Article

Iceland: Fiscal, Monetary Tightening Required to Reverse Economy Overheating

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
October 2006
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Iceland is experiencing an economic boom—driven by an expansion of the aluminum sector—that is generating large imbalances, the IMF said in its recent economic review. Strong domestic demand, reflecting rapidly growing investment and private consumption, is causing the economy to overheat and leading to high inflation and record-high current account deficits. Financial market volatility in Iceland has also increased in response to international investors’ concern about the risks associated with macroeconomic imbalances and potential financial sector vulnerabilities.

IMF Executive Directors noted that, although medium-term prospects are favorable, large and growing imbalances pose risks to real growth and financial stability in the near term. They welcomed measures taken to curb demand pressures but called for further decisive policy actions to stabilize confidence, help ensure an orderly adjustment, and maintain financial stability.

Iceland
Proj.
2003200420052006
Real GDP (percent change)3.08.25.54.0
Consumer price index (percent change)2.13.24.06.1
Gross domestic investment (percent of GDP)19.723.428.626.3
Central bank policy rate (period average, percent)5.46.19.4
Current account balance (percent of GDP)-5.0-10.1-16.5-12.5
Data: Central Bank of Chile and Ministry of Finance; Haver Analytics; and IMF staff estimates.
Data: Central Bank of Chile and Ministry of Finance; Haver Analytics; and IMF staff estimates.

Despite low and declining public debt, further fiscal restraint is essential for reducing imbalances and averting their associated risks. The authorities could achieve the required fiscal tightening, Directors emphasized, by postponing additional public investment projects and reducing growth in public consumption expenditure. To lessen economic volatility, they called for a further strengthening of the medium-term fiscal framework and agreed that additional increases in the monetary policy rate would likely be required to anchor expectations and return inflation to target.

Directors also noted that despite the strong balance sheets of financial institutions, rapid expansion has increased banks’ risk profile. While welcoming the steps banks have taken to make these risks more manageable, they stressed that the process needs to continue, with the encouragement of and close monitoring by supervisory authorities.

Directors also recommended an immediate reform of the Housing Finance Fund. Increased competition in the mortgage market between banks and the state-owned Housing Finance Fund had undermined the effectiveness of monetary policy, exacerbated excess demand, and increased the risks to financial stability. They encouraged the authorities to consider establishing a privately held wholesale funding institution that would retain the positive features of the current system while allowing for healthy competition in the mortgage market.

For more information, please refer to IMF Public Information Notices Nos. 06/97 (Chile) and 06/92 (Iceland) on the IMF’s website (www.imf.org).

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