Finland: The world's happiest country has a debt problem it can no longer ignore

A sense of unease pervades Finland, the country renowned for its happiness for nine straight years. An unusually frigid winter is on the horizon, accompanied by the harshest austerity budget in years. The election slated for April will not merely focus on the magnitude of cuts, but rather on which services, benefits, and pensions will bear the brunt.

Finland's debt and deficit levels have reached their worst since the 1990s, when a banking crisis and the collapse of a key export partner, the Soviet Union, plunged the Nordic nation into its own Great Depression. As of the second quarter, the national debt stood at 90.3% of gross domestic product (GDP), up from approximately 65% pre-pandemic.

Factors exacerbating this situation include Finland's increased military spending post-NATO accession and the nation's pivot to other energy suppliers following Russia's invasion of Ukraine.

The state treasury anticipates the fiscal deficit to climb to 4.2% of GDP by 2026. The European Union has urged Finland to reduce its borrowing gap, which exceeds the 3% of GDP threshold. In January, the European Council issued an excessive deficit procedure, granting Finland until the end of 2028 to meet the target. Prime Minister Petteri Orpo's government pledged to trim about €9 billion during this legislative term.

However, economists caution that whoever assumes office post-election will need to implement deeper cuts, with estimates ranging from €8 to €11 billion. Recently, all political parties, except one, agreed to support a debt brake, committing to reduce the deficit to 2-2.5% of GDP by 2031. The center-right National Coalition party, led by Orpo, has pledged additional €9 billion in cuts if it secures a second term.

These cuts could target health, social care, welfare, and workplace pensions, sparing current payouts. Orpo's approach aims to achieve his target without raising taxes, implying that public services will suffer.

While Finland's at-risk-of-poverty rate is lower than the EU average, unemployment is higher than any other bloc member. In August, Finland's jobless rate stood at 10.3%, just above Spain's 10%, according to Eurostat. Youth unemployment reached 23.3%, compared to the EU average of 15.4%. With household spending already declining, Lauri Olappa, director of the Finnish Centre for New Economic Analysis, warned that another round of austerity would deal a significant blow to the domestic economy.

More than a quarter of Finland's population works in the public sector, so if workers face potential layoffs, savings will rise, and private spending will fall further. The 2027 budget proposal still anticipates a €12.4 billion spending gap. Prior to the Russia-Ukraine war, Finland had already earmarked €8.4 billion for 64 F-35A fighter jets, while military spending increased from $4.5 billion to over $8 billion annually during the Ukraine conflict.

In April, the government announced a further hike in defense spending to 3.2% of GDP, nearing NATO's 3.5% target. Despite the Iran war keeping oil prices near $100 a barrel, the government has resisted calls to increase fuel subsidies. Even as the Bank of Finland observed a 50% surge in the cost of imported energy in the early months of the Iran war, Finland's central bank cautioned that sustained high oil and gas prices would result in lower economic growth and higher inflation next year.

On the brighter side, parts of Finland's export sector are thriving due to robust metal and shipbuilding orders, reminiscent of the Nokia boom years. This export sector may help steer Finland out of the recession, provided demand from Europe remains strong. Despite the multitude of challenges, market reactions to Finland's debt issues have thus far been mild.

Rating agencies have maintained the country's outlook as stable, except for S&P, which downgraded to negative in April without altering the rating. The premium Finland pays over Germany for borrowing ten-year bonds is currently 38 basis points, significantly lower than France's 128 and Italy's 107. This suggests that investors still perceive Finnish debt as among the safest in Europe, provided the next shock doesn't involve prolonged oil-price spikes, fresh Russian escalations, or a euro-area debt crisis.