Iceland: Staff Report for the 2003 Article IV Consultation
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International Monetary Fund
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Publication Date:
29 Aug 2003
eISBN:
9781451819243
Language:
English
Keywords:
ISCR; CR; exchange rate; foreign currency; investment; debt; investment boom; current account; interest rate; output gap; fiscal policy; banking sector; Global
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Rapid growth during the second half of the 1990s led to overheating and the emergence of financial vulnerabilities by the end of the decade. Over the medium term, investment projects will impart a significant impetus to economic activity, and output will grow for some years above its long-term trend pace. There are, however, significant upside risks to this medium-term central scenario. Executive Directors supported the authorities' view that macroeconomic policies would have to remain restrictive to counteract the expected demand pressures over the medium term.

Abstract

Rapid growth during the second half of the 1990s led to overheating and the emergence of financial vulnerabilities by the end of the decade. Over the medium term, investment projects will impart a significant impetus to economic activity, and output will grow for some years above its long-term trend pace. There are, however, significant upside risks to this medium-term central scenario. Executive Directors supported the authorities' view that macroeconomic policies would have to remain restrictive to counteract the expected demand pressures over the medium term.

I. Introduction and Key Issues

1. Rapid growth during the second half of the 1990s, led to overheating and the emergence of financial vulnerabilities by the end of the decade. Fostered initially by economic liberalization and investment, the economic boom was accompanied by export diversification and buoyant incomes. Nevertheless, by 1998, it became increasingly driven by private consumption fueled by a rapid credit expansion—resulting in financial vulnerabilities reported in the 2001 Financial System Stability Assessment (FSSA)—and sustained by a current account deficit that widened to 10 percent of GDP in 2000.

A01ufig01

Iceland: Real GDP Growth—International Comparisons, 1996–2001

(in 1995 USS, PPP exchange rates, average annual growth rates)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: AMECO database.

2. The economy has stabilized since then, and appears poised for a resumption of growth (Table 1, Figure 1). By mid-2000, a turn in sentiment and the deterioration in global economic conditions caused a reversal of capital flows, and the króna depreciated steeply through end-2001, triggering a domestic demand adjustment. This, combined with a dynamic export response, resulted in a rapid redirection of activity towards the external sector. The current account returned to broad balance in 2002, which contributed to a recovery of the króna (Table 2). Tight monetary conditions drove down inflation, which has remained close to the Central Bank of Iceland’s (CBI) 2½ percent inflation target since November 2002. After a mild recession in 2002, most indicators point to a pickup in activity in 2003 and prospects are strong for investment-led growth over the medium term.

A01ufig02

Output Growth and Current Account

(In percent)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; and CBI.
Figure 1.
Figure 1.

Iceland: Soft Landing

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Central Bank of Iceland; Statistics Iceland; and staff projections.
Table 1.

Iceland: Selected Economic Indicators

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Sources: Statistics Iceland; Central Bank of Iceland; Ministry of Finance; and staff estimates.

Staff estimates. Actual minus potential output, in percent of potential output.

In percent of labor force.

A positive (negative) sign indicates an appreciation (depreciation).

National accounts basis.

A positive (negative) sign indicates a decrease (increase) in gross official foreign reserves.

External liabilities minus equity investment.

Ratio of long-term external debt service payments to exports of goods and services.

Excluding imports from the construction of hydropower facility and smelters in 2003.

Table 2.

Iceland: Balance of Payments

(In millions of US dollars 1/, unless otherwise indicated)

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

Based on official estimates in domestic currency converted into US$ at current exchange rates.

Preliminary figures.

3. The economy’s soft landing owes much to the stability-oriented policies implemented by the authorities. The adoption of inflation targeting, CBI independence, and a floating regime for the króna in March 2001 have resulted in an effective monetary policy framework that has successfully managed a difficult transition, anchoring inflation expectations. After an expansionary stance in 2001, fiscal policy has remained tight, helping to curb domestic demand. Financial vulnerabilities were addressed resolutely, including through a proactive supervision by the newly created Financial Supervisory Authority (FME), resulting in significant improvements in financial soundness indicators. From a broader perspective, the remarkable flexibility shown by the economy is, to a large extent, the consequence of structural reforms implemented since the early 1990s, including financial and external capital account liberalization undertaken in connection with membership in the European Economic Area (EEA), public finance consolidation, privatization, and other initiatives aimed at promoting robust and efficient markets (Figure 2).

Figure 2.
Figure 2.

Iceland: Economic Developments 1980–2002

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; Central Bank of Iceland; OECD; and World Economic Outlook, IMF.

4. The upcoming period, however, will pose significant policy challenges:

  • Large planned foreign investments in aluminum smelting and construction of associated power-generating facilities will complicate macroeconomic management (Box 1). The investment projects, which will extend over 2003–10, amount to about 35 percent of 2003 GDP. They will substantially increase growth and export revenues, and by further diversifying the export base they will ultimately enhance the stability of the economy. But during the construction period, they will put pressure on limited resources. Policies will need to focus on avoiding economic overheating and an over-appreciation of the real exchange rate that could cause lasting damage to the export and import-competing sectors. To this end, the demand expansion will need to be countered primarily through a tight fiscal policy.

  • After increasing rapidly in recent years, the external liabilities of the Icelandic private sector are high. This makes the economy vulnerable to external shocks and reinforces the case for a fiscal retrenchment aimed at increasing national saving.

  • In this context, continued progress on strengthening the institutional policy frameworks, particularly in the fiscal area, and on market-oriented structural reforms will be crucial to seize the new growth opportunities and further increase the resilience and flexibility of the economy.

II. Recent Developments and Outlook

5. Activity slowed sharply in 2002, as the 2001 impulse from net exports waned. The 2001 depreciation of the króna triggered a swift reallocation of resources towards exports, which provided the main contribution to growth in 2001 and 2002. Simultaneously, private domestic spending and imports contracted. In addition to tight credit conditions and the depreciation of the króna, negative wealth effects had a further sobering effect on domestic demand. Labor markets softened although unemployment was contained at relatively low levels, peaking at 4.1 percent in February 2003, and the participation rate has remained high. While there is much uncertainty surrounding the level of potential output, staff agreed with the authorities that the output gap, if any, was small, with staff estimating it at a negative 1 percent of GDP in 2003.

Planned Aluminum and Power Plant Investments

During 2003–10, Iceland will undertake some of the largest investment projects in its history. Their cost is estimated at 281 billion krónur (US$3.7 billion or 35 percent of 2003 GDP) and they will result in aluminum production increasing almost three-fold. The projects comprise the expansion of the existing Nordural aluminum smelter; construction of a water reservoir and power-generating facilities for the Nordural plant; construction of an Alcoa aluminum smelter; and construction by Landsvirkjun of hydropower facilities to supply the Alcoa plant.1

Work on these projects will start in 2003 and peak in 2005–06. It is anticipated that 50 percent of the construction cost will be financed by foreign investors. Staff estimates that the current account will deteriorate during the construction period—including as a result of the induced consumption—reaching a deficit of 5.6 percent of GDP at the peak of activity.

Macroeconomic Impact of Power Intensive Projects 2003–08

(In percent of GDP, unless otherwise indicated)

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Sources: Central Bank of Iceland, Ministry of Finance; and staff estimates.

Although the Nordural project is included in the official and staff projections, some decisions regarding this project are still pending.

6. In 2002, the real exchange rate of the króna reverted to more normal levels from the lows reached in 2001 (Figure 3). Since the 2001 depreciation, booming export earnings, flagging imports, interest rate differentials, and more recently, expectations of large foreign investment inflows, have sustained the recovery of the króna in nominal and real effective terms. By the time of the mission, the real exchange rate had regained a level consistent with its long-term average.

Figure 3.
Figure 3.

Iceland: Exchange Rate and Competitiveness

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Central Bank of Iceland.

7. Output growth is projected to recover to about 2¼ percent in 2003 and gather pace subsequently, as the investment projects in electricity generation and smelting take place. The activity pick up is being spearheaded by a consumption upswing in 2003, as suggested by high frequency indicators and national accounts data for 2003Q1 (Figure 4). The output gap is expected to close by early 2004 as domestic demand growth takes hold, buttressed by the start of power-generation and smelting construction projects in the second half of 2003.

Figure 4.
Figure 4.

Iceland: Activity Indicators

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; Directorate of Labor.1/ Index, 1990=100.

8. Over the medium term, the investment projects will impart a significant impetus to economic activity and output will grow for some years above its long-run trend pace (Table 3). Staff’s baseline projections indicate that capital inflows will temporarily widen the current account deficit to a peak of about 5½ percent of GDP in 2005–06. This deficit will be mainly driven by imports directly related to construction projects, and largely financed by foreign direct investment. Staff projections—postulated on the adoption of appropriately tight macroeconomic policies consistent with the authorities’ intentions—also indicate that the demand push could be accommodated with only a moderate appreciation of the real exchange (most of which appears to have already taken place), while gross external debt could decline to below 100 percent of GDP by 2008.

Table 3.

Iceland: Medium-Term Scenario

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Sources: Statistics Iceland; Central Bank of Iceland; and staff projections.

Imports of goods excluding temporary direct imports for the energy intensive investment projects that are financed through foreign direct investment.

In percent of potential output.

9. There are, however, significant upside risks to this medium-term central scenario. While, at present, a weak global outlook and high levels of private sector indebtedness may temper the recovery, the investment demand push will soon gather momentum, including through forward-looking expectations. Thus, the main risks will increasingly be the emergence of overheating and loss of external competitiveness, particularly if an asset price boom or unrealistic expectations of income growth develop. In this connection, the upcoming wage round in early 2004 will provide a first test. Also, the high levels of external debt, particularly short-term liabilities, will continue to make the economy vulnerable to unexpected swings in sentiment and external financial conditions.

III. Policy Discussions

10. The authorities have responded appropriately to the macroeconomic policy challenges identified in previous Article IV consultations and policies have been consistent with Board’s recommendations. At the conclusion of the last consultation (June 2002), Directors commended the authorities for progress in resolving macroeconomic imbalances and in overcoming financial vulnerabilities identified in the 2001 FSSA. While considering sound the underlying position of the public finances, Directors expressed concern on spending slippages and recommended strengthening the budgetary process and the medium-term orientation of fiscal policy. The introduction of inflation targeting and a floating regime for the króna was welcomed by the Board and financial supervisory reforms recommended by the 2001 FSSA have been implemented.

11. The 2003 consultation discussions focused on the medium-term economic policies required to accommodate the envisaged acceleration of demand while maintaining external competitiveness and macroeconomic balance. The authorities considered that tight fiscal and monetary policies would be essential to forestall a resurgence of imbalances as activity strengthened, spurred by the planned large investment projects. They attached high priority to stemming a potential real overvaluation of the króna, which could otherwise prompt a “Dutch disease” through attendant competitiveness losses. To this end, there was agreement that, given the size and extended duration of the expected demand shock, fiscal policy would have to bear most of the burden of the necessary adjustment. In particular, the authorities saw a need for expenditure restraint and increasing structural fiscal surpluses following the profile of the envisaged investment activity. In this regard, staff welcomed the authorities’ assurances of a prudent and gradualist approach to implementing some of the more potentially expansionary aspects of the coalition parties’ electoral platforms—including tax cuts and increases in the loan-to-value ratios of the Housing Financing Fund (HFF).1 Plans to expand labor immigration during the construction phase would also lessen resource strains. Although the economic program for the government’s new period in office still awaited detailed development, it was apparent that the authorities faced an enviably broad consensus on the thrust of these policies among the private sector and social groups.

A. Monetary Policy

12. Monetary policy, combined with recessionary conditions and the appreciation of the króna, has successfully stabilized inflation close to its target level (Figure 5). After an initial burst following the 2001 depreciation, the 12-month rate of inflation receded swiftly in 2002. As inflation came down, the CBI cut the policy rate gradually, while still maintaining a tight real stance until early-2003 (Figure 6). Short-term nominal market rates followed closely, while rates on inflation-indexed instruments experienced a lesser decline, partly reflecting their longer maturities but also suggesting that the fall in inflation expectations largely matched the rate cuts. Staff estimates that the ex post real policy rate, after dipping into negative territory in mid-2001, increased steeply in 2002, and has remained relatively high until recently.2 The 12-month growth of credit to the private sector had declined to less than 5 percent by mid-2003—compared to rates in excess of 20 percent through mid-2001—owing mainly to demand conditions, but also to stricter lending criteria (Figure 7).

Figure 5.
Figure 5.

Iceland: Inflation and Wage Developments

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Statistics Iceland.1/ Consumer Price Index excluding agricultural products, fruits, vegetables, petrol and public services.2/ Imported goods less alcohol and tobacco.
Figure 6.
Figure 6.

Iceland: Interest Rate Developments

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Central Bank of Iceland.
Figure 7.
Figure 7.

Iceland: Money, Credit and Liquidity Operations

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Central Bank of Iceland.1/ From January 2000, 12-month changes include lending by FBA investment bank. By way of its merger with commercial bank Íslandsbanki, FBA entered the Deposit Money Banks data set in June 2000.
A01ufig03

Nominal Effective Exchange Rate and Consumer Prices 1/

(12-month percent change)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; and Central Bank of Iceland.1/ Nominal effective exchange rate measured as krónur per unit of foreign currency. An increase reflects depreciation.
A01ufig04

Iceland: Real Short-Term Interest Rates1

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: CBI: Statistics Iceland; and staff estimates.1/ Nominal rates less smoothed (HP-filtered) actual monthly inflation.

13. Staff supported the CBI’s broadly neutral policy stance, which struck a balance between incipient domestic demand pressures and the cooling effect of the appreciation of the króna. On the demand side, consumption had edged up, although from low levels. Consumer confidence indicators were also firming, reflecting the announced investment projects, and real earnings and disposable income growth had been sustained during the recession, soft labor markets notwithstanding, owing partly to buoyant public wages (Figure 8). Both real housing and stock prices had resumed an upward trend in 2002—possibly mitigating negative wealth effects and the dampening impact of high private indebtedness. Finally, the lagged effects of earlier rate cuts and the recent reform of banks’ reserve requirements would continue to impart a moderatetimulus.3 However, although historical estimates would have indicated that the current policy stance was slightly accommodating, inflationary pressures had been countered by the increasing strength of the króna in 2002–03, which was expected to generate downward price pressures into 2004. As a result, core inflation indicators had shown little underlying inflationary pressure, with increases concentrated on imputed housing costs, petrol, and government-provided services, and with significant decreases in imported good prices. Inflation was 1.6 percent in July 2003 and the CBI projected that it would remain below target until end-2004.

Figure 8.
Figure 8.

Iceland: Income and Asset Prices

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; Bloomberg; and IMF staff estimates.
A01ufig05

Iceland: Real (CPI-Deflated) Wage Indices

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Stastistics Iceland: and staff calculations.
A01ufig06

Iceland: Real Asset Prices

(Indices)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; Datastream: and staff calculations.

14. As the upturn in activity takes hold, the CBI envisaged an interest rate tightening, with the rate remaining restrictive over the medium term. This was also the expectation of market participants. The authorities agreed, however, that containing demand pressures over the extended period of project-related investments would mainly be the responsibility of fiscal and structural government policies, if Iceland’s external competitiveness was to be safeguarded. This would allow monetary policy to remain the first line of defense against unexpected and short-term demand and external shocks. While welcoming this approach, staff expressed concern in this connection regarding plans to raise the loan-to-value ratios applied by the HFF in its mortgage lending—a measure included in the government’s Policy Statement. The authorities agreed that this should be complemented with countervailing reforms to prevent a destabilizing expansion of HFF credit, which if not kept within strict limits could undermine CBFs liquidity management and contribute to higher real interest and exchange rates as well as to housing price increases.

15. The successful stabilization of 2001–02 had consolidated confidence in the inflation targeting framework, which was being buttressed by market infrastructure reforms. Through its policy actions, as well as through outreach activities and publications, the CBI had enhanced confidence in and understanding of the monetary policy framework by market participants, and inflation expectations—survey and market-based—appeared anchored around the CBI inflation target. Further in this direction, staff suggested consideration of holding regular rate-setting meetings of the CBI Board of Governors and publishing their minutes. Without ruling out such an approach in the future, the authorities indicated that the CBI quarterly bulletin was effectively used to explain policy decisions. The CBI was purchasing foreign currency through a pre-announced schedule to bolster its net foreign reserves, which should further cement confidence in its capacity to face unexpected liquidity shocks. The authorities had reformed the payments and securities settlement systems along best international practices, to increase their efficiency and safety. Staff recommend exploring reforms to promote the depth of domestic money markets, thus reducing banks’ reliance on the CBI’s repo facility and external borrowing for short-term funding needs.

B. Fiscal Policy

16. Although the downturn in activity and expenditure slippages eliminated the fiscal surpluses experienced during the boom of the 1990s, the public finances remain sound with the budget close to balance and the debt burden low (Table 4, Figure 9). The overall balance deteriorated from a 2½ percent of GDP surplus in 1999 to the broad balance expected for 2003. Staff estimates that about half of this change was the result of the automatic stabilizers. The remainder reflects hikes in health, education, and social spending—to a large extent, the result of wage increases. The cyclically-adjusted fiscal stance was somewhat restrictive in 2002–03 with revenue over-performance offsetting expenditure overruns—despite tax cuts passed in 2001.4 General government debt has continued declining as privatization proceeds have been used to redeem debt and capitalize future pension liabilities.

Table 4.

Iceland: Summary Operations of the General Government 1/

article image
Sources: Ministry of Finance; and Fund staff estimates and calculations.

Accrual basis.

Official forecast of the Ministry of Finance as of April 2003.

Staff forecast.

Change in percent.

Actual output less potential in percent of potential.

Figure 9.
Figure 9.

Iceland: Fiscal Developments

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Statistics Iceland; Ministry of Finance; and staff projections.1/ Actual output minus potential output, in percent of potential GDP.

17. The authorities agreed that maintaining stability and competitiveness in the face of the upcoming demand expansion would require sustained budget surpluses over a number of years. Based on the authorities’ policy goals, staff discussed macroeconomic projections that limit the current account deficit to a level close to project-related imports, which could be mostly financed with envisaged foreign direct investment. These estimates suggest the need for increasing budget surpluses, peaking at about 3 percent of GDP in 2006, i.e., at levels similar to those experienced during the late-1990s economic upswing. This would require a structural retrenchment of about 2 percentage points of GDP, with the remainder contributed by the automatic stabilizers. Given the risks and uncertainties associated with the projections, staff emphasized that policies should be reassessed in the light of developments with a view to limit current account deficits. In particular, a more restrictive fiscal stance might be necessary if signs of overheating emerged. The authorities agreed with the thrust of this scenario, including the need to build up significant budget surpluses, but indicated that specific fiscal projections would not be developed until the 2004 budget discussions in Autumn 2003.

18. The authorities explained that their focus would be on expenditure restraint and that the tax cuts announced during the elections would be implemented in a manner consistent with macroeconomic stability. The authorities indicated that investment spending would be reduced, partly because some investment projects had been brought forward into 2003 to palliate unemployment. But cuts in current spending (as a percent of GDP) would also be necessary. Staff supported this view and pointed out that government wage increases had significantly outpaced those in the private sector for some time, which was not only unsustainable but particularly damaging in the run-up to the general 2004 round of private sector wage negotiations. In order to mitigate strains on the budget, staff suggested expanding the role of private provision of public services and of user fees and co-payments (which could be means-tested)—particularly in health and higher education. On other expenditure areas, the authorities indicated that the reduction in debt would prompt interest savings and that demographic prospects and a largely fully-funded pension structure insulated the public finances from the pressures anticipated in many other European economies (Annex I). The authorities explained that they intended to continue their tax reform agenda by lowering personal income tax, inheritance tax, and some VAT rates; eliminating wealth taxes; and possibly increasing saving incentives. But these were measures to be implemented over the government’s period in office and their timing would be contingent, inter alia, on macroeconomic circumstances.

19. To facilitate fiscal consolidation, the authorities were intent on strengthening the medium-term orientation of the fiscal framework—a timely objective given the need to avoid an unbalanced policy mix and cement confidence in the stability of the economy. The new government announced that the 2004 budget would be designed within an explicit multi-year context. The authorities were considering various possible medium-term fiscal rules and budget targets—which in their view should allow the unrestricted operation of automatic stabilizers. They also planned to switch to a national accounts-based budget formulation. Staff encouraged the authorities to advance in this direction and announce soon the details of a medium-term fiscal policy strategy that included ambitious budget balance targets buttressed by commitments to contain expenditure. Staff argued that, while confidence among market participants in the monetary policy framework was strong, considerable uncertainty still surrounded the intended fiscal path, particularly given the past reliance on supplementary budgets and the short-term horizon of the current budget process. This perceived risk of a lopsided policy mix might explain part of the still relatively high medium- and long-term interest rates.

C. Financial Sector

20. Aided by a proactive supervisory response, the financial sector imbalances identified in the 2001 FSSA have subsided and Iceland’s financial sector has returned to a more balanced risk profile (Table 5). This was the main conclusion of this year’s FSSA update. Icelandic banks recorded increased profits in 2001 and 2002, and encouraged by supervisory recommendations, bolstered their regulatory capital ratios, including through the issuance of new shares and qualifying subordinated debt. Savings banks experienced more difficult conditions than commercial banks, as their non-performing loans and credit losses were proportionately larger.

Table 5.

Iceland: Financial Soundness Indicators

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Sources: Financial Supervisory Authority; and Central Bank of Iceland.

Deposit money banks, i.e., commercial banks and savings banks. Consolidated accounts

Deposit money banks. In the year 2000 FBA was merged to Íslandsbanki which partly explain considerable increase in figures.

Includes private business operations of individuals.

Net of specific provisions and including appropriated assets. Commercial banks and savings banks. FBA and its predecessors included.

Stock of general and specific provisions overstock of non-performing loans. Commercial banks and savings banks. FBA and its predecessors included.

Including equity mutual funds.

21. The legal, regulatory, and supervisory frameworks have been significantly strengthened, and the new assessment found major improvements in the degree of compliance with Basle Core Principles (BCP). The Financial Undertakings Act and other related pieces of financial legislation substantially extended the powers of the FME—including to mandate capital ratios in excess of 8 percent if warranted by a bank’s risk profile—and FME resources had been appropriately increased. The FME implemented exhaustive bank-by-bank on-site examinations of loan classification, provisioning, and collateral valuation practices. As a result of the quick and comprehensive regulatory and supervisory changes implemented since the 2001 FSSA, Iceland is now compliant or largely compliant with all but one of the BCP—the exception owing to the lack of a country risk reporting system. Staff encouraged the authorities to remain vigilant in the coming years in light of the potential for emerging macroeconomic tensions, including from high levels of indebtedness.

22. The discussions also touched upon some areas that could benefit from additional improvement. The HFF, although under the oversight of the Ministry of Social Affairs and Parliament, was exempt from regular prudential laws and regulations, such as capital requirements, provisioning rules, etc. The authorities agreed with the staff’s recommendation that the HFF should be subject to explicit prudential guidelines regarding its operations. Also, careful monitoring of some weaker savings banks would continue to be warranted to ensure improvements in their management and solvency position, notwithstanding their minimal systemic importance.

D. External Position

23. The relatively high external debt of Iceland corresponds mostly to the private sector and, in the authorities’ view, has its roots in low household savings (Annex II). At end-2003Q1, Iceland’s gross external debt amounted to about 127 percent of GDP and net external liabilities (as measured by the negative net international investment position) were 80 percent of GDP (Table 6). External debt rose rapidly during the 1998–2000 economic boom and its ratio to GDP was bolstered by the 2001 depreciation of the króna, edging down only recently. Most of this gross debt—95 percent of GDP—corresponds to the private sector, of which the banking sector accounts for 67 percent of GDP. The authorities considered that the main reason of the high external debt of Iceland vis-á-vis other comparable economies had been a rapid raise in household indebtedness following the financial liberalization of the mid-1990s. Household debt increased from 47 percent of GDP to 98 percent of GDP in 1990–2002. Non-financial corporations’ debt had also increased substantially, although their debt-to-equity ratios had been relatively stable. With both a low supply of domestic savings and a high demand for credit, the banking sector had intermediated foreign savings—helped by the good credit ratings of Icelandic banks and the country as a whole. Banks, however, have limited open foreign currency positions and the exchange rate risk lies with the ultimate borrowers, which are mostly organically hedged corporations, such as fisheries and other exporters.

Table 6.

Iceland: Indicators of External and Financial Vulnerability

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Sources: Financial Supervisory Authority; Central Bank of Iceland; and Statistics Iceland.

Preliminary figures

Imports of goods and services

Based on freely usable reserves (excluding contingent credit lines) over short-term debt on an original maturity basis.

Debt figures are based on end-of-period exchange values, while GDP is valued at average-of-period rates.

A01ufig07

Iceland: Gross External Debt and Net International Investment Position International Comparisons 1/

(As percent of GDP)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources Central Bank of Iceland; International Financial Statistics; and Balance of Payments Statistics, IMF.1/ Data for Australia, Iceland, Finland and the UK are of end-2002: data for Sweden are end-2000; all others are end-2001. A positive: gross external debt or a positive International investment position indicate a liability.

24. As to underlying trends, the authorities explained that the increase in private sector debt was rooted in fundamentals. Regarding the household sector, the age profile of the Icelandic population is younger than in most other European countries, which reduces aggregate saving due to life-cycle behavior.5 Also, the pension system is mainly private and highly capitalized, underpinning household confidence. When pension and other assets are included, the net worth of households has increased despite the parallel increase in indebtedness.6 The increase in corporate debt corresponds to rapid asset growth during the past decade, including takeovers and expansion abroad.

25. Moreover, external liabilities are well regulated and carefully monitored. Iceland has strict reporting and prudential banking regulations regarding liquidity ratios and open foreign-currency positions—consistent with EU financial directives, which Iceland has adopted as part of the EEA. Moreover, the CBI monitors closely banks’ short-term obligations on original and residual maturity bases, and liquid assets. On the asset side, banks’ foreign currency-denominated portfolios are strong, as demonstrated by their good performance during the recent sharp depreciation of the króna.

26. The authorities concurred that policies should aim to increase national saving, but did not expect a rapid reduction of private indebtedness. The authorities noted that, although most of the external debt of Iceland corresponds to the private sector, fiscal retrenchment would help to increase national saving and contribute to curb external liabilities. Indeed, staff projections envisage a steady decline of gross and net external liabilities over the coming years. Still, the authorities argued that, since borrowing levels are not caused by market distortions, lax supervision, or weak public finances, but are possibly an equilibrium outcome, the policy levers available to affect credit and associated external borrowing directly are limited. They also argued that given these factors, and since private sector balance sheets are strong, the level of indebtedness is manageable and should not be a cause of systemic stress. Staff acknowledged these reasons and concurred that tight macroeconomic policies aiming to limit current account deficits and a strong prudential framework are the primary means to address the external exposure. Staff noted, however, that this exposure highlights the risks associated with a rekindling of external imbalances and narrows the room for policy slippages. These risks are confirmed by standard external sustainability stress tests analysis (Appendix IV). This analysis shows that, among the stress test scenarios, those that assume a pronounced depreciation or a repetition of the large current account deficits of the late 1990s result in the highest debt growth.7

27. On the external side, the discussions also covered exchange rate developments, which had recently eroded the windfall export profits of 2001. The pronounced 2001 depreciation of króna prompted unusually high profits in export-oriented activities. Conversely, the subsequent appreciation has caused a decline in export profitability—particularly among fisheries and the tourism industry. The impact of exchange rate volatility, however, was partly dampened by shifts in destination markets towards the euro area and by the foreign-currency denomination of most of the liabilities in export industries. Also, the built-in profit-sharing clauses in the wage arrangements of the fishing industry provided an additional buffer.

A01ufig08

Sectoral Profitability

(Gross profits as percent of revenue)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Ministry of Finance.1/ Excluding finance and insurance.

28. Looking forward, the authorities and private sector analysts considered that, at the exchange rate prevailing around the time of the mission (which has since then depreciated somewhat), export industries would remain competitive. This assessment was born out by sustained export performance and by the stock prices of most listed exporting companies, which had generally recovered since the stock market trough despite the strengthening of the króna. This performance is consistent with the remarkable flexibility shown by export industries over the last decade, reflected in increased diversification towards high value-added export activities such as pharmaceuticals, high technology manufacturing, and financial and business services. Staff estimates of relative export profitability vis-à-vis trading partners and market share indicate a continual improvement since the mid-1990s. In particular, the fishing sector has undergone substantial consolidation over a number of years, seeking increased efficiencies and moving up in the value added chain.8 Profitability prospects are also supported by an ongoing recovery in fish stocks, which resulted in a recent 11 percent increase in the total allowed fish catch for next year. Market analysts, however, expected that a stronger króna would cause stress in specific export sectors, forcing further consolidation and restructuring—particularly in fisheries.

A01ufig09

Iceland: Stock Market Indices

(August 2001 = 100)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Datastream.
A01ufig10

Iceland: Measures of Competitiveness

(Indices, 1990 = 100)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Central Bank of Iceland; Statistics Iceland: and staff estimates.1/ Real effective exchange rates. A decline indicates more competitiveness.2/ Ratio of the ULC share in Iceland’s export prices relative to partner countries. See Lipschitz and McDonald: “Real Exchange Sates and Competitiveness” (Empirica-Austrian Econ. Papers, 1992).

E. Structural Reforms and Other Issues

29. The privatization agenda had continued to advance rapidly, but progress in other structural reforms appeared more protracted. In 2002–03, the government successfully divested its remaining stakes in banking, opening the door to efficiencies in the sector through mergers and acquisitions. Having passed all necessary enabling legislation, the authorities expected prompt privatization of the telecommunications company, which awaited favorable market conditions. Progress had been slower in the rationalization and liberalization of the electricity sector, where the authorities were in the process of introducing the relevant EU directives. The authorities agreed to consider reforms of the HFF, which in the staffs view should aim to limit gradually the HFF role to strictly social objectives and open the bulk of the mortgage market to banks.

30. Staff encouraged faster progress on trade and agriculture liberalization in the context of the Doha round of multilateral world trade negotiations, although the authorities envisaged a more gradualist approach. There had been a significant decline in the overall level of agricultural support in Iceland, from 5 percent of GDP in the late 1980s to 1.6 percent of GDP in 2001, and a partial shift away from quotas and other relatively more distorting trade barriers to direct budgetary income support payments. Nevertheless, agricultural protection remains among the highest in the OECD. The authorities pointed out a number of factors inhibiting bolder reform efforts, including possible rural poverty traps and regional inequality. Staff argued, however, that the current system unduly distorts resource allocation and burdens consumers—as suggested by the recent substantial decline in retail prices as tariffs on vegetables were replaced by direct budgetary support.

31. Iceland conforms to the standards of the Anti-Bribery Convention, and has a comprehensive system to combat money laundering and the financing of terrorism. Iceland was among the first to adopt the Anti-Bribery Convention and implement enabling legislation, which the OECD considers conforming to the standards of the Convention. It had additionally undertaken a Phase 2 review, and the authorities were considering its recommendations. Iceland was also among the first to complete the Fund’s Anti-Money Laundering/Combating the Financing of Terrorism questionnaire. The Financial Action Task Force (FATF) considered that the Icelandic anti-money laundering system met most of the essential requirements of the initial 40 recommendations. Subsequently, Iceland had passed additional legislation to adopt the recent “40+8” FATF recommendations.

32. Iceland grants duty-free access to imports from least developed countries and has increased Official Development Assistance (ODA). Imports from least developed countries are afforded equal treatment to those from the EEA. Projected at 0.16 percent of GNP, ODA has continued to increase, albeit modestly.

IV. Staff Appraisal

33. The Icelandic economy has overcome the macroeconomic imbalances that developed at the end of the 1990s and is beginning to rebound. The 2001 depreciation of the króna prompted a redirection of activity toward exports and curtailed domestic demand. As a result, the large current account deficits of previous years were eliminated and the króna recovered in 2002–03, helped by tight interest rates. Simultaneously, the 12-month rate of inflation was swiftly brought down to the 2½ percent target. The real effective exchange rate has appreciated since early-2002, eroding the windfall profits of export industries. However, at the levels prevailing in mid-2003, it did not compromise external sustainability. Led by a pickup in consumption, output appears to be bottoming out after a ½ percent decline in 2002.

34. The authorities are to be commended for the successful stabilization of the economy—to a great extent, the result of strong monetary and financial supervisory frameworks and stability-oriented structural reforms. The adoption in March 2001 of inflation targeting, independence of the CBI, and a floating exchange rate regime was crucial in subduing inflationary pressures and cementing confidence. The FME, aided by the prompt passage of supporting legislation, proved instrumental in overcoming financial vulnerabilities reported in the 2001 FSSA. Overall, the remarkable economic adjustment of 2001–03 bears witness to the success of a decade of structural reforms focusing on market and external liberalization, public finance consolidation, privatization, and rationalization of the public sector.

35. The prospects are for a resumption of growth of about 2¼ in 2003, accelerating through the medium term as large foreign investments take place—while risks will tilt to the upside. The investment projects in smelting and associated energy-generating facilities will impart a significant demand stimulus. Associated capital inflows are expected to reopen a current account deficit broadly equivalent to direct project-related imports—peaking in 2005–07. In the near term, a hesitant global recovery and debt overhang may weaken somewhat the upswing in activity. But over the medium term, the main risks will remain a reemergence of earlier imbalances driven by excessive domestic demand growth. Pressure on resources could result in inflationary strains and a real over-appreciation of the króna, eroding export competitiveness and causing excessive current account deficits.

36. Consequently, although the public finances remain sound, the stability of the economy will require a medium-term plan for fiscal consolidation in the context of a strengthened fiscal policy framework. Thus, the authorities’ intention to build up budget surpluses to counteract the envisaged demand push is welcome and should underpin the 2004 budget proposal. This would leave room for monetary policy to play its stabilization role while avoiding sustained high interest rates. Also, it would mitigate current account deficits, providing for a gradual decline in external debt. Specifically, the authorities’ stability objectives will require focusing first on implementing the necessary restraint in current spending. The planned tax cuts should be introduced only once commensurate additional expenditure savings have been identified. In addition, increasing the scope of means-tested user fees and co-payments as well as the private provision of currently publicly-provided services would usefully reduce pressures on the budget. The authorities’ plan to frame the 2004 budget within a multi-year horizon is welcome. In this regard, explicit cyclically-adjusted balance targets and expenditure limits would crucially contribute to the predictability and credibility of budget policies. Fiscal transparency will be enhanced by the planned budget adoption of national accounts methodology.

37. The current broadly neutral monetary stance is appropriate, but will need to tighten over the medium term. The sustained reduction in interest rates over the past year was appropriate in light of the easing of activity, the firming of the króna, and the drop in inflation. But as the recovery takes hold, the monetary stance will need to tighten and remain restrictive over the coming period, as is the policy intention of the authorities. A destabilizing expansion of HFF credit, which could be prompted by the planned relaxation of its lending criteria, should be avoided.

38. The recent successful stabilization has consolidated confidence in the monetary policy framework and anchored inflation expectations. Further, market infrastructure has been reinforced by the adoption of reforms aiming to minimize risk in payment systems and bring them in line with international practices. And the ongoing CBI program of pre-announced foreign exchange purchases to shore up net reserves will strengthen the capacity to deal with unexpected shocks. Further along this lines, the transparency of monetary policy would be enhanced by setting regular rate-setting meetings and publishing their minutes. Also, the authorities could consider reforms to deepen money markets, thus minimizing the need for banks’ resort to the CBI repo facility and short-term foreign funding.

39. Financial vulnerabilities identified in the 2001 FSAP have substantially subsided. The banking sector increased profits in 2001–02 and bolstered its capital base. The authorities took determined steps to strengthen the prudential supervisory framework and implemented many of the 2001 FSSA recommendations. As a result, the FSAP follow-up assessment found major improvements in BCP compliance.

40. Iceland’s high private external debt levels, while not a cause of systemic concern at this point, pose potential medium-term vulnerabilities. Private sector borrowing appears rooted in demographic trends and the buildup of substantial private assets—rather than weak public finances or market distortions. In this respect, the authorities’ approach, emphasizing macroeconomic policies that limit current account deficits, strict prudential supervision, and close monitoring of banks’ liquidity positions, is appropriate. The high external liability position, however, underscores the risks associated with potential external imbalances and reduces the room for policy slippages.

41. The authorities have made commendable progress on their privatization program, but agricultural liberalization could be accelerated. The swift divestment of the public stake in banking has already prompted increased sectoral efficiencies and the prospect of telecommunications privatization is welcome. The authorities are encouraged to intensify efforts at agricultural trade liberalization, where distortions, as well as potential efficiency and welfare gains are large.

42. Staff welcomes the duty-free access accorded to imports from least developed countries and encourages the authorities to continue increasing ODA towards to U.N. target of 0.7 percent of GNP. Iceland enjoys a well-recognized international standing for its efforts to fight money laundering, the financing of terrorism, and other financial crime.

43. Given the positive assessment of the FSAP follow-up and the successful correction of earlier macroeconomic imbalances, it is recommended that Iceland return to a 24-month cycle for Article IV consultations.

ANNEX I Iceland’s Demographic and Pension Prospects1

Demographic and pension prospects in Iceland are relatively benign, in comparison to most continental European economies. This largely reflects two factors: the projected increase in Iceland’s old-age dependency ratio is lower than in other economies; and the pension system is firmly based on compulsory fully-funded defined-contribution private pension schemes. Thus, the expected budgetary impact of population aging is expected to be quite limited.2

Iceland’s population is comparatively young, with an old-age dependency ratio below most other European countries, and more similar to those in Ireland, New Zealand, and the United States. Moreover, the projected increase in this ratio is relatively small and is of less consequence in Iceland than in economies with pay-as-you-go pension systems. Additionally, Iceland has relatively high elderly labor force participation rates, reflecting both a high statutory retirement age (67 years for most workers) and high effective retirement ages.

Of equal or more importance is Iceland’s use of a three pillar system. The government provides a basic pension equivalent to about 10 percent of average earnings, and a means-tested supplementary pension, both financed out of tax revenues. The second pillar comprises mainly private pension funds, with mandatory contributions of at least 10 percent of wages, invested in a variety of assets, including an increasing share of foreign claims. Contributions into these (and optional tax-advantaged third pillar supplementary pensions) are presently more than double the pension payments from these funds, resulting in a rapid accumulation of assets, currently in excess of 80 percent of GDP.3 Once these schemes mature, total assets are anticipated to exceed 150 percent of GDP, with pensions equivalent to 50–60 percent of full-time earnings (in addition to the basic pension), thereby leading to a phasing out of public supplementary pensions.

A01ann01ufig11

Old-Age Dependency Ratio

(65+years/15–64 years, in percent)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: International Bank for Reconstruction and Development.
A01ann01ufig12

Pension Fund Assets and Flows

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Central Bank of Iceland

ANNEX II What Explains Iceland’s High Levels of External Indebtedness?1

1. Iceland’s external liabilities and short-term debt has increased rapidly in the past years. Ultimately, low household’s saving rates explain these levels of indebtedness. During the boom years banks resorted to foreign borrowing in other to extend credit to the corporate sector while domestic liabilities were increasingly devoted, directly or indirectly, to household lending.

2. Although as a result Iceland’s external vulnerability has increased, there are some mitigating factors that make external risks manageable. Currency risk lies mainly with organically hedged non-financial corporations—either through direct borrowing or intermediated by banks. Most banks’ foreign borrowing is on-lent to these corporates or invested in foreign assets. Household debt, on the other hand, is denominated mainly in domestic currency and, when in long-term maturities, it is indexed to inflation.

3. This note takes a closer look at the factors behind Iceland’s high levels of indebtedness and provides a brief assessment of the balance sheets of households, and of the corporate and banking sectors.

What do the data tell us?

4 Iceland’s gross external debt has risen sharply since the mid-1990s, more than offsetting the increase in foreign assets (Figure 2.1). As a result, both external debt and net liabilities remain high by historical and international standards representing about 127 and 80 percent of GDP respectively, at end-March 2003.2 Only 2 percent of Iceland’s external debt is denominated in Icelandic krónur.

Figure 2.1
Figure 2.1

Iceland: External indebtedness

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Source: Central Bank of Iceland.

5. Most of Iceland’s gross external debt growth relate to the banking sector (Figure 2.2). External debt of banks has increased more than twofold since end-1999, rising to 67 percent of GDP at end-March 2003, and accounting for about half of total gross external debt. Banks’ foreign currency risk is limited by prudential regulation on open positions and the application by banks of selective criteria for qualifying borrowers, like restricting foreign currency loans to borrowers who are organically hedged.3 By contrast, public external debt has declined as a result of fiscal surpluses and the use of privatization receipts to retire external debt and stood at 31 percent of GDP at end-March 2003. Corporate external indebtedness has also declined, accounting for 28 percent of GDP.

Figure 2.2
Figure 2.2

Estimated External Debt by Sector

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: Central Bank of Iceland; and staff estimates.

6. Short-term debt has increased sharply as percent of GDP, pari passu with total debt, keeping the maturity structure broadly stable (Table2.1). As of end-2002, Iceland’s short-term debt (on a residual maturity basis) was estimated at 52 percent of GDP against 27 percent three years earlier. The highest increase in short-term financing resides within the financial sector where banks owed about 36 percent of GDP in short-term maturities at end-2002 reflecting the increased intermediation of flows facilitated by banks’ access to international capital markets owing to high credit ratings (Table 2.2).

Table 2.1

Iceland: Gross External Debt 1/

(In percent of GDP)

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Source: Central Bank of Iceland

Partly estimated using Central Bank of Iceland data.

Table 2.2.

Iceland: Banks’ Ratings

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Sources: Moody’s; and Fitch.

Maximum rating on long-term is Aaa. Maximum rating on short-term is P-l. Maximum rating on financial strength is A+.

Maximum rating on long-term is AAA+. Maximum rating on short-term is F1+.

7. Iceland’s young population seems to be a key factor explaining its relatively higher levels of indebtedness. Staff estimates—based on work by Lane and Milesi-Ferretti (2001)—suggest Iceland’s age structure alone can account for 60 percent of its higher external liabilities relative to other industrial countries.4 In theory there are several channels through which a younger population can affect net foreign asset positions. For example, countries with younger workforce may save less, given that retirement is still far away, to smooth consumption and invest more, among other things in housing.

Balance Sheets

8. Households. Over the last decade, household balance sheets have changed dramatically, influenced by the spread of indexation of financial instruments and housing benefits. Household debt to the financial system increased from about 80 percent of disposable income at the beginning of the 1990s to an estimated 176 percent at end-2002. Mortgage debt remains the major household liability (around 70 percent of the stock), and although it is indexed, debt servicing costs are still relatively low due to the preferential rates offered by the housing system and pension funds to their members. Correspondingly, housing is the main household asset representing about 66 percent of household’s net worth. Although household debt is relatively high and net worth relatively low compared to other countries (Figure 2.3), household default rates in Iceland have been relatively low in the past, even in times of high nominal interest rates, and income prospects for the near term are positive. A possible factor explaining household balance sheets is the build up of pension assets, representing 88 percent of GDP as of end-2002, which may have induced an increase in household’s leverage.

Figure 2.3
Figure 2.3

Household Wealth and Indebtedness in 2001 1/

Citation: IMF Staff Country Reports 2003, 266; 10.5089/9781451819243.002.A001

Sources: OECD Economic outlook, December 2002, Reserve Bank of New Zealand, Reserve Bank of Australia; and Central Bank of Iceland.1/ As percent of disposable income excl. pension assets.2/ 2000 data.3/ Data on net worth is net financial wealth.4/ Data on debt is house loans.

9. Non-financial corporations. Balance sheets indicators for the non-financial corporate sector are good despite the distress experienced by some companies during 2002 (Table 2.3). During the second half of the 1990s, corporate leverage increased. In fact, measured as percentage of GDP, corporate debt went from 80 percent in 1997 to 120 percent in 2001. However, net worth increased at the same time, and debt-to-equity ratios for listed non-financial sector firms declined in 2002 to levels unseen since 1996. Profitability has continued to be high except for the retail and service sectors, where there has been an increase of corporate bankruptcies reflecting weak economic conditions.

Table 2.3.

Iceland: Corporate Balance Sheet Indicators

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Sources: Central Bank of Iceland; and Lánstraust credit rating agency.

Publicly listed companies (excluding banks).

Earnings before interest, taxes, depreciation, and amortization

10. Banks. Icelandic banks balance sheets are strong:

  • In spite of the economic slowdown banks were profitable in 2002, registering a return on total assets of 1.1 percent and return on equity of 18.1 percent.

  • Banks are also well capitalized and, after bolstering their regulatory capital ratios in 2001 and 2002, they maintain total capital of 12.1 percent and tier-one capital of 9.7 percent of risk-weighted assets.

  • As anticipated, asset quality has deteriorated since 2000, especially in the consumer and retail sector as a result of a weak domestic demand. However, there are signs that the loss phase of the credit cycle may have reached its peak. The accuracy of reported NPLs and the adequacy of loan loss provisions has been verified by the FME through focused on-site examinations that reviewed the loan performance, collateral valuation and provisions in all deposit taking institutions.

  • Foreign currency loans—78 percent of which are to the corporate sector—have performed better than anticipated because of the transitory nature of the depreciation experienced in 2000–01 and the banks’ strict lending criteria.

  • Liquidity risk is limited given the restrictive central bank regulations based on a maturity ladder and involving an overall assessment of the payment structure of all assets and liabilities, including off-balance sheet items.5 The ratio of short-term assets to liabilities with maturity shorter than 3 months was 1.2 as of April 2003.

APPENDIX I Iceland: Basic Data

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

APPENDIX II ICELAND: Fund Relations

(As of April 30, 2003)

I. Membership Status: Joined 12/27/45; Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Payments to Fund:

Under the Repurchase Expectations Assumptions

(SDR Million; based on existing use of resources and present holdings of SDRs)

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VII. Exchange Rate Arrangements: Iceland adopted a floating exchange rate regime for the króna, effective March 28, 2001.

Iceland continues to maintain exchange restrictions pursuant to UN sanctions against Iraq (see EBD/90/242, 7/13/90).

VIII. Last Article IV Consultation:

Discussions for the 2002 Article IV Consultation were held in Reykjavik during March 18–27, 2002. The Staff Report (SM/02/158) was considered by the Executive Board on June 21, 2002 (SUR/02/70). Article IV consultations with Iceland are currently on the 12-month cycle.

IX. Technical Assistance: None

X. Resident Representative: None

APPENDIX III Iceland—Statistical Issues

Iceland’s economic database is comprehensive and sufficient for effective surveillance. Iceland has subscribed to the Special Data Dissemination Standard (SDDS).

Data on a wide range of economic and financial variables are provided to the Fund in a timely manner during and between consultations. In addition to periodic press releases, statistical information is disseminated to the public through a range of monthly, quarterly and annual publications by three main institutions (The Central Bank of Iceland, the Ministry of Finance and Statistics Iceland), and is increasingly available on their internet sites. Provision of electronic data in English has improved substantially in the last year, specially from Statistics Iceland.

Iceland is not yet fully compliant with all SDDS requirements. Non-compliance stems from inadequate coverage of the producer price index. Iceland’s authorities have expressed their intention to address this issue and become fully compliant.

As regards the national accounts data, the authorities shifted to ESA95 in August 2000 and revised the corresponding time series back to 1990. Another revision was carried out in 2002 going back only to 1997.

Iceland’s balance of payments data deviate from the IMF’s Balance of Payments Manual, fifth edition. In particular, the CBI follows the methodology applied by the European Central Bank (ECB) for the calculation of income payable by collective investment institutions (e.g., mutual funds). Unlike the fifth edition of the Fund’s Balance of Payments Manual, the ECB’s methodology includes portfolio investors’ shares of retained earnings in the balance of payments statement.

Iceland: Core Statistical Indicators

(As of July 17, 2003)

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APPENDIX IV Iceland—Sustainability Exercise

External Sustainability

Iceland’s external debt level is high both by historical and international standards—specially in regard to the net international investment position—with the bulk of it corresponding to the private sector. Gross external debt stood at 131 percent of GDP at end 2002 (in US dollars), with government debt accounting for about 33 percent of GDP (Table A1). A significant part of the volatility of the debt-to-GDP ratio in 2000–02 was due to valuation effects (as the krona first depreciated steeply and then partly recovered)—which illustrates Iceland’s vulnerability during an episode of exchange rate volatility. The likelihood of a repetition of such a pronounced exchange rate correction was diminished with the adoption of inflation targeting and a floating regime in 2001. Stabilization of the krona in 2003 at close to current levels is envisaged to result in a significant year-on-year appreciation and, with the projected small current account deficit, a decline of the gross debt-to-GDP ratio to about 111 percent by end-2003.

Under the baseline projection, staff expects that the external debt-to-GDP ratio will continue declining to about 96 percent by 2008. This evolution is the result of high output growth rates—in turn, stemming from large investment projects financed mainly through non-debt creating foreign direct investment—and a stabilization of the private sector saving ratio around its historical level, to which it recovered in 2002.

The external debt sustainability exercise was performed following standard cross-country methodology. In this context, the stress tests should be understood as representing extreme situations and not necessarily likely scenarios. The results show that among the standard stress tests, those that set variables at their historical averages or postulate a large and sustained depreciation have the most negative consequences in debt levels. The former result is not surprising, as most of the outstanding debt was in fact built up during the last five years, which dominate the averages. The result indicates that a repetition of the trends that prevailed during the past consumption boom would have seriously deleterious effects on the external debt position. Finally, the relatively lesser impact of a raise in interest rates of two standard deviations reflects the high credit ratings of Iceland, which have allowed it to borrow at a minimal premium over LIBOR and therefore, at low and stable rates.

Fiscal sustainability

The solvency of the public finances in Iceland has not been a cause of concern. Past budgetary surpluses and allocation of privatization proceeds to retire public debt have resulted in gross general government debt of 43 percent of GDP at end-2002, with net debt at 25 percent. The fiscal sustainability exercise confirms this benign assessment with the stress tests indicating quite manageable debt levels, even in extremely adverse scenarios (Table A2).

Table A1.

Iceland: External Debt Sustainability Framework, 1993–2008

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(l+g) + εα(1+r)]/(l+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(l+g) + εα(l+r)]/(l+g+ρ+gρ) times previous period debt stock, p increases with an appreciating domestic currency (ε>0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

Table A2.

Iceland: Public Sector Debt Sustainability Framework, 1993–2008

(In percent of GDP, unless otherwise indicated)

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Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.

Derived as [(r-π(l+g) - g + αε(i+r)]/(l+g+π-gπ)) times previous period debt ratio, with r = interest rate; π = growth rare of GDP deflator; g = real GDP growth rate; α = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r-π(l+g) and the real growth contribution as -g.

The exchange rate contribution is derived from the numerator in footnote 2/ as αε (1+r).

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debt at end of previous period.

Derived as nominal interest expenditure divided by previous period debt stock.

Real depreciation is defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
1

The HFF is a public entity that provides mainly residential mortgages financed with government-guaranteed long-term inflation-indexed bonds. The HFF does not receive budget support, although it passes to borrowers the interest savings from lower risk premia.

2

Staff estimates that the real policy rate was 2.9 percent in June 2003. The CBI typically gauges the real policy stance as the difference between the 14-day repo rate and the market-determined inflation premium on available up to 5-year Treasury maturities. On this measure, the real policy rate stood at 2.7 percent.

3

In March and April, 2003, the CBI implemented changes in liquidity reserve requirements—aiming to bring them in line with international practices—equivalent to a release of banks’ reserves of about 1 percent of GDP. This liquidity was offset by lower repo liquidity demand, but was expected to have an easing impact though lower lending rates and interest rate margins.

4

The 2001 tax reform covered cuts in personal and corporate income and wealth taxes, as well as a number of other smaller items, phased in during 2002–03 (SM/02/167).

5

Staffs cross-country analyses supported the view that the deviation of Iceland’s international investment position with respect to comparable economies was largely explained by demographic factors (Annex II).

6

In 1990–2002, household gross debt increased from 80 percent to 176 percent of disposable income, while net worth (including pension fund assets) increased from 287 percent to 298 percent. Households’ leverage, however, also increased.

7

The standard stress tests performed explore the evolution of external gross debt under relatively extreme, not necessarily likely scenarios.

8

The proportion of quota rights held by the largest 10 fishing companies increased from 27 percent in 1995 to 53 percent in 2002.

1

Prepared by Mark Lutz.

2

Health care expenditures, however, may face aging-related pressures.

3

The government has made additional contributions in recent years to fund projected liabilities to the old, pay-as-you-go public sector pension system, while newly hired employees (and those opting to switch from the old system) pay into a fully-funded scheme. It is expected that 25 percent of government liabilities will be funded by the end of 2003.

1

Prepared by Marialuz Moreno Badia.

2

Net liabilities are measured as the negative of the net international investment position (IIP).

3

Total foreign exchange exposure is capped at 30 percent of capital by regulation. For each currency, the exposure is limited to 15 percent, except for the U.S. dollar and the euro which have a limit of 20 percent. Moreover, regular capital charges also apply.

4

Lane, Philip R., and Milesi-Ferretti, Gian Maria, 2001, “Long-term Capital Movements,” IMF Working Paper 01/107 (Washington: International Monetary Fund Working Paper). In their model, shifts in relative output levels, the stock of public debt and demographic factors explain the evolution of net foreign asset positions. If all these factors are considered, Iceland’s actual data fall within the 95 percent confidence interval of the simulated model.

5

Four time bands are defined: liquid within 1 month, 1–3 months, 3–6 months and 6–12 months. Banks must evaluate all assets and liabilities within each bracket with respect to the ease and security of liquidating them. The requirement is that liquid claims shall be greater than liquid liabilities in the first two brackets. Liquidity of 3–12 months is monitored but no special levels are required.

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Cover IMF Staff Country Reports
Iceland: Staff Report for the 2003 Article IV Consultation
Author:
International Monetary Fund
Volume/Issue:
Volume 2003: Issue 266
Publisher:
International Monetary Fund
ISBN:
9781451819243
ISSN:
1934-7685
Pages:
58
DOI:
https://doi.org/10.5089/9781451819243.002

Iceland: Real GDP Growth—International Comparisons, 1996–2001

(in 1995 USS, PPP exchange rates, average annual growth rates)

Output Growth and Current Account

(In percent)
Figure 1.

Iceland: Soft Landing
Figure 2.

Iceland: Economic Developments 1980–2002
Figure 3.

Iceland: Exchange Rate and Competitiveness
Figure 4.

Iceland: Activity Indicators
Figure 5.

Iceland: Inflation and Wage Developments
Figure 6.

Iceland: Interest Rate Developments
Figure 7.

Iceland: Money, Credit and Liquidity Operations

Nominal Effective Exchange Rate and Consumer Prices 1/

(12-month percent change)

Iceland: Real Short-Term Interest Rates1
Figure 8.

Iceland: Income and Asset Prices

Iceland: Real (CPI-Deflated) Wage Indices

Iceland: Real Asset Prices

(Indices)
Figure 9.

Iceland: Fiscal Developments

Iceland: Gross External Debt and Net International Investment Position International Comparisons 1/

(As percent of GDP)

Sectoral Profitability

(Gross profits as percent of revenue)

Iceland: Stock Market Indices

(August 2001 = 100)

Iceland: Measures of Competitiveness

(Indices, 1990 = 100)

Old-Age Dependency Ratio

(65+years/15–64 years, in percent)

Pension Fund Assets and Flows

(In percent of GDP)
Figure 2.1

Iceland: External indebtedness

(In percent of GDP)
Figure 2.2

Estimated External Debt by Sector

(In percent of GDP)
Figure 2.3

Household Wealth and Indebtedness in 2001 1/