ICELAND Staff Report for the 2005 Article IV Consultation

Iceland’s 2005 Article IV Consultation reports that new projects have rekindled rapid growth and the economy is exhibiting signs of overheating, with imbalances evident in inflation, the current account, and external debt. GDP grew at an average rate of 3.8 percent between 1995 and 2004, second only to Ireland among industrial countries. Major investment projects have contributed both to the high growth rate and to overall macroeconomic volatility because of their size relative to that of the economy.


Iceland’s 2005 Article IV Consultation reports that new projects have rekindled rapid growth and the economy is exhibiting signs of overheating, with imbalances evident in inflation, the current account, and external debt. GDP grew at an average rate of 3.8 percent between 1995 and 2004, second only to Ireland among industrial countries. Major investment projects have contributed both to the high growth rate and to overall macroeconomic volatility because of their size relative to that of the economy.

I. Introduction

1. Economic growth in Iceland has been impressive over the last decade. GDP grew at an average rate of 3.8 percent between 1995 and 2004, second only to Ireland among industrial countries. As a result, Iceland’s GDP per capita is now 84 percent of that in the United States. This success arises from a combination of factors that unfolded throughout the 1990s: major investment projects in the energy and aluminum-smelting sectors that helped diversify the economy and build export capacity; wide-ranging market liberalization and privatizations; and fiscal consolidation. The structural reforms implemented throughout the 1990s, the floating of the currency and the adoption of inflation targeting in 2001, and significant improvements in financial sector supervision introduced in the early 2000s have also helped improve the economy’s resilience. This was illustrated by the relatively soft landing achieved in 2002, as the large imbalances from the investment boom of the late 1990s were resolved.


Average Real GDP Growth, 1995–2004

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001


GDP per Capita Relative to U.S. 1/

(PPP terms)

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

1/ Normalized relative to a U.S. value of 1.Source: World Economic Outlook.

Output-Growth and Inflation Variability

(standard deviation from sample mean, 1995–2004)

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

2. While average growth has been strong, macroeconomic volatility has been pronounced. Both inflation and output-growth variability in Iceland have been notably higher than in other industrial countries. The major investment projects have contributed both to the high growth rate and to overall macroeconomic volatility because of their size relative to that of the economy. In addition to their direct effect on investment spending, the income and employment effects stimulate consumption, adding to upward pressure on the exchange rate and inflation. After the peak of the investment cycle has been passed, the unwinding of the built-up imbalances results in sharp adjustments in domestic demand, the demand for imports, the exchange rate, and inflation. These features of the Icelandic economy pose significant challenges for macroeconomic policy aiming for both growth and stability.1

3. Following the recession in 2002, new investment projects have rekindled rapid economic growth and imbalances have reemerged. After declining by 2.1 percent in 2002, GDP grew by 4.2 percent in 2003 and a further 5.2 percent in 2004. The direct effect of the investments and their indirect effect on consumer confidence generated total domestic demand growth of close to 8 percent in both 2003 and 2004. The extensive use of foreign labor in the construction phase of the projects helped to limit labor market pressures. In addition, the slack in the goods market initially accommodated growth. However, the slack was quickly exhausted, and imbalances have started to emerge in the current account, external debt and—albeit to a more modest extent than in previous episodes—inflation (Figure 1).

Figure 1.
Figure 1.

Iceland: Macroeconomic Indicators

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

Sources: Central Bank of Iceland; Directorate of Labor; Ministry of Finance; Statistics Iceland; and staff calculations.1/ In May, the methodology for calculating the user cost of housing in the CPI changed. Moving to a 12-month moving average of interest rates from a 5-year moving average reduced y-o-y CPI inflation by roughly 0.5 percentage points.

4. After recovering to a small positive balance in 2002, large current account deficits have reemerged. As the investment projects require significant imports of capital goods, the reversal in the current account was to be expected. However, the additional contribution of imported consumption goods has been stronger than anticipated. The current account deficit is now forecast to peak at 12 percent of GDP in 2005, double that forecast at the time of the last Article IV consultation. In part, the increase reflects an upward revision to the size of the projects and the share occurring during the peak year. However, a significant portion also reflects the buoyant response of households to their improved prospects.

Decomposition of the Current Account in Percent of GDP

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Sources: Central Bank of Iceland.

5. External liabilities have increased sharply, primarily reflecting banks’ use of foreign borrowing to fund domestic credit expansion. Preliminary data show that the net external debt-to-GDP ratio increased from 98 percent in 2003 to 122 percent in 2004. In 2004, banks’ lending to households grew by 98 percent and that to firms by 30 percent. Although banks’ net external debt has risen sharply, limits are enforced on their open currency positions. Consequently, banks intermediate a large volume of foreign currency-denominated lending. While a significant portion of this goes to firms with foreign currency revenue streams, banks have also been increasingly extending foreign currency loans to domestic firms (although not in significant amounts to households) without such a natural hedge. The increase in banks’ external liabilities also reflects their expansion abroad, principally to other Nordic countries and the United Kingdom. Encouragingly, banks’ credit ratings have been improving over the last two years owing to their strengthening financial position. Capital adequacy ratios have been increasing well above required minimums, profitability has been high (in particular reflecting a stock market boom over the last year), and default rates are low and declining (Figure 2).

Figure 2.
Figure 2.

Iceland: Banking Sector Developments.

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

Sources: Bloomberg, Central Bank of Iceland, FME, and Statistics Iceland.1/ICEX Main is an all-share index while ICEX 15 is calculated for the 15 largest and most traded companies.2/ As a percent of loans to households.3/ As a percent of total loans.4/ As a percent of loans to industry.

6. In August 2004, banks began to compete with the Housing Financing Fund (HFF) for first mortgages, thereby accelerating the rate of expansion in household credit. Prior to August 2004, the publicly guaranteed HFF dominated the first-mortgage market, and banks primarily provided the second mortgages required by households because of HFF lending limits. In the summer of 2004, banks saw an opportunity to enter the market when the HFF started issuing noncallable housing bonds directly to the market and offering mortgage loans at a fixed spread above the cost of finance. Given the increased transparency and the magnitude of the spread, banks matched loan rates, plus offered larger mortgages, higher loan-to-value limits, and the option to refinance existing mortgages, allowing equity withdrawal. Consequently, banks were able to quickly capture a large share of the market and HFF mortgages were prepaid in significant amounts. In response, the government accelerated reforms at the HFF to raise loan limits.

7. Inflation exceeded the upper bound of the central bank’s target range in early 2005, but has since moderated. In February, with year-over-year CPI inflation at 4.5 percent, the central bank was obliged to submit a report to the government outlining why inflation had breached the 4 percent upper bound and the prospects for returning it to target (Figure 3). Domestic demand pressures, most notably in the housing market, were cited as the main factor underlying high inflation. In May, Statistics Iceland changed the methodology for calculating the user cost of housing in the CPI. The new methodology uses a 12-month moving average of real mortgage rates rather than the previous five-year moving average. With real mortgage rates declining between August and November 2004, this change, along with developments in food prices, resulted in year-on-year CPI inflation of 2.9 percent in May, considerably below the 4.3 percent reported in April.2 However, underlying inflationary pressures remain strong as reflected in year-on-year CPI inflation of 3.5 percent in July.

Figure 3.
Figure 3.

Iceland: Inflation

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

Sources: Central Bank of Iceland, Statistics Iceland, and staff estimates.1/ Policy rate deflated by the CPI.

Components of Inflation as of July 2005

(In percent)

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

8. The central bank has responded decisively to accelerating inflation. Since May 2004, the policy rate has risen from 5.3 percent to 9.5 percent. However, because of the acceleration in inflation, the real policy rate has increased more slowly, only recently rising above the upper end of the range estimated for the neutral real rate. In spite of the policy tightening, increased competition and related developments in the mortgage market over the last year have led to a decline of roughly 150 basis points in effective long-term real mortgage rates. Although mortgages are indexed to the CPI, the resulting increase in servicing costs from higher inflation is small because the impact is spread over the remaining life of the mortgage.3 The policy tightening has been reflected in the krona trade-weighted exchange rate index, which has appreciated by 10 percent over the last year.


Policy Rates

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

1/ Deflated by CPI.

9. The fiscal stance has been tightened in 2004 and 2005, but the planned tax cuts will make for a broadly neutral stance going forward. The general government balance shifted from a deficit of 1 percent of GDP in 2003 to an estimated surplus of 0.4 percent in 2004. General government nominal expenditure growth exceeded that budgeted by 4 percentage points in the last year, with the largest slippages occurring at the local level. However, these slippages were more than offset by faster-than-budgeted revenue growth. For 2005, the budget contains additional restraint, with the most recent ministry forecast estimating a surplus of 0.9 percent of GDP, virtually the same as the staff’s. Based on the multiyear spending targets, no significant further tightening will occur in 2006. A permanent reduction of 1 percentage point in labor income taxes took effect in January 2005, and additional reductions have been announced for 2006 and 2007. Permanent tax reductions can be introduced because of the extended period of prudent fiscal management, as illustrated by the low and declining ratio of general government debt to GDP, which stood at 23 percent at end–2004.

General Government, 2000-06

(in percent of GDP)

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Source: Ministry of Finance; and staff estimates.

In percent of potential GDP.

Implementation of Past Fund Policy Advice

The authorities have generally followed policies consistent with Fund advice, most particularly in the structural and institutional areas (market liberalization, privatization, monetary policy framework, and financial sector reform). In particular, the 2001 Financial Sector Assessment Program (FSAP) served as the basis for strengthening the legal framework for the financial supervisory system and establishing standards for risk control and risk management for the payments system. On fiscal policy, introducing multi-year spending targets into the budget was consistent with Fund advice on strengthening the medium-term framework. However, there has at times been less agreement with the advice on the appropriate cyclical fiscal stance.

Regarding the effectiveness of Fund surveillance, the authorities noted that the enhanced transparency of the IMF and the publication of the concluding statements were welcome developments. At the same time, a slower turnover in mission team members would ease resource costs of consultations.

Public information notice (PIN) following 2003 Article IV consultation is available on the web at

II. Report on the Discussions

10. With large imbalances emerging and likely to grow, discussions centered on ensuring that appropriate policies were in place to help contain the imbalances and their associated risks, and limit their reemergence beyond the current cycle. There was agreement that the flexibility arising from wide-ranging structural reforms, a profitable and well-capitalized financial sector, and sound public finances were likely to have increased the economy’s resilience, as testified by the relatively smooth unwinding of imbalances in 2002. Nonetheless, staff stressed that enhancing macroeconomic stability should be a central policy objective and accordingly focused the discussions on the following:

  • achieving a tighter fiscal stance than currently envisaged over the remainder of the cycle;

  • ensuring that the rapid expansion in external liabilities and domestic credit does not intensify vulnerabilities that will amplify the downturn once investment slows; and

  • modifying the inflation-targeting and the medium-term fiscal frameworks to help limit the extent to which imbalances develop when large shocks hit the economy.4

A. The Outlook and Risks

11. There was broad agreement that growth will be robust and imbalances will persist throughout 2005-06. Staff and the authorities forecast GDP to grow by roughly 6 percent in 2005, driven by domestic demand. Project-related investment will peak in 2005, with the associated confidence and income effects on consumption amplified by the easing in mortgage credit conditions and cuts in labor income taxes. The current account deficit is forecast to be 12 percent of GDP in 2005. In 2006, growth is expected to ease, in part reflecting an anticipated further tightening in monetary policy. Higher interest rates and rapidly rising household debt levels are expected to moderate consumption growth and investment is forecast to decline from its project-related peak—although the share of investment in GDP will remain well above normal. While the level of imports is expected to remain high, given investment and consumption demand, net exports will contribute positively to growth in 2006, as some of the aluminum sector investments become productive and the fishery sector continues to redirect its output toward higher-value-added products and markets. Little improvement is expected in the current account deficit in 2006, as the narrowing of the trade deficit will be partially offset by a deterioration in the income account, owing to the rapidly growing stock of foreign debt and the expected gradual rise of foreign interest rates.

Contribution to Growth in Percent of GDP

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Source: staff estimates.

12. The authorities and staff both project inflation to remain well above the central bank’s target through 2005-06. Both the central bank and the staff forecast that strong growth will overheat the domestic economy and generate above-target inflation. The finance ministry, however, sees only modest excess demand pressures and attibutes inflationary pressure mainly to an expected gradual króna depreciation. This difference arises because the ministry forecasts a rapid increase in aggregate supply from a strong labor supply response to the tax cuts and the immediate addition of investment flows to the effective capital stock. Staff expect the labor supply response to be more modest because Iceland’s labor force participation rate of 81 percent is high by all standards; furthermore, for the group aged 16 to 24, which has a relatively low participation rate, the tax cuts increase the incentives to acquire more education. Furthermore, it seems prudent to add investment flows to the capital stock only after the associated plant and equipment become fully productive.


Labor Force Participation Rates

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

1/ Total for ages 16–74.

13. Beyond 2006, the shared outlook is for growth to slow to close to its potential rate, with staff, however, pointing to appreciable risks of a less benign outcome. Although private consumption is expected to continue to be supported by strong income growth, investment will return to a normal level with the completion of the projects. More of the increased aluminum capacity will then be productive, and the reequilibration of the exchange rate is expected to stimulate exports and dampen imports. Consequently, the current account deficit is forecast to narrow sharply in 2007 and then exhibit a gradual improving trend beyond. The slowing in aggregate demand is forecast to result in modest excess supply, which, in combination with a slowing in house price appreciation due to the response of housing supply, will bring inflation back to target. This baseline view assumes that the increased flexibility in the Icelandic economy, not least of all in the exchange rate, will allow the built-up imbalances to be resolved in an orderly fashion. Staff, however, saw considerable risk of a less benign outcome, whose preemption provided the motivation for its policy advice.

14. While there was broad agreement on the central scenarios, there was a different appreciation of the balance of risks. In the near term, staff viewed the risks to be on the upside, in terms of persistent overheating pressures, with—in contrast—considerable downside risk of slower growth later on. Staff argued that, given the easing in credit conditions, households could respond more than forecast to their improved income and wealth positions, thereby widening the imbalances—a concern shared by the central bank. In addition, staff stressed that relying primarily on monetary policy to contain demand pressures, as the currently expected policy mix does, risks further exchange rate appreciation and a greater-than-forecast widening of the external imbalances. Staff observed that once the investment projects have been completed, the extent of the downside risk would be related to the magnitude of the built-up imbalances. A sharp correction in the currency, possibly sparked by the scale of the imbalances or disorderly conditions in international capital markets, could then produce a much larger retrenchment than expected in domestic demand, particularly in light of the high and rapidly growing level of foreign indebtedness. The finance ministry contended that the increase in debt-servicing costs from the growing household debt burden would provide a natural brake on consumption, limiting risks in both the near and long term.

B. Fiscal Policy

15. Although the fiscal stance has tightened as growth has accelerated, no additional tightening relative to the multiyear plan in the 2005 budget is currently envisaged. With projections of general government surpluses during 2005-06 of less than half of the average achieved over 1999–00, the peak years of the previous investment-led boom, staff called for a tighter fiscal stance, as outlined in the text table. With the forecast for higher growth and wider imbalances than when the 2005 budget was drawn up, staff saw a strong case for additional fiscal restraint. The authorities’ view was that the fiscal stance did not need to be as tight because the structural change in the economy since the previous boom had increased its resilience. In addition, the authorities noted that the 2005 fiscal surplus would likely be larger than the most recent projection because tax receipts were running above forecast. Given that the main surprises were in value-added tax receipts and stamp duties on housing transaction, staff suggested that this could point to greater-than-projected demand pressures.

General Government, 2005-06 - Suggested Measures

(in percent of GDP)

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Source: Staff estimates.

In percent of potential GDP.

16. Views differed on whether the labor supply response to the tax cuts would prevent them from adding to the overheating. The staff advised that the tax cuts planned for 2006 and beyond be postponed until it was clear that excess demand conditions had dissipated fully. Staff reasoned that the tax cuts would contribute to overheating, particularly in light of the increased availability of low-cost finance (Box 2). The authorities expected that a strong labor supply response to the tax cuts, estimated at 800 people a year through 2005-07, would satisfy the additional demand. Staff expected, however, that the labor supply response would be more modest.5

The Effect of Permanent Tax Cuts


MULTIMOD Simulation: Permanent Reductions in Labor Income Taxes

(percent or percentage point deviation from baseline)

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

A permanent reduction in labor income taxes is simulated in MULTIMOD under two assumptions about the proportion of liquidity-constrained households (solid line 40 percent and dotted line 10 percent).1 The path for the tax cut replicates that announced for Iceland starting in 2005 (1 percentage point in 2005,1 percentage point in 2006, and 2 percentage points in 2007). Government spending is permanently reduced to sustain the tax cut. These simulations illustrate how the tax cut may contribute to the projected short-term overheating in the economy, and how the developments in the mortgage market in Iceland, which have reduced the proportion of liquidity-constrained households, may amplify these effects.

1 Selected issues paper, “Some Illustrative Simulations of the Potential Impact of Income Tax Cuts in Iceland”.

17. There was more agreement on the scope for reducing government expenditures, particularly public investment. The authorities noted that public investment projects scheduled for 2005-06 could be postponed without impeding the economy’s supply capacity. Because the multiyear spending targets for public consumption are formulated in real terms and then converted to nominal terms using the CPI forecast, nominal public consumption is projected to grow at above 7 percent in 2005-06. Staff argued that more modest increases would be both possible and advisable, pointing to the introduction or expansion of user fees in health care and education as a possible option. In addition, staff noted that the risk of stronger-than-expected municipal spending in the run-up to the local elections in early 2006 strengthened this case. Without agreeing on the specific measures, the authorities concurred that reducing the growth in public consumption could be considered, especially if economic indicators suggested more overheating than currently forecast.

18. The authorities were receptive to staff recommendations for strengthening the medium-term fiscal framework. Although the debt sustainability analysis presented in Appendix II indicates that fiscal policy is on a sound footing from a medium-term perspective, staff saw a stronger role for fiscal policy in supporting monetary policy and helping to reduce overall macroeconomic volatility. It recommended that the multiyear pending targets be specified in nominal—rather than real—terms at the general government level and that central and local governments cooperate more closely to ensure that slippages do not occur. Nominal spending targets, it noted, were more transparent, enforceable, and consistent with the inflation-targeting framework. The authorities agreed that closer cooperation between levels of governments would be beneficial, but noted that local governments highly valued their independence and would resist spending constraints imposed by the central government. They noted that although nominal spending targets had several positive features, the indexing culture was strong in Iceland because of the experience of high inflation in the 1970s and in the 1980s and that such a change would need to be implemented gradually. Staff also called for the introduction of a rules-based system to derive the multiyear spending targets to ensure the simultaneous achievement of the government’s medium-term debt target and a consistently countercyclical fiscal stance.6 The authorities saw merit in introducing such a system to guide the medium-term fiscal framework.

19. The authorities noted that the privatization of Iceland Telecom was proceeding as planned. They indicated that they had strived to ensure an open and transparent process. Proceeds from the sale, a significant portion of which the authorities anticipate will go to debt reduction, are expected to be higher than the ISK 35–40 million sought in 2001. Staff encouraged the authorities to use the entire proceeds for debt reduction.

C. Monetary Policy

20. The shared view was that the pace of monetary tightening over the last year has been appropriate. Although overheating in the housing market has been one of the main reasons for above-target headline inflation, the decisive monetary policy response was appropriate for several reasons. First, the central bank’s mandate specifies the inflation objective in terms of headline CPI including housing. Second, because headline CPI is used to index mortgages, house price inflation has important long-term implications for household welfare. Third, excess demand conditions in the housing market are often a leading indicator of general demand conditions, and forward-looking monetary authorities need to respond to such indicators.

21. There was agreement that, although temporary factors had recently lowered CPI inflation, persistent inflationary pressures were still strong and further increases in the policy rate were likely. Three key factors that had temporarily lowered CPI inflation were pointed out: revisions to the methodology for computing the user cost of housing (see para 7);7 a price war among discount food stores; and the pass-through of the exchange rate appreciation. The revision to the CPI methodology—given base effects—is not expected to have a downward impact on inflation beyond November 2005. While the food price competition effect was expected to be short-lived, the exchange rate pass-through could continue for the remainder of the year. However, the central bank expected that despite these temporary factors, excess demand conditions would continue to exert upward pressure on inflation.

22. The developments in the mortgage market were seen by all to be forcing the central bank to rely more heavily on the exchange rate channel for monetary transmission. The monetary authorities emphasized that even though long-term mortgage rates had been falling and credit availability increasing while the policy rate was rising, monetary policy was not impotent. At the same time, they recognized the increase in downside risk further out, inherent in relying heavily on the exchange rate channel, especially in the absence of a tighter fiscal stance.

23. Staff suggestions for improving the monetary policy framework were well received. The authorities noted that inflation expectations continue to be based heavily on actual outcomes. Staff suggested two changes that could help anchor inflation expectations. First, in addition to the current practices associated with the publication of the quarterly Monetary Bulletin, a preannounced schedule for the intervening monetary policy meetings could be introduced. These meetings would also conclude with a public statement of the central bank’s decision regarding interest rates. This would increase the public profile of monetary policy, enhance transparency, and help formalize the communications and decision-making process within the central bank. Second, the Monetary Bulletin could include a scenario based on an interest rate path that the central bank viewed as necessary to return inflation to target. In response, the central bank noted that they did conduct regularly scheduled monetary policy meetings; however they agreed that the staff recommendations could prove helpful.

24. The authorities and staff concurred that controlling inflation was more difficult in Iceland than in many other inflation-targeting countries and discussed possible measures to address this. Empirical analysis presented by staff suggested that inflation was more likely to be outside the Icelandic central bank’s tolerance band than for a larger inflation-targeting country like Canada (Box 3). The staff discussed with the authorities the relative costs to credibility of being outside the band versus operating within a wider band. The authorities felt that the recent episode of inflation outside the band had not been costly to credibility and were reluctant to risk the potential cost of widening the range, especially given the relative newness of the framework. Staff suggested that targeting a price index that removed some volatile components—such as food and energy prices, as has been done in other countries—could help address the issue. The authorities agreed, but noted that it would be important to wait until headline inflation had been firmly reanchored to the target before changing the targeted index.

Achievable Inflation and Output Variability in Iceland


Efficient Monetary Policy Frontiers

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

The efficient policy frontiers for Iceland, the United States and Canada suggest that the inflation-output variability tradeoff faced by the monetary authorities in Iceland is considerably less favorable than that faced by either Canadian or U.S. authorities. This reflects the small size of the Icelandic economy relative to the magnitude of the economic shocks to which it is subjected.

The frontiers are constructed by using estimated macroeconomic models of these countries to examine simple efficient monetary policy rules for Iceland.1

1Selected issues paper, Simple Efficient Policy Rules and Inflation Control in Iceland.

D. Competitiveness

25. Even allowing for the uncertainty about its equilibrium level, there was broad agreement that the real effective exchange rate was modestly overvalued. Expectations were that the overvaluation, which long-term averages suggest is in the 10 to 15 percent range, would gradually dissipate as investment and interest rates returned to more normal levels. The authorities noted that, although the level of the exchange rate was squeezing profits in some sectors, most export-oriented companies were becoming adept at adjusting to exchange rate fluctuations. For example, the fisheries have been very effective at adopting processing techniques that increase value added and allow them to direct their output toward markets where prices were high. There have been some fish-processing plant closures, but the authorities saw this as a required rationalization that was being accelerated by the current exchange rate level. Furthermore, these closures were not raising employment concerns as there will be job opportunities in some of the affected areas at the new aluminum facilities. Regarding economywide competitiveness, discussions with labor and employer federations suggested that the parties to the private sector wage agreements will act responsibly, as they have in the past, when deciding whether the current multiyear wage agreements should be reviewed in November 2005.

E. Financial Sector

26. Financial Supervisory Authority (FME) officials observed that stress tests and other indicators suggested that the financial sector was sound, despite the rapid pace of credit expansion. In aggregate and by institution, the major banks would continue to meet minimum capital adequacy standards if bond and equity prices were to fall sharply and defaults increased substantially. Given the recent large increase in equity and house prices, FME officials also noted that they would be implementing more stringent tests in these areas. Staff asked about progress on the ongoing work related to exchange rate and interest rate stress tests, which are becoming increasingly important because of the rapidly growing levels of external, household, and firm debt, a large portion of which is foreign-currency denominated (Box 4, Figure 4). Regarding exchange rate stress tests, FME officials noted that, in cooperation with the central bank, they had compiled a preliminary data set that would allow them to examine the vulnerabilities presented by banks’ indirect exchange rate exposure. Work on interest rate stress tests was still in a preliminary phase. FME officials expressed some concern about recent developments at the HFF, which they now supervised. With the HFF relying extensively on noncallable bonds for funding and prepayments running high as a result of banks’ entry into the mortgage market, the HFF is lending excess funds to banks. This is not a legislated core activity for the HFF, and its capital adequacy requirements do not reflect the risk of such activities. FME officials stressed the need for the government to quickly address this issue.

Iceland’s Corporate Leverage

Icelandic firms’ debt has risen sharply since the mid-1990s, reaching more than 160 percent of GDP in 2004. Since high leverage can contribute significantly to corporate distress in the presence of macroeconomic shocks, it is important to verify whether these rates are Iceland-specific and identify driving forces. Using a unique data set on corporates, the staff finds that, irrespective of the measure of leverage used, Icelandic firms are more leveraged than in other Nordic countries, both throughout the sample (1995–2003) and across industries.1 Further analysis shows that there may be fundamental reasons for this finding. Specifically, the tax regime, which until recently has been more beneficial to debt than to equity issuance, and the industrywide degree of internationalization, as measured by the ratio of exports to production, seem to have a particularly strong impact on leverage in Iceland.


Corporate Debt 1968–2004 1/

(in percent of GDP)

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

1/ New classsfication of lending from 2003.Source: Central Bank of Iceland.

Leverage Measures Medians

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

1Selected issues paper, “Corporate Leverage: How Different is Iceland?”
Figure 4.
Figure 4.

Iceland: Households and Firms’ Balance Sheets

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

Sources: Central Bank of Iceland.1/ Deflated by CPI.2/ Household debt decreased in 2003 as a result of loan reclassification. Adjusted data not available prior to 2003.3/ Debt as percentage of equity.4/ 2004 data as of June.5/ Listed companies.6/ Earnings before interest, taxes, depreciation, and amoritization.

27. It was agreed that the entry of banks into the mortgage market was a positive development, and that the HFF should be reformed to ensure that this presence could be sustained. To diversify their assets and increase the stability of earnings, domestic banks need to increase their share of the mortgage market. Starting in August 2004, banks have begun to do so, competing directly with the HFF for first mortgages (Box 5). However, as the HFF enjoys a public guarantee, it is not clear whether banks will be able to sustain this activity on a profitable basis without taking on excessive risk on the funding side. Given the country’s level of wealth and high rate of homeownership, staff questioned the need for a publicly backed retail mortgage finance institution such as the HFF. The authorities noted that, in addition to ensuring access to homeownership regardless of income or region of residence, the HFF served two other important functions. First, because Iceland is so small, having a single entity securing the funding allows for economies of scale that help ensure low-cost mortgage finance. Second, having a single institution issuing housing bonds has increased those bonds’ international profile, ensuring a liquid market for domestic-currency-enominated bonds. Staff suggested, and the authorities agreed, that the HFF could be reformed in such a way that banks could profitably remain in the mortgage market, thereby increasing financial stability, while still retaining the positive features of the current system.

Mortgage Market Developments in Iceland1

In 2004, the publicly-guaranteed Housing Financing Fund (HFF) reformed its mortgage financing and increased its lending limits, in part in response to the entry of commercial banks into the mortgage market. As a result, mortgage lending increased sharply and real mortgage rates declined substantially. New possibilities to refinance and withdraw equity have contributed to the demand pressures in the economy, with spill-over effects on the housing market, residential construction, and household debt.


House Prices and Construction Cost

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

1/ Deflated by CPI.Source: Statistics Iceland.

Household Debt

Citation: IMF Staff Country Reports 2005, 367; 10.5089/9781451819304.002.A001

Source: Central Bank of Iceland.

Few countries provide public support through the mortgage system to the extent that is done in Iceland today, with interest rate subsidies for single-family housing generally focused on social needs. The recent developments in the Icelandic mortgage market might constitute a golden opportunity for reform of the HFF, aimed at maintaining the benefits of the current system while also allowing for banks to remain profitably in the mortgage market.

1 Selected issues paper, “Mortgage Market Developments in Iceland and the Role of the Housing Financing Fund.”

F. Other Issues

28. Statistics Iceland officials and staff discussed the motivation for the change in the CPI methodology introduced in May. Officials indicated that moving to a shorter moving average of interest rates was more consistent with the objective of capturing the spot user cost of housing. Initially, the longer moving average was used to avoid the possibility that interest rate volatility would induce excess volatility in the CPI. However, real mortgage rates have turned out to be less variable than expected, and the decision was made to shorten the averaging period. While agreeing with the theoretical motivation for the change, staff raised concerns about the timing and the lack of preannouncement. Officials agreed that these were important considerations and in the future such changes would be announced well in advance. Furthermore, they saw the merit of keeping such methodological changes to a minimum.

29. Official development assistance (ODA) is targeted to increase from an expected 0.21 percent of GNP as of end-2005 to 0.35 percent in 2009. The authorities noted that one of the greatest challenges with ODA was ensuring that it effectively alleviated poverty. To that end, they have increasingly been focusing on specific projects, and because it has worked well, plan to continue with this approach.

30. A successful conclusion to the Doha round would be welcomed by the authorities. It was noted that this would likely imply a reduction in agricultural subsidies and trade protection. Although agricultural subsidies were politically important in Iceland, the authorities expressed confidence that adjustment could be accommodated.

III. Staff Appraisal

31. The authorities have consistently implemented policies that have supported strong economic growth, but the challenge now is to increase macroeconomic stability. In particular, at the current point in the economic cycle, appropriate policy measures need to be put in place so that the unwinding of the imbalances in the current account, external debt, domestic demand and inflation following the completion of the current investment projects do not generate excessive volatility in real activity.

32. Although fiscal policy has been tightened, a more restrictive stance than that contained in the 2005 budget is required. While the increased flexibility of the economy—not least of which is the flexible exchange rate regime introduced in 2001—has enhanced its ability to quickly adjust, prudence is called for to avoid the potentially large negative impact of a disorderly unwinding of the imbalances. Since the drafting of the 2005 budget, the outlook for aggregate demand has been revised upward considerably and projected imbalances have widened. Consequently, fiscal policy should be tightened appropriately.

33. The required fiscal tightening will need to rely on both expenditure and tax measures. On the expenditure side, additional public investment projects, including some of those planned for the remainder of 2005, should be delayed until after the energy-intensive investment cycle peaks. On the tax side, although reducing income taxes stands to have longer-term benefits for labor supply, the impact is likely to unfold gradually and be modest, given Iceland’s already commendably high labor market participation rate. It would, therefore, be prudent to postpone the tax cuts announced for 2006 and beyond until it is clear that excess demand in the economy has dissipated. If the tax cuts cannot be delayed, offsetting cuts in government expenditure, beyond those currently planned, should be identified and implemented. This may also be an opportune time to introduce or extend the application of user fees in health care and education. Additionally, proceeds from the privatization of Iceland Telecom should be fully used for debt reduction.

34. Although public finances are on a sound footing from a medium-term perspective, the medium-term fiscal framework could usefully be strengthened. The introduction of multiyear spending targets was a step in the right direction, but more can be done. Defining these targets in nominal terms at the general government level would be beneficial and the central and local governments should cooperate more to prevent slippages. Furthermore, the multiyear spending targets should be derived from a rules-based approach that ensures the simultaneous achievement of the government’s medium-term target for public debt and a consistently countercyclical fiscal stance. This would enhance the prospects for achieving both strong and stable growth.

35. Monetary policy has been responding appropriately to emerging demand and inflationary pressures. Rising house prices have contributed significantly to inflation. However, they are indicative of the general overheating of the economy, and the policy response has hence been appropriate. While temporary factors have recently lowered measured CPI inflation, monetary policy should continue to focus on the underlying demand conditions that are the primary source of persistent inflation. The developments in the mortgage market, which have lowered the cost of long-term financing to households, have increased the challenge of stabilizing inflation. The central bank will need to be prepared to respond to changing economic circumstances, while recognizing that having to rely heavily on the exchange rate channel for the transmission of monetary policy, given the current overvaluation, will add further to external imbalances and the sharpness of the eventual unwinding.

36. Because of the size of the economy, stabilizing inflation in Iceland is a more difficult task than in larger inflation-targeting countries and measures to help address this should be implemented. Introducing a schedule for preannounced monetary policy meetings that conclude with a public announcement of the central bank’s decision regarding interest rates could help enhance inflation stability by more firmly anchoring inflation expectations. The inclusion in the Monetary Bulletin of a scenario based on an interest rate path that would return inflation to its target could also be helpful in this regard.

37. Once the current investment cycle has been completed, further enhancements to the monetary policy framework could increase the stability in both inflation and real economic activity. Although the indexation of mortgage loans in Iceland, among other reasons, makes it important to continue to target a measure of inflation that includes house prices, removing volatile components—such as energy or food, as has been done in other countries—could be considered.

38. The risks to financial stability of the ongoing credit boom should be monitored closely and prudential measures implemented quickly if required. Financial institutions have strong balance sheets. Given that asset prices are continuing to accelerate sharply, the development of more stringent stress tests is welcome and staff looks forward to the FME’s prompt implementation. Furthermore, in light of the rapidly growing debt levels, a large portion of which is foreign-currency denominated corporate debt, the FME should accelerate the pace of developing and implementing interest rate and exchange rate stress tests. The importance of this is further highlighted by the sensistivity of the external debt positon to exchange rate movements, as illustrated in the external debt sustainability analysis.

39. The entry of commercial banks into the mortgage market has been a positive development from a financial stability perspective, but reform of the HFF will be necessary to ensure that the banks’ presence can be sustained. If banks must compete directly with the HFF, which enjoys a funding advantage because of its state guarantee, it is not clear whether they can profitably sustain their mortgage-market lending. Consequently, expeditious reform of the HFF is necessary. The reform should be guided by broad principles that will retain the positive aspects of the current system, while allowing it to evolve in a manner that will strengthen the stability of the financial system.

40. To provide the opportunity for an early assessment of developments in current demand pressures and related imbalances, it is proposed to move the next Article IV consultation temporarily to the standard 12-month cycle.8

Table 1.

Iceland: Selected Economic Indicators, 2000-06

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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.

Excluding imports from the construction of hydropower facility and smelters in 2003-04.

Table 2.

Iceland: Summary Operations of the General Government, 1999–2006

(in percent of GDP)

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

In percent of potential GDP.

Change in percent.

Actual output less potential in percent of potential.

Table 3.

Iceland: Financial Soundness Indicators, 1998–2005

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Sources: Financial Supervisory Authority and Central Bank of Iceland.

Commercial banks and six largest savings banks. Fisheries Investment Fund and Industrial Loan Fund included 1996–1997. FBA include 1998–1999. Kauphting Inc. included from year 1996. Figures for Islandsbanki include both the banking and insurance part of the corporation.

Inflation adjusted accounting principles were discontinued in year 2002. Results for year 2002 and onwards are therefore in nominal terms but were in real terms before year 2002.

Deposit money banks, adjusted for FBA and Commercial Loan Fund. Kaupthing bank Inc. included from year 2002 and Glitnir included from May 2003.

Figures from year 2003 onwards for sectoral breakdown of lendings is not comparable with the past because of new loan classification.

Item “miscellaneous” also includes individuals’ private business operations. Changed with new loan classification in year 2003. See note above.

Loans for which special provisions have been posted less specific provisions, and other loans which have been interest frozen. Appropriated assets not included.

New loan classification results in a break for this series in the year 2003.

Table 4.

Iceland. Medium-Term Scenario, 2003–10

(Percentage change, unless otherwise indicated)

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Sources: CBI; and IMF staff estimates.

Contributions to growth

In percent of GDP

In percent of potential output

Table 5.

Iceland: Balance of Payments, 1999–2004

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Sources: Central Bank of Iceland.

APPENDIX I Iceland: Fund Relations

(As of May 31, 2005)

I. Membership Status: Joined: December 27, 1945; Article VIII

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IV. Outstanding Purchases and Loans: None

V. Latest Financial Arrangements: None

VI. Projected Payments to Fund

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

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VII. Implementation of HIPC Initiative: Not Applicable

VIII. 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 sanction against Iraq (see EBD/90/242, 7/13/90).

IX. Last Article IV Consultation:

Discussion for the 2003 Article IV Consultation were held in Reykjavik during May 21–June 2, 2003. The Staff Report (Country Report No. 03/266) was considered by the Executive Board on August 22, 2003. Article IV consultations with Iceland are currently held on the 24–month cycle.

X. Technical Assistance: None

XI. ROSC: Data module assessment took place in February 2005. The draft report has been sent to the authorities for comments.

XII. Resident Representative: None

APPENDIX II Iceland: Sustainability Exercise

Public Debt Sustainability

The staff’s baseline scenario predicts a decline in the gross public debt-to-GDP ratio from 37 percent in 2004 to 27 percent in 2010, suggesting that risks to medium-term debt sustainability are limited (Table A1). When the historical average values of real GDP growth, the real interest rate, and primary balance are used throughout the projection period (scenario A1), the gross debt ratio falls to only 15 percent by 2010. Keeping the primary balance unchanged over the projection period (A2) lowers the debt ratio almost as much, to 16 percent by 2010. The most significant “bound test” is the shock to real GDP growth in 2005 and 2006 (B2), which increases the gross debt ratio to 57 percent by 2010. A 10 percent of GDP increase in other debt-creating inflows in 2005 (B6) raises the debt ratio to 38 percent by 2010 while a one time real depreciation of 30 percent in 2005 (B5) raises it to 35 percent. Meanwhile, shocks to the real interest rate (B1) and to the primary balance (B3) have little impact on debt dynamics compared with the baseline scenario.

Table A1.

Iceland: Public Sector Debt Sustainability Framework, 2000–2010

(In percent of GDP, unless otherwise indicated)

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Gross general government debt.

Derived as [(r - π(1 + g) - g + αε(1+ r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate 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 (1+g) and the real growth contribution as -g.

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

For projections, this line includes exchange rate changes.

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.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

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

Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.