory since it peaked in 2015 at 63.4% of GDP, falling to just under the 60% Maastricht threshold in 2018. This gradual debt reduction since 2015 was helped by above-potential economic growth over 2016-18, with growth peaking at 3% in 2017, and by sizeable and well-targeted public expenditure cuts, in line with the Competitiveness Pact signed in June 2016. Expenditures as a percentage of GDP decreased by nearly 4pp between 2015 and 2018 (from 57% to 53.6% of GDP), supported by reductions in personnel costs and by current expenditures growing slower than nominal growth, even while growth in public investments was prudently maintained. Going forward, Scope expects only a gradual decline in the government debt ratio over the medium term. Scope projects Finland’s debt ratio to decrease to about 57% of GDP by 2021, as the main budgetary variables are expected to remain close to balance in the coming period. Headline and primary fiscal balances stood at respectively -0.7% and 0.2% of GDP in 2018 and are expected at -0.7% and -0.2% of GDP by 2021, accounting for actions in the new government’s fiscal programme.

Specifically, the new government’s fiscal framework includes a EUR 4bn expenditure increase (1.2% of GDP). Of this, EUR 1.23bn is allocated for permanent spending by 2023 in areas including education, income inequality and climate change, alongside EUR 3bn to one-off measures and socially relevant experiments, to be funded through the sales of state-owned assets. Planned tax revenue increases amount to EUR 730m.

As a small, open economy, however, Finland is vulnerable to regional and global shocks, which could stress the future trajectory of public and private debt. In 2017, Finnish government guarantees amounted to 32% of GDP¹, a ratio that is higher than that of Nordic and euro area peers. Nevertheless, the sustainability of Finnish debt is supported by its high affordability, the government’s strong market access and sizeable government assets. Amidst the highly accommodative global interest rate conditions, Finland can now borrow for 10 years with a negative yield. Gross financing needs are moreover low, at 6.6% and 7.1% of GDP in 2019 and 2020, respectively, according to European Commission estimates (with an average term to maturity of government debt of 6.5 years as of 2019). Finland has a high stock of financial assets stemming from its public pension scheme. At 56.5% of GDP in Q1 2019, Finland’s net government asset ratio is one of the highest in Scope’s universe of rated sovereigns²; however, most of these assets are illiquid and cannot be assumed to be fungible under severe scenarios for contingent use in government debt service.

Finland’s AA+ ratings are further supported by the improved external competitiveness of the economy. Reforms have included reductions in employers’ social security contributions, extensions in working time, cuts in public sector holiday pay and wage freezes (vis-à-vis the 2016 Competitiveness Pact), coupled with tax concessions to compensate for purchasing power losses. As a consequence, nominal unit labour costs have decreased by 2.5% since 2015. Unit-labour-cost-deflated real effective exchange rates (against 37 trading partners) have corrected 6.7% since 2014, fully unwinding the external competitiveness losses suffered over the euro area sovereign debt crisis. Competitiveness gains have supported export sector growth.

Despite increased external sector competitiveness, Finland maintains a current account deficit, at 1.6% of GDP in 2018, after 0.7% in 2016-17, however. In view of the high share of imported inputs in the export industry and uncertainties on growth rates in export markets moving ahead, Scope expects a modest current account deficit over 2019-21 of 0.5%-2% of GDP. External debt, at 230.8% of GDP as of Q1 2019, is high compared to that of Nordic and euro area peers and has increased from 181.9% of GDP at end-2017. Moreover, the sizeable share of short-term external debt, at 84.8% of GDP as of Q1 2019, signals vulnerabilities to external shocks. However, the net international investment position is in a solid balanced position (at 1.9% of GDP in Q1 2019).

Despite these inherent credit strengths, Scope sees key challenges related to the country’s growth potential, long-run fiscal costs related to an ageing population as well as financial stability risks.

First, Finland’s medium-run rate of growth potential remains modest. Scope foresees growth potential at 1.3%, close to the euro area average but below that for Nordic peers Sweden and Norway. The country’s potential growth outlook balances negative working-age population growth of 0.2% per annum, according to UN estimates, with steady labour force participation growth, alongside annual labour productivity growth of around 1.0%.

Real growth has slowed, to 1.7% in 2018 and 0.9% YoY by Q1 2019 (from 2.9% over 2016-17). In the first quarter, weak private consumption and investment growth constituted drags, while net exports and government consumption provided some cushion. Consumer and industrial sentiment further weakened in Q2. Scope expects Finnish growth to reach 1.5% this year and 1.6% in 2020, supported in the latter case by the government’s investment programme.

Second, despite a declining debt-to-GDP ratio, the structural rigidities in the labour market coupled with ageing-population dynamics are putting fiscal pressures on Finland’s system of social benefits.

The shrinking working-age population, which is projected by Statistics Finland to decline 0.0%-0.2% per year over 2019-24, increases pressures on the financing of old-age benefits. In the medium run, the Bank of Finland’s autumn 2018 estimate shows a sustainability gap in public finances of 3% of GDP to stabilise general government debt-to-GDP through 2065.

Scope notes that the new government’s objective of achieving a balanced budget by 2023 depends on raising the employment rate to 75% by the end of this parliamentary term, from 72.9% as of Q1 2019. According to the Bank of Finland, in view of current soft economic conditions, reaching this employment objective would require real growth of around 2.5% over 2020-23 – which appears optimistic. This poses risks to the fiscal target.

Implementing reforms to address costs has proven difficult. The failure to adopt the healthcare (SOTE) reform (aimed at ensuring cost-effectiveness by shifting the governance of social and sanity services from local to regional level and allowing greater intervention by private providers) contributed to the collapse of the former Centre Party-led government in March 2019. After general elections on 14 April, during which no party reached 20% of votes, a five-party coalition government formed on 6 June, led by the Social Democrats, together with the Centre Party, Greens, Left Alliance and liberals of the Swedish People’s Party. Scope will therefore monitor closely the ability of this government to implement labour, health and social security reforms that address structural rigidities.

Finally, Finland’s credit ratings are also constrained by its banking sector, whose structure and size poses financial stability risk. As a consequence of Nordea moving its headquarters from Sweden to Finland in October 2018, the Finnish financial sector became one of the largest in Europe relative to the size of the domestic economy, now totalling over four times Finnish GDP. Nordea’s balance sheet alone amounts to 2.6 times Finland’s GDP. The banking sector is highly concentrated, with the three largest banks (Nordea, OP Group and Danske Bank) accounting for over 70% of the market.

One of the main risks to financial stability regards the high household indebtedness (at 127.4% of gross disposable income in 2018), mostly related to household mortgages. Housing prices have remained fairly stable (only a 2.8% cumulative increase over the last four years), even if there are significant differences in house price dynamics between cities (Greater Helsinki house prices have increased by 10.8% since 2015). However, in view of the financial system’s exposure to other Nordic economies and banking systems, spill-over risks may stem from Swedish and Norwegian housing markets, where price imbalances are more severe.

Capital adequacy ratios have decreased. Weighted average common equity tier 1 ratios fell from 21% of risk-weighted assets at the end of 2017 to 17.2% in 2018, following Nordea’s re-domiciliation, in view of restrictions imposed by the ECB on its internal models for capital adequacy calculations, and the risk weight floor set for Swedish mortgages, and then further to 16.4% by Q1 2019, owing to brisk corporate lending and an individual business acquisition. Still, capital adequacy in Finland remains comfortably above EU averages. Asset quality and profitability are strong, with the non-performing-loan ratio low at 1.6% of total loans outstanding and return-on-equity at 7.7% in Q1 2019. Moreover, according to the IMF, Finland is at the forefront regarding digitalisation of financial services.

Risks are mitigated moreover by financial oversight measures. Finland’s Financial Supervisory Authority together with the central bank conducts oversight to mitigate systemic risks. Recent key measures include a systemic risk buffer of new capital requirements of 1-3%, which entered into force this month. Another relevant action regards the decision to raise risk weights applicable to housing loans to 15%, effective since 2018, which partially addresses the issue of low risk-weight assumptions in the internal models of Finnish credit institutions. In March 2018, the Financial Supervisory Authority decided to lower the maximum loan-to-collateral ratio to 85% for loans other than for first-time home buyers. Scope considers these macro-prudential steps to be credit-positive.

After recent scandals related to money laundering in Nordic and Baltic countries and following the recommendations issued by the inter-governmental Financial Action Task Force, Finland’s Financial Supervisory Authority announced a new risk-based supervision model and cut the threshold for issuing sanctions against banks. This was accompanied by an increase in supervisory resources and capacities.

_{1 Regarding local government guarantees, Eurostat signalled the possibility of overestimation embedded in this figure as data may not be fully consolidated.
2 The net financial assets of the general government (EUR 132.1bn, or 56.5% of GDP) is composed as follows: EUR 201.9bn (or 86.3% of GDP) of net financial assets from the employment pension scheme; EUR 65.6bn (28% of GDP) of net financial liabilities of the central government; and EUR 4.1bn (or 1.8% of GDP) of net financial liabilities of local governments.}

Sovereign rating scorecard (CVS) and Qualitative Scorecard (QS)

Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative ‘AA’ (‘aa’) rating range for the Republic of Finland. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.

For Finland, the following relative credit strengths are identified: i) economic policy framework; ii) fiscal policy framework; and iii) market access and funding sources. The following credit weaknesses are identified: i) current account vulnerability; ii) vulnerability to short-term external shocks; and iii) financial imbalances and financial fragility.

Combined relative credit strengths and weaknesses generate overall a one-notch upward adjustment and signal a sovereign rating at AA+ for Finland.

The results have been discussed and confirmed by a rating committee.

Factoring of Environment, Social and Governance (ESG)

Scope considers sustainability issues during the rating process, as reflected in its sovereign methodology. Finland’s performance on sustainability factors is considered in the country’s AA+ sovereign rating. Governance factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’ under its methodology, within which Finland has one of the highest CVS scores among Scope’s rated sovereign universe on a composite index of six World Bank Worldwide Governance Indicators. Qualitative governance-related assessments reflect Scope’s QS evaluations of ‘neutral’ on ‘recent events and policy decisions’ (balancing the policy framework of the new government) and ‘neutral’ on ‘geo-political risk’ compared with Finland’s sovereign peer group.

Social factors are reflected in Finland’s high GDP per capita (USD 49,845 in 2018), medium level of risk with relation to the national unemployment rate, and very high level of risk from its old-age dependency ratio (with more than 34% of the population aged 65 or older relative to the working-age population, one of the highest such ratios among EU member states). In terms of education, Finland has the distinction of ranking second highest in Europe (and eighth in the world) on the OECD’s 2015-16 PISA results. The unemployment rate decreased from above 9% in 2014-16 to an average of 7.4% in 2018 and is expected to fall to 6.5% this year. Over the medium term, the unemployment rate is expected to stabilise at slightly above 6%, below the estimate for the structural unemployment rate, which, at 6.7%, is high compared with that of peers, pointing to labour market shortages and skills mismatches. With an income quintile share ratio of 3.5, Finland is among the best in the EU at tackling income inequality. Finland also has one of the lowest shares of low-skilled workers to total employment in the EU (at 10%). Social considerations and impacts of social factors on the economy are reflected in Scope’s QS evaluation of ‘neutral’ on Finland’s ‘growth potential of the economy’, ‘good’ on ‘economic policy framework’ and ‘neutral’ on ‘macro-economic stability and sustainability’ compared with ‘aa’-indicative sovereign peers.

Finland maintains a strong record on environmental sustainability and recorded the 10th-highest score (out of 180 countries) in the 2018 Environmental Performance Index. Strong public support for environmentally friendly public policies was signalled during this year’s general elections, reflected moreover in the government’s objective to achieve carbon neutrality by 2035. The new government’s programme of higher spending includes extra monies for combating climate change and EUR 250m (to be raised via higher taxes) on fossil fuels, promotion of a circular economy via taxation policy as well as higher taxes on mining.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s view that risks to Finland’s sovereign ratings are balanced.

The ratings/Outlooks could be downgraded if, individually or collectively: i) fiscal discipline and/or reform implementation were to deteriorate materially, adversely affecting the medium-term outlook for economic growth and/or debt sustainability; ii) an economic shock of either domestic or external origin significantly damages the government’s balance sheet; and/or iii) financial stresses were to crystallise, with the large size of Finland’s banking system presenting non-negligible recapitalisation demands for the government.

Conversely, the ratings/Outlooks could be upgraded if, individually or collectively: i) a materially higher growth potential is realised, stemming from continued structural reform and public investment initiatives; ii) improvements in structural fiscal deficits are seen, resulting in greater confidence that a sustained and significant debt reduction trajectory will be realised going forward; and/or iii) improvements are seen with respect to financial stability risk, including enhancements in macro-prudential supervisory steps and/or a material de-risking within the financial system.

Rating committee
The main points discussed by the rating committee were: i) debt developments; ii) growth potential; iii) competitiveness and external vulnerabilities; iv) banking sector developments; v) ESG considerations; and vi) peer considerations.

Methodology
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
Historical default rates of the entities rated by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default as well as definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The rating was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: the Ministry of Finance of Finland, Bank of Finland, European Commission, European Central Bank (ECB), Statistical Office of the European Communities (Eurostat), IMF, OECD, and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the rating, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.

Regulatory disclosures
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Dennis Shen, Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 16.02.2018.

Potential conflicts
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.

Conditions of use / exclusion of liability
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