OeNB-SUERF Workshop of 25 years of EU Northern Enlargement 21 September 2020

1. The Board, Bank of Finland
Finland through three crises
OeNB-SUERF Workshop of 25 years of EU Northern Enlargement
21 September 2020
Tuomas Välimäki

2. | Public | BOF/FIN-FSA-UNRESTRICTED
85
90
95
100
105
t t+1 t+2 t+3 t+4 t+5
Nordic banking crisis GFC COVID-19
Peak of the business cycle = 100
Source: Statistics Finland, Bank of Finland.
39682@Chart6
GDP development 5 years since the peak of the 3 crisis
21.9.2020 2

3. | Public | BOF/FIN-FSA-UNRESTRICTED
Short description of the crisis
Finnish perspective
21.9.2020 3

4. | Public | BOF/FIN-FSA-UNRESTRICTED
I Nordic Banking crisis in Finland
• One of the ”Big Five” recessions in Reinhart and Rogoff (2009)
• Typical boom-bust cycle where monetary and fiscal policies played a role
first in creating and subsequently in alleviating the crisis
• Financial deregulation together with low real rates of interest initiated rapid
credit expansion. Lending in foreign currency rose dramatically exposing
many SMEs to foreign exchange risk.
• Rapid wage increases led to weaker foreign competitiveness and growing
trade deficits.
• Biggest trading partner (exports market) was lost.
21.9.2020 4

5. | Public | BOF/FIN-FSA-UNRESTRICTED
II Finland and the Global Financial Crisis (GFC)
• This time was different…
• Thanks to the memory of the previous crisis. Finnish banking sector was in a
good shape after major restructuring in the 1990s.
• Corporate sector balance sheets were strong. Households’ mortgage credit had
grown hand in hand with disposable income and the public sector’s debt to GDP
ratio had been brought down to around 35%.
→ In Finland, GFC wasn’t really a financial crisis, rather a huge shock to external
demand.
• Single monetary policy
21.9.2020 5

6. | Public | BOF/FIN-FSA-UNRESTRICTED
II Finland and the Global Financial Crisis (GFC)
• … although with some major similarities:
• Rapid wage increases at the onset of the crisis led to weaker foreign
competitiveness and deteriorating trade balance.
• (One of the) Biggest exports market lost.
• Other idiosyncratic events (ITC sector, forest industry,…).
• Single monetary policy.
21.9.2020 6

7. | Public | BOF/FIN-FSA-UNRESTRICTED
III COVID-19
• Pandemic with unexperienced lockdowns brought about a major
drop in domestic demand (first phase).
• As a global phenomenon, external demand will drop hurting our
economy that exports investment goods (the coming phase).
• Global shock – with global crisis response.
• Biggest uncertainty: health.
21.9.2020 7

8. | Public | BOF/FIN-FSA-UNRESTRICTED
On crisis responses
21.9.2020 8

9. | Public | BOF/FIN-FSA-UNRESTRICTED
Monetary policy in the 1990’s crisis
• In the boom phase, the tightening of domestic monetary conditions
was offset by the inflow of foreign capital.
• Fixed exchange rate policy constrained Monetary Policy, leaving
economic stabilization to the fiscal side.
• Eventually the unilateral ECU-peg was discontinued
(devaluation in 1991, followed by floating markka in 1992)
• Unprecedented wave of bankruptcies, credit losses in the banking
sector, surge in unemployment and fall in house prices.
21.9.2020 9

10. | Public | BOF/FIN-FSA-UNRESTRICTED
The trilemma for an open economy
• The crisis is a good illustration of the impossible trinity (trilemma):
one cannot combine free capital mobility, fixed exchange rate and
monetary policy sovereignty.
• Prior to the crisis, the stable (or strong) markka policy was supported by
theories stressing the role of rules and credibility.
• New theories suggested, however, that monetary policy should
concentrate on fighting inflation as the anchor for economic policy –
domestic instead of external price stability.
→ In February 1993, Bank of Finland assumed inflation target:
stabilization of inflation at about and on average 2%.
21.9.2020 10

11. | Public | BOF/FIN-FSA-UNRESTRICTED
Recovery and lessons from the 1990’s crisis
• Long recovery facilitated by
• Strong external demand
• Rapid fall in the short- and long-term interest rates
• Luck: rapid growth of the ICT sector (Nokia cluster) boosting productivity
• Lessons
• Indebtedness and financial risks within the private sector need to be more
closely supervised
→ Banking Supervision Office was established to the proximity of the Bank of Finland
• Buffers needed to mitigate the consequences of a crisis: public debt to
GDP can suddenly jump due to excessive leveraging in the private sector.
21.9.2020 11

12. | Public | BOF/FIN-FSA-UNRESTRICTED
-15
-10
-5
0
5
10
15
20
1990 1995 2000 2005 2010 2015
Primary deficit Interest expenditures
Debt-deficit adjustment Change in GDP (denominator effect)
Change in debt/deficit-ratio
%-points
Source: Statistics Finland, Bank of Finland.
39670@Chart4
Improvement in fiscal balances was supported by strong growth,
declining interest payments and smaller unemployment costs
21.9.2020 12
0
10
20
30
40
50
60
70
1990 1995 2000 2005 2010 2015
EDP Debt as % of GDP
Source: Statistics Finland, Bank of Finland.
39670@Chart4

13. | Public | BOF/FIN-FSA-UNRESTRICTED
Planting the seeds of the Great Recession
• The great moderation lowered crisis awareness (globally) and allowed
macroeconomic and financial imbalances to grow under the surface
• Macroeconomic imbalances manifested as high and uneven credit growth
− With single monetary policy, higher wage growth and inflation resulted in lower real interest rates
in the periphery
• Regulatory and supervisory failings
− Before the financial crisis, financial stability was more seen as a precondition to price stability rather
than a separate goal
• Beliefs that this time is different
− Large current account deficits can be permanently financed in a currency union
Similar
failures
that we
faced
before the
1990s’
crisis,
only this
time in
European/
global
level
21.9.2020 13

14. | Public | BOF/FIN-FSA-UNRESTRICTED
Macroeconomic imbalances in the euro area
-15
-10
-5
0
5
10
15
1985 1990 1995 2000 2005 2010 2015
Greece Portugal Italy Spain
Germany Finland Netherlands
Great moderation
%
Source: IMF World Economic Outlook Database
39559@Chart2
GFC and euro debt crisis
Eurosystem starts
21.9.2020 14

15. | Public | BOF/FIN-FSA-UNRESTRICTED
Managing the crisis from monetary policy perspective
• …see the article 
21.9.2020 15

16. | Public | BOF/FIN-FSA-UNRESTRICTED
In Finland, terms of trade adjusted cost competitiveness
decreased considerably before and during the GFC
21.9.2020 16
90
95
100
105
110
115
120
1999 2004 2009 2014 2019
Index, 1999 = 100
Relative to the 12 original euro area member states.
Compensation of employees relative to real domestic income, total economy.
Sources: European Commission, OECD, Macrobond and Bank of Finland calculations.
34093@KKK-indik (6) EN
Good luck was not
handled perfectly:
Productivity growth
in the ICT sector,
resulted in high
wage increases
also in closed
sectors

17. | Public | BOF/FIN-FSA-UNRESTRICTED
-40
-20
0
20
40
60
80
1990-2005 2006-2019
Primary deficit Interest expenditures
Change in GDP (denominator effect) Debt-deficit adjustment
Change in debt/GDP ratio
Role of different factors in the growth of Finnish debt to GDP ratio
21.9.2020 17

18. | Public | BOF/FIN-FSA-UNRESTRICTED
Lessons from the two previous crises and way forward
• Banking sector resilience and credit developments are key factors behind
economic stability: macroprudential tools are needed, BU and CMU should be
completed
• The public debt to GDP ratio decreased in the euro area during the recovery
from the GFC. However, despite the very accommodative monetary policy
stance, deleveraging has been modest and uneven across member states.
• Also in Finland, persistent deficit in public finances since the financial crisis
and only marginal decrease in debt ratio
• Monetary policy not normalized since financial crisis: a need to review the
strategy
21.9.2020 18

19. | Public | BOF/FIN-FSA-UNRESTRICTED
Recovery from the ongoing crisis will be slow
• Global recession and weak investment in
export markets keep export outlook
gloomy
• Growth rests on private consumption –
outlook very sensitive to a resurge of the
epidemic
• High uncertainty to act as a drag on
growth? Extended period of high saving?
• Fiscal policy space further reduced – role
of fiscal monetary policy coordination (?)
21.9.2020 19

20. | Public | BOF/FIN-FSA-UNRESTRICTED
For Finland: this time exporting ourselves out of the
crisis won’t be so easy
86
88
90
92
94
96
98
100
102
t t+1 t+2 t+3
Finland euro area
2020Q1 = 100
Source: Statistics Finland, Bank of Finland, European Central Bank.
39682@Chart7
85
90
95
100
105
110
Finland EU 15
Source: Eurostat, Bank of Finland calculations.
39682@Chart1
1990Q1 = 100
t+1 t+2 t+3 t+4 t+5
85
87
89
91
93
95
97
99
101
103
t t+1 t+2 t+3 t+4 t+5
Finland EU 15
Source: Eurostat, Bank of Finland calculations, ECB.
39682@Chart1
2007Q4 = 100
21.9.2020 20

21. | Public | BOF/FIN-FSA-UNRESTRICTED
Summing up
• Excess credit growth common for deep recessions and a cause of slow recoveries (despite monetary
policy regime)
→ macro prudential tools, regulation, BU, CMU…
• Sustainable fiscal policy is a key condition for everyone, but especially for a sovereign in single currency
area
→ significant monetary accommodation also an opportunity to create fiscal space
• Single monetary policy brought stability for Finland in the GFC and euro crisis
→ interest rates remained extremely low throughout the crisis period
• Lack of flexibility (labor market in particular) a key vulnerabilities of Finland: deterioration of cost
competitiveness, slow recovery from the crisis
→ Important to avoid same mistakes in the current crisis (structural reforms needed)
21.9.2020 21

22. | Public | BOF/FIN-FSA-UNRESTRICTED
Thanks!
21.9.2020 22