Scope affirms Finland's credit rating at AA+ with a Stable Outlook
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Scope Ratings GmbH (Scope) has today affirmed the Republic of Finland’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at AA+. The agency has also affirmed the short-term issuer ratings at S-1+ in local- and foreign-currency. All Outlooks are Stable.
Summary and Outlook
The affirmation of Finland’s AA+ long-term ratings reflects: i) a wealthy and resilient economy, underpinned by a highly educated workforce; ii) high government debt affordability, with fiscal resilience further supported by the government’s net financial asset position and the ECB’s accommodative monetary policy stance; and iii) high institutional quality, with Finland ranking among the best countries globally in terms of respect for the rule of law, accompanied by strong commitment to structural reform. On the other hand, the ratings are constrained by challenges related to: i) the country’s moderate growth potential, constrained by weak productivity dynamics and labour market rigidities in the context of a declining working-age population; ii) rising fiscal pressures from Finland’s ageing population that weigh on the medium-term trajectory of public finances; and iii) financial stability risks, including those arising from the size of the Finnish banking sector relative to that of the domestic economy and those related to elevated private-sector indebtedness.
The Stable Outlook reflects Scope’s view that risks to Finland’s ratings over the next 12 to 18 months are balanced.
The ratings/Outlooks could be upgraded if, individually or collectively: i) the country’s growth potential increased due to continued structural reforms and public investment initiatives; and/or ii) the fiscal outlook improved notably via a sustained debt reduction. Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) reform implementation deteriorated materially, adversely affecting the medium-term economic outlook; ii) the fiscal outlook notably weakened, resulting in a material increase in government debt; and/or iii) financial stresses were to crystallise, with damage to the financial and non-financial private sector balance sheets hampering the economic and fiscal outlook.
The first driver of Finland’s AA+ ratings is the country’s wealthy, resilient and modern economy that benefits from elevated human capital, effective policies and strong infrastructure in future economic areas such as digitalisation and the environmental transition.
Finland’s per capita GDP of about EUR 43,000 or 130% of the euro area average constitutes a source of resilience for the economy to shocks, such as the Covid-19 pandemic. Last year, Finland’s output contraction was relatively contained at 2.9%, about half that of the euro area. This was due to a less severe virus outbreak, low reliance on the tourism sector and a strong fiscal policy response. Government support, equivalent to 4.6% of GDP in direct budgetary stimulus over 2020-21 plus liquidity measures, has helped facilitate a rapid recovery so far this year, after restrictions to prevent the spread of the virus were relaxed in the spring. Real GDP returned to pre-crisis levels in Q2 2021, with quarterly growth of 2.1%, while economic sentiment indicators, industrial production and employment data suggest that strong economic performance will continue in Q3 2021. Employment rose by 3.7% YoY in August, as the number of employed and the employment rate (72.8%) returned to pre-crisis levels. The latter slightly declined in September to 72.5%. In addition, the number of unemployed has fallen sharply, although it remains about 30,000 higher than before the crisis, with a trend rate of 7.6% or about 1pp higher than pre-crisis levels. At the same time, job vacancies continue to trend upwards, signaling labour market mismatches.
While a tight labour market, the recent rapid rise in energy prices and supply-chain bottlenecks pose some downside risks for the economic outlook, given strong performance in Q2-Q3, Scope expects Finland’s real GDP to grow by 3.4% this year. Scope expects this figure to decline to 2.7% in 2022 and gradually fall towards Scope’s estimated potential growth rate of 1.2% as fiscal support measures fade away and the output gap closes. HICP inflation is likely to increase towards 2.5% in Q4 from 2.1% in September and then gradually decline resulting in an annual average rate at just below 2% in 2021-22. Further elements of downside risk to the economic outlook relate to the development of the pandemic, given a resurgence of cases and hospitalisations in recent weeks in Finland. These risks are, however, mitigated by a high vaccination rate, as over 76% of the total population is inoculated with at least one dose, above the EU average of 69%.1,2
The long-term resilience of the Finnish economy is further anchored in the country’s leadership in the global trends of digitalisation and the environmental transition. Finland is a digital leader, placing first among EU member states in the Digital Economy and Society Index (DESI) 2020, which ranks countries’ performance in digital infrastructure, integration of digital technology in business and public services, and human capital for digital skills. The environmental transition plays a central role in Finland’s policy agenda, with one of the most ambitious emission reduction targets globally, namely to become carbon neutral by 2035. This transition will require significant policy efforts and economic transformations. The government has quantified its emission gap at about 10-15 Mt CO2-eq to be covered via new measures. At the same time, Finland benefits from several factors facilitating such efforts on a comparative basis, including a small population and economy size with ample natural resources. These include land sector use for emissions sinks as well as renewable energies, which already account for more than 40% of the county’s total energy consumption, one of the highest shares in the EU. These aspects, along with Finland’s low vulnerability to natural disaster risks as captured by the World Risk Index, point not only to a favorable position when it comes to adapting to these global trends but also to a relatively low risk of stranded assets.3,4
Finland’s economy also benefits from a very effective education system supporting its high human capital. It outperformed average OECD countries’ results in every main subject based on its 2018 PISA results. In the WEF 2020 Global Competitiveness Report, Finland ranked first in terms of its ability to update educational curricula in response to skills requested in rapidly evolving job markets. Elevated educational standards and an efficient connection to the labour market are reflected in 47% of working people having at least a bachelor’s degree versus an average of 37% for the euro area. Similarly, only 9% of employed people are low-skilled versus 18% for the euro area. This results in low inequality, social stability and high-income levels, which underpin the country’s macroeconomic resilience.5,6
The second driver of Finland’s AA+ ratings is high government debt affordability, which mitigates challenges related to the increase in debt and borrowing requirements caused by the Covid-19 pandemic.
While Finland’s general government debt as a share of GDP jumped by 10pp last year, to 69.5% from 59.5% in 2019, interest expenditure relative to government revenue has continued to decline to about 1.3%, and is now at half of 2014 figures, signalling improved affordability. This is thanks to favourable financial market conditions for Finland, whose Treasury can currently borrow at close to 0% on a ten-year maturity. This also reflects support from the ECB’s accommodative monetary policy stance. Net purchases of Finnish government securities under the ECB’s PEPP and APP programs amounted to over EUR 29bn in 2020-21 (as of September). As of end-2020, the Bank of Finland’s holdings of government debt on the part of the Eurosystem were close to 22% of total debt (18% at end-2019) and are likely to approach 25% by the end of this year.7
In addition, a favourable debt structure and prudent liquidity management result in a long and increasing average debt maturity of 7.4 years and a sizeable cash buffer, which could cover more than 20% of expected central government gross borrowing requirements for this year (as of September). The cash buffer is likely to be gradually reduced going forward as risks related to the pandemic gradually fade. These favourable factors help mitigate risks related to the significant increase in annual gross borrowing requirements for the central government following the pandemic, which are expected to remain about twice their pre-crisis levels in the next five years, gradually declining to 12% of GDP from 14% last year, versus 6% of GDP in 2019. A further meaningful element of resilience for Finland’s government finances is the government’s ample net financial asset position stemming from its public pension scheme. This stood at 71.6% of GDP as of Q2 2021, up from 62.6% at end-2019, fully recovering losses in value suffered last year during the peak of the crisis. In this respect, Finland’s government is by far the wealthiest among euro area sovereigns. Still, most of these assets are earmarked to fund pension expenditures and thus are not fungible for contingent use in debt service under severe scenarios.8,9
The third driver of Finland’s AA+ ratings is the country’s outstanding institutional quality. Finland ranks among the top countries globally in governance indicators and has a strong track record of implementing structural reforms in areas such as enhancing external competitiveness, strengthening the sustainability of the welfare system and addressing labour market rigidities. Finland ranks above the 99th percentile in five out of six World Bank governance indicators, especially respect for the rule of law, regulatory quality, governance effectiveness and accountability. These elements materially contribute to favour a business-friendly environment and strengthen macroeconomic stability. Finland also benefits from EU and euro area membership, which strengthens the structural reform framework, budgetary processes oversight, and banking sector supervision.
The track record of the Finnish authorities’ commitment to structural reform includes improvements to external competitiveness, supported by the implementation of the Competitiveness Pact agreed in 2016. Real unit labour costs remain below 2015 levels, while the balance of goods and services has improved in recent years. This supports a rebalancing of the current account, which last year was in a small surplus position (0.8% of GDP) for the first time in the last decade.
In June of this year the government obtained parliamentary approval for a complex reform of social and healthcare services (known as SOTE) after several years of negotiations, including by preceding governments. The reform will take effect by 2023. It aims at improving cost-effectiveness in the provision of social and healthcare services by shifting governance from the highly fragmented municipal sector to newly created county governments. If corroborated by solid fiscal targets, the rationalisation in service provision could support cost containment in one of the key drivers of structural imbalances in Finland’s government finances. In addition, several labour market reforms are being implemented in the framework of the 2021-22 budget sessions, the mid-term fiscal plan update and the Next Generation EU (NGEU) recovery and resilience plan. These reforms include measures aimed at increasing the effectiveness of public employment services, activating older segments of the population by shortening unemployment benefits for older workers, streamlining permit procedures for labour and education-based migration in sectors suffering from labour shortages and strengthening training programs for strategic sectors. The government hopes to increase employment by 80,000 people and to raise the employment rate to 75% by the middle of the decade.10
Despite these credit strengths, Finland’s ratings face important medium-term credit challenges.
First, the country has a modest growth potential, constrained by weak productivity dynamics and labour market rigidities in the context of a declining working-age population.
Total factor productivity is stagnant at early 2000’s levels. A structural economic shift away from the industrial and manufacturing sectors toward services that started with the global financial crisis has so far prevented a recovery to earlier productivity levels. While such structural factors appear unlikely to be reversed, several aspects could in part support the productivity outlook going forward. Scope notes that the 2021-22 budgets target very elevated public investment spending (close to 5% of GDP) driven by the ‘future-oriented investments’ part of the government program and by the first tranches of the NGEU recovery funds. The latter totals EUR 2.1bn (0.8% of 2021E GDP). In addition, the government aims to increase R&D expenditure as a share of GDP to 4% by 2030, from 2.8% in 2019, which is already above the EU average of 2.2%. Overall, investment levels are elevated, near 25% of GDP, although they are mostly related to construction, which tends to lag behind other sectors in terms of productivity spillovers.
Further obstacles to potential output growth are represented by structural rigidities in the Finnish labour market. This exacerbates downward pressure on labour input caused by a working-age population that is set to decline by 0.2% annually in the next fifteen years, according to UN estimates. Finland’s labour market metrics compare unfavourably to other Nordic peers with similar welfare models, despite a gradual improvement in recent years. Structural unemployment remains relatively elevated, at about 7%, down from 7.8% in 2015, but still above that of Denmark and Sweden and also euro area peers such as Austria. The employment rate, now close to 73% remains below the 76% average across Nordic peers. The lag is particularly evident among older workers, despite a tangible 5pp increase over the past five years.
A second challenge is rising fiscal pressure from Finland’s ageing population that weighs on the trajectory of public finances.
The general government fiscal balance is set to rapidly recover from last year’s deficit of 5.5% of GDP, driven by reduced pandemic-related support measures that are expected to be phased out almost entirely by 2022, and by robust government revenue growth that has been boosted by improved economic and employment conditions. At the same time, structural imbalances in public finances driven by unfavourable ageing dynamics remain. Finland’s budget has posted structural deficits since 2010, and these have gradually worsened from 0.7% to 1.2% of potential GDP between 2015-19.11
Finland has the second highest old-age dependency ratio in the euro area after Italy. The share of people over 65 increased to 36% of the working-age population last year, versus 22% in 2000. Ageing-related fiscal pressures are set to further increase in the next 20 years, with the old-age dependency ratio projected to reach 45% by 2040 in the UN’s baseline scenario, driven also by a 3% decline in the working-age population. At that time, the Finnish population over 85 years of age will be twice the size it is today, which will have an exponential impact on long-term care spending. According to estimates from Finland’s ministry of finance, annual ageing-related expenditure is set to increase by more than 1pp of GDP by 2030 from 2019 levels and by more than 4pp by 2070. This will significantly challenge efforts to rebalance government finances in the medium-to-long term, even after subtracting savings in education spending of about 1% of GDP by 2070.
The government strategy for rebalancing public finances relies on achieving robust employment and productivity growth and on the social and healthcare reform, which have created significant up-front costs. They include an increase in permanent spending (about EUR 1.3bn at the 2022 level) envisaged in the government’s program, but also a need to increase pre-set spending ceilings for 2022-23 last spring. Scope notes some downside risks on achieving the 75% employment target, given the moderate economic growth outlook expected after next year. Potential cost savings from the healthcare reform are not likely to materialise until near the end of the decade, given initial investment needs associated with setting up administrative capacity for the new counties. This is likely to result in budget deficits for the sector during the first years of existence, besides requiring central government pre-funding and transition costs of above EUR 1bn in 2022. Further upward pressure on the debt trajectory will come from defence spending of about EUR 10bn through 2030 to replace fighter aircrafts.12
Scope expects a rapid recovery in Finland’s government budget in 2021-22, with the fiscal deficit declining to about 3.9% and 2.7% of GDP this and next year respectively. The budget is expected to remain structurally in deficit in the medium term, however, at about 1.5% of GDP. This, coupled with a moderate outlook for medium-term growth, would result in the debt-to-GDP trajectory trending upwards until 2026, to about 76%, from 71.2% expected this year. In addition, elevated contingent liabilities, stemming from central government guarantees worth nearly 26% of 2021E GDP, triple their 2010 level, pose risks to the trajectory. About half of the stock comprises guarantees released to the export credit agency Finnvera, while pandemic-related guarantees have only registered a moderate take-up so far. Finland’s debt-to-GDP ratio is thus set to remain about twice the size of its Nordic peers in the medium term, although well below the euro area average of above 90%.
Finally, Finland’s credit ratings are constrained by potential financial stability risks, including those arising from the size of the Finnish banking sector relative to that of the domestic economy and those related to elevated private-sector indebtedness.
When Nordea moved its headquarters from Sweden to Finland in October 2018, the Finnish domestic banking sector became one of the largest in Europe relative to the size of the domestic economy, now totalling over three times GDP. The large relative size of financial institutions also results in very elevated external debt levels for Finland. These stood at 243.6% of GDP as of Q2 2021, which is high compared to that of Nordic and euro area peers. Moreover, the sizeable share of short-term external debt (106.8% of GDP as of Q2 2021) signals vulnerability to external shocks. However, the net international investment position was close to balance as of Q2 2021. Core mitigating factors to banking sector risks derive from the solidity of the Finnish banking system as reflected in capitalisation and profitability metrics. The CET1 ratio stood at 18.6% in Q2 2021, above the EU average of 15.8%. The Finnish banking sector also outperforms European peers in terms of asset quality and profitability, with a lower NPL ratio (1.4%) and a higher ROE (9.0%). In addition, liquidity metrics are solid with a coverage ratio of 178%, although a loan-to-deposit ratio significantly above the EU average signals that Finnish banks rely significantly more on wholesale funding.
Other risks to financial stability stem from elevated private sector indebtedness. Finland’s private sector debt-to-GDP ratio stood at 192.6% in Q2 2021, up 5pp from three years before. This is high compared to the euro area average of 173.8%, although well below levels in Denmark and Sweden. Household indebtedness relative to disposable income has been following an increasing trend in recent decades and reached 134.7% in Q2 2021. Most household debts refer to housing loans. Housing price dynamics have remained rather stable in Finland compared to other Nordic economies, although accelerating significantly as of end-2020, especially in the Greater Helsinki area. In response, Finland’s Financial Supervisory Authority tightened the maximum loan-to-collateral ratio for new residential mortgage loans other than first-home loans by 5pp to 85% in June 2021.13
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on the relative rankings of key sovereign credit fundamentals, provides an indicative rating of ‘aa+’ for the Republic of Finland. The country receives a one-notch positive adjustment for the euro’s status as a global reserve currency under the reserve currency adjustment. The resulting ‘aaa’ indicative rating can be adjusted in the Qualitative Scorecard (QS) by up to three notches depending on the size of relative qualitative credit strengths or weaknesses versus a peer group of countries.
For Finland, ‘environmental risks’ and ‘institutional and political risks’ have been identified as relative credit strengths. Conversely, the ‘growth potential of the economy, ‘current account resilience, ‘external debt structure and ‘financial imbalances’ have been identified as relative credit weaknesses.
The QS generates a one-notch downward adjustment and indicates AA+ long-term ratings for Finland.
A rating committee has discussed and confirmed these results.
Factoring of Environment, Social and Governance (ESG)
Scope explicitly factors in ESG sustainability issues during its ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with a 20% weighting under the quantitative model (CVS) and in the qualitative overlay (QS).
Under governance-related factors in the CVS, Finland has outstanding scores in all the World Bank’s Worldwide Governance Indicators. The ruling government is composed of a five-party coalition led by Social Democrat prime minister Sanna Marin, who took office in 2019. The government’s pro-growth reform agenda includes increasing social and investment spending while aiming to stabilise public finances by boosting employment. This year saw the government obtaining parliamentary approval for the landmark social and healthcare system reforms mentioned above. Its management of the Covid-19 crisis has been effective, with the lowest cumulative death toll per million inhabitants among EU countries, while fiscal support measures have helped shield the country from the economic shock. The government has recently faced some stability challenges, particularly on the decision to raise the expenditure ceiling for 2022-23 and on the approval of the NGEU recovery plan, which required a two-thirds parliamentary majority. In the QS assessment of Finland’s ‘institutional and political risks’, Scope evaluates this qualitative analytical category as ‘strong’ versus Finland’s ‘aaa’ indicative sovereign peer group.
Credit factors related to social criteria are similarly captured under Scope’s CVS quantitative model and QS qualitative overlay. In the CVS model, Finland receives top scores on income inequality and labour force participation, and a very weak mark on the old-age dependency ratio. The complementary QS assessment of ‘social risks’ is assessed at ‘neutral’, balancing the relative strengths of Finland’s advanced welfare and education systems, which support social inclusion and stability, against elevated challenges stemming from adverse demographic trends relative to peers. Scope also notes that Finland ranks first among UN members in the 2021 Sustainable Development Report, which assesses countries’ progress towards achieving the UN’s 2030 goals.
With respect to environmental risks Finland receives high scores in all CVS indicators. These include carbon emissions per unit of GDP, exposure and vulnerability to natural disaster risks, and the ecological footprint of consumption compared with available biocapacity. Scope assesses Finland’s QS adjustment for ‘environmental risks’ as ‘strong’. Finland is committed to the Paris Agreement and to emission reduction obligations under EU law. Moreover, Finland set the target to become carbon-neutral by 2035 and carbon-negative thereafter. According to Statistics Finland’s preliminary estimates for 2020, the country’s GHG emissions (UNFCC) fell by 32% (23 Mt CO2 eq.) from 1990 levels although there was significant volatility year-on-year. This was excluding the net sink of the land use sector, which is expected to have improved by more than 8Mt CO2-eq since 2019. Net emissions would thus have dropped to just above 25Mt CO2-eq, down 13Mt CO2-eq from 2019 and by 56% from 1990. Finland is on track to meet its 2020 emission reduction commitments under EU law, but will need to implement additional policy measures to achieve its objective of carbon neutrality, which the environment ministry estimates at 27 Mt CO2-eq below current levels. Measures already in place are expected to deliver emission reductions of about 16Mt CO2-eq. To close the remaining gap, the government is implementing policies including an update to the Climate Change Act, an energy taxation reform and a roadmap for fossil-free transport. Finland has allocated 50% of NGEU recovery funds to environmental efforts, above the required target of 37%.
The main points discussed by the rating committee were: i) Finland’s economic outlook and medium-term growth potential; ii) fiscal sustainability developments; iii) competitiveness and external vulnerabilities; iv) banking sector and non-financial private sector balance sheet developments; v) ESG considerations; and vi) peer comparisons.
Rating driver references
1. Economic Survey Autumn 2021 – Ministry of Finance
2. Interim Forecast for the Finnish Economy – September 2021 – Bank of Finland
3. Digital Economy and Society Index (DESI) 2020
4. Annual Climate Report 2021 – Ministry of the Environment
5. PISA 2018 results for Finland - OECD
6. Global Competitiveness Report 2020 – World Economic Forum
7. ECB asset purchase programmes
8. Quarterly Review Q3/2021 – State Treasury
9. Finnish central government borrowing – October 2021
10. EC endorsement of Finland’s recovery and resilience plan
11. 2022 Draft Budgetary Plan
12. General Government Fiscal Plan 2022-25
13. Macroprudential decisions – Financial Supervisory Authority
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021), is available on https://www.scoperatings.com/#!methodology/list.
Scope Ratings GmbH and Scope Ratings UK Limited apply the same methodologies/models and key rating assumptions for their credit rating services, while Scope Hamburg GmbH’s methodologies/models and key rating assumptions are different from those of Scope Ratings GmbH and Scope Ratings UK Limited.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/#!governance-and-policies/rating-scale. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/#governance-and-policies/rating-scale. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://www.scoperatings.com/#!methodology/list.
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Lead analyst: Giulia Branz, Analyst
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