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.
III. INTERNAL BALANCE, THE CURRENT ACCOUNT, AND COMPETITIVENESS25
A. Introduction
70. Over the past two decades, the Icelandic economy has seen declining savings and investment rates so that both are now among the lowest in the OECD. Furthermore, with savings lower than investment, the current account position has been negative for most of this period. The persistence of fiscal deficits has contributed significantly to the low rate of savings and current account imbalances. For many years, the authorities unsuccessfully attempted to correct current account imbalances by resorting to frequent exchange rate devaluations. This policy led to high rates of inflation while external imbalances persisted. In 1989, the authorities adopted an exchange rate target, used primarily to control inflation rather than to remove external imbalances. This policy has been crucial in bringing inflation down.
71. Following a substantial improvement in competitiveness during 1992-93, resulting from devaluations in the krona, and also owing to improved public finances, the external current account turned positive in 1994 for the first time since 1986. The surplus reflected a rise in the national saving rate in the face of unchanged investment. More recently, in 1996 the current account turned negative again, in part reflecting new investment in the aluminum industry.
72. This chapter discusses recent developments in the current account and the savings-investment balance, factors that influence current account sustainability, and the relationship between the current account and competitiveness. It argues that despite some modest increases in both government’s and private sector’s savings in the past few years, national savings at around 15 percent of GDP remain relatively low and that most of the fall in the saving rate over the past decade has been due to fiscal imbalances. It also argues that external sustainability in Iceland may not be as serious a problem as it was in the mid-1980s since, among other things, the external-debt-to-GDP ratio has fallen and the exchange rate remains competitive. Nevertheless sustainability remains a cause for concern because of low savings, fiscal imbalances, low external reserves, and undiversified exports. Finally, the chapter presents some evidence to suggest that exchange rate devaluations are unlikely to permanently reduce the current account in Iceland because of the low price elasticity of exports and because devaluations tend to lead to inflation.
B. Developments in Savings, Investment, and the Current Account
73. National saving as a ratio to GDP has had a declining trend in Iceland over the past two decades (Chart 1). Although the national saving ratio has been falling in most industrial countries26, the decline has been more pronounced in Iceland: prior to the early 1980s, Iceland’s saving rate was higher than the EU average, but since then it has fallen below.27 Although, the national saving rate has picked up somewhat recently, reflecting improved public finances and higher private savings, it still is among the lowest in the OECD.
ICELAND SAVING AND INVESTMENT COMPARISONS
(In percent of GDP)
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Sources: National Economic Institute; and IMF World Economic Outlook.1/ Average for France, Germany, Italy, and United Kingdom (PPP-weighted).74. The fall in national saving during the 1978-84 period largely reflected the decline in household saving (Chart 2). Financial liberalization was clearly the major single factor behind the fall, as the increased availability of consumer credit eased liquidity constraints and increased private indebtedness.28
ICELAND NATIONAL SAVING COMPARISONS
(In percent of GDP)
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Sources: National Economic Institute; and IMF World Economic Outlook.1/ Average for France, Germany, Italy, and United Kingdom (PPP-weighted).2/ Defined as the difference between private and household saving.75. The fall in the saving rate during this period may not necessarily be worrisome to the extent that financial liberalization has increased efficiency and welfare. Moreover, the fall in private saving has been partially reversed since 1985. A number of factors have contributed to the recent increase. Private sector indebtedness has increased significantly over the past 15 years, facilitated by financial liberalization, and the increased saving could in part reflect the need to repay this debt. Second, the real short-term rates have increased following the strong slowdown in inflation in 1987. Finally, the rise in corporate saving in part reflected higher profitability since at least 1995.
76. A more worrying feature of savings in Iceland, and the main cause of the fall in national saving since 1984, has been the trend decline in government savings (see Chart 2). The share of government savings in GDP has fallen by 6 percentage points over the past decade, fully offsetting the rise in private savings during the same period. Public savings have only recently started to pick up, reflecting improvements in government balances.
77. Investment has also been declining in Iceland, and like savings, its share in GDP has fallen below the EU average since the first half of the 1980s (see Chart 1). The decline has been sharp after a rise in the early 1970s, reflecting the rise in private investment from 21 percent of GDP to 30 percent during the first half of 1970s, and then the fall to below 12 percent in early 1990s, before recovering to around 15 percent of GDP recently (Chart 3). In contrast to private investment, government investment as percentage of GDP is not lower than the average for the 1980s.29 This also is in contrast with other European countries where public investment has been declining. One reason behind the low rate of private investment in Iceland is likely to be the history of high and variable inflation and the generally unstable macroeconomic environment that prevailed until recently, reducing incentives to invest in the face of uncertainties regarding the future state of demand and prices.
ICELAND PRIVATE AND PUBLIC INVESTMENT COMPARISONS
(In percent of GDP)
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Sources: National Economic Institute; and IMF World Economic Outlook.1/ Average for France, Germany, Italy, and United Kingdom (PPP-weighted).78. Low and declining investment in Iceland is also likely to reflect (until recently) limited capital mobility which to a considerable extent forced investment to mirror the movements in national savings.30 Gross capital movements are relatively small in both directions except for new long-term foreign borrowing and amortization of long-term debt. Both foreign direct investment and portfolio investment by foreigners have very small magnitudes. The hypothesis of limited capital mobility as an explanation for why low savings have coincided with low investment is, therefore, consistent with the experience of Iceland.
79. Although savings and investment have been broadly moving together over the past two decades, savings have generally been lower than investment. As a result, the external account has been in the deficit except for brief periods of modest surpluses. More recently, the current account turned positive in 1993 and remained so until 1995 (Chart 4). The improvement in the current account over the 1992-95 period reflected strong performance by the trade balance (see Chart 4), resulting in part from a 12 percent devaluation of the krona during 1992-93 in response to exchange-rate realignments elsewhere in Europe that brought the real exchange rate down to historical lows.
ICELAND CURRENT ACCOUNT AND TERMS OF TRADE
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Source: National Economic Institute.1/ Estimates.80. During the course of 1996 the current account balance turned negative again despite improvements in the fiscal position. Although the deficit largely reflects new investment in the aluminum industry, which would presumably add to productive capacity and, in the future, improve the current account position, it nevertheless raises the issue of external sustainability given Iceland’s large external debt and a history of current account imbalances. To assess current account sustainability a number of internal and external indicators need to be examined.
C. Current Account Sustainability
81. Since in equilibrium an imbalance in the current account is associated with a saving-investment imbalance, examining the latter is a key factor in assessing sustainability. While external deficits that reflect high levels of investment may be less worrying because they imply higher future growth and improved intertemporal solvency, imbalances that are due to unreasonably low levels of savings raise genuine sustainability concerns.
82. In Iceland, fiscal imbalances have been an important cause of domestic saving-investment and current account imbalances in recent years (Chart 5). The government financial balance has been in the red for a large part of the period since 1970, and the situation has been particularly severe during the past decade. By contrast the private sector’s financial balance, after being negative for most of the 1970s and early 1980s, in part reflecting oil price rises, has been relatively healthy over the past decade. Although the magnitude of the current account deficit has been negatively affected by the fiscal deficits, the movements in the current account position seem to largely reflect those in the private sector’s financial balance, while the government’s financial position appears to have moved the opposite direction, partially offsetting the privates sector’s deficits or surpluses (see Chart 5).
ICELAND SAVING, INVESTMENT, AND FINANCIAL BALANCES
(In percent of GDP)
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Source: National Economic Institute.83. Despite modest increases in both government’s and private sector’s savings in the past few years, and improvements in the current account position relative to the late 1980s, national savings remain relatively low: as a ratio to GDP it has averaged around 15 percent over the past decade, compared with 25 percent in the 1970s. The saving rate is also low in view of the high external debt and the desirability of higher investment. Since most of the fall in the saving rate over the past decade has been due to fiscal imbalances, further improvements in the fiscal position would enhance current account sustainability, but clearly there is also scope for private savings to rise further.
84. The ratio of external debt to GDP is a key external indicator of current account sustainability. Following the oil shocks of the 1970s, debt rose from less than 20 percent of GDP to a peak of around 60 percent in 1983 (Chart 6). Currently it stands at 47 percent of GDP. The debt service ratio has accordingly fallen to 25 percent of exports from a peak of 35 percent in 1994. Although these ratios are relatively high by international standards, in themselves they do not indicate an impending financial crisis, especially since they have been falling recently31. External reserves, another important indicator particularly when the exchange rate is fixed, have fallen as a ratio to imports over the past two years to less than 15 percent of imports, the lowest level since 1973-74 (see Chart 6), although the level of reserves increased in 1996.
ICELAND EXTERNAL DEVELOPMENTS
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Sources: IMF, Internotional Financial Statistics; and National Economic Institute.85. The size of the export sector relative to GDP is another important indicator because it determines the ability of a country to service debt. At around 30-40 percent of GDP, this is relatively large in Iceland, although perhaps not as large as its small population would imply.32 However, an assessment of sustainability should also take account of variability in export revenue, which is rather high in the case of Iceland, making the economy’s ability to service foreign debt more uncertain. Vulnerability is also increased by the degree of concentration of exports; Iceland’s exports are not well-diversified and this weakens the economy’s ability to sustain current account deficits.
86. The composition of capital flows can also be important in determining current account sustainability. There were large capital outflows due to low domestic interest rates and the easing of capital restrictions in 1994, contributing to a fall in reserves. Since then, however, there have been episodes of both inflows and outflows. The experiences of other countries suggest that vulnerability to external shocks may be enhanced when portfolio investment and short-term flows, rather than long-term flows and foreign direct investment, account for most of the capital inflows. In the case of Iceland both foreign direct investment and portfolio investment by foreigners have very small in magnitude. Portfolio investment by Icelanders abroad and short-term capital movements are relatively more sizeable (each in the range of 4-5 percent of export earnings in 1993-95), but by far the largest components of gross flows consist of new long-term foreign borrowing and amortization of long-term debt (each at about 30 percent of export earnings in 1993-95). Moreover, of the new long-term debt in recent years about 60 percent has been by the public sector. The large share of borrowing by the public sector may reduce the possibility of default compared with a case when borrowing is intermediated by the domestic financial system. However, it is also likely to reduce the intertemporal efficiency of borrowing.
87. Finally, problems with external sustainability are often associated with persistent real exchange rate overvaluation. This, however, does not seem to be a problem in Iceland. The real exchange rate has been at historically low levels since 1993 (Chart 7). The next section looks more closely at developments in the exchange rate and its relationship with the current account.
ICELAND EXCHANGE RATE AND COMPETITIVENESS
(Indices: 1990 = 100)
Citation: IMF Staff Country Reports 1997, 015; 10.5089/9781451819205.002.A003
Sources: National Economic Institute; and Central Bank of Iceland.1/ Against the official currency basket -- up to September 6, 1995: ECU=76x, US$=18K, JPY=6x; trade-weighted basket thereafter.2/ An index of wage and non-wage costs relative to output prices. A decrease denotes an improvement in competitiveness.D. Exchange Rate, Competitiveness, and the Current Account
88. The frequency of supply shocks to exports together with the lack of diversity in the composition of exports would appear to strengthen the case for flexible exchange rates or fixed rates with frequent realignments in Iceland, but such a policy does not seem to have been successful in stabilizing the economy in the past.33 The exchange rate policy followed until 1989 had an inflationary bias resulting from excessive use of devaluations to correct current account imbalances and to cut real wages during recessions. The cost of frequent exchange rate adjustments in generating inflation has been high relative to its benefits in terms of reducing current account imbalances. Current account imbalances, moreover, persisted during this period, suggesting that, as should be expected in the long run, the devaluations did not provide a permanent remedy for the imbalances.
89. By contrast, the fixed but adjustable exchange rate policy followed since 1989 has aimed at providing a nominal anchor to control inflation, but at the same time allowing sufficient flexibility to counteract the external shocks that the Icelandic economy is vulnerable to. The new policy has been crucial in bringing down inflation, fostering financial stability, and strengthening central bank credibility following a long period of monetary accommodation of high inflation. Moreover, adopting the exchange rate against other alternatives as the nominal anchor has been a reasonable choice in view of the insufficiently developed foreign exchange market and limited central bank independence.
90. The krona has been relatively stable in the years since the adoption of the new policy in 1989. The two devaluations during this period were directed at absorbing external shocks without causing a devaluation-inflation spiral of the type observed in the past. The first devaluation of the currency, by 6 percent, took place in November 1992 following turmoil in the European currency markets, and the second, by 7.5 percent in June 1993 in the face of adverse supply shock in the fishing industry. Moreover, the widening of the band to 6 percent in 1995 does not appear to have negatively affected policy credibility and in practice the exchange rate has remained within the old 2¼ percent band (see Chart 7).
91. The failure of the policy of using the exchange rate to correct current account imbalances in part reflects the low response of the trade balance to changes in the real exchange rate and the difficulty of containing domestic prices following a devaluation. Exports are dominated by fish and fish products, the supply of which are largely determined by the fish stock and total allowable catches rather than relative prices. Therefore, although import volumes are likely to respond to relative price changes, the overall price sensitivity of the trade balance may be small.
92. To assess the price sensitivities of exports and imports the following standard export and import equations have been estimated:
where X and M denote total export and import volumes, W, Y, and P are respectively world income, domestic income, and the real exchange rate, and u and v are random errors. The equations are estimated using error-correction specifications with the change in the (logarithms) of the dependent variable as a linear function of changes in the independent variables and the error-correction term which is defined as the last period’s deviation from the long-run equation. This specification helps to deal with possible unit root problems in the relationships, and allows for short-term dynamics. The short- and long-run coefficients are estimated simultaneously by the nonlinear least-squares method. Using lower-case letters to represent logarithms of variables, the following two equations are estimated:
where gamma’s are short-run elasticities, delta’s are the error-correction coefficient, and eta’s are the long-run elasticities, and superscript x and m refer to exports and imports. The data cover the period 1970-95 and are from the World Economic Outlook database that is based on official statistics.
The results are as follows, with t-ratios in parentheses:
Exports
Imports
93. Both estimated equations pass the standard diagnostic tests. However, while in the case of exports the fit is weak and the coefficients are mostly insignificant, the opposite is true for imports.
94. The results for exports suggest that export volumes respond to relative prices only temporarily, with a short-run elasticity of 0.43. In the long run they seem to be independent of both world demand and relative prices, as indicated by the insignificant estimated coefficients in the error-correction component of the equation (the terms in parentheses), including the error-correction coefficient itself. The results provide support for the view that in the long run exports are determined largely by supply factors and are independent of changes in the exchange rate.
95. The estimated equation for imports, by contrast, suggests reasonable estimates for both income and price elasticities. Short- and long-run price elasticities are both significant (at 5 percent and 10 percent, respectively). A one percent rise in relative prices is estimated to raise imports by 0.66 percent in the short run and by 0.57 percent in the long run. The estimated income elasticities also have reasonable values, falling from 1.30 in the short run to 0.80 in the long run. The error-correction coefficient of-0.80 suggests a relatively fast speed of adjustment to short-run deviations from the long-run equation.
96. The above results seem to suggest that the Marshall-Lerner condition holds in the short run (the sum of the export and import short-run price elasticities is larger than one) but not in the long run. This implies that starting from a situation of balanced trade and taking account of the value effects of relative price changes, such changes would only be effective in favorably altering the trade balance in the short run; they cannot permanently improve the current account position.34 This also implies that revaluations may not have drastic negative effects on the current account either.
97. Exchange rate changes may not have been successful in correcting current account imbalances also because devaluations need not necessarily translate into relative price changes. In Iceland, devaluations seem to have largely led to inflation, with little favorable permanent effect on the current account, both because of the erosion of their effect on relative prices due to inflation, and because export and import price elasticities are not sufficiently large. This evidence provides further support against the previous policy of using the exchange rate to correct current account imbalances, and in favor of the present policy of using it as a nominal anchor to control inflation.
E. Concluding Remarks
98. Despite some modest increases in both government’s and private sector’s savings in the past few years, national savings at around 15 percent of GDP remain relatively low, and the primary origin of current account imbalances. The saving rate is also low in view of the high external debt and the desirability of higher investment. Since a large part of the fall in the saving rate over the past decade has been due to fiscal imbalances, further improvements in the fiscal position would enhance current account sustainability, but clearly there is also scope for private savings to rise further.
99. External sustainability in Iceland may not be as serious a problem as it was in the mid-1980s since the ratio of external debt to GDP has fallen, the exchange rate remains competitive, capital outflow does not seem to be a problem, and the recent deterioration in the current account may be transitory as it largely reflects an addition to productive capacity. Nevertheless sustainability remains of potential concern because savings are relatively low, fiscal imbalances have persisted, external reserves have fallen to levels that are low by historical standards, and exports remain relatively undiversified.
100. Moreover, empirical evidence presented above suggests that exchange rate devaluations are unlikely to permanently reduce the current account in Iceland because of the low price elasticity of exports and because devaluations tend to lead to inflation. By contrast, the current policy of using the exchange rate as a nominal anchor to control inflation, with infrequent adjustments to accommodate external shocks, has been relatively successful. The results also imply that moderate appreciation in the period ahead would probably not damage the external position seriously because of the low elasticities, particularly given that external competitiveness, already favorable by historical standards, is if anything likely to be boosted further by recent and prospective power-intensive investments.
REFERENCES
Bosworth, Barry, 1995, “Prospects for Savings and Investment in Industrial Countries,” Brookings Discussion Papers in International Economics No. 113, [May].
Central Bank of Iceland, 1996, Autumn Statement, [October].
Devereux, Michael P., 1996, “Investment, Saving, and Taxation in an Open Economy,” Oxford Review of Economic Policy, Vol. 12, no. 2 [Summer], pp. 90-108.
Feldstein, Martin and Charles Horioka, 1980, “Domestic Savings and International Capital Flows”, Economic Journal Vol. 90, pp. 314–329.
Gudmundsson, Mar, 1992, “Export Supply and the Exchange Rate: The Case of a Small Open Economy with a Natural Resource Based Export Sector”, in Economic Policy Coordination in an Integrating Europe, (eds. H Motamen-Scobie and C. C. Starck), Bank of Finland, Helsinky.
Gudmundsson, Mar, 1994, “In Search of Stability: Iceland’s Exchange Rate and Monetary Policies”, Economic and Financial Review 2 & 3, pp. 123-152.
Jappelli, Tullio and Marco Pagano, 1994, “Saving, Growth, and Liquidity Constraints”, The Quarterly Journal of Economics, v. 109, [February], pp. 83-109.
Krugman, Paul, 1991, “Iceland’s Exchange Rate Regime: Policy Options”, (published in Icelandic), Fjarmalatidindi, 3.
Masson, Paul, Tamim Bayoumi, and Hossein Samiei, 1995, “Saving Behavior in Industrial and Developing Countries,” in Staff Studies for the World Economic Outlook (IMF, Washington DC, September), pp. 1-27.
Milesi-Ferreti, Gian Maria, and Assaf Razin, 1996, “Current Account Sustainability: Selected East Asian and Latin American Experiences”, IMF Working Paper WP/96/110, [October].
Prepared by Hossein Samiei.
See, for example, Bosworth (1995) and Masson, et. al. (1995) for a discussion of this issue and the factors that have contributed to the fall.
See Central Bank of Iceland (1996) for a discussion of savings in Iceland.
This is consistent with the experience of other industrial countries. See Japelli and Pagano (1994).
It has to be noted that construction activity is a significant part of public investment.
Feldstein and Horioka (1980) argue that investment and savings move together in most countries largely because of limited capital mobility. Alternative hypotheses in the literature are based on policy reactions or common factors affecting both variables; see Devereux (1996).
See Millesi-Ferreti and Razin (1996) for a discussion of the relationship between current account sustainability, the external debt position, and other factors.
See Krugman (1991).
The above calculations concentrate on the effect of exchange rate changes on the current account through the trade balance. A more direct but methodologically less appealing procedure to test the effect on the current account would be provided by estimating a model that specifies the current account (as a ratio to GDP) as a function of the exchange rate and other variables. The results of estimating such a model (not reported here), however, also indicate a relatively small short-run effect which diminishes over the long run.
