June 21, 2002
My Icelandic authorities would like to thank Mr. Escolano and his team for their reports and the constructive discussions with the Fund mission during their visit. My authorities are in broad agreement with the main conclusions of the staff report. I would like to draw attention to some recent developments and prospects and a few policy issues.
Recent developments and prospects
Following several years of rapid growth through 2000 the Icelandic economy slowed down significantly in 2001, mostly due to declining private consumption and investment. Exports continued to grow and, as a result, the current account deficit fell from 10.2% to 4.3%. This adjustment process followed the build-up of private debt by households and businesses during the upswing. A rapid depreciation of the króna exchange rate during 2001 added further momentum to this development and led to a substantial, but temporary, hike in inflation.
This year, the economy has continued to cool down and inflation has declined rapidly, the 12 month rate fell to 4.8% in June after peaking at 9.4% in January. In the Central Bank’s assessment, the seasonally adjusted underlying inflation rate has in recent months been in the neighborhood of 3%. Furthermore, the króna has continued to appreciate, boosted by the sharply shrinking current account deficit. The current account deficit is expected to fall below 2% of GDP this year. Private consumption and gross fixed investment have contracted significantly from last year, and domestic demand is expected to remain subdued for the remainder of the year. However, a buoyant external sector has softened the impact of the adjustment of the domestic sector. Business profitability appears strong in general, but business investment as well as private consumption will continue to be constrained by a relatively heavy debt service burden.
According to the latest inflation forecast of the Central Bank, inflation will fall within the tolerance limit later this year and be in line with the Bank’s inflation target late next year, as envisaged when the inflation target was adopted. However, my authorities agree with staff that monetary restraint should be eased cautiously as the continued decline in inflation is further confirmed. At present, the monetary stance still imposes considerable restraint on activity, as reflected by a policy rate in real terms of up to 6% in recent months.
The main message of the staff report regarding the public finances is that they are sound. The slowdown in the global economy as well as the fall in domestic demand affected government revenues. Nevertheless, the public finances have been sound and the tight overall fiscal stance has contributed to stabilizing the economy. The Government has pursued a policy which aims at fiscal consolidation and debt reduction and intends to achieve a structural budgetary surplus of about 1 per cent of GDP over the medium term. The Government plans to continue to use privatization proceeds to reduce net government debt.
My authorities agree with the staff that reforms of the fiscal framework would strengthen budgetary discipline and improve the transparency and predictability of fiscal policy. In this context, my authorities have been looking towards introducing multi-year budget plans with explicit expenditure limits and cyclically-adjusted balance objectives. My authorities agree with staff that a medium-term strategy of fiscal consolidation would be helpful and could contribute to containing current spending in coming years.
The staff concludes that monetary conditions, while broadly appropriate at present, were largely accommodative during the past year. This conclusion is based on the mission’s assessment that real interest rates were low or at times even negative as calculated on the basis of past inflation. It is true that the monetary stance was ex post not as firm as intended, basically due to the fact that the króna fell much more than expected, causing a temporary unanticipated surge in the rate of inflation. The stance of monetary policy therefore should be viewed from a broader perspective. The depreciation of the króna from the peak in April 2000 to the trough in November 2001 was mainly brought about by contractionary forces, diminishing capital inflows and a lack of confidence in the domestic economy. The remarkably swift current account reversal over the course of 2001 and contraction in domestic demand suggest that monetary conditions were not overly accommodative, even if less restrictive than intended.
The exchange rate depreciation in 2001 had the potential to undermine price stability. The appreciation of the króna since November 2001 has therefore been important. In view of the current account reversal and other changes in underlying fundamentals, the appreciation of the króna appears sustainable. While the króna may have been slightly overvalued in 2000, my authorities do not consider this overvaluation to have been a major force behind last year’s decline, as may be concluded from the staff report.
My authorities take note of the staffs suggestions of ways to improve the operational procedures of the monetary framework. My authorities broadly agree with the staff on the need to address imperfections in the money market. The recently established foreign currency swap market and steps taken to improve the Bank’s ability to forecast liquidity demand serve towards this purpose.
The new monetary regime was installed at the end of March last year and the independence of the Central Bank was subsequently confirmed in a new Central Bank Act. In the course of 2001 there was considerable pressure at times from various parts of society for an easing of monetary policy. The current legislation and the Bank’s analytical capacity, however, make it well equipped to withstand such pressures. The Bank’s monetary policy decisions since the adoption of the new regime have been backed by its own analysis. The staff suggests preannounced monetary policy meetings. In the initial phases of the new monetary policy regime, the Bank has found the flexibility of the current practice of some value. However, as the new framework becomes more established, the Board of Governors may consider to move towards deciding in advance and officially announce a meeting calendar.
My authorities would like to highlight two structural issues. The first is the recently implemented tax reforms, effective as of 2002, which serve to simplify the tax system, improve efficiency by reducing distortions and encourage saving as rightly pointed out in the staff report and further highlighted in the Selected Issues paper. The tax reform is an important element of the structural reform process and will set the Icelandic tax system in line with neighboring countries and thus improve the competitive position of Icelandic enterprises.
Second, last week, one-fifth of the shares in the larger of the two commercial banks with majority state ownership were offered in a general sale. With all the shares in the offering being sold, the Government is no longer a majority stakeholder in the bank. This operation will no doubt have a catalytic effect on the privatization process after a slight interlude and further steps will be taken later this year.
Financial sector policies
The staff report recognizes the progress and improvements that have been made in the regulatory framework and in supervisory resources and activities by the Financial Supervisory Authority (FSA) over the last year. The FSA intends to further strengthen the accounting rules covering the assessment of loans and advances of credit institutions. Concerns regarding securities lending have already been taken into consideration by the FSA, inter alia by improving information collection in that area. The FSA also recognizes the importance of issues related to connectedness in the financial market and is currently making an effort in that field. Furthermore, in the supervisory work of the FSA in the period ahead, a special focus will be placed on investment banking activities.
Important progress has been made in improving the observance of the CPSS Core Principles for Systematically Important Payment Systems since the preparation of the FSSA report. Measures necessary to ensure full compliance with these principles have been identified and a plan has been adopted for their implementation. Full compliance with all the principles is envisaged in Spring 2003.
In the spring session of parliament, an act was adopted providing for the necessary legal amendments in order to ratify two recent UN conventions on the financing of terrorism. For this purpose the penal code has been amended accordingly.
As mentioned in the report, my authorities have been working on a comprehensive legislative package on banking, securities, and financial market regulation. The draft legislation is in the final stages of preparation.