Iceland: Recent Economic Developments

This paper reviews economic developments in Iceland during 1990–96. It analyzes the origins of the current economic expansion associated with a swing in the current account and in emerging inflation pressure. Three driving forces are emphasized: the positive supply shock affecting the fisheries; the expansion of the power intensive industry; and brisk increases in real wages over the past two years (1995–96). The paper highlights that the main sources of upside risks comprise the likely construction of a new aluminum smelter.

Abstract

This paper reviews economic developments in Iceland during 1990–96. It analyzes the origins of the current economic expansion associated with a swing in the current account and in emerging inflation pressure. Three driving forces are emphasized: the positive supply shock affecting the fisheries; the expansion of the power intensive industry; and brisk increases in real wages over the past two years (1995–96). The paper highlights that the main sources of upside risks comprise the likely construction of a new aluminum smelter.

I. ORIGINS OF THE RECENT EXPANSION AND INFLATIONARY PRESSURES1

A. Introduction

1. The expansion of economic activity in 1996 was spearheaded by a surge in domestic demand led by buoyant private consumption and investment. The National Economic Institute (NEI) estimates real GDP growth for 1996 at 5.5 percent, up from 2.1 percent in 19952; private consumption is estimated to have expanded 7 percent and investment 24 percent (Chart 1). Notwithstanding export growth at 5.2 percent the current account balance is estimated to have reversed its positive sign of recent years to a 1.8 percent deficit of GDP in 1996, reflecting a 12.8 percent rise in imports. Meanwhile, indicators suggest inflation is edging up following years of modest price increases; underpinned by domestic demand and rising import prices, inflation is estimated to have climbed to 2.3 percent in 1996 from 1.7 percent in 1996.

CHART 1
CHART 1

ICELAND CONTRIBUTIONS TO GROWTH

(In percent)

Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A001

Source: National Economic Institute.

2. This section analyzes the origins of the current economic expansion associated with a swing in the current account and in emerging inflationary pressure. Three driving forces are emphasized: the positive supply shock affecting the fisheries; the expansion of the power intensive industry; and brisk increases in real wages over the past two years. Expectations of higher future incomes are buoyed by the performance in the fisheries and new investment in the aluminum industry prompting a surge in consumer and investment demand. The main sources of upside risks comprise the likely construction of a new aluminum smelter, and the outcome of the upcoming wage negotiations conducted in a new bargaining framework3.

3. Official projections for 1997, excluding construction of a new aluminum smelter, show economic activity slowing down. Helped by a leveling off of fisheries output and of consumption and investment, GDP growth is projected to decelerate to 2.5 percent, limiting the deterioration in the current account deficit to 2.9 percent of GDP. Consumer price inflation is projected to move lower to 2.0 percent, based on the assumption of a 3.5 percent wage rise. Staff projections for 1997 indicate a similar picture but are less optimistic about a slowdown in inflation and GDP, partly reflecting an assumption of a 5.0 percent wage increase, and GDP growth is projected at 3.0 percent, resulting in a current account deficit of 3.2 percent, and inflation is projected at 2.8 percent.

B. Real Sector Developments in 1996

Domestic demand

4. Domestic demand rose 8.7 percent in 1996 and national income 4.9 percent, with consumption and investment providing the impetus for growth (Chart 1).

5. Consumption expanded briskly (7 percent) in 1996, making it the largest contributor to GDP growth. It was propelled by expectations about future income based on favorable shocks to the fisheries and investment in power intensive industry. Demand for consumer durables was particularly vigorous; annualized car imports were up almost 40 percent in August.

6. The surge in consumption was largely associated with strong growth of real disposable income by 5.5 percent in 1996 as a result of lower-than-expected inflation since the last general wage agreement in February 1995, increased employment, longer work hours and a lower tax burden. On top of a rise of 5 percent in 1995, this brings the increase in purchasing power to more than 10 percent over two years. Consumption in excess of the increase in disposable income was largely financed by build–up of household debt supported by a rise in consumer credit of 11.5 percent year-on-year in July. Consumption smoothing has been helped by financial market liberalization in recent years and is reflected in an 8.8 increase in consumer debt in 1996, which brings the debt ratio to 125 percent of GDP4. Lower interest rates in 1996 also contributed to higher consumption, particularly as consumer loans are primarily extended at floating rates.

7. Total fixed investment increased sharply by an estimated 24 percent during 1996, as reflected in movements in several indicators: imports of investment goods other than for the power intensive industry is up 23 percent during the first six months compared with the same period last year; cement sales rose 18 percent in the first eight months and housing starts strengthened. During the same period, the fishing industry recorded investment growth of 69 percent, the manufacturing sector 116 percent and the energy sector 38 percent.

8. Excluding the smelter expansion, total investment growth is still high at 15 percent, underpinned by increased business profits5 and strong domestic demand. Business investment is estimated to surge at 50 percent in 1996 with the two investment projects in the aluminum

smelter and the tunnel under Hvalfjordur accounting for 42 percent of the rise in investment. Public investment is estimated to have declined 1.8 percent in 1996 reflecting unchanged street and sewage construction and reduced investment in government buildings. Total investment growth has brought the investment–to–GDP ratio to a more comfortable level of 18.8 percent, up from 15.2 percent in 1995.

External developments

9. The current account balance reversed its positive trend of recent years, swinging from a surplus of 0.8 percent of GDP in 1995 to an estimated deficit of 1.8 percent in 1996. The main reason for this swing was the 12.8 percent estimated growth in imports (Chart 2). General merchandise imports, excluding ships and aircrafts (i.e., “special imports”), rose 11.1 percent in the first half of 1996 compared with 1995. Imports of cars and investment goods rose by 20-30 percent while the imports of other consumer goods and intermediate goods increased by 7 percent and 6 percent respectively. Special imports grew 8.4 percent in nominal terms in the first six months, with investment goods providing the impetus with a 57.3 percent hike.

CHART 2
CHART 2

ICELAND EXTERNAL DEVELOPMENTS

Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A001

Sources: Central Bank of Iceland; National Economic Institute.

10. Export growth, estimated at 5.2 percent in 1996, was largely driven by the fisheries with marine exports growing 16 percent in the first six months in 1996 over the same period in 1995 (Chart 2). All fisheries sectors encountered favorable export trends (with the largest increase of 92 percent in the fishmeal and herring factories).

C. Prices and Wages

11. Consumer prices are estimated to have climbed by 2.3 percent in 1996, up from 1.7 percent in 1995, reflecting strong domestic demand and increasing import prices (Chart 3). Annualized inflation stood at 2.5 percent in September, compared with increases of 1.5-2.0 percent early in 1996. The composition of price increases is uneven: the service component of the index has been rising at 4 percent year-on-year since April, nursed by dwindling slack in the labor market. Prices of imported goods showed an increase of 3.3 percent during the first nine months over the same period of 1995, underpinned by a higher-than-expected 3.9 percent rise in import prices and a small effective depreciation of the exchange rate. With the restraining influence of already favorable profit margins and subdued wage increases ahead of expiring wage contracts, prices of domestic consumer goods, excluding agricultural products, rose moderately by 1.5 percent (Chart 4).

CHART 3
CHART 3

ICELAND UNEMPLOYMENT AND INFLATION

Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A001

Sources: National Economic Institute; Central Bank of Iceland; and OECD, Main Economic Indicators.
CHART 4
CHART 4

ICELAND COMPONENTS OF CPI AND WAGE DRIFT

(Percent change for a year ago)

Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A001

Sources: Control Bonk of Iceland; and Stotictlco) Bureau of Iceland.

12. Wages are expected to increase 11 percent over the period 1995 to 1996, supported by the general wage agreement in early 1995 (Chart 3). Meanwhile, unemployment is estimated to fall to 4.2 percent in 1996 from 5.0 percent in 1995, as a result of strong domestic activity.6 While historically still high, several factors suggest that the unemployment level compatible with price stability has moved higher in recent years. Consequently, the present economic upturn has brought the economy close to and likely slightly above its potential capacity7. These developments pose a threat to price stability as labor market conditions tighten and the upcoming wage negotiations, conducted in a new bargaining framework, may feed inflationary pressure. Comparison between the Statistical Bureau’s Wage Index for the private sector and the estimated changes in negotiated wages indicate a 1.7 percent and 1.5 percent wage drift for the first and second quarters of 1996 respectively, but slowing to 0.7 percent in the third quarter (Chart 4).

13. Monetary and asset price developments have been mixed (as discussed in more detail in Chapter V). On the one hand, monetary aggregates are expanding at a pace broadly consistent with price stability; currency and total deposits (M3) rose by 7 percent in 1996, mainly reflecting a portfolio shift into other assets. On the other hand, the hefty economic expansion is underpinned by vigorous consumer credit growth of above 10 percent and corporate lending of 7 percent. Yet, although in the Reykjavik area house prices appear to be edging up following a decline since the beginning of 1995, house prices have overall remained subdued. Meanwhile, the stock market has been bullish with stock prices rising on average 61 percent on expanding trading volumes in 1996.

D. Supply Shocks, Power–intensive Investment and the Current Account

14. Two major shocks had an important effect on activity and external balance in 1996. Following a contraction of 3 percent in 1995, marine production is estimated to rise 7 percent in 1996 resulting from an increase in cod quotas8 and favorable catches in distant waters. Fisheries represent some 15 percent of GDP, 12 percent of the labor force and 75 percent of export earnings. In the fall of 1995, a decision was taken to expand the capacity of the aluminum smelter in Straumsvik from 100,000 tones to 160,000 tones over 1996-97.

15. The directions of trends in output, investment and consumption, resulting from these two shocks are broadly consistent with intertemporal analysis of the current account deficit. Following a persistent positive supply shock, future output levels are expected to be higher by more than the size of the initial shock. Consumption smoothing behavior implies that the shock will cause an even larger increase in consumption. As a result, positive innovations tend to produce a current account deficit and lower savings rates (consumption initially rising more than output).

16. However, the size and the composition of the current upswing seem to indicate domestic demand growing in excess of what the supply shocks would imply. The sharp demand pressure is manifested in domestic demand rising by almost 9 percent, outperforming growth in national income and resulting in a deterioration of the current account. The composition of the current expansion, with consumer durables providing a strong impetus and with buoyant general investment activity is likely to generate inflationary pressure as labor market slack diminishes.

ANNEX I The New Wage Bargaining System

Introduction

17. Legislation passed in 1996 is intended to establish a new framework f moderation or industrial relations, making negotiations more orderly and conducive for wage. In response, the employers association has proposed a two–tier bargaining structure, with standard (minimum) wages negotiated at the central level, and with productivity–linked wage increases to be negotiated at the firm level. The first set of negotiations were scheduled to be concluded in mid-January.

18. An important issue in the current macroeconomic context is the extent of wage increase that will result from the current negotiation round. Following the move in recent years toward macroeconomic stabilization, unemployment rose to a 5.0 percent historical high in 1995, then improving to 4.1 percent in 1996 with the cyclical expansion. In light of upbeat domestic demand conditions, indicators suggest that wage drift is appearing in the market after two years of stagnant or minimal wage drift. Although the authorities’ baseline assumption is for a wage increase of 3.5 percent, there have been concerns that actual wage increases will be higher.9

19. This annex describes recent labor market reforms, discusses the implications for the bargaining system, and places the new legislation in the context of some theoretical and empirical results in the literature.

Labor market institutions and the current bargaining system

20. Iceland’s unionization rates of 85-90 percent are among the highest in the OECD, shy only of the other Nordic countries. Two union federations dominate the labor movement: the Icelandic Federation of Labor (ASI) which is by far the largest with about 65,000 members in 9 national federations and more than 200 unions affiliated, and the Federation of State and Municipalities (BSRB) with some 17,000 members in 37 unions. The employers are organized in two separate confederations. The Confederation of Icelandic Employers (VSI), the larger, and the Association of Cooperative Employers (VMS). The two confederations cooperate closely and engage in joint negotiations. The Government, being the largest employer in Iceland, has a common negotiation committee, as is also the case for banks.

21. The legislative framework comprises the Industrial Relation Act covering the private sector, dating from 1938, and the 1996 Act on Rights and Obligations of State Employees that, together with the act on Wage Contracts, determine the industrial relations in the state sector. While the wage bargaining system in Iceland has been characterized by considerable centralization in some respects, indicated by a high degree of unionization, it is best described as a multi-level system. In this system, individual unions needed not adhere to a general wage increase but could use that as a minimum for subsequent wage bargaining. This system was associated with frequent and lengthy work stoppages and wage drift (SM/95/311).

Implications of the current bargaining system

22. Real wage flexibility in Iceland has been one of the highest in the OECD10, which is particularly important in a small open economy with a limited industrial base buffeted by exogenous shocks. This flexibility, though, has largely been achieved by high and variable inflation, and it is not clear how the bargaining process per se has contributed. Iceland recorded unemployment levels below 2 percent until the early 1990’s.

23. There are at least two specific issues in Iceland that could propitiously be handled in a decentralized setting. First, Iceland has comparatively low labor productivity: it ranked 18th in the OECD in output per hour although it is ranked above average in terms of GDP per capita. Several arguments can be put forward to explain this difference, including the small size of manufacturing firms. Another issue is the incentives the existing wage structure provides for long hours: about half of the full-time employed worked 46 hours or more per week in 1995. Incentives to recourse to extensive overtime stem from the large differences in renumeration, partly held responsible for the poor hour-based labor productivity. Second, reflecting the limited discipline in the old system, negotiated wages are generally much lower than actual average wages (e.g. 20-40 percent lower for unskilled workers), possibly leading to widespread use of hours of work as a signaling mechanism, although also helping avoid the compression of actual earnings that is often associated with high unionization in centralized bargaining systems.

24. Some analytical and empirical research has examined the implications of alternative wage bargaining structures. A widely cited result in the literature on wage bargaining and macroeconomic outcomes is the Calmfors and Driffill (1988) finding of a hump-shaped relationship between centralization and real wages11. The logic behind the finding that very centralized bargaining systems tend to produce real-wage moderation and high employment, is that with cooperative behavior, external effects are considered in an individual bargaining situation12. The beneficial effects in a decentralized system follow from the restraints imposed by market forces. The worst outcome arises in the intermediate case, where the constraints from neither systems are sufficiently binding to moderate wage increases. Centralized systems often involve multi-level bargaining where the national wage agreements are followed by local bargaining. One possible hypothesis that squares with the Icelandic experience is that high inflation may be a necessary requirement for a multi-level bargaining system to produce real-wage restraint. Helped by cooperative behavior, central bargainers may strive for real-wage moderation, but may be unable to achieve it without high and variable inflation when there is local wage drift (Calmfors, 1993).

25. Local unions may exert a large influence on productivity; as higher output in the individual firm will increase wages, the incentives for collective effort are strengthened compared with the case of centralized bargaining, when wages will be influenced by the aggregate output in the economy. In fact, in a cross-country analysis, Dowrick (1993) finds that fully decentralized or fully centralized systems of wage setting do better than partially centralized systems as far as productivity growth is concerned. It has also been found that these productivity-raising incentives remain with multi-level bargaining when centralized wage agreements are followed by local negotiations (see discussion in Calmfors, 1993).

The new bargaining framework

26. Legislation passed this year is intended to establish a new framework for industrial relations by committing groups of workers that participate in centralized wage bargaining to stick to a pre-agreed schedule; by giving the State Conciliation and Mediation Officer extensive powers to resolve industrial disputes; and by restricting the right to strike to cases approved by secret ballot13.

27. The most important amendments in the Industrial Relations Act include: (i) unions can no longer seek general authority from members to threaten to strike, as a new paragraph stipulates conditions of voting in secret ballots, making the rules similar to the public sector; (ii) ten weeks ahead of the expiry of the existing contract the parties have to agree on a schedule according to which the negotiations shall be conducted; (iii) the State Mediator is empowered to submit a proposal if negotiations have not taken place in accordance with the schedule, or when the deadline according to the schedule is passed; the Mediator’s proposal is rejected if more than half of the votes are against, with a minimum participation rate of 25 percent; (iv) the definition of industrial action is broadened to include collective quitting, etc., and; (v) authorization of the negotiating committee of a union, mainly clarifying existing procedures, but also curtailing the power of unions to restrict authority of negotiating committees.

28. Changes to the Act on Rights and Obligations of State Employees more in the direction of hiring and firing rules more flexible in the public sector. For instance, employees are divided into state employees and civil servants. A 3-month length of notice for firing and quitting pertains to the former group, while the latter are employed under a 5-year tenure.

29. In response to the Industrial Relations Act, the Federation of Icelandic Industries has proposed a two-tier system for negotiations. The minimum wage increases are determined centrally in the first stage, while in the second stage additional pay increases, reflecting productivity differentials, and issues of work organization will be negotiated at the firm level. In the ongoing wage round the first-tier negotiations are to be completed by mid January 1997 according to the negotiation schedule. The second-tier negotiations are expected to be finalized by March. This proposal has not yet won approval by all concerned parties. If approved, however, the two-tier system may address the issues of comparatively low labor productivity and the high margins between actual and negotiated wages.

Concluding discussion

30. The new legislation will be conducive for more orderly and focussed negotiations, but predicting the actual bargaining process is difficult and the wage outcomes, even more so. However, rules for adapting negotiation schedules and for calling strikes and the threat of the State Mediator’s entering the process affect the parties’ fall-back strategy in a way that may improve incentives for wage restraint.

31. The two-tier system proposed by the employers, if adopted, may be instrumental in contributing to higher productivity on the firm level, dealing with issues of work organization. Supported by the hump-shaped hypothesis, the proposal skips the intermediate industry-level negotiation and places the second tier at the level of the individual firm. Its overall success, however, will largely depend on the wage increases in the first round of negotiations, under the pressure of rapidly-expanding economic activity.

REFERENCES

  • Calmfors, Lars, 1993, “Centralisation of wage bargaining and marcoeconomic performance: A survey”, OECD working paper no. 131.

  • Calmfors, Lars and John Driffill, 1988, “Centralization of wage bargaining”, Economic Policy, April 1361.

  • The Central Bank of Iceland, 1996, “Economic development”, chapter 5 in Iceland the Republic.

  • Dowrick, Steve, 1993, “Wage bargaining systems and productivity growth on OECD economies”, Austrailian Economic Planning Advisory Council background paper no. 26.

    • Search Google Scholar
    • Export Citation
  • Iceland - Staff Report for the 1996 Article IV Consultation, SM/95/311.

  • OECD Economic Surveys, 1991: Iceland.

1

Prepared by Lars Meuller.

2

The surprising aspect of 1996 growth is demonstrated by the sharp upward revision of GDP from 2.4 percent in February.

3

The official baseline projections for 1997 are compared with preliminary estimates by NEI of the impact of a new aluminum smelter. The wage bargaining system is discussed in Annex II.

4

Household debt to the credit system has increased from about 20 percent of GDP in 1980 to 125 percent in 1996, amounting to ISK 314.7 billion with about 60 percent pertaining to the housing funds.

5

As a share of total valued added, business profits increased 3.5 percent in 1995 and are expected to stay the same this year, up from below 0.75 percent in 1992-93. Post-tax return on equity is estimated at about 6 percent for 1996.

6

Long-term unemployment, defined as a duration of six months or more, trended upward in 1996 standing for one third of all unemployed. In this regard, proposed changes to the law of Unemployment Benefits planned to take effect July 1, 1997 may prove instrumental. Important reforms include a limit on benefits not exceeding the former wage and each benefit period is extended from 1 to 5 years but to regain the right to benefits the unemployed must work for six months out of the last 12 months, in effect doing away with the possibility of continuously collecting benefits.

7

See Chapter II on potential output and output gap.

8

As recommended by the Marine Research Institute, fishing quotas in tons of cod equivalent were raised by 2 percent over last year.

9

For instance, in the early stages of negotiations, the Icelandic General and Transportation Workers’ Union was demanding a 16½ percent hike in monthly minimum wages.

10

Examining the period 1970 to 1987, OECD (1991) finds that Iceland has the second-highest real wage volatility (after Portugal) and the second-lowest employment volatility (after Japan) in the OECD.

11

Calmfors and Driffill, defining centralization as “the extent of inter-union and inter-employment cooperation in wage bargaining with the other side”, rank the other Nordic countries together with Austria as “centralized”. In the “intermediate” group, Germany and Australia are found among others, and notable “decentralized” systems are found in USA, UK and Japan.

12

Incentives for wage restraint are created when negative externalities of one group of wage earners are internalized.

13

The new legislation emanates from a tripartite commission, initially mandated to propose changes to the negotiating process and to issues related to work hours. Labor unions distanced themselves from the conclusions of the commission as further changes had been made by the Ministry of Social Affairs and by the parliament before the proposals were finally passed as a bill.

Iceland: Recent Economic Developments
Author: International Monetary Fund