Status of the Faroese Economy, Mid-2006

Christian Ølgaard, Economics

SUMMARY

In the past year, the Faroese economy has picked up after some years of weak activity. This is primarily reflected in rising payroll expenditures, but also in an improved labour market. Better market prices for fish and an upward trend for housing prices have contributed to a higher level of activity than expected a year ago.

The current account continued to show a surplus in 2005, in spite of extraordinarily high imports of ships and rising oil prices.

In view of the slowdown in previous years, government finances are relatively sound. In 2005 the government deficit was approximately 2 per cent of GDP, and government finances will be close to balance in 2006.

The favourable economic development is set to continue in the coming years.

ECONOMIC ACTIVITY^[1]

Key indicators for the Faroese economy point to moderate growth in activity since last summer. Payroll expenditures have increased significantly, employment has risen, and unemployment has fallen. This upswing follows 3-4 years of stagnation.

Payroll expenditures, which normally account for between 2/3 and 3/4 of the Faroe Islands' gross domestic product at factor cost, were a good 6 per cent higher in the 1st half of 2006 than in the same period of 2005, cf. Chart 1. Since Faroese consumer prises rose by only just under 2 per cent, real incomes increased considerably.

Payroll expenditures increased in most sectors, notably in fisheries and the financial sector, but the private service sectors also saw an increase.

In the period from January to May 2006, waged employment was just over 1 per cent higher than one year before. Again, the increase was particularly strong in the financial sector, where intensified competition and sound profits have contributed to staff increases by the Faroese banks, cf. Chart 2 (right). Employment in the private service sectors also rose, driven by among other factors trade and transport. The latter sector has benefited from the fact that only Faroese airlines have operated routes between the Faroe Islands and Denmark since the autumn of 2004.^[2]

Fisheries recorded a slight decline in employment, cf. Chart 2 (left). The combination of falling employment and rapidly rising payroll expenditures indicates that the improvement in the fisheries sector is primarily a result of higher prices rather than larger catches^[3], and that the downsizing and rationalisation seen in parts of the sector in recent years have continued.

In contrast, employment in the fish-processing industry increased after a pronounced decline for several years. This is attributable to larger catches of saithe in particular, cf. below, and growth in imports of fish for processing. After two financially difficult years, the situation of the fish-processing industry improved in 2005. Overall, the sector is, nevertheless, still struggling to be profitable. The two largest fish-processing enterprises passed from semi-public to private ownership in 2005, and it is hoped that this will help to enhance their competitiveness.

The near-collapse of the sea-farming industry in 2003 in the wake of falling prices and disease resulted in a sharp drop in production up to 2005. However, rising prices in the last year, combined with a number of initiatives to reduce the risk of disease, as well as reconstruction of the industry with new, larger units, give grounds for renewed optimism. In 2004, releases of smolt were only approximately 15 per cent of the 2002 level, but this figure rose to 25 per cent in 2005 and is expected to reach around 45 per cent in 2006.^[4] Exports of salmon and trout continued to fall in the 1st half of 2006, when volumes were 70-75 per cent lower than one year before. In contrast, the average price was around 50 per cent higher.

Building and construction activity has been high in recent years in spite of the general slowdown. Even so, 2005 and the first part of 2006 saw a small decline in employment, while payroll expenditures remained more or less unchanged. The slightly weaker activity should be viewed against the background of the completion of a major tunnel construction project between Klaksvík and Eysturoy. On the other hand, the housing construction market is expanding – particularly in and around Tórshavn. In recent years housing prices have risen strongly, cf. Chart 3 (left), and since prices are higher in the Tórshavn area than elsewhere in the Faroe Islands, new building has become attractive. In addition, the population of Tórshavn continues to increase, as it has done for many years.

Housing prices accelerated in the 1st half of 2006, partly in response to the introduction of 30-year mortgage loans with deferred amortisation for up to 10 years. This product has been offered by the banks since the autumn of 2005. Since home purchases were previously mainly financed via 15-20-year annuity loans, the new loan product has made it considerably less expensive to service a mortgage loan. The rising housing prices were also stimulated by the general economic upswing and price competition in the market for mortgage loans. The combination of higher housing prices and lower mortgage payments also contributed to a rapid expansion of private consumption, not least purchases of new passenger cars.

The percentage increase in Faroese housing prices since the mid-1990s has more or less matched the Danish level, but it should be taken into account that Faroese prices dropped to a very low level during the economic crisis in 1993-94. With the recent increases, the price of an average home in the Faroe Islands as a ratio of income is back at the 1990 level, cf. Chart 3 (right). Since 1990, the mortgage interest rate has more than halved, however, and viewed against that background the current housing prices are not excessive. A number of planned residential construction projects in and around Tórshavn can augment the housing stock considerably. If a significant proportion of these plans are realised, this will dampen the development in housing prices in the coming years.

Growth in public-sector employment was 1.4 per cent year-on-year in the first five months of 2006. This was lower than in the preceding years, but slightly higher than the overall growth in employment. On the other hand, growth in payroll expenditures in the public sector was below average in the 1st half of 2006. This difference reflects the conclusion of collective agreements for the public sector in the autumn of 2005 that keep wage increases at just under 1 per cent in the first year, in order to curb growth in government expenditure. The negotiated wage increase was below the average rate of wage increase – and also substantially lower than the increases seen in the preceding years.

The higher employment rate was reflected in the unemployment figures, which declined from almost 4 per cent of the labour force in the 2nd quarter of 2005 to just under 3 per cent in the 2nd quarter of 2006, cf. Chart 4. The more favourable economic climate is also apparent from the immigration and emigration statistics. The net emigration trend seen in the last two years reversed, and minor net immigration was registered in the 2nd quarter of 2006. Historically, migration has been a good gauge of the temperature of the Faroese economy, so if the economic upswing continues, immigration is likely to increase.

Fisheries
Catches of demersal fish in Faroese waters, which is the commercially most important branch of fisheries, rose in the 1st half-year. The increase is almost entirely attributable to catches of saithe, which were just over 40 per cent higher than in the 1st half of 2005. In the same period, the more valuable species, cod and haddock, saw a decline by, respectively, just over 15 per cent and 5 per cent. However, a substantial increase in market prices for practically all species – particularly saithe – meant that the value of demersal catches in domestic waters increased by almost 20 per cent year-on-year in the 1st half of 2006. But the higher catch values were offset by rising oil prices. This was particularly evident for the energy-intensive trawlers, while the finances of the fishing fleet are otherwise rather favourable.

The reduced catch volumes for cod reflect that the stock in Faroese waters is limited; in fact, it is estimated to be at the second-lowest level for the last 40-50 years. Moreover, the stock of haddock has weakened. In their annual recommendation to the Faroese government in June 2006^[5], the marine biologists at the Faroese Fisheries Laboratory, Fiskirannsóknarstovan, therefore recommended reducing the number of fishing days for vessels that primarily catch cod and haddock (line fishing vessels and the cutter fleet) by 25 per cent.^[6] As on previous occasions, the Løgting (parliament) nonetheless gave priority to short-term commercial interests, in that the number of fishing days in 2006-07 was reduced by only 3 per cent. Consequently, it will take longer for the cod stock to be replenished, and fishing revenues will be poorer in the long term than if a more appropriate preservation policy had been applied. The Faroese marine biologists have pointed out that lower fishing intensity for demersal species could lead to higher catch values because lower fish mortality would result in a higher average weight per fish and thus a higher price per kilo.^[7] In addition, it will be possible to catch the same volumes using fewer resources.

The decline in cod fishing in recent years has contributed to intensified fishing for other species, particularly monkfish, of which the catch value has more than doubled within the last two years, reaching 10 per cent of the catch value in domestic waters in 2005.

The downward trend in shrimp fishing has continued, and today there is only one active trawler left as the Faroese fleet. Five years ago there were more than 10.

The most lucrative branch of the Faroese fishing industry in recent years has been pelagic fish (primarily herring, mackerel and blue whiting). In addition to good prices, this part of the fleet has benefited from the increase in the stock of herring in the Norwegian Sea. Fishing provides good incomes for both the crew and the vessel, and over the last five years considerable new investments have been made, so that the current fleet is modern and efficient. In the early summer one of these vessels was traded for approximately kr. 350 million, of which an estimated kr. 200 million was payment for the appurtenant fishing rights – rights that were granted to the previous owner by the Faroese government free of charge.

This transaction has triggered discussion in the Faroe Islands about who should reap the resource yield from fisheries, i.e. the supernormal profits that can be made in large parts of the sector. In pelagic fishing, the resource yield currently primarily accrues to the vessel's owner, who among other things capitalises the value of future supernormal profits on selling the vessel, but also to the crew, who are paid high wages. In other parts of the Faroese fishing sector, e.g. cod and haddock fishing, the resource yield is to a large extent distributed by granting more fishing licences than necessary from a purely economic point of view. As a consequence, fishing becomes inefficient. An alternative option, which has not been tried out in the Faroe Islands, is that the government sells time-limited fishing rights. In that case the resource yield would accrue to the government and thus to the whole population of the Faroe Islands. How the resource yield is to be distributed is ultimately a political issue.

BALANCE OF PAYMENTS AND FOREIGN TRADE

In the last decade, the Faroe Islands have generally had large current-account surpluses – often exceeding 10 per cent of GDP. In 2005 the surplus is estimated to have been approximately kr. 300 million (equivalent to around 3 per cent of GDP) against approximately kr. 800 million in 2004, cf. Chart 5.

The declining surplus is related to a weakening of the trade balance. Exports of goods fell by 3 per cent, while imports rose by 14 per cent. The high growth in imports was first and foremost attributable to extraordinarily high imports of ships, but the costs of imported fuel also increased as oil prices rose, cf. Chart 6 (left). Other import elements remained unchanged or fell in 2005.

The 1st half of 2006 saw a broadly based rise in imports compared with the 1st half of 2005. This indicates growth in domestic demand and thereby supports the impression that the Faroese economy is picking up.

The decline in exports in 2005 reflects a substantial fall in volumes of exported fish, with saithe as the most significant exception. For example, the exported volume of cod was 25-30 per cent lower than one year earlier, while exports of farmed fish halved.

The reason that the value of exports did not decline by more than 3 per cent is that export prices rose by an average of 13 per cent. Prices improved for most species of fish, notably salmon. This trend continued in the 1st half of 2006, with average export prices that were 20 per cent higher than in 2005, cf. Chart 6 (right). However, this was not sufficient to prevent a slight decline in the total value of exports in relation to the 1st half of 2005.

THE FINANCIAL SECTOR

Lending by Faroese banks to households and non-financial corporations was almost 20 per cent higher in June 2006 than one year earlier. The rapid upturn, which follows some years of stagnation or decline, reflects the rising level of economic activity, but also the financing by Faroese banks of a number of major corporate acquisitions, and the upward trend in property prices.

The banks' profits before tax rose from approximately kr. 250 million in 2004 to kr. 340 million in 2005, cf. Table 1. The increase was primarily attributable to lower losses and provisions than in 2004, when the banks registered substantial losses and provisions concerning loans for sea farming. Net interest and fee income remained virtually unchanged compared to 2004. The banks continued to achieve sound profits in the 1st half of 2006.

In connection with the accounts for 2005, Føroya Banki paid out kr. 600 million in dividend to shareholders, equivalent to just over one third of its equity capital. This large disbursement, which almost exclusively accrued to the government, was made in order to achieve a more normal capital structure as part of the preparations to privatise the bank.^[8] With a solvency ratio of 28 per cent at end-2005, the bank still remains very well-consolidated.

Competition between the banks has intensified in recent years. For instance, the banks have set up branches in each other's local areas, the rate of interest on housing loans has been reduced, and the range of mortgage-finance products has been increased via the introduction of 30-year loans with deferred amortisation for up to 10 years. In addition, Icelandic banks are increasingly entering the market for corporate finance.

PUBLIC FINANCES

In 2005 the government had a deficit of just over kr. 200 million, equivalent to approximately 2 per cent of GDP. The deficit was more or less in line with the budget and must be deemed to be moderate in view of the prolonged stagnation of the economy.

The 2006 Finance Act entails a virtually neutral fiscal policy and budgets for an almost unchanged deficit. However, data for the 1st half of the year indicates that government finances will be close to balance since income from direct and indirect taxes has been higher than anticipated. The extraordinary dividend from Føroya Banki has not been included in the government balance, but will be used for debt reduction.

In recent years the municipalities have continued to reduce the considerable debts run up 15-20 years ago. As the debt burden has become lighter, the municipalities have, however, reduced their debt more slowly in order to focus on improving services. From 2002 to 2005 municipal current and capital expenditure thus rose by just over 20 per cent.

ECONOMIC PROSPECTS

The economic upswing is likely to continue in the next couple of years, e.g. because the sea-farming industry is gradually being reconstructed and the level of building activity appears to be rising. There are plans for a number of residential construction projects in the Tórshavn area, and a major enlargement of the airport is in the pipeline.

In addition, a number of business acquisitions are currently taking place, with family-owned enterprises being taken over by investors with more financial clout. Presumably this will enhance the competitiveness and growth opportunities of these enterprises. The government's plans to privatise large government-owned enterprises will support this process, provided that government monopolies do not turn into privately owned monopolies.

Nevertheless, there are also some downsides. The sustained high fishing intensity means that cod fishing may weaken further, and after a few years with substantial price increases for fish there is a risk that prices may fall.

It is still uncertain whether the Faroese underground contains hydrocarbon in quantities that make production viable. As part of the 2nd tender, which commenced last year, a test drilling is currently being performed in a hitherto unexplored area. This is the first test drilling for five years. UK experience shows that even if hydrocarbon is present quite a few test drillings may be required before it is located.