Journal Issue

Statement by Per Callesen, Executive Director for Iceland and Lilja Alfredsdottir, Advisor to Executive Director

International Monetary Fund
Published Date:
January 2011
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The Icelandic economy continues to recover from the effects of the negative financial and economic shocks of 2008, aided by the Fund’s program. Progress has been more than satisfactory in most program areas. All relevant structural benchmarks have been met, except for the passage of legislation for the new fiscal framework for local governments, which is in its final stages and will be presented to Parliament in February 2011. While all end-December performance criteria are expected to be fulfilled, the authorities request waivers of applicability for all end-December performance criteria; except for net domestic assets of the Central Bank as data to confirm these targets is not yet available. Although the program is on track and the authorities are fully committed to achieving program targets, significant challenges remain.

Fiscal policy

Fiscal policy is on track on the basis of the program. The budget for 2011 has been passed by Parliament, and the fundamental fiscal objectives of the Government have been met. The 2011 budget for the central government was passed with a primary balance surplus as aimed for, at the equivalent of 0.3 percent. The overall budget deficit will be reduced by more than half, or by 3.6 percent of GDP, and will be less than 3.0 percent of GDP. The accomplishment of these objectives paves the way for the achievement of an overall surplus in 2012. However, if the interest payments resulting from the new Icesave agreement are included the deficit will be higher according to staff estimates. Additional economic stimulus is planned through investment in road infrastructure projects that will be economically sound while providing support for the construction sector and labor market. These projects are within the medium-term consolidation path. Comprehensive legislation will strengthen local government finances, which have proven to be a weak link in public finances. Among other items, a three-year budget and limits on borrowing will ensure a more disciplined approach and compliance with overall fiscal strategies.

A debt management strategy that is compatible with and supports the medium-term fiscal consolidation path will be published in January but has already been put into practice. The Treasury’s financing need in 2011 is estimated at ISK 130 bn or EUR 850 m. Which will be met by bond issuance in the amount of ISK 120 bn, and a reduction of the Treasury’s Central Bank balance by 10 bn. Net issuance will be ISK 67 bn. Foreign reserves have been bolstered significantly under the IMF program and are sufficient to meet repayments of the Government’s foreign debt in the medium term. Foreign currency obligations originally amounting to EUR 1.3 bn will mature in 2011. Approximately half of this amount has already been prepaid or purchased in the market. The remainder is expected to be refinanced. Restoration of market confidence overseas will be facilitated by a generally sound fiscal situation, declining debt, and the implementation of the new Icesave agreement. Market-based indicators of Icelandic risk have declined steadily over the past year.

Legislation authorizing the Minister of Finance to sign the new Icesave agreements with the Netherlands and United Kingdom and to undertake the commitment contained therein has been presented to Parliament and referred to the Parliamentary Budget Committee following its first reading. The authorities are confident that this agreement, which was negotiated by a team jointly approved by all parliamentary parties, will be approved by Parliament.

Monetary policy

Inflation declined rapidly and reached the 2½ percent inflation target in the last months of the 2010. This achievement was underpinned by the appreciation of the króna by close to 12 percent in trade-weighted terms over the course of 2010 and the anchoring of inflation expectations at the target, with the economic slack speeding up the process. The Monetary Policy Committee (MPC) has cut Central Bank interest rates four times since August. Since the interest rate corridor was narrowed at the MPC’s December meeting, the current account interest rate stands at 3.5 percent, and the Central Bank’s collateralized lending rate at 4.5 percent. The bias of the MPC has been shifted towards a more neutral stance although, depending on developments, it considers that there might still be some scope for further monetary easing. Monetary policy continues to be guided by exchange rate stability as an interim objective but by inflation over the medium term.

The Central Bank bought last year approximately EUR 195 m in the interbank market in Iceland so as to bolster foreign exchange reserves. Towards the end of the year the Central Bank bought FX spot and forward with the aim of reducing excessive FX imbalances of financial institutions. These transactions will expand the Central Bank’s foreign reserves by around EUR 472 m during the term of the agreement, in addition to promoting increased financial system stability.

The Central Bank recently published a report to the Minister of Economic Affairs on monetary policy framework options after the IMF program ends and the capital controls have been lifted. The central proposal of the report is to radically alter the present inflation targeting (IT) framework, drawing lessons from experience gained since its introduction in 2001. The changes would augment IT with macro-prudential tools, provide better support from fiscal policy and improved policy co-ordination, and substitute relatively free float with a managed one. Following the publication of the report, the Ministry of Economic Affairs is initiating a wide-ranging consultative process on the relevant options. A second report of the Central Bank is planned focusing on the pros and cons of EMU membership.

Capital controls imposed after the collapse of the banking system have been successfully implemented, particularly after regulation and enforcement were tightened in late 2009. The controls have played an important role in stabilizing the króna while confidence was being restored; however, economic distortions created by the capital controls over the long term are a matter of concern. Hence it is important to lift the controls as soon as feasible without jeopardizing the stability of the króna and the financial system. In order to prepare the ground for removal of the capital controls, the capital account liberalization strategy published in August 2009 is currently being revised. The Central Bank has hired an experienced consultant to assist with the revision of the strategy. The preconditions for successful gradual liberalization of the capital account are largely in place as far as macroeconomic fundamentals are concerned; however, substantial non-resident ISK positions, which may be cause for instability if the controls are lifted abruptly, remain a major challenge to financial and currency stability during the liberalization process. The revised strategy will include proposals on ways for either tying down or releasing some of these positions in advance of the general removal of capital controls.

The financial sector and debt restructuring

Progress has been made in recapitalizing the savings banks, and the Government has recapitalized the Housing Financing Fund (HFF) up to the regulatory minimum, following an extensive review of its business plan. The budget outlay is estimated to total ISK 33 bn, with up to ISK 16 bn allocated to meet the cost of household debt restructuring. Further revision of the Fund’s operational environment is underway, and the Government is committed to submitting legislation to Parliament by end-March 2011 so as to place the HFF under the full supervisory oversight of the FME.

The Central Bank recently concluded contractual agreements concerning the restructuring of five small savings banks’ debt with the Bank. In addition, two savings banks have paid their debts to the Central Bank. Claims to be written off amount to ISK 4.5bn, whereas a total of ISK 4bn was received in satisfaction of the claims. During the restructuring process, the Central Bank acquired a large part of the savings banks’ guarantee capital. The guarantee capital shares have been transferred by the Ministry of Finance to Icelandic State Financial Investments, which administers the holding on behalf of the State.

New legislation to reduce legal uncertainties and clarify the value of exchange rate-linked loans in the wake of the Supreme Court decisions of June and September 2010 has just entered into force. Financial institutions were granted 90 days to convert foreign-denominated motor vehicle loans in accordance with the interest rates published by the Central Bank of Iceland. Furthermore, households with residential mortgages will have the option of converting these loans into inflation-linked or non-indexed loans. The legislation aims at the efficient recalculation and reimbursement of foreign-denominated loans that have been deemed to carry unlawful exchange rate linkage clauses, despite the complicated and diverse nature of the loan contract arrangements. The legislation facilitates household debt restructuring through substantial debt write-offs without threatening the stability of the financial system or generating significant further costs for the Treasury.

Other debt restructuring measures have been introduced or reinforced in cooperation with banks and the pension funds. These include a formal process for writing down mortgages to 110 percent of the value of mortgaged assets, a temporary supplementary progressive tax rebate and an interest rate subsidy financed by the financial sector, limitation of the discharge period following bankruptcy to two years, and a final extension to March 2011 of the three-month suspension of forced sales, which is granted so as to enable households to benefit from the new debt restructuring measures. In addition, the Office of the Debtor’s Ombudsman has been strengthened.

For corporate debt restructuring, a new fast-track framework aimed at accelerating voluntary debt restructuring of SMEs is available, and new legislation addresses corporate tax arrears and tax liabilities arising from corporate write-downs.

With these measures, the authorities are giving a clear signal that no further “more advantageous” actions will be taken in this area. The authorities believe that these measures are sufficient to resolve one of the most difficult problems arising in the wake of the financial crisis. Targeted debt restructuring is a slow and complex process, but authorities are finally seeing some encouraging signs that these new final measures are effective, including a vast increase in the number of voluntary participants.

The outlook

According to the Central Bank’s latest baseline forecast, published in the November 2010 issue of Monetary Bulletin, the current account balance excluding accrued interest due to deposit institutions undergoing winding-up proceedings remains positive, supported by healthy export demand and improvements in terms of trade. The trade surplus is projected at slightly over 10 percent of GDP this year, yet export volume increases are somewhat restricted, with the November forecast projecting a 5 percent decline in the volume of marine product exports in 2011. Nonetheless, news of groundfish recruitment is encouraging, which could boost exports in the future. The net international investment position of the economy is still uncertain, but according to the latest statistics from the Central Bank it is likely to be in a deficit in the range 30-50 percent of GDP once the winding-up process of banks and leveraged asset holding companies is concluded a few years from now. The gross external debt of the Icelandic economy is around 330 percent of GDP according to the staff report. There is considerable uncertainty around these figures, but the gross assets of the economy can be estimated to be around 280-300 percent of GDP.

Output growth has been somewhat weaker than previously hoped, although the latest data suggest that recovery began in Q3. Unemployment also remains very high compared to previous years, despite significantly reduced labor costs, and investment (especially FDI) remains at historically low levels. Despite this, the authorities have seen many new entrepreneurial opportunities coming into existence, aided by various programs initiated by the authorities and private organizations in cooperation. Also in the pipeline are several large investment projects based mainly on utilization of energy resources. The tourist industry has not suffered as feared from last spring’s volcanic eruptions and is as vigorous as ever. Although significant risks remain, not least from delayed growth in Iceland’s main trading partner countries, authorities are optimistic that economic activity will pick up in 2011, thus facilitating the continuing recovery of Iceland from the economic and financial crises.

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