Status of the Faroese Economy, Mid-2008

Niels Bartholdy, Economics

SUMMARY

Growth in the Faroese economy is slowing down after a couple of years with a sustained upswing. Surging oil prices have led to considerably higher costs in the fisheries sector. At the same time, 2008 to date has seen falling fish prices, and stocks are critically low for cod and haddock – species that are important to the Faroe Islands.

Other sectors are experiencing lower growth than in the preceding few years, but there are no indications of an actual downturn yet. The public sector, particularly local government, is expanding and reporting employment growth, which has helped to keep unemployment at a re cord-low level of close to 1 per cent of the labour force.

The trade balance showed a very large deficit of kr. 1.3 billion in 2007, driven by sustained growth in imports. Preliminary data points to a def icit of a similar magnitude in 2008. Imports are declining as a result of dampened growth and private consumption, but exports have also declined due to the less favourable conditions for fisheries.

ECONOMIC ACTIVITY¹

Growth in the Faroese economy is slowing down. Payroll expenditures and employment continue to rise, cf. Chart 1, but there are indications that the economy has reached its capacity limit, and conditions for fish eries are difficult.

Payroll expenditures, which normally account for between 2/3 and 3/4 of the Faroe Islands' gross domestic product at factor cost, were 4 per cent higher in the period January-July 2008 than in the same period of 2007, and employment was just over 1 per cent higher in January-May 2008 than in the first five months of 2007. This is a substantial slowdown on full-year growth in 2007, which was 8 per cent for payroll expend itures and 3 per cent for employment.

These developments reflect the continued and increasingly serious setbacks for fisheries and the fish-processing industry, as well as a more subdued growth in other sectors, except the public sector, cf. Chart 2.

Fisheries and the fish-processing industry have so far in 2008 seen a pronounced downward trend in employment. Part of the fishing fleet has remained in port for shorter periods on account of the high oil prices, which, coupled with falling fish prices, have rendered certain types of fisheries unprofitable. Both fisheries and fish processing were already affected by the low stocks of cod and haddock, and one fish-processing factory has closed down. Payroll expenditures in fisheries were down by 22 per cent in the period January-July 2008 compared with the same period of 2007.

The fall in employment also reflects problems in attracting labour to the less profitable fisheries segments and to the fish-processing industry. New legislation adopted in June 2008 enables EU citizens to obtain resi dence permits in the Faroe Islands with a view to taking certain types of employment.

Unlike fisheries, sea farming has seen considerable growth in both em ployment and payroll expenditures.

Activity in the building and construction sector remains strong, with sound growth in employment and payroll expenditures, albeit weaker than in 2007. Two new tunnel projects are on the drawing board, Streymoy-Eysturoy and Streymoy-Sandoy. The construction and financ ing plans for these projects have yet to be finalised.

The slowdown in the housing market that started in 2007 continued into 2008, but house prices rose a little in the 2nd quarter, cf. Chart 3. For the Tórshavn area, average housing prices are now back at the mid-2006 level, which is 11 per cent below the most recent peak in the 3rd quarter of 2007. In the settlements, housing prices have also been re ceding. For the Faroe Islands overall, housing prices in the 2nd quarter of 2008 were 9 per cent below the peak in the 3rd quarter of 2007.

Following a couple of years of strong expansion, the Faroese banks are still growing, but at a far more measured pace. Employment has risen by a mere 1 per cent in 2008 so far, compared with employment growth of around 8 per cent in the preceding two years. One of the underlying factors is the difficulty in attracting additional qualified labour to this sector. Payroll expenditures rose appreciably, by 12 per cent, in the period January-July 2008.

In the private service sectors, payroll expenditures have risen by 9 per cent and employment by 3 per cent in 2008 to date. Growth is broadly based across sectors such as business services and road and sea transport and reflects, inter alia, higher activity in connection with oil drillings (support ships, etc.) in the Faroe Islands. On the other hand, a slowdown in private consumption has affected the retail sector, where employment has been stagnant in 2008 after a couple of years with growth rates of 4-5 per cent a year.

The public sector is unique in that it is the only subsector with higher employment growth in 2008 to date, just below 4 per cent. Payroll expenditures rose by 7 per cent in the period January-July compared with the same period of 2007. This development is to a large extent attributable to fairly strong expansion in local government employment in spite of the tight labour market.

High overall employment has reduced unemployment to a record-low level of 1.2 per cent of the labour force, cf. Chart 4.

Previously, fluctuations in unemployment were smoothed by immigra tion and emigration, e.g. around 2002 when the decline in unemploy ment was offset by considerable net immigration to the Faroe Islands. Conversely, substantial net emigration was seen during the economic setback in 2004-05. However, this trend has been broken in recent years, as rapidly falling unemployment has coincided with net emigration, which further reduces unemployment.

In the 2nd quarter of 2008, the consumer price index stood almost 7 per cent higher than in the 2nd quarter of 2007, cf. Chart 5. The strong increase is mainly attributable to higher oil prices and surging vegetable food prices, but even if these components are excluded, price inflation has picked up considerably over the last six months, reaching 3 per cent in the 2nd quarter of 2008. This reflects the lagged pass-through of higher oil and food prices to other subcomponents of the index such as transport and restaurant prices. High oil prices have a relatively large direct impact on household finances since oil burners are the predomin ant source of heating in the Faroe Islands.

Fisheries
Coastal fisheries in Faroese waters, which account for approximately 60 per cent of total fisheries, are dominated by the demersal species cod, haddock and saithe. For the former two, stocks are very low, and catches fell by 6 per cent for cod (from an already low level) and 22 per cent for haddock in 2007.

The International Council for Exploration of the Seas, ICES, recom mends a complete ban on all cod and haddock fishing for some time in order for stocks to recover. Faroese marine biologists have proposed a reduction of the number of fishing days for certain vessel types by up to 50 per cent and a significant expansion of the non-fishing zones in 2008/09. In August 2008, the Løgting (parliament) opted for a general reduction in the number of fishing days by 10 per cent.

The high oil prices have increased costs for the fishing fleet consider ably, particularly for the very energy-intensive deep-sea trawlers. The oil price hike in the spring of 2008 meant that a number of vessels re mained in port as the costs of fishing exceeded potential earnings.

Fish prices, which generally showed a favourable trend in 2007, have so far been declining in 2008.

The total value of fish caught in Faroese waters fell by 7 per cent in 2007. In the first seven months of 2008, the value was 18 per cent lower than in the same period of 2007.

In contrast, salmon and trout farming has recovered strongly after the crisis in 2004-06, when the sector was affected by epidemic diseases. Output rose from 18,000 tons in 2006 to 30,000 tons in 2007, and the forecast for 2008 is around 45,000 tons. The sector is now better pro tected against the spread of disease since production is concentrated on a few farms that are subject to detailed regulation and supervision.

FOREIGN TRADE

Exports of Faroese goods, which are entirely dominated by fish products, amounted to kr. 4 billion in 2007, cf. Table 1. This was in line with the 2006 level in spite of lower catches of the most important species: cod, haddock and saithe. Overall, price developments remained favourable in 2007.

Exports of salmon from the re-established sea farming sector increased considerably. In 2007, salmon and trout accounted for 15 per cent of total export revenue. Mackerel also played a larger role, constituting 5 per cent of the value of exports in 2007. This reflected significant in creases in both prices and volumes.

However, late 2007 and 2008 to date have seen substantial declines in the catches of haddock, saithe and mackerel, among other species. Com bined with lower fish prices this has reduced exports. Excluding ships, exports in the 1st half of 2008 were 18 per cent lower than in the 1st half of 2007. Due to considerable export revenue from ships, overall exports fell by only 4 per cent.

The upswing in 2006 and 2007 entailed substantial growth in imports, and the trade deficit increased rapidly to kr. 1.3 billion in 2007. The recent dampening of economic activity has, however, curbed growth in imports for most subcomponents, cf. Chart 6. Imports of cars and build ing materials fell in the 2nd quarter, and total imports in the 1st half of 2008 were 2 per cent below the level in the same period of 2007.

Developments in 2008 so far, with falling export revenue and de clining imports, point to a trade deficit in 2008 of the same magnitude as in 2007.

The current account, which comprises the trade balance as well as trade in services, transfers to and from abroad, etc., has shown a surplus for some years. At end-2006, the Faroe Islands had accumulated net ex ternal assets of kr. 3.7 billion. The large trade deficits in 2007 and 2008 will invariably entail substantial current-account deficits, thereby re ducing the net external assets.

THE FINANCIAL SECTOR

The two largest banks in the Faroe Islands, Eik Bank and Føroya Banki, were stock-exchange listed in Copenhagen and Reykjavik in 2007. For both banks, 2007 was characterised by expansion. Eik Bank acquired the Faroese activities of Iceland's Kaupthing Bank, and the subsidiary, Eik Bank Danmark, expanded by acquiring the Danish branch of Skandia Banken. Føroya Banki set up a subsidiary in Denmark.

The total profit before tax for the Faroese banks was kr. 652 million in 2007, cf. Table 2. This was a 29 per cent increase on the 2006 result, which had been record high. However, a large part of the 2007 profits related to capital gains. The higher level of activity has a clear impact on costs, which rose by almost 30 per cent in 2007. Expansion in Den mark is reflected in increasing transfers from subsidiaries.

The 1st half of 2008 saw considerable downward adjustment of secur ities prices, and the overall profit before tax was close to zero.

Lending by banks, which rose strongly in 2006 and 2007, has levelled off somewhat during 2008 to date. In the 2nd quarter of 2008, lending to the corporate sector was 23 per cent higher than in the 2nd quarter of 2007, while lending to households was 6 per cent higher². Lending to the public sector has increased in 2008 to stand 16 per cent higher in the 2nd quarter than in the same quarter of 2007. Growth in total deposits has not matched growth in lending, implying that the banks are increas ingly dependent on money-market financing.

PUBLIC FINANCES

The favourable economy in 2007 was reflected in government finances, since higher income from taxes and duties, including import duties, boosted total income by just over 5 per cent. Expenses also rose by 5 per cent, entailing an unchanged balance compared with 2006 and a surplus of kr. 146 million. The dampening of the economy, combined with tax cuts adopted by the previous government, exerts downward pressure on income growth in 2008. However, income from customs and other duties is expected to grow, partly on account of increases in certain duties, partly because duty-free sales of tobacco to travellers entering the Faroe Islands will be abolished from October 2008. In total, the budget oper ates with a 3-per-cent increase in income.

On the expenses side, an increase of almost 7 per cent is expected in 2008, reflecting e.g. higher costs for interest subsidies due to rising inter est rates. In the Faroe Islands, interest is not tax-deductible; instead the government subsidises 40 per cent of interest on housing and student loans.

As capital investments are expected to be slightly lower in 2008 than in 2007, this overall means that the Finance Act budgets for a result close to balance in 2008.

The government's outstanding debt has more or less been eliminated by the surpluses in recent years and the privatisation of Føroya Banki.

The local government sector has budgeted for large deficits in both 2007 and 2008, which has undoubtedly contributed to the pronounced rise in public-sector employment in 2008 to date, and to the increase in bank lending to the public sector.

ECONOMIC PROSPECTS

The Faroese economy is slackening its pace after the high-growth years 2006 and 2007, but so far only fisheries and fish processing have seen an actual downturn. Declining imports and slower bank lending growth do, however, indicate that the economy is shifting to a lower gear.

In spite of the lower imports, a sizeable trade deficit is still expected as export revenue is also falling on account of the problems in the fisheries sector. The considerable net external assets of the Faroe Islands provide a buffer, but this buffer will soon be eroded unless the trade deficit is reduced.

It looks as if employment is buoyed up, and unemployment kept at a very low level, by strong employment growth in the public sector, par ticularly local government, while parts of the private sector are still short of labour. The granting of residence permits to EU citizens taking certain types of employment may to some extent ease pressures in the labour market.

It is encouraging that sea farming has been successfully re-established and once again constitutes a major source of export revenue.

Test drillings for oil in the Faroese underground have yet to yield re sults that provide a basis for initiating production.