Iceland: Selected Issues and Statistical Appendix
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The abolition of the fluctuation bands by the Icelandic government is seen as the final step of a consistent and gradual move toward increased exchange rate flexibility. Supplemented by the adoption of an inflation targeting regime, the new monetary policy framework should suit Iceland better. Iceland's new monetary policy framework has been introduced against a backdrop of a sound legal environment. The institutional and operational framework of the inflation targeting regime is well defined. The statistical data on the economic indices of Iceland are presented.

Abstract

The abolition of the fluctuation bands by the Icelandic government is seen as the final step of a consistent and gradual move toward increased exchange rate flexibility. Supplemented by the adoption of an inflation targeting regime, the new monetary policy framework should suit Iceland better. Iceland's new monetary policy framework has been introduced against a backdrop of a sound legal environment. The institutional and operational framework of the inflation targeting regime is well defined. The statistical data on the economic indices of Iceland are presented.

Iceland: Basic Data

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Sources: National Economic Institute; Central Bank of Iceland; Ministry of Finance; and IFS.

I. Iceland’s Impossible Trinity—A Case for Increased Exchange Rate Flexibility1

A. Introduction and Overview

1. An intense debate among economists and policymakers has been ongoing in recent years on the suitability of soft exchange rate pegs in countries with highly integrated financial and capital markets.2 This discussion is based on the recognition that most of the countries experiencing an exchange rate and/or financial market crisis since the mid-1990s had implemented some form of a pegged exchange rate, in contrast generally to countries with flexible exchange rate regimes. In turn, there has been a broad-based trend toward either hard exchange rate pegs or floating regimes, illustrated by a decline in the proportion of intermediate exchange rate arrangements.3

2. Iceland’s exchange rate arrangements, implemented over the last decade, provide a textbook example of the difficulties involved in sustaining a soft exchange rate peg in an environment of open capital accounts. The decision on March 27, 2001, to abolish the fluctuation bands of the exchange rate peg and to adopt a floating regime, supplemented by implementation of an inflation targeting framework, reflects the authorities’ recognition that a soft peg was no longer suitable for Iceland.

3. Against this background, the paper addresses the following questions: What were the driving economic forces for the decision to eventually abolish the soft exchange rate peg and adopt a flexible regime? Is the adoption of a floating exchange rate the most suitable regime for Iceland, and why is an inflation target an appropriate anchor for Iceland’s monetary policy? The questions are addressed in Sections B and C, respectively. Section D provides some concluding remarks.

B. Iceland’s Impossible Trinity

4. In choosing a monetary policy framework, monetary authorities principally face the dilemma that exchange rate stability, monetary independence and financial market integration cannot easily be achieved simultaneously; they must choose between two of the three policy goals. If countries are open to international capital flows, this policy conflict, which is commonly known as the ‘eternal triangle’ or ‘impossible trinity’4, tends to narrow to the choice between exchange rate stability and monetary independence, i.e. the degree of exchange rate flexibility. Over the last 12 years, Iceland’s approach to resolving this dilemma can be divided into two main episodes, with the liberalization of the capital account in 1995 as the main turning point.

5. Prior to the opening of the capital account in 1995, the choice between exchange rate stability and monetary independence was governed by the necessity to adopt an exchange rate anchor for monetary policy to combat chronic high inflation. The policy-shift in 1989 from a managed float (point A in Figure 1) to an almost rigid exchange rate peg, defined as a trade-weighted currency basket with narrow horizontal fluctuation bands of ±2½ percent (point B), was necessary following the experience with almost two decades of real exchange rate targeting, a highly accommodative monetary stance, and widespread backward-looking wage indexation. In fact, the authorities’ renewed commitment to an exchange rate anchor was perceived as a credible policy-shift and contributed to reducing inflation expectations. This set the stage for moderate and forward-looking multi-year wage agreements in the early 1990s, resulting in an impressive disinflation (Andersen and Guðmundsson (1998)).

Figure 1.
Figure 1.

Iceland’s Impossible Trinity

Citation: IMF Staff Country Reports 2001, 082; 10.5089/9781451819250.002.A001

6. Iceland’s subsequent move to increased financial integration pushed the country toward the bottom of the policy triangle (point B to point C) at a constant degree of exchange rate stability. In view of the newly liberalized capital account and the economy’s proneness to external and supply shocks, the authorities decided to widen the fluctuation bands of the peg to ±6 percent in September 1995 to allow for increased monetary independence (point D). In 1999 and 2000, monetary policy took advantage of the increased room for policy maneuver to contain inflationary pressures stemming from the sustained overheating of the economy. The repeated tightening of the policy stance, however, resulted in a large positive international interest rate spread, attracted international capital flows and pushed the value of the króna upward close to its fluctuation band, making a further widening of the bands to ±9 percent in February 2000 indispensable to sustain the soft peg (point E).

7. While Iceland managed to maintain its soft exchange rate peg throughout 2000, the fundamental and interrelated policy conflicts between price stability, exchange rate stability, and external competitiveness became increasingly apparent. As monetary policy relied, inter alia, on an exchange rate anchor to achieve low and stable prices, shocks to the real exchange rate induced inflation-deflation cycles, with domestic prices and wages essentially having to accommodate such shocks. This points to a policy conflict between price and exchange rate stability, which was intrinsic to a country like Iceland with its pegged exchange rate and substantial fluctuations of the real exchange rate. While the gradual widening of the fluctuation bands may have lessened these tensions, it set the stage for a policy conflict between price stability and external competitiveness. Given that the adjustable peg of the króna provided some degree of policy independence to pursue the objective of price stability, the CBI repeatedly raised its policy interest rate. The inflow of foreign capital attracted by the positive interest rate differential resulted in a prolonged nominal appreciation of the domestic currency, thus aggravating the prevailing external imbalances.

8. The combination of financial liberalization, a soft exchange rate peg, and shortcomings in the supervision of the financial system further contributed to the accumulation of external imbalances, triggering downward pressure on the króna. Given the unrestricted access to foreign capital at relatively favorable interest rates, domestic agents either issued foreign denominated debt or borrowed from domestic financial institutions, with the latter intermediating foreign credit to domestic non-financial institutions and the private sector. Policy interest rate hikes were rendered less effective, given a highly interest inelastic lending policy of domestic banks. Shortcomings in the regulatory and supervisory framework allowed banks to overstate their capital base, providing further leeway to banks to expand their lending activity. Moreover, the soft exchange rate peg may have set the stage for moral hazard, with domestic agents perceiving the adjustable peg as an implicit guarantee against a potential depreciation. Negative news on the total allowable fish catch for the 2000/2001 fishing season eventually resulted in the perception that the large current account deficit was not sustainable, leading to downward pressure on the króna.

9. Notwithstanding the room for policy maneuver provided by the widened fluctuation bands of the peg, the CBI’s ability to prevent downward pressures on the exchange rate remained fairly limited against the backdrop of highly integrated capital markets. The CBI was eventually forced to intervene massively in the foreign exchange market to defend the peg against increasing downward pressures. Moreover, given that the interventions were followed by increases in the accepted bids at repo auctions, the adverse domestic liquidity impact of the interventions was roughly neutralized by a more-than-offsetting rise in outstanding repos (Figure 2). This may have added to the downward pressure on the króna5. In the end, the authorities decided on March 27, 2001, to abolish the fluctuation bands of the peg, and to adopt a flexible exchange rate regime (point F).

Figure 2.
Figure 2.

Iceland: Sterilization of Interventions

Citation: IMF Staff Country Reports 2001, 082; 10.5089/9781451819250.002.A001

Source: Central Bank of Iceland.

C. The Need for Increased Exchange Rate Flexibility

10. While Iceland’s soft exchange rate peg had clearly become unsustainable in an environment of highly integrated capital markets, the authorities’ decision to allow the króna to float raises two questions. First, why not have chosen an alternative exchange rate arrangement? As pointed out by Fischer (2001), countries with a liberalized capital account can adopt a hard peg solution (point G), choose among a wide spectrum of flexible rate arrangements (points between G and F, but preferably between E and F), or impose capital controls in order to be able to conduct an independent monetary policy while maintaining a soft exchange rate peg (point H). Second, why is an inflation target a suitable new anchor for monetary policy?

11. As regards hard-peg arrangements, either the adoption of a currency board or membership in a currency union would have been potential options. The adoption of a currency board would have most likely resulted in an abrupt decline of the risk premium of the króna, and thus allowed for lower domestic interest rates, with the CBI loosing monetary independence. Empirical evidence, however, suggests that there is virtually no correlation between shocks to the Icelandic economy and shocks to its main trading partners (Table 1), due mostly to Iceland’s high degree of export specialization (Guðmundsson et al. (2000)). Given the loss of monetary independence, the costs of asymmetric shocks would have to be born by domestic labor markets through highly flexible wages and labor mobility. The latter, however, is clearly limited by Iceland’s geographic location, and real wage flexibility, even though relatively high by international standards, is thought to have fallen due to the successful disinflation. As regards the option of joining a currency union, Buiter (2000) considers the pros and cons of Iceland adopting the euro as legal tender. It is stressed that any form of ‘euroization’ would not only lack political legitimacy but also political accountability, unless Iceland joined the EU and participated in the EMU. The latter, however, is not under active consideration by the Icelandic government, given its earlier decision to wait and see, whether other Nordic countries and the UK would eventually participate in the EMU.6

Table 1.

Iceland: Structural Conditions of the Icelandic Economy

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Sources: Guðmundsson, Pétursson, and Sighvatsson (2000); staff estimates.

12. Capital controls, while appealing on theoretical grounds, have proved to be of limited effectiveness and efficiency over time as suggested by a wide range of country experiences (Edwards (1999), Ariyoshi et al. (2000)). The imposition of capital controls would have also implied a reversal of the 1995 decision to fully liberalize short-term capital flows. Moreover, in order to be effective and prevent prolonged speculation against the króna against the backdrop of extremely large external imbalances, the maintenance of a soft exchange rate peg would have required in any event a significant widening of the fluctuation bands (i.e. a point somewhere between E and F in Figure 1). At the same time, however, this would have weakened the exchange rate as nominal anchor for monetary policy.

13. In choosing the optimal degree of exchange rate flexibility, it is essential to take into account the structural characteristics of the domestic economy (Eichengreen et al. (1998). Notwithstanding the small size and openness of the Icelandic economy, which would normally argue for a fixed exchange rate, several structural conditions suggest that a flexible exchange rate regime should serve Iceland better in future (Table 1). Supply shocks, that is shocks to the real exchange rate, appear to be the dominant source of output variation in Iceland, and its business cycle is virtually uncorrelated with that of its main trading partners. In such circumstances, there is a need for increased nominal exchange rate flexibility and independence of domestic monetary policy to weather shocks. In fact, Iceland’s proneness to real exchange rate shocks is due to the high share of commodity-based products-notably marine products-in overall exports, and to the relative openness of the economy. That said, supply shocks, be they temporary or permanent, could be partially accommodated by nominal exchange rate changes in a flexible exchange rate regime, rather than by changes in the domestic price level within a fixed exchange rate arrangement. Moreover, Iceland’s high integration in international capital markets and limited labor market flexibility also argue for the adoption of a flexible exchange rate.

14. A frequently used argument against the adoption of flexible exchange rates is that increased nominal exchange rate flexibility might involve greater uncertainty about future competitiveness of export and import-competing industries. This argument is of limited relevance to Iceland, given that the previous exchange rate peg was based on a trade-weighted currency basket that allowed for unlimited flexibility of bilateral exchange rates, such as between the króna and the dollar, or the króna and the euro. As a consequence, the margins of Iceland’s export and import-competing industries have already been exposed to currency risks under the previous exchange rate regime. Given that the trade-weights of the euro area and the US in the exchange rate index are roughly balanced, and in view of the divergence of euro and dollar exchange rate movements, the variability of the exchange rate index of the króna is not expected to increase due to a floating of the currency.7 In any event, the impact of nominal exchange rate fluctuations on competitiveness is mainly of a short-term nature, and long-run changes in competitiveness are caused by real exchange rate changes, a variable over which monetary policy exerts no sustained impact.

15. The adoption of a flexible exchange rate arrangement requires that a new anchor for monetary policy be chosen. Highly transparent and easily understood by the broad public, an inflation target raises the potential for lowering inflation expectations (Mishkin (1999)). It therefore clearly provides a nominal anchor for the path of the price level and, due to its forward-looking nature, helps to tie down inflation expectations through its direct constraint on the value of domestic money. At the same time, the central bank’s commitment to achieve an inflation target helps to avoid the time-consistency problem of monetary policy promoting short-term output gains at the cost of higher future inflation. Moreover, and in contrast to money targeting, the nominal anchor in an inflation targeting framework is effectively insulated from velocity shocks.

16. In view of Iceland’s proneness to shocks, it is important to understand how monetary policy would respond to shocks under an inflation targeting regime. As an inflation target is a domestic nominal anchor, the focus of monetary policy shifts to the domestic cycle. Given their impact on the central bank’s inflation forecast, domestic demand shocks would automatically be offset by monetary policy through interest rate changes. Overseas demand shocks, however, have typically no long-term impact on the domestic price level and, therefore, trigger no policy response under an inflation target. A tightening of overseas monetary policy, for example, would result in a real depreciation of the domestic currency, inducing import prices to rise. However, imported inflationary pressures are usually offset over time by the response of overseas prices to the tightening of monetary policy. Moreover, the real depreciation might lead to a temporary increase in the competitiveness of domestic exports, thus resulting in a nominal appreciation, which would counterbalance the first-round effect of the overseas demand shock on domestic prices.8 Supply shocks, however, are more difficult to cope with under an inflation target (Mishkin and Posen (1997)). If a negative supply shock were to occur, output would shrink and inflation would rise. Given this first-round effect on domestic prices, however, central banks would run the risk of attempting to offset a supply shock by raising interest rates and, hence, would act pro-cyclically and contribute to increased output variability. This problem highlights the importance of central banks conducting inflation forecast targeting, that is, to ensure that monetary policy feeds back from projected inflation rather than the inflation outcome. Likewise, as terms-of-trade shocks or any other shock to the real exchange rate typically induce only one-off price level shocks, monetary policy should be accommodative.

D. Conclusions

17. The abolition of the fluctuation bands by the Icelandic authorities can be seen as the final step of a consistent and gradual move toward increased exchange rate flexibility. Supplemented by the adoption of an inflation targeting regime, the new monetary policy framework should suit Iceland better. Given the progressive widening of the exchange rate bands during the past decade, the floating of the króna and adoption of an inflation targeting regime provide a suitable new framework for the monetary authorities in coping with aggregate shocks. In contrast to the previous exchange rate peg, the new regime allows monetary policy to focus on the domestic cycle and to respond to shocks to the domestic economy. Moreover, the inflation targeting framework provides a highly transparent nominal anchor, which is not dependent on a stable relationship between monetary aggregates and inflation, but rather is based on the central bank’s inflation forecasts. The CBI’s relatively reliable inflation forecasts over the past few years have helped it earn confidence.9 This policy shift, however, has required a coherent institutional and operational environment. And indeed, most preconditions for the new regime to succeed are either in place or expected to be introduced in the near term. Chapter II reviews the extent to which Iceland appears to satisfy, or soon should meet, this broad range of institutional and operational pre-requisites.

References

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1

Prepared by Frank Engels.

3

See various reports of the Fund’s Exchange Arrangements and Exchange Restrictions publication.

4

Each side of the triangle represents full achievement of the particular policy goal. See Frankel (1999).

5

Foreign exchange interventions may also have generated the perception among market participants that exchange rate rather than price was the main objective of monetary policy. Lack of clarity on the monetary policy objective, in turn, may have contributed to a decline in the credibility of the soft exchange rate peg.

6

This topic was discussed with the authorities in the context of the 1999 Article IV consultations. See SM/99/90.

7

This, however, would not prevent an increase in the variability of bilateral exchange rates under the new regime, which may then unduly affect the margins of Icelandic exporters, as roughly 75 percent of the exports are invoiced in foreign currency terms. While a complete analysis of invoicing effects also needs to take into account the currency denomination of imports, this data has not been available.

8

If an overseas demand shock were to influence domestic output and inflation through a permanent change in net exports, monetary policy under an inflation targeting regime would need to offset the shock.

9

In fact, Icelandic labor unions have supported a switch to an inflation target given the focus of monetary policy on expected inflation.

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STATISTICAL APPENDIX

Table A1.

Iceland: GDP and Expenditure Components1/

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Source: National Economic Institute.

Volume changes in 1995 to 1998 are based on 1990 prices, but the provisional figures for 1999 and 2000 are on previous year’s prices.

Percentage figures indicate contribution to GDP growth; i.e. changes in aggregates expressed as a percentage of GDP of the previous year, at fixed prices.

Net transfers from abroad other than factor income.

GNP adjusted for changes in terms of trade.

Table A2.

Iceland: Unemployment, Wages, and Prices

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Source: National Economic Institute; Central Bank of Iceland.

Official estimates.

At September of each year; in percent of labor force.

Deflated by the consumer price index.

Table A3.

Iceland: Gross Domestic Product by Sectors

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Source: National Economic Institutes.

Official estimate.

Table A4.

Iceland: Gross Fixed Capital Formation 1/

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Source: National Economic Institute.

Volume changes are based on 1990 prices.

Official estimates.

Including aquaculture.

Table A5.

Iceland: Fish Catch and Marine Production

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Source: The National Economic Institute.

Official estimates.

Catch values deflated by average price of export production.

Table A6.

Iceland: Selected Short-term Interest Rates

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Source: Central Bank of Iceland.
Table A7.

Iceland: Selected Long-term and Deposit Money Banks’ Interest Rates

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Sources: Central Bank of Iceland: and IMF, International Financial Statistics.

End of period figures.

Annual average or end of month figures.

Central Bank’s bids on the Icelandic Stock Exchange.

Market makers’ bids on the Icelandic Stock Exchange.

Table A8.

Iceland: Credit System 1/

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Source: Central Bank of Iceland.

Includes the banking system, investment credit funds, penion funds, state lending funds, insurance companies, leasing companies, mutual funds, and foreign sector.

Effective June 30, 2000, due to the FBA-Islandsbanki merger, figures for FBA investment bank, previously tallied in the category of industrial credit funds, are now tallied in the category “banking system”.

Table A9.

Iceland: Monetary Survey

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Source: Central Bank of Iceland.
Table A10.

Iceland: Foreign Reserves of the Central bank

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Source: Central Bank of Iceland.
Table A11.

Iceland: Accounts of the Central bank

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Source: Central Bank of Iceland.

Base money=deposit money banks + notes and coins in circulation.

Table A12.

Iceland: Central Government Finances, 1995–2001 1/

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Source: Ministry of Finance of Iceland.

From 1999 onwards on accrual basis.

Table A13.

Iceland: General Government Finances

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Source: Ministry of Finance.