By Giulia Branz, CFA, Senior Analyst, Sovereign Ratings

The Finnish economy has proven remarkably resilient to the Covid-19 pandemic, underpinning our decision to affirm the AA+/Stable rating on 14 October 2022.

Still, the three simultaneous shocks of energy, geopolitical risks and rising interest rates will materially affect the country’s economic and fiscal outlook in the near-term. We expect flat economic growth next year of just 0.2%, following a robust 2.3% this year and a deterioration of the fiscal deficit to 2% of GDP in 2023, from 1.6% expected this year. Interest expenditure will gradually increase from about 0.5% of GDP last year to over 1% by 2025, reflecting the shifting monetary policy and interest-rate environment. Robust nominal GDP growth and a contained fiscal deficit should result in a moderate decline in the debt-to-GDP ratio this year to 71%, down from 72.3% in 2021.

However, we expect the debt ratio to resume an upward trajectory in the medium-term, increasing towards 75% of GDP by 2027, given a moderate growth outlook and persistent fiscal deficits driven by Finland’s ageing population, on top of gradually higher debt-servicing costs.

Finland has the second highest old-age dependency ratio in the euro area after Italy. The share of people over 65 increased to 37% of the working-age population last year from 22% in 2000. Age-related fiscal pressures are set to further increase in the next years, with the old-age dependency ratio projected to reach 45% by 2040, driven by a 3% decline in the working-age population. At that time, the number of Finnish people above 85 years of age will be more than twice the number today. This will have an exponential impact on health and long-term care spending.

According to Finland’s Ministry of Finance, the consolidation effort needed to ensure balanced government finances over the long-term accounting for population ageing is around 3% of GDP.

Finland’s demographic developments
Population structure, people thousands (lhs); Old-age dependency ratio*, % (rhs)

*Old-age dependency ratio: the ratio of the number of people aged 65+ to that of the people in working-age (15-64)
Source: United Nation population projections, Macrobond, Scope Ratings

Sound pension system and progress on welfare sustainability reform are important mitigating factors

The Finnish pension system performs well in terms of social and financial sustainability. The system is mostly based on earnings-related pension schemes, complemented by national and guarantee pensions that secure a basic livelihood to people with limited income.

Earnings-related pensions in Finland are part of statutory social security and include, in addition to the pay-as-you-go scheme, partial funding in both private sector and public sector schemes. This is relatively rare in European social security pensions, which are usually funded as pure pay-as-you-go systems.

The pre-funding element supports the resilience of the system for the future, especially given the significant accumulation of pension schemes’ assets over the past decades. The assets increased from about EUR 40bn in 1995 to above EUR 250bn last year, or over 100% of GDP, and remain elevated at EUR 245bn despite the weak performance of global financial markets in the first half of 2022.

Employment pension schemes assets
EUR bn (lhs); % of GDP (rhs)

Source: Statistics Finland, Macrobond, Scope Ratings

The investment return of pension assets plays a key role in the Finnish earnings-related pension system, by supporting the financing of annual pension payments. This allows a reduction in contributions collected both at present and in the future, thereby limiting distortions in the labour market. Earnings-related pensions today are already in part covered by returns on investment funds. Annual investment returns are generally higher than the contribution required to cover pension costs, allowing a further increase in the asset positions of the schemes.

Despite this favourable position, adverse demographic trends will challenge the financial sustainability of the pension system over the long run as the latest projections from the Finnish Centre for Pensions show.

That said, Finland is better prepared than many other European countries, because it set up a forward-looking system, together with proactive reform and high social acceptance. This is demonstrated by the strong link between retirement age and life expectancy introduced with the major pension reform of 2017.

The government has also been proactive in addressing health and long-term care spending. The IMF estimates the net present value of the cumulative change in healthcare spending between 2021 and 2050 for Finland amounts to 36% of GDP. Next year, the landmark healthcare reform (SOTE) will take effect, providing for the shift of social and healthcare services from the highly fragmented municipal sector to newly-created county governments. If corroborated by solid fiscal targets, the rationalisation in service provision could contain costs in an area driving structural imbalances in Finland’s government finances.

References: Finnish Centre for Pensions, The Finnish Pension Alliance TELA