The Icelandic economy continues to navigate the rough seas created in the wake of the 2008 banking and currency collapse. Although smooth sailing has not yet been fully achieved, significant progress has been made towards economic stabilization and growth. All end-March performance criteria have been met. Our authorities request a modification of end-June performance criteria and a rescheduling of access by combining the last two purchases, due to delays in completing recent reviews.
Recent developments indicate a strong trade surplus, some revival of private consumption and growth of investment. Headline inflation is seeing some uptick to above the 2.5 percent inflation target. The challenges ahead include reintegrating Iceland into international financial markets through capital account liberalization and Treasury borrowing as well as revitalizing the lending and financing activities of the banking system with the objective of enhancing economic growth and reducing high unemployment. While progress has been made in the restructuring of household and corporate balance sheets, our authorities acknowledge the importance of accelerating the pace of restructuring.
The Icelandic authorities continue to seek an amicable solution to the Icesave-dispute and reiterate their commitment to honor Iceland’s international obligations. It is important to note that the estate of the fallen bank now estimates that it will cover at least 99 percent of priority claims. This means that the UK and Dutch authorities – and also unsecured UK and Dutch depositors such as the UK charities and Dutch depositors with over 100,000 Euros in deposits – will in all likelihood be repaid by the estate in full. In addition, the repayment profile is more frontloaded than previously estimated with nearly a third of the claims being paid before the end of this year. Our authorities continue to be willing to explore ideas with the UK and Dutch authorities, keeping in mind and respecting that the Icelandic people have rejected the issuance of a State guarantee of these obligations by over 60% in the April referendum. The EFTA Surveillance Authority has initiated a legal process which could lead to a court pronouncing whether Iceland and other European countries carry legal obligations to honor all contingent liabilities of deposit insurance funds. The European legal structures are set up to deal with disputes of this nature and small nations need to be able to rely on these structures for the common European market to serve its purpose as an equal playing field. Iceland will of course honor a legal obligation defined by a competent court.
Our authorities welcome staff’s careful analysis and useful recommendations in this fifth review and thank our Nordic, Polish, and Faeroese neighbors that have contributed to the financing of the economic program.
Fiscal targets for 2010 were met and our authorities will continue on the path set in the program to achieve a primary balance in 2011 and an overall surplus in 2013. So far, the outcome of the first months of 2011 is in line with projections. On the revenue side a new tax will be levied on financial institutions to finance the temporary interest subsidy to households. On the expenditure side, the new 3 year wage agreements will put pressure on public spending and create additional inflationary pressures. The agreements are, however, important for economic stability as they remove key uncertainties in the labor market for the next three years. Local government finances have been given greater focus in recent months. The Government intends to pass a new law in June setting a stricter framework for local government finances including requirement of a rolling three-year balanced budget, limits on municipal borrowing, and enhanced monitoring of municipal finances. The number of municipalities in Iceland has been reduced significantly in recent years, which has helped to increase efficiency and stability.
Public and external debt ratios are expected to decline rapidly with gross external debt going from 240 percent of GDP in 2011 to around 150 percent of GDP in 2016. Staff finds that external and public debt is sustainable and stress tests by staff suggest that the downward trajectory is robust. The Central Bank of Iceland of has estimated that once assets and liabilities of banks in winding-up procedures have been settled and other distorting factors have been taken into account, Iceland’s international investment position will be satisfactory or around -25 percent of GDP, which is a more favorable position than has been for decades. Our authorities look forward to discussions with staff on the medium-term fiscal path in the next review. The medium-term debt strategy was well received by the market. It lays out the borrowing strategy in a transparent manner. Domestic financing is considered well-anchored. Access to external financing, however, will be important to relieve pressures on foreign reserves and promote capital account liberalization. Preparations for a reentry into the international bond market are underway. Recent rating actions, a recent bond repurchase tender, and contained CDS spreads on Iceland should support access to capital markets.
Financial Sector and Debt Management
The banking sector is slowly recovering. The commercial banks currently have capital ratios well exceeding the regulatory minimum of 12 percent of core tier one capital. Our authorities agree with staff on the need for more frequent ICAAP assessments and stress testing on the basis of macroeconomic scenarios prepared by the authorities and in line with the European Banking Authorities exercise. Finalizing the recapitalization of the remaining savings banks does not require substantial public financing. A reform of the Housing Financing Fund is underway and the necessary actions will be taken when the results of the assessment of HFF’s asset quality are available.
The high level of non-performing loans in the banking system and slow progress of household and corporate debt restructuring continue to be of concern. Our authorities will ensure the full implementation of the measures that have been put in place. It should be kept in mind, however, that restructuring following a collapse is traditionally a time-consuming and costly process. In the case of Iceland there have been additional complications resulting from court rulings on the illegality of FX-denominated lending.
Assets and liabilities of the new banks are still subject to mismatches and uncertainty of valuation but strong capital and liquidity requirements in addition to improvements in banking supervisions have reduced the likelihood of surprises of a systemic nature from this sector. The Icelandic authorities continue to work on implementing measures aimed at keeping up to speed with international best practices in the area of financial supervision, including the adoption of best practices of banking supervision in line with Basel Core Principles on effective Supervision.
Monetary policy has shifted to a neutral stance and continues to focus on preventing any significant depreciation of the krona in the short term and ensuring price stability over the medium term. The annual inflation rate rose to 3.4 percent in May which is above the inflation target of 2.5 percent. Global oil and commodity price increases have contributed to higher prices in areas such as food and transport. If the exchange rate does not weaken and inflation expectations become anchored, inflation should return to target next year.
Implementing independent monetary policy with a floating exchange rate in a small open and financially integrated economy has proved to be challenging in the face of volatile capital flows and high dependence on external price developments. The Central Bank is exploring possible improvements in the monetary framework, including macro-prudential tools and strategic foreign exchange interventions. The lessons from the crisis have also underlined the need for much better synchronization of fiscal and monetary policies.
Lifting the capital controls on outflows is a difficult task as underlined by staff. The large overhang of offshore krona holdings needs to be reduced without disrupting financial stability or undermining bank liquidity. Adverse balance sheet effects through a further depreciation of the krona must also be avoided. A conditions-based strategy to liberalize capital flows has been put forward by our authorities. The first step to be executed in early June is an auction where owners of offshore krona holdings can buy a limited amount of foreign currency. This step will test the market and, if successful, will be repeated to significantly reduce the amount of “impatient” money in the system. Our authorities agree with staff that existing controls need to be vigorously enforced and that the process of bringing relevant cases to court needs to be enhanced. Having said that, it is clear that a prolonged use of capital controls leads to loss of economic efficiency, inter alia, by limiting the appetite of foreign investors to supply equity and risk capital to research and development intensive industries. It is therefore not surprising that impatience towards capital controls is growing among the more dynamic sectors of the economy. The risk of going to slow in lifting capital controls should thus be appreciated along with the risk of going too fast, as emphasized by staff.
Structural Reforms and Outlook
The management of the fisheries resource in Icelandic waters has been successful in maintaining and protecting fish stocks. The government has put before the parliament a draft legislation containing fundamental changes of the fisheries quota system for allocation of quotas which is currently being debated. The draft legislation is not expected to materialize in its final form until next year. Besides the work undertaken to stimulate private entrepreneurship, retraining the unemployed, and establishment of small businesses, the authorities aim to create a climate conductive to more FDI inflows.
On the export side, the outlook for fish prices is still favorable but supply constraints are present. Prices for aluminum have also remained robust and production levels stable. The prospects for further investment in the energy sector remain encouraging. Firms in other sectors such as software and pharmaceutical industries are still expanding. The tourist industry experienced record bookings for this summer, and the recent eruption in the Grímsvötn volcano will probably cause only limited setbacks.
Our authorities believe that full implementation of the present economic program will create favorable conditions for economic progress based on sustainable public finances, private enterprise, and free markets.