Journal Issue

IMF Executive Board Concludes 2005 Article IV Consultation with Iceland

International Monetary Fund
Published Date:
October 2005
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On October 3, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iceland.1


An extended period of structural reforms, privatizations, and fiscal consolidation as well as large investment projects in the aluminum-smelting sector have resulted in high average GDP growth in Iceland over the last decade. At the same time, in large part because of the magnitude of investment projects relative to the size of the economy, the volatility in output growth and inflation has been notably above that in other industrial countries.

Following a recession in 2002, growth has been accelerating, fueled by new investment projects in the energy and aluminum-smelting sector. With GDP growth of 3.6 percent in 2003 followed by growth of 6.2 percent in 2004, the available slack in the economy was quickly absorbed. Consequently, inflation recently breached the 4 percent upper bound of the tolerance range, prompting a report from the central bank to the government outlining the underlying factors and prospects for returning inflation to target. Domestic demand pressures, particularly in the housing market were cited as the key factors. With private consumption and investment being the key drivers of growth, the current account has deteriorated sharply, reaching a deficit of 8.5 percent of GDP in 2004. Domestic demand has been supported by rapid credit expansion that the banks have funded largely through external borrowing, increasing net external debt by 24 percentage points to122 percent of GDP in 2004.

Monetary policy has been responding to the growing demand pressures, and since May 2004 the policy rate has risen by 420 basis points to 9.5 percent. However, with increased competition in the mortgage market lowering long-term mortgage rates and increasing the availability of credit to households, monetary policy has been working largely through the exchange-rate channel. The fiscal stance has tightened, as the general government balance moved from a deficit of 1.0 percent of GDP in 2003 to an estimated surplus of 0.4 percent of GDP in 2004.

GDP is forecast to grow by 6 percent in 2005. Strong domestic demand is expected to be the key driver as project-related investment peaks, and consumption spending is further stimulated by mortgage market developments and labor income tax cuts. The current account deficit is projected to peak at 13 percent of GDP in 2005. Inflationary pressures are expected to persist and markets anticipate further increases in interest rates. Some additional fiscal tightening is expected in 2005, as the general government surplus is forecast to rise to almost 1.5 percent of GDP. However, the multi-year spending targets in the 2005 budget and planned labor income tax cuts imply no additional tightening in 2006.

Growth is forecast to moderate to less than 5 percent in 2006 and rebalance toward the external sector. However, the expected improvement in the trade balance will be partly offset by a further deterioration in the income balance and the current account is projected to improve only modestly. Once the new export capacity associated with the investment projects comes on line and investment returns to a more normal level in 2007, the current account deficit is anticipated to fall to just under 8 percent of GDP and improve gradually beyond that point.

Executive Board Assessment

The Executive Directors commended Iceland’s recent economic performance on the back of stability-oriented polices and structural reforms undertaken over the last decade. These included central bank independence, the introduction of inflation targeting and a floating exchange rate regime, strengthening of financial supervision, privatization, and export diversification. Directors also noted that more recently the ongoing major investment projects, while central to export diversification, have contributed to economic volatility and macroeconomic imbalances. Consequently, the key challenge for policy is to enhance macroeconomic stability by ensuring an orderly unwinding of the current imbalances and limiting their reemergence in the future.

Directors stressed that the main policy task in the near-term is to contain the current pressures in private consumption, the housing market, the current account, and inflation. They considered that both monetary and fiscal policy would need to contribute to this end. Directors recognized that, in the absence of appropriate fiscal tightening, too heavy a reliance on monetary policy would increase the likelihood of further exchange rate appreciation that would, in turn, widen the external imbalances and induce more borrowing from abroad.

With strong public finances and low and declining public debt, Directors agreed that medium-term fiscal sustainability is not at risk. However, they emphasized that further tightening of the fiscal stance is needed to contain imbalances and their associated risks. Directors noted that the tightening could be achieved by some combination of delaying planned tax cuts, postponing additional public investment projects, and reducing growth in public consumption expenditure.

While welcoming the introduction of multi-year spending targets, Directors called for a further strengthening of the medium-term fiscal framework. In particular, the introduction of a rules-based, multi-year framework would help ensure a counter-cyclical fiscal stance without jeopardizing medium-term targets for public debt. Directors also noted that the introduction of nominal rather than real expenditure targets would contribute to the credibility of budgetary policies, with nominal targets being more transparent and enforceable.

Directors commended the proactive and vigilant monetary policy stance of the Central Bank of Iceland, including the most recent tightening, announced on September 29. They stressed that, in an environment with strong growth in domestic demand and rising inflation, this policy stance was appropriate. At the same time, Directors noted that the expansion of credit that followed the entry of commercial banks into the mortgage market has increased the difficulty of the central bank’s inflation stabilization task. Some Directors noted that further increases in policy rates might be warranted. More generally, Directors considered that these circumstances reinforced the need for strong fiscal adjustment.

Directors welcomed the successful implementation of the inflation-targeting monetary policy framework, noting that it has served Iceland well. Most felt that it could be further improved, taking steps to enhance the communication of monetary policy to the public. Several Directors suggested that once the current cycle is over, modifications to the framework, such as removing volatile components from the targeted inflation index, should be considered.

Directors pointed to the risks to financial stability of the ongoing credit boom and emphasized that close monitoring of the financial sector is critical. Despite the strong balance sheets of financial institutions, risks reside in accelerating asset prices, highly leveraged corporations, and rapidly expanding credit, a portion of which is financed by borrowing in foreign currency. They encouraged the Financial Supervisory Authority to implement quickly their plans for more stringent stress tests and—given the large and growing portion of foreign-currency-denominated debt—to expand their scope to include interest rate and exchange rate risks.

Directors noted that the increased presence of commercial banks in the mortgage market has diversified their asset base and increased financial stability. At the same time, Directors expressed concern that banks would find it difficult to fund their mortgage portfolios profitably in the medium term if they had to compete at the retail level with the Housing Financing Fund, a publicly guaranteed mortgage institution. They also noted that increased competition in mortgage lending has led to a surge in housing prices and private consumption that has fueled inflation. Directors called for a reform of the Housing Financing Fund in a manner that would both strengthen the stability of the financial sector and retain the positive features of the current system.

Directors commended the authorities’ progress in the privatization of Iceland Telecom and welcomed intentions to use a significant portion of the proceeds for retiring public debt.

Directors welcomed the targeted increase in Official Development Assistance (ODA). They also welcomed the authorities’ efforts to reduce agricultural subsidies in the context of the Doha round, and encouraged them to take further trade liberalization measures towards opening Iceland’s market to developing country imports.

Public Information Notices (PINs) form part of the IMF’s efforts to promote transparency of the IMF’s views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

Iceland: Selected Economic Indicators
20012002200320042005 1/
Real Economy (change in percent)
Real GDP3.3-
Domestic demand-2.8-
Unemployment rate (in percent of labor force)
Gross domestic investment (in percent of GDP)-4.9-19.620.521.022.2
General Government Finances (in percent of GDP)
Financial balance 2/0.20.2-
Structural overall balance-0.81.3-0.4-0.1-0.2
Gross debt47.343.541.635.931.4
Moneyt and Credit (change in percent)
Deposit money bank credit (end of period)
Domestic credit (end of period)13.20.816.441.3
Broad money (end of period)14.915.323.515.7
CBI policy rate (period average, in percent)
Balance of Payments (in percent of GDP)
Trade balance-0.81.8-2.0-4.1-9.0
Current account balance-4.51.4-5.0-8.4-13.0
Financial and capital account balance2.
Gross external debt120.3132.3156.4213.7197.0
Reserves 3/
Fund position (as of August 31, 2005)
Holdings of currency (in percent of quota)84.2
Holdings of SDRs (in percent of allocation)0.0
Quota (in millions of SDRs)117.6
Exchange Rate
Exchange rate regimeFloating Exchange Rate
Present rate (September 21, 2005) 4/110.4
Nominal effective rate (change in percent)-
Real effective (change in percent)-
Sources: Statistics Iceland, Central Bank of Iceland, Ministry of Finance, and IMF staff estimates.


National accounts basis.

In months of imports of goods and services.

Trade weighted index of the exchange rate as kronur per unit of foreign currency (12/31/1991=100).

Sources: Statistics Iceland, Central Bank of Iceland, Ministry of Finance, and IMF staff estimates.


National accounts basis.

In months of imports of goods and services.

Trade weighted index of the exchange rate as kronur per unit of foreign currency (12/31/1991=100).

Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities.

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