Status of the Faroese Economy,
Mid-2007

Niels Bartholdy, Economics

SUMMARY

The Faroese economy is booming. Employment has risen, particularly in the building sector, the financial sector, the service sectors and sea farming. In spite of favourable market conditions, fisheries and the fish-processing industry have witnessed a decline in employment, primarily reflecting a shortage of labour. Unemployment was down to 1.4 per cent in July 2007.

Marine biologists estimate that the cod stocks in Faroese waters are at the lowest level for 100 years.

In 2006, the balance of trade showed a substantial deficit for the second year running, but unlike in 2005 the deterioration was clearly related to higher imports of consumer goods, cars, etc.

There was a government surplus in 2006, and the same is expected in 2007.

ECONOMIC ACTIVITY^[1]

The upswing in the Faroese economy that began in 2006 has so far continued into 2007. Payroll expenditures and employment have both risen significantly over the last year or so, cf. Chart 1.

Payroll expenditures, which normally account for between 2/3 and 3/4 of the Faroe Islands' gross domestic product at factor cost, were more than 9 per cent higher in the 1st half of 2007 than in the 1st half of 2006, and employment was 3.5 per cent higher in the first five months of 2007 than in the same period of 2006. To the extent that productivity has also increased, economic growth has been very strong. Consumer prices have risen by just under 3 per cent, implying a significant increase in real wages.

The upswing is particularly pronounced in the private service sectors, which now employ just over one quarter of the labour force, and in the financial and building sectors, cf. Chart 2.

In the private service sectors, employment was approximately 5 per cent higher in the first five months of 2007 than in the same period of 2006. Employment growth has been especially high in business service and road transport, while employment in maritime transport has declined after the opening of the tunnel to Klaksvík in April 2006.

The strong economy, rising house prices and sound earnings in the banking sector have in recent years resulted in the expansion of the Faroese banks' activities, not least portfolio management. In mid-2007, Føroya Banki was privatised and stock-exchange listed, and Eik Banki (until 2006 Føroya Sparikassi) was stock-exchange listed in July 2007. Total employment in the Faroese financial sector was 8 per cent higher in January-May 2007 than in the corresponding period of 2006.

Payroll expenditures and employment in the building and construction sector increased considerably in 2006 and the 1st half of 2007. This should, however, to some extent be seen in the context of falling employment in 2005, resulting from the completion of a major tunnel-construction project. The building and construction sector is expected to experience further pressure in the near future, as a large residential and non-residential building project in the Tórshavn area and two new tunnel projects, Streymoy-Eysteroy and Streymoy-Sandoy, are implemented.

Housing prices in the Tórshavn area soared in 2006, but receded somewhat in early 2007, cf. Chart 3. For the Faroe Islands as a whole, prices have shown a steady upward trend over the last year, following a sharp increase in early 2006. The latter can be attributed to the introduction of new loan structures in the autumn of 2005, with longer maturities and deferred amortisation, leading to fierce price competition for housing loans. The new loan types seem to have led to a one-off upward adjustment of prices. The greater supply of housing resulting from the current building projects can be expected to dampen price developments further.

Growth in public-sector employment was 0.4 per cent in 2006, and payroll expenditures in the public sector rose by 2.4 per cent, reflecting the conclusion in 2005 of a collective agreement for the public sector that keeps wage increases at a low level. A new agreement was concluded in February 2007, entailing wage increases of 1.7 per cent in 2007 and 3 per cent in each of the following three years.

Data for the first months of 2007 points towards accelerating growth in public-sector employment in spite of the very tight Faroese labour market. Better coordination of the government and municipal finances could help to ensure that overall employment in the public sector does not become procyclical.

Employment in fisheries and fish processing fell further. For fisheries, employment in the first five months of 2007 was approximately 3 per cent lower than in the same period of 2006. Catch volumes of cod and haddock, traditionally very important species in the Faroe Islands, have declined, and the high overall level of employment has made it difficult to attract crews in some parts of the fisheries sector. Prices have, however, been good and earnings sound. This is reflected in payroll expenditures, which were 14 per cent higher in the 1st half of 2007 than in the 1st half of 2006.

Fish-processing factories have been severely affected by labour shortages and to some extent also by the lower catches of cod. On the other hand, price developments for filleted fish have been favourable, and overall the fish-processing industry made a profit of kr. 15 million in 2006, compared to a loss of the same magnitude in 2005. There are, however, considerable variations from factory to factory.

The sea farming industry has re-established itself after some crisis-ridden years, and employment rose by more than 50 per cent in 2006. Although this sector accounts for only a small share of total employment and payroll expenditures (approximately 1.5 per cent), the recovery in 2006 nevertheless contributed significantly to overall employment growth in the Faroe Islands.

The increase in employment has led to a pronounced fall in the already low rate of unemployment, to 1.4 per cent in July 2007. Unlike previously, this has not led to net immigration, cf. Chart 4. The acute shortage of labour has sparked a discussion in the Faroe Islands about facilitating access for foreigners to the Faroese labour market.

There are no clear signs that the tight labour market will be reflected in wage inflation. Following the conclusion of the collective agreement for the public sector, agreements for the private labour market were concluded in the spring of 2007, entailing wage increases in the range of 3 per cent in the coming years. However, this does not exclude the possibility of accelerating wage inflation due to wage drift.

The year-on-year rate of increase in the consumer price index was 2.7 per cent in the 2nd quarter of 2007. If energy is excluded, the rate of increase was only around 1 per cent.

Fisheries
Fishing in waters close to the Faroe Islands, which accounts for around 60 per cent of total fisheries, has traditionally been entirely dominated by demersal fishing for cod, haddock and saithe. The depletion of the stocks of cod has constituted an increasing problem in recent years. The volumes of cod caught in Faroese waters almost halved from 2004 to 2006. Faroese marine biologists estimate that stocks are now at the lowest level for 100 years, and the International Council for Exploration of the Seas, ICES, is calling for a complete ban on direct cod fishing. Faroese fisheries are primarily regulated by controlling the number of fishing days. The Faroese marine biologists proposed reducing the number of fishing days by 40 per cent in 2007/08. The Faroese government decided to cut fishing days by 2 per cent and to extend conservation orders for certain fishing areas.

Catches of haddock have also declined, and the marine biologists assess stocks to be " medium" (whereas cod stocks are " low" ). The decline is, however, moderate and is offset by higher prices. In contrast, catches of saithe were very high in both 2005 and 2006, and stocks are not threatened. Saithe now accounts for 25 per cent of the catch value in Faroese waters, compared with 21 and 16 per cent for cod and haddock, respectively. Monkfish has also gained importance and now accounts for 11 per cent of the catch value. Both prices and volumes rose further in 2006 following strong increases in 2005.

The most lucrative fishery activities in 2006 were pelagic fishing for herring, mackerel and blue whiting, and fishing from large factory trawlers, primarily in the Barents Sea. Together, these two activities accounted for 46 per cent of the total Faroese catch value in 2006.

Limiting cod fishing is difficult, partly due to deep-rooted traditions in this area, partly due to the substantial demand for cod for processing and the favourable price developments in recent years. The market price for cod was 25 per cent higher in 2006 than in 2004. The diversification of fisheries will make it easier to survive a period with a complete ban on e.g. cod fishing without major economic consequences, but in the short term parts of the fleet and some local communities will obviously be affected.

In 2006, production of sea-farmed salmon and trout was less than one third of the level at the peak in 2003, before epidemics triggered a major crisis in the sector as well as stagnation in the overall Faroese economy. Sea farms have now been reconstructed to provide better protection against disease and dissemination, including limitations on production in each fjord and segregation of different year classes. On the basis of these new health initiatives, fish farmers expect production to increase to about 30,000 tons in 2007 and 2008, around half of the 2003 level.

FOREIGN TRADE

Exports of Faroese goods, which mainly consist of fish products, were relatively stable at kr. 3.6-3.9 billion in 2004-06. The substantial declines in cod catches and farmed salmon have been offset by higher prices and increasing catches of other species such as saithe, blue whiting and monkfish.

The favourable economy of the Faroe Islands is clearly reflected in imports. The trade deficit did actually decline from kr. 900 million in 2005 to kr. 810 million in 2006, but the 2005 figure was influenced by the registration of a new passenger ferry, Smyril.

Imports excluding ships rose by more than kr. 800 million in 2006, and the trade balance deteriorated by more than kr. 400 million, cf. Table 1. The upward trend in imports, especially of cars and building materials, continued in the 1st half of 2007, cf. Chart 5. Car imports rose by 50 per cent in 2006 and have continued their strong increase in 2007. Imports of consumer goods also rose sharply in 2006, but the curve flattened out in the 1st half of 2007.

The most recent data for the overall Faroese balance of payments relates to 2004. Besides the trade balance, the current account includes trade in services, transfers from abroad, etc., and for some years up to 2004 there were sizeable surpluses. At end-2004, the Faroe Islands had accumulated net external assets of kr. 3.4 billion. The substantial trade deficits in the last couple of years have presumably resulted in a current-account deficit. A simple projection, with the balance of services and transfers remaining at the 2004 level, would indicate a zero on the current account in 2006.

THE FINANCIAL SECTOR

The economic upswing is clearly reflected in the financial statements of the Faroese banks and provided a good foundation for privatising Føroya Banki and listing Eik Banki in mid-2007^[2].

Lending growth is strong. Business lending was 56 per cent higher in the 2nd quarter of 2007 than one year earlier, while lending to households had increased by 18 per cent. This is now also resulting in rising interest and fee income, which had been stable for a number of years and was limited by intense price competition for housing loans in 2005, cf. Table 2. However, the banks' operating expenses have also increased as a result of the higher level of activity. The positive outcome of the sea farming crisis is reflected in the development in losses and provisions, as provisions were reversed in both 2005 and 2006.

The profit before tax was kr. 500 million in 2006, which is almost 50 per cent higher than in 2005. The interim financial statements for the 1st half of 2007 point to even higher profits in 2007.

PUBLIC FINANCES

The government is also profiting from the upswing, which brings higher revenue from taxes and duties, including import duties. Revenue rose by 13 per cent in 2006, while expenditure rose by slightly less than 3 per cent. The result was a surplus of kr. 142 million, cf. Table 3, equivalent to approximately 1.3 per cent of GDP.

The 2007 Finance Act budgets for a small surplus. In view of the sustained economic growth and rising imports year-to-date, revenue has undoubtedly been estimated on the low side, so that the surplus for 2007 will be greater. On the expenditure side, the Act budgets for an increase of just over 4 per cent, which is high, given the recovery and the shortage of labour.

The government's outstanding debt was reduced considerably in 2006 due to the surplus and extraordinary dividend payments from Føroya Banki prior to the privatisation.

With regard to the municipalities, preliminary data from the Faroese bureau of statistics, Hagstova Føroya, indicates that overall current and capital expenditure declined slightly in 2006 after having risen for some years.

The gross debt of the municipalities is assessed to have been approximately kr. 0.7 billion at end-2006.^[3]

ECONOMIC PROSPECTS

The Faroese economy is in a period of strong growth, with good fish prices and very low unemployment. The privatisation of Føroya Banki marks a clear step out of the shadow of the banking crisis in the early 1990s and the subsidy-managed economy of the preceding years. Now the Faroe Islands are emerging as a modern, market-based economy on a sound, relatively diversified basis.

Obviously, fisheries remain crucial as a source of export income, but the sector's significance in terms of employment and total economic activity is declining. Nevertheless, an important downside risk in the current favourable economic environment is that fish prices are unlikely to rise forever, and that for instance a global slowdown may send prices plummeting, leading to a significant increase in the already large trade deficit.

On the other hand, restructuring of the sea farms provides a healthier basis for the essential diversification of export earnings and reduced dependence on individual species such as cod, where stocks are at an all-time low. On account of the low stocks, there have been attempts to farm cod, but as yet it is uncertain whether this is commercially viable.

The mounting trade deficit and the very low rate of unemployment are clear signals that the economy is running at full steam. In view of the pronounced shortage of labour it would make good sense for the municipalities and the government to show budget restraint in the coming years.

Test drillings for oil in the Faroese underground have still to yield results that provide a basis for initiating production. There are plans for a third tender, presumably in 2008.